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Let’s talk about war. After all, that’s much easier than trying to resolve the corporate meltdown taking place right in front of us. One cannot pick up the newspaper today without reading about another corporation being exposed for securities fraud. No one can listen to the news without hearing a report of another indicted executive. An investor cannot make it through a month without feeling the weight of the sinking stock market. Our surprise as to the depth of corporate greed and fraud is gone. Now when we hear the news of the next corporate disaster, and the next and the next, we are more likely to yawn, say a curt word or two and quickly turn the conversation to something more pleasant. Congress has passed a new law, the Sarbanes-Oxley Act, to address the problem. The Securities and Exchange Commission and the Department of Justice have stepped up enforcement, indicting corporate crooks right and left. The courts will see to it that justice is done — at least we hope. The stock market has hit a five-year low. The inventory of securities fraud class actions is at a six-year high. The Enrons and the WorldComs and the Arthur Andersens have gone under and may never have to pay for their sins. The executives who committed these dastardly deeds are seeing their assets being depleted by defense costs or they have moved them overseas and out of sight. The insurance industry has stopped settling cases and hopes for a return of positive cash flow. And the lawyers and investment banks that helped perpetrate these frauds may go untouched given that there is no aider-and-abettor liability. Thus, it is likely that the investors who got fleeced will have no place to turn. How did we get into this mess? How do we get out? While one hates to lay blame, in this case it is easy. We are all to blame. We are all to blame for buying into the promises and mantra of corporate America and their lobbyists who used the glitter of ever increasing profits to persuade Congress to ease up on Depression-era restrictions and regulations that supposedly were preventing companies from bringing us even greater returns. We are all to blame for allowing our political representatives to pass the laws that set companies free and shut down private remedies for corporate fraud. And we are still to blame today for buying into the notion that Congress’ recent actions will cure the ethical and moral illness sweeping through the executive suites. Remember the accountants and investment banking firms who, rightfully got burned by the S&L crisis of the late 1980s? Remember Merrill Lynch, which invested Orange County’s funds in risky derivatives, forcing the county into bankruptcy in 1994? Remember the promises that flowed out of Silicon Valley and from the backers of the dot-com craze? This privileged group of finance professionals, with their MBAs and CPAs, banded together in the early 1990s to buy Congress through campaign contributions and promises of economic prosperity. The result was the sweeping destruction of the investor protections set in place in our country in the 1930s. In 1994 Congress was asked to overrule that year’s U.S. Supreme Court decision in Central Bank of Denver v. First Interstate Bank, 511 U.S. 164, which threw out 60 years of precedent that had imposed aider-and-abettor liability on auditors and attorneys who participated in fraudulent corporate schemes. Under pressure from the accountants and investment bankers who were needed to fund re-election campaigns, Congress refused to disturb the high court ruling. These same accountants and investment bankers joined the high-tech community a year later in asking Congress to pass the Private Securities Litigation Reform Act (PSLRA), which stripped investors of most of the weapons needed to go after corporate fraud and wrongdoing. That legislation took away the ability of investors to: •Obtain any discovery of the facts hidden deep within the possession of corporate wrongdoers without first having to meet the most onerous pleading standard ever created in the United States. It is a standard that requires defrauded investors to plead particularized facts showing a “strong inference” that the defendants intended to defraud the investors. •Hold any and all defendants liable for the total amount of their losses. Instead, in order to protect accountants and other big contributors to political campaigns, Congress eliminated joint and several liability. As a result, the accountants could argue that even in the most egregious of circumstances they were no more liable than any other defendant, drastically reducing their incentive to effectively police against wrongdoing. •Hold corporate executives and investment bankers liable for making knowingly false projections or other forward-looking statements. •Use the 1970 Racketeer Influenced and Corrupt Organizations Act (RICO), along with its treble damages provisions. This law, which had been used against junk-bond king Michael Milken and Lincoln Savings’ Charles Keating, was now no longer available to investors alleging wrongdoing on the part of investment bankers and others who falsely hyped the stock they underwrote. •Recover all of their losses. In 1996 Californian voters rejected Proposition 211, an initiative that would have made it easier for stockholders to sue companies in state court and made board members personally liable in cases of investor fraud. Opponents reportedly spent $36 million to defeat the measure, including more than $500,000 from the nation’s stock exchanges, $3 million from the accounting firms and millions more from investment bankers and high-tech companies. Flush with these victories, the accountants, investment banks and high-tech companies went for the final kill. In 1998, they asked Congress to pass the Securities Litigation Uniform Standards Act of 1998, SLUSA, which prohibits investors from banding together to use state law to recover their losses. The markets were booming, and Congress once again rewarded their contributors. Finally, after years of lobbying in 1999, Congress