Tuesday, October 6, 2009

Securities Litigation and Corporate Reform

Cycles are common in business and investing, indeed in all of life. What’s most important is not that cycles occur, but rather their depth and frequency. In the long, dark years that followed the Great Depression it must have seemed that the upswing would never occur, and the frustration of the slow climb back combined with the sheer magnitude of what had been lost to focus a great deal of American energy on securities reform.

The results of that effort, the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940, set new standards for corporate reporting and disclosure, and for the relationship between investors, professional money managers and the corporations themselves which are still in effect today. Their primary goal: to prevent such losses from ever happening again.

Our current down cycle has often been compared to that period, and the magnitude of loss is not dissimilar. The calls for reform – to prevent this happening again – ring from boardroom to facebook.

Though history tells us in no uncertain terms that such reforms will ultimately fail, the more important consideration is that the right reforms can help us greatly extend the time line between such dramatic crashes, and better dampen the relatively minor up-and-down cycles that occur in between. In the day of the digital dollar –and what is truly different about this crash is the accelerated speed with which it occurred, and the apparent speed of our recovery – the extended period of relative prosperity that occurred between World War II and 2008 seems all the more remarkable, and suggests that our sense of the critical relationships, as defined by the Acts of ’33, ’34 and ’40, is still fundamentally true. What’s needed are incremental reforms, particularly in the areas of better reporting and disclosure, and greater clarity about the optimum balance of power between shareholders, boards of directors, and corporate management.

When all else fails, we litigate. Here again we should marvel at the resiliency of the ’33 and ’34 Acts, which for the most part continue to serve us well as the foundation for legal recourse, at least at the Federal level. Our most recent effort at reform in this area occurred just fourteen years ago, when the US Senate overrode then-President Bill Clinton’s veto of the Private Securities Litigation Reform Act of 1995, or “PSLRA”. From the perspective of 2009 the great controversy surrounding the PSLRA back in 1995 is hard to fathom. The most important changes included heightened plaintiff pleading requirements; the stay of discovery until after the court has ruled the defendant’s motion for dismissal; and greater clarity regarding appointment of the lead plaintiff, and approval of the lead counsel – sweeping changes by some standards, yet ultimately incremental, building as they did upon existing standards.

More specifically the PSLRA reforms were intended to, 1) weed out the more frivolous claims that might waste the courts’ time and resources, 2), protect defendants from costly but unnecessary discovery demands, and 3) to insure that more large institutional investors would serve as lead plaintiff, further reducing the likelihood of frivolous or unfounded claims clogging the courts. Legal experts continue to disagree as to the overall effectiveness of these reforms, but no one can deny that the higher pleading standards are being met, or that institutional investors are increasingly likely to serve as lead plaintiffs in these cases.

This last change is especially important, as the increased involvement in Federal securities litigation by institutional investors has had at least one additional major impact: the greatly increased legitimization of such litigation as an essential tool for shareholder protection and recourse. An unanticipated and almost certainly unintended consequence of the PSLRA, this may ultimately prove to be one of its most important contributions.

Which raises a key question: protection from whom?

A top executive at one of America’s largest providers of Director & Officer liability insurance answered it this way: “We don’t have any issue with the plaintiff’s bar, they’re just doing their job. What we worry about are the CEOs and other top executives who think they can cheat and get away with it, and the boards that either don’t know how or are unwilling to stop them – those are the bad guys.”

Which brings us back around to cycles, which in the case of business and investing are driven almost entirely by human ambitions, and reflect the deeply conflicted, dichotomous nature of such ambitions. We like our CEOs hungry, and are strongly in favor of given them the right incentives to better lead our companies to growth and prosperity, but we don’t want them to be too greedy, or focused more on their own needs than our own. We want our corporate managers to be the smartest, the toughest, the strongest possible individuals, and openly admire and reward them for it, but only up to a point, and whenever they cross that line we will be outraged, and rightly so.
One of the most recent developments in the world of securities litigation, perhaps yet another unintended consequence of the PSLRA, is the rise in ‘corporate reforms’, where the reforms involved are company-specific, based on proven corporate governance practices, and imposed on the company as an integral part of the settlement agreement. This may be the most important form of ‘corporate reform’ possible, as it is directed not at corporations in general but at one specific company where management and/or the board have clearly crossed the line, and are intended not to provide recourse for past damages but rather to help insure that future shareholders not suffer the same kind of damages going forward.

Such reforms won’t solve all the problems in our system, but they might have more impact that you’d think. For one thing, the worst corporate governance problems in the American system aren’t hidden away among the smaller companies, as some would have us believe, but live at the very top, in the full spotlight glare of the Dow and the S&P. The worst corporate disasters of the past two years didn’t happen around the margins, but among our largest companies, a failure of leadership of almost unprecedented proportions.

Would these new corporate reforms born out of litigation have made a difference? They might have for Merrill Lynch, which prior to its failure was by far the most often named securities defendant in corporate America, even looking all the way back to passage of the PSLRA. They might also have made a difference at Bear Stearns or Lehman Brothers or Citigroup, all repeat defendants. They would have come too late for either Countrywide, where undisclosed liabilities had accumulated beyond all hope for independent recovery long before, and it might not be too late for AIG, propped up as it has been by the US government, and clearly in need of ‘corporate reform’.

Corporate reform? Yes, I believe it is needed, but I hope that our touch will be light, and that any regulatory changes will be incremental, and sit squarely on our already solid foundation. Better yet let’s focus on the bad guys, one company at a time, as responsible investors, as regulators with a clear mandate for enforcement, as active and informed shareholders, and, as necessary, as proactive plaintiffs.

Who Owns the Corporation?

In the earliest days of free enterprise there was little distinction to be drawn between the ownership and management of business entities. In most cases these roles were played by the same individuals, who brought to the economic system their own personal goals and aspirations, and in turn their own sense of accountability. For better or worse, this direct personal involvement provided the essential driving force of our economic growth and development.

As these private enterprises grew and evolved, however, new forms of ownership emerged, beginning with the various forms of partnership and proceeding to the development of the modern corporation. In these forms a gap began to appear, and then widen, between the functions of ownership and management, and the direct human involvement of individual owners grew increasingly removed from management. The need to bridge this gap has in turn provided the foundation for much of our contemporary system of contract law and our standards of accounting practice, all formal mechanisms devised to codify and monitor the various relationships between and within business entities. The development of the modern publicly held corporation accelerated this process tremendously, as represented by the rise of the U. S. Securities and Exchange Commission, a powerful source of standards for corporate life.

The key advantages of the corporate form – limited liability and a vastly expanded capacity for raising capital – have led in turn to the development of a corporate culture far removed from the greater concerns of individual owners, with a resultant focus on near term growth and profitability. This tendency of large corporations to organize themselves around short term interests is increasingly a matter of public concern, for despite the continued existence of other business forms the large publicly held corporations dominate the developed world’s economic landscape.

It is also important to note that corporations are legal inventions, and can only exist within a particular legal and regulatory milieu. In the US corporations are chartered by the individual states, where considerable variations exist in this milieu. Traditionally, of course, Delaware is the most corporate friendly state. In this particular context Delaware is also the most management friendly state. Sarbanes-Oxley, however, represents a significant departure from this historical pattern, as it is the first federal law related to corporate governance to be enacted.