The outside counsel interviewed for this Special Section discuss civil justice and litigation-relatedrecommendations designed to improve the competitiveness of U.S. capital markets and the institutions that use them. These recommendations, which were also highlighted in our May and June issues, are contained in one or more of the following reports: (1) Report and Recommendations of the Commission on the Regulation of U.S. Capital Markets in the 21st Century established by the U.S. Chamber of Commerce ("Chamber Report"), (2) Interim Report of the Committee on Capital Markets Regulation ("CCMR Report") and (3) Sustaining New York's and the U.S.' Global Financial Services Leadership ("Bloomberg/Schumer Report").
Beginning with our September issue, we will run a monthly Special Feature to keep our readers informed of developments relating to the recommendations covered in the reports.
Editor: Is our securities litigation system uncompetitive?
Dugan: Compared to London or other major overseas financial centers, the prevalence of securities class action litigation in the U.S. is a significant cost of doing business. Although the latest surveys indicate that the number of securities class actions decreased last year, the value of settlements continued to rise. So while there may be fewer cases, the significant size of settlements is staggering and is a discouraging factor for companies considering entering the U.S. capital markets.
Editor: Should punitive damages be capped?
Dugan: I think so. The Supreme Court has issued guidance on what a reasonable punitive damages award might be, but this is still an unregulated area where awards cannot be predicted. Legislation that would provide clearer guidance and more predictable guidance would be helpful.
Editor: Should the issue of "scheme" liability be addressed?
Dugan: The Supreme Court should implement a clear cut interpretation of Rule 10b-5, similar to the approach taken by the Eight Circuit. Even though Congress could implement legislation to govern when third party businesses would face liability for participating in a scheme to defraud investors, I do not believe that this would be an appropriate response. Any legislation will most likely result in unintended consequences and could inhibit the ability of parties to engage in legitimate arms length transactions. There is already concern that regulators have gone too far and any measure that may curtail legitimate business activity by creating an increased sense of risk for business should be avoided.
The argument that "scheme" liability is necessary to prevent parties from conspiring to defraud investors is not supported by a proper reading of Section 10(b). There are currently laws and regulations in place designed to hold accountable companies that conspire with their counterparties to defraud. I was involved in a case where a company had an arrangement with a series of vendors to inflate receivables to make the company's financial statements look better. The vendors signed false confirmations and provided them to the manufacturer's auditors. The vendors were all prosecuted under existing criminal statutes. The problem with using an amorphous SEC rule such as 10b-5 to protect shareholders from this type of fraud is that it does not provide clarity. While the case I referred to was a clear cut example of vendors knowingly submitting false documents, there are many other cases where parties acting in good faith without knowledge of any wrongdoing could be exposed to liability.
Editor: What can be done to discourage accounting fraud?
Dugan: The Chamber Report suggests that financial reporting fraud is often the result of considerable pressure to meet analysts' expectations. The Report recommends that quarterly earnings per share guidance be abolished in favor of a variety of alternative financial indicators that could track how a business is doing. I believe that this would be a positive step to minimize the incentive for engaging in financial reporting fraud.
Editor: Would a prudential regulatory system help?
Dugan: The SEC models its approach on that of a prosecutor's office and seems to have an adversarial mindset. At times, the SEC does not appear to view its mission as helping a well-intended company correct a problem. Their investigations often seem to be undertaken with a view of penalizing companies. Companies have increased their efforts to cooperate with the SEC, but they still confront a very hostile process.
A change in the culture of the Enforcement Division would encourage open communication and foster compliance. The SEC should adopt the approach taken by our banking regulators where problems are discussed and the regulator supervises to make sure they are corrected but there is less of a focus on punishment.
Editor: Should the SEC adopt a principles-based approach to regulation?
Dugan: A rules-based approach results in the SEC being more concerned about following the rules than in implementing the policies behind those rules. For example, in one investigation in which I was involved the SEC adopted an inflexible view of GAAP on a revenue issue and would not consider alternative interpretations even though GAAP is frequently subject to different interpretations. This resulted in people being subjected to fines or suspended from practicing as accountants, including many people who were probably trying to do the right thing. Cases like these could be better resolved by clarifying the rules and not imposing a penalty.
