Issues & Opinions

In today’s WSJ, a story: “SEC’s Allegiances Are Put to Test“. Opportunities like this for achieving melodramatic judicial/regulatory outcomes occur periodically, given the repetition with which a given question is asked. The SEC, of course, has every right to attenuate its position on such matters, since things change over time, and with those changes come changes in regulatory stance. The Supreme Court hasn’t yet asked for an amicus brief from the SEC in a current case involving ongoing litigation in the Enron matter, but that hasn’t stopped melodrama seekers from making the request themselves.

When the Securities and Exchange Commission files a brief in legal disputes, it is usually a nonevent. But the cases usually don’t involve Enron Corp.

In recent weeks, the agency has been publicly and noisily pressured by a congressman, a union leader and a Democratic presidential candidate, amid increasing consternation the agency is favoring business interests in its decision making. As a result, the SEC’s decision about whether to weigh in on a Supreme Court case — as well as on a similar case seeking the high court’s attention — has become a test of its own motto: “investor protection.”

It seems that in 1994, the Supreme Court limited the ability of shareholders to sue third parties (presumed, by me, to mean primarily underwriters but I suppose it could include lawyers, accountants, and window-cleaners, among others) for “aiding and abetting” fraudulent activities on the part of their clients. I find that interesting, given certain examples of which I’m aware that came after 1994. Detail excerpt, from one of the 1997 cases against Donaldson Lufkin & Jenrette:

IV. On January 24, 1997, various money management firms and others who allegedly purchased and/or beneficially owned $116 million aggregate principal amount of Senior Subordinated Notes (the “Notes”) issued in May 1994 by Mid-American Waste Systems, Inc. (”Mid-American”) filed a complaint against DLJSC and a number of other financial institutions and several former officers and directors of Mid-American in the Court of Common Pleas, Franklin County, Ohio. The action seeks rescission, compensatory and punitive damages. The suit alleges violations of federal securities laws and the Ohio Securities Act, and common law fraud, aiding and abetting common law fraud, negligent misrepresentation, breach of contract, breach of fiduciary duty/acting in concert and negligence.

While I’m sure there’s a difference between my example and those supposedly scope-limited by the Court, the (highlighted) allegation at least throws some confusion into the mix.

The SEC itself last formally addressed the issue, known as “scheme liability,” in 2004. Then, the SEC filed an amicus brief in a case before a lower court in which it said that an investment bank may be classed as a “lead violator” if it intentionally engaged in a “deceptive act” as part of a scheme to defraud investors.

Seems clear enough - since the third parties (supposedly) cannot be sued for aiding and abetting, the class action hounds want to ensure that the legal system has left some avenue from which to attack them. I get that. What I don’t get is why the SEC is being “publicly and noisily pressured” to weigh in again on the matter, a scant three years after having already done so.

The SEC hasn’t been asked by the Supreme Court to file a “friend of the court,” or amicus brief, but lobbying by high-powered plaintiffs lawyer Bill Lerach, who represents shareholders in the Enron case, has boxed the agency into a corner. Unless it sides with shareholders, the SEC could be criticized as an ally of business for wanting to restrict the number of ways investors can sue.

Where the SEC comes down is “an absolute litmus test” of the agency’s leanings under Chairman Christopher Cox, said Ralph Ferrara, a former SEC general counsel who is now in private practice at LeBoeuf, Lamb, Greene & MacRae LLP. He thinks the agency should support the plaintiffs: “The SEC should be in there saying this is what’s best for small investors,” he said.

Great. A couple of lawyers, neither of whom impresses me with his past actions, want the SEC to reaffirm its stance as the protector of the otherwise bereft investors of America. Calling it a litmus test? Brilliant, unless you count the fact that the SEC already made its stance on this issue perfectly clear.

The issue in Lerach & Ferrara’s minds is apparently this: The SEC filed a brief earlier this year (in the Tellabs matter) that was seen by some to be “pro-business”, whatever that means.

In the brief, the SEC said investors need to establish a “strong” inference that defendants acted with fraudulent intent compared with a standard of a “reasonable” inference that is being challenged.

In response to complaints that followed the brief, the SEC said its view is in line with a majority of courts. Mr. Cox, a former Republican congressman, himself championed a 1995 law aimed at preventing frivolous lawsuits.

After reading it, a reasonable reader could (and I did) view the SEC’s stance not as “pro-business” in the Tellabs case, but “anti-frivolous lawsuit”.

That same reasonable reader could further infer that when Lerach, Ferrara, et al argue for the SEC to act clearly and unambigously for “investor protection”, they actually mean “class action lawyer protection”. Forcing companies to defend against ill-supported lawsuits does far more harm to investors than Lerach and his ilk would be willing to admit in public. The SEC’s already-articulated stance against frivolity cramps their style, without providing any sort of “litmus test” that the agency is acting against the interests of investors, notwithstanding Ferrara’s politicking in opposition.

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