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June 2007 Archives

By Ted Frank

This piece originally appeared in the Wall Street Journal, 5-31-07.

Subsequent to the publication of this article, the Securities and Exchange Commission voted 3-2 to recommend submitting a plaintiffs' side brief in Stoneridge. The Department of Justice declined to accept the SEC's recommendation and did not submit a brief for the plaintiffs; the DoJ may or may not decide to file a defendant's side brief within the remaining filing deadline.

Treasury Secretary Henry Paulson called securities litigation the "Achilles heel for our economy," endangering the global competitiveness of American financial markets. Last January a report released by Senator Charles Schumer, Democrat of New York, and New York City's Republican Mayor Michael Bloomberg concluded that investors were being driven away from American shores because "the highly complex and fragmented nature of our legal system has led to a perception that penalties are arbitrary and unfair."

The proposed solution to the legal mess offered by the so-called Paulson Committee Report was modest enough: "Greater clarity for private litigation." Yet even this small step could suffer a big setback. The plaintiffs' bar is heavily lobbying the SEC to intervene in a pending Supreme Court case, Stoneridge v. Scientific-Atlanta, on the side of a gigantic expansion of private litigation.

The case's facts are straightforward: Charter Communications purchased set-top cable boxes, but got back some of the money in the form of advertising bought by the vendors. Charter executives recorded the outgoing money as a "capital expenditure" (to be depreciated over several years) but the incoming money as revenue recorded within a single year, thus falsely inflating operating cash flow. Three Charter executives went to prison over the shenanigans. Plaintiffs' attorneys sued Charter and the executives, of course, but named as codefendants two of the vendors, Motorola and Scientific-Atlanta.

The suit makes little sense. The vendors had no say in how Charter accounted for or reported its transactions. Worse is the precedent it represents: How can a business function if it is potentially liable for hundreds of millions because those whom they trade with misreport a day-to-day transaction? The Supreme Court stopped such private "secondary liability" suits in Central Bank v. First Interstate Bank, a 1994 decision that Congress ratified the next year, explicitly rejecting private suits for "aiding and abetting" in the Private Securities Litigation Reform Act (repeating the rejection in the 2002 Sarbanes-Oxley Act.)

A federal court in Missouri dismissed the case against the equipment vendors, and the Eighth Circuit Court of Appeals affirmed that decision: Such liability would, the court said, create far-reaching "uncertainties for those engaged in day-to-day business dealings." Nevertheless, the Supreme Court has agreed to hear an appeal.

Why? The Court may—one hopes—be stepping in to reassert itself, since some courts have permitted plaintiffs' lawyers to whittle away at Central Bank. In the Enron litigation, for example, a federal court in Houston erroneously certified a class action after plaintiffs alleged investment banks doing business with Enron were "primary violators" of the securities laws—even though these defendants took huge losses when Enron collapsed. With plaintiffs claiming total liability of $40 billion, many banks caved when offered a chance to settle for less than a nickel on the dollar. Such a settlement is a better bargain than a 90% chance of winning at trial—a basic cost-benefit analysis the plaintiffs' bar counts on when bringing baseless litigation. (Plaintiffs with meritorious cases do not settle for pennies on the dollar with a solvent defendant.)

Innocent investors paid out $7.3 billion in settlements, about $700 million of which was diverted to attorneys, including Democratic fundraiser and trial lawyer William Lerach. Merrill Lynch, among others, fought the court's ruling and was vindicated when the Fifth Circuit Court of Appeals tossed out the case.

Mr. Lerach has appealed to the Supreme Court, asking that his case be joined with Stoneridge. Representative Barney Frank, Democrat of Massachusetts, will helpfully hold hearings in June to highlight trial-lawyer criticisms of the SEC; meanwhile trial lawyers are attacking SEC Chairman Christopher Cox for supposedly being insufficiently supportive of investors—by which they mean, of course, the interests of trial lawyers.

But one can help investors without paying billions to the likes of Mr. Lerach. The SEC has criminal and civil enforcement authority against real "secondary violators," and Sarbanes-Oxley mandated that fines collected by the SEC be returned to defrauded investors instead of to the Treasury. These "Fair Funds," while suffering from bugs of government bureaucracy, are still more efficient and fair than the contingency fees of up to 30% to trial lawyers.

Unfortunately, we cannot be certain why the Supreme Court has taken the case, or if it will do the right thing. While Chief Justice John Roberts and Justice Stephen Breyer have spoken of the need for judicial modesty, both have recused themselves from the case. All the more reason for Treasury and the SEC to stand firm and ask the solicitor general to urge the Supreme Court to keep liability circumscribed. And for Senator Schumer to explain to his Democratic colleagues why that would be a wise choice—before they criticize the Bush administration for making the wrong decision.

Ted Frank is a resident fellow and director of the Liability Project at AEI.

By WALTER OLSON

This piece originally appeared in the Wall Street Journal, 5-18-07

The terse four-page judicial order handed down in a California courtroom last month hasn't made much of a ripple among commentators. But if it stands as precedent following the near-inevitable appeal—and if states and municipalities also follow President Bush, who signed an executive order on Wednesday barring the federal government from entering into contingency fee agreements with trial lawyers—the ruling by Superior Court Judge Jack Komar might slow down the destructive litigation trend of ambitious private lawyers' enlistment of government as a client.