Editor: Should there be a federal self-evaluation privilege for SEC regulated institutions?
Dugan: This is a good idea although it should not be limited to broker-dealers and financial institutions that operate under heavy regulation. For listed companies, protection of the results of investigations made available to the SEC or government would be very helpful. Angst over disclosure issues drives how companies conduct internal investigations and memorialize the results. A self-examination privilege would mitigate those concerns.
Documents prepared by attorneys are generally protected by the attorney-client privilege. The problem arises when those documents are shared with auditors or regulators. A self-examination privilege would protect this information and information prepared by compliance officers who are not attorneys. At the moment there is a disincentive for open and transparent communication because of the danger of potential plaintiffs having access to information.
Editor: Should the SEC permit an outside director's good faith reliance on (1) an audited financial statement or an auditor's SAS 100 review report or (2) representations of senior offices, as conclusive of due diligence?
Dugan: I have mixed feelings about this proposal. It is probably necessary for directors to have some exposure to encourage proper oversight. Allowing directors to escape liability based solely on reliance on management discourages their independent and diligent inquiry. There needs to be a balance so directors have an incentive to conduct these inquiries. There are different ways to do that and maybe liability is not the best way to do it. However, rules that might reduce the incentive for directors to be thorough need to be carefully considered.
Editor: Should organizations be held vicariously liable for the activities of their officers or directors?
Dugan: The Arthur Andersen situation was troubling because, after all was said and done the Supreme Court overturned the conviction, but by then the company was gone. It was an established firm with decades of solid corporate citizenship. Vicarious liability and its application is a very serious issue. Prosecutors tend to impute to companies the disparate knowledge of different actors in situations where there is suspected wrongdoing. This results in corporate prosecutions in situations where the individual actors may not meet all the requirements of wrongdoing, but their individual actions, when considered together, create an argument that the company was responsible. Situations like that have caused the pendulum to swing too far.
The indictment of a significant company (such as one of the Big Four accounting firms) would create a high potential for public harm. Proposals that would require egregious and widespread misconduct - wrongdoing at high levels, a lack of board supervision, and no practical way to correct the bad behavior - before a company is prosecuted would be a step in the right direction. Companies with appropriate checks in place - where wrongdoing is investigated and remediated on a proactive basis - should not be candidates for indictment.
Editor: If exposed to possible indictment, what steps should a company take to avoid having to operate under an independent monitor?
Dugan: I always caution clients who are at risk of being ordered to implement a monitor to be aggressive about addressing wrongdoing in the company. They should not sit back and pretend that nothing happened. They should root out any problems and take appropriate steps to implement an internal process to make sure that compliance problems are quickly discovered and remediated. If you do these things on your own initiative, it reduces the risk of someone forcing a monitor on you.
The problem with monitors is that they have no knowledge of the company's operations and do not report to anyone in the company. They have full authority to investigate anything at any time and that can be very disruptive.
Editor: Has the McNulty Memo reduced prosecutorial abuses?
Dugan: It is now automatic for the government to request waiver of attorney-client privilege and attorney work product protection where there has been an internal investigation of wrongdoing. A lot of boards feel that they have to comply because the alternative - a full blown government investigation or indictment - can be death. If the Department of Justice revised its charging guidelines to do away with any consideration of a waiver as a cooperative factor, that would help.
Editor: Do policies asking corporations to refrain from advancing attorneys fees to officers, directors and employees elicit similar concern?
Dugan: I know that there are cases where prosecutors have insisted on this and I believe it is unfair because the individual without effective counsel does not stand a chance against the government.
Editor: Should the SEC reverse its position on indemnification of directors for Section 11 damages?
Dugan: You do not want to reward people for doing something wrong, but no one is going to serve as a director if you do not give people the comfort of knowing that they are not going to be personally wiped out for serving on a board. The prospect of a crippling lawsuit and having to pay for your own lawyer is a significant problem in getting quality people to serve. I agree that this reform is a good idea.
James C. Dugan is a Partner at Willkie Farr & Gallagher LLP in New York City. He specializes in federal litigation, securities litigation, accountant's liability, and corporate internal investigations.