The collapse of Enron has produced some serious proposals to reform our accounting, financial reporting and pension systems. But it also has generated one really bad idea: the suggestion that Congress should gut the Private Securities Litigation Reform Act (PSLRA), which was enacted in 1995 to bring some rationality to the conduct of lawyers alleging securities fraud.
Some who are in the litigation business, like leading plaintiffs’ lawyer Bill Lerach, now argue that the PSLRA is somehow responsible for the Enron debacle. Before their argument gains currency, it ought to get critical examination.
It goes without saying that the victims of securities fraud should be made whole and the perpetrators forced to pay. The hard question is how best to accomplish that goal.
The PSLRA was proposed at a time when the system for redressing securities fraud was out of whack. Frivolous and abusive securities strike suits – really, exercises in legal extortion – were common. Congressional hearings found that plaintiffs’ lawyers often sued companies whenever their stock price fell for any reason, alleging that securities fraud was the cause of the drop in share price. Lawyers recruited and paid special bounties to “professional plaintiffs” who had bought and held a few shares of many companies’ stock for the sole purpose of initiating a class action lawsuit the day after the share price declined.
In fact, Congress documented situations where law firms would file the same boilerplate complaint in case after case, sometimes even forgetting to change the name of the company listed as the defendant.
The point of this exercise, of course, was for the lawyers to extract quick settlements – with the attendant, hefty attorneys’ fees – from companies that couldn’t afford to fight lawsuits that inevitably would drag on for years. The result: Many cases settled with token payments for the shareholders who sued and enormous fees for the lawyers. This did nothing for the victims of real securities fraud. As well, it injured the shareholders of companies that paid the judicial blackmail, and it had an especially pernicious effect on the innovative startups that got their seed money from venture capitalists.
The PSLRA, enacted by substantial bipartisan majorities in both Houses of Congress over President Clinton’s veto, offered some modest reforms to deal with this problem. For example, the statute bans the use of professional plaintiffs. It also provides that the “lead plaintiff” in a securities class action generally should be the shareholder with the most at stake, typically a pension fund; that way, the suit is controlled by someone who has the investors’ interests at heart, rather than by the first plaintiffs’ lawyer to dash through the courthouse door.
The PSLRA also took aim at the some of the elements of securities litigation that made it easy for lawyers with frivolous cases to hold up defendants. The act heightens the standard for filing a complaint that alleges securities fraud: Instead of making wholly unsubstantiated allegations, the lawyer now has to state facts supporting the conclusion that the defendant acted with fraudulent intent. The PSLRA also provides that each defendant in a multi-party suit usually should be required to pay only that portion of the judgment for which the jury finds it responsible, rather than the entire judgment.
That is where matters stand today.
Did the PSLRA make Enron possible by crippling the rights of plaintiffs, and, therefore, encouraging fraud, as Mr. Lerach suggests? This idea is more than silly. It is preposterous.
Does anyone really believe that Andrew Fastow and other Enron executives would have behaved differently when they realized that the PSLRA requires pleading fraud with particularity? Or is it remotely possible that Arthur Andersen accountants decided to cook the books because they knew that, under the PSLRA proportionality standard, they would be on the hook for only $5 billion rather than the full $10 billion (or $60 billion) of investor losses if Enron tanked?
If you believe that, I’ve got a nice bridge in Brooklyn and some Enron shares you might be interested in.
In fact, Enron is a bad poster child for opponents of the PSLRA because the nation’s newspapers already have done Mr. Lerach’s investigative work for him. If ever there were a situation in which investors had a slam dunk case, it is Enron. That is why Mr. Lerach and other plaintiffs’ lawyers are now locked in a titanic battle over Enron’s carcass, fighting among themselves to be named lead counsel in the shareholder litigation. They have no doubt that a huge payment is assured for the plaintiffs and an unprecedented payday for themselves.
While that struggle goes on, the real question for the rest of us is whether – Enron aside – the PSLRA is working. Has the act locked the courthouse doors to victims of securities fraud, as its opponents warned would happen? The answer is, clearly not.
In the year immediately after enactment of the PSLRA, the number of federal securities class actions dipped, almost certainly because plaintiffs’ lawyers had rushed to file suits that were in the pipeline before the act took effect. But in each of the next four years the number of shareholder suits bounced back to (or above) pre-PSLRA levels. And last year, plaintiffs filed more than twice as many securities fraud class actions than had been brought in any prior year.
These numbers are significant because the plaintiffs’ securities bar doesn’t file suit just to make a point. These lawyers are intensely focused on the bottom line: They bring actions because there is money in it. We should watch what they do and not what they say. And what the lawyers are doing demonstrates that, post-PSLRA, the securities fraud class action suit is alive and well.
Other empirical evidence, albeit necessarily tentative at this point, confirms that the PSLRA is working effectively. The race to the courthouse, in which lawyers try to seize control of a case by being the first to file suit, appears to have slowed, at least a little. The complaints filed by plaintiffs now have more factual detail, meaning that the lawyers are doing a little homework before bringing suit. The dismissal rate for insubstantial claims has increased a bit, while the number of suits settled for nuisance value has declined. And, most important, the average settlement value of post-PSLRA claims is up substantially.
This development is precisely what we should want. It is harder to bring abusive strike suits now than it was in 1995. At the same time, those cases that have merit and remain in the system are producing significantly better returns for shareholders. The system may not be quite the feeding trough for lawyers that it had been prior to the PSLRA, but it is a lot better for the investors who should be the real beneficiaries of the securities litigation process.
The Enron fiasco has produced many victims. Our sensible, effective, bipartisan reform of the securities laws should not be one of them.
Steve Krausz is a general partner with U.S. Venture Partners. He focuses on investments in communications, Internet infrastructure, networking and systems technology. Krausz has a B.S. in Electrical Engineering from Stanford University and an MBA from Stanford Business School, where he was an Arjay Miller Scholar. He sits on the board of the National Venture Capital Association.