Some background: In the case of County of Santa Clara v. Atlantic Richfield, a number of California counties and cities filed suit asking that lead paint manufactured and sold decades ago be (retroactively and creatively) declared a "nuisance" so that the paint's original makers could be ordered to pay for its removal. As usual in such suits, the localities had hired private lawyers on a promise to share in the winnings if a recovery was made.

Long regarded as ethically suspect if not unthinkable, the public-client contingency fee can be traced back to a case in the 1980s when the state of Massachusetts decided to hire private lawyers to pursue claims over asbestos removal. The innovation quickly spread to other states and issues, most notably the late-1990s tobacco-Medicaid crusade which resulted in multibillion-dollar payouts to both the states and their lawyers.

Trial lawyers love these deals. Even aside from the chance to rack up stupendous fees, they confer a mantle of legitimacy and state endorsement on lawsuit crusades whose merits might otherwise appear chancy. Public officials find it easy to say yes because the deals are sold as no-win, no-fee. They're not on the hook for any downside, so wouldn't it practically be negligent to let a chance to sue pass by?

Now, only two decades later, trial lawyers representing public clients on contingency fee are suing businesses for billions over matters as diverse as prescription drug pricing, natural gas royalties and the calculation of back tax bills. The South Carolina law firm now known as Motley Rice moved into the state of Rhode Island and quickly made itself the No. 1 political donor there, just as it was winning a contract from then-Attorney General Sheldon Whitehouse (now a U.S. senator) to file the first action on behalf of a state against former lead paint makers.

Mayors of over 30 cities signed up for a gun-control-through-legal-coercion campaign of suits against firearms makers so abusive and unpopular in other parts of the country that Congress stepped in to pass a law against it. Authorities in New Jersey, California and elsewhere have hired percentage-fee lawyers to pursue groundwater contamination claims; in the resulting litigation, other environmental aims have tended to be subordinated to the overriding goal of maximizing deep-pocket dollar payout.

But the ethical doubts about the practice haven't gone away, which brings us to Judge Komar and his April 4 ruling in the lead-paint case. The defendants were able to cite a 1985 precedent in which the California Supreme Court ruled contingent fee representation improper as "antithetical to the standard of neutrality that an attorney representing the government must meet when prosecuting a public nuisance abatement action." Agreeing that the case was on point, Judge Komar granted a motion to disqualify the private lawyers.

The principle here isn't hard to grasp. Lawyers who act on behalf of government as distinct from private clients come under special ethical obligations of impartiality. If a lawyer claiming to speak in the name of the people charges you with misconduct, his judgment on whether to drop the charges should not be clouded by the prospect that one-third of any penalties extracted from you would drop into his own private pocket.

Such at least is the logic almost universally accepted when it comes to criminal prosecution. Many court opinions confirm that public prosecutors must not be given a financial stake in the success of the actions they press. In a 1987 trademark-infringement case, for example, the U.S. Supreme Court held it a violation of due process for the government to delegate control of a criminal contempt action to a nongovernment party with a financial stake in the outcome.

What about when the fines or penalties are civil in nature? That question came up in a 1985 case from the city of Corona, Calif. The city had enacted a civil nuisance statute aimed at closing adult bookstores, and then to enforce it hired James Clancy, the attorney who'd drafted the statute, with a bonus to be paid if he succeeded in closing the stores. But the high court in Sacramento disqualified Mr. Clancy, saying that such a proceeding "demands the representative of the government to be absolutely neutral" and that "any financial arrangement"—such as a contingent fee—"that would tempt the government attorney to tip the scale cannot be tolerated."

The California counties and cities that had filed the lead-paint suit—including some of the nation's most populous, with some of the richest tax bases—absurdly tried to plead poverty, suggesting it would prove a hardship for them to hire lawyers on hourly fees. Judge Komar rejected this argument. In reality state and municipal plaintiffs often have more extensive resources than the businesses they sue, as when cities like Boston and Atlanta sue family-owned gunmakers. It's also a practical irrelevance, since smaller governments can and do band together in groups to facilitate litigation that is of common benefit.

The fact is that most such suits are dreamed up by the private law firms and sold to the local officials, not vice versa. Competitive bidding is the exception rather than the rule in retaining the law firms, which routinely recycle handsome donations to the campaigns of the mayors, attorneys general and other officials who hire them. Pay-for-play is so routine that it hardly raises even a shrug anymore. When government legal officers refuse the overtures and instead employ their own staff attorneys to handle such suits, they can face bitter resentment and political pressure for not playing the game in the expected way.

On its face the Santa Clara ruling (like the Clancy case before it) applies only to nuisance-abatement cases, and it's uncertain to what extent courts will agree to extend its logic to other sorts of suits filed by states and municipalities. Moreover, a number of courts in other cases have turned down defendants' motions challenging such fee deals. So it's not the beginning of the end for today's trial-lawyer public-entity alliance. It's more likely just the beginning.

 

 


Isaac Gorodetski
Project Manager,
Center for Legal Policy at the
Manhattan Institute
igorodetski@manhattan-institute.org

Katherine Lazarski
Press Officer,
Manhattan Institute
klazarski@manhattan-institute.org

Published by the Manhattan Institute

The Manhattan Insitute's Center for Legal Policy.