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 mayone hopesbe 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 lawseven 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 triala 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 investorsby 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 choicebefore they criticize the Bush administration for making the wrong decision.
Ted Frank is a resident fellow and director of the Liability Project at AEI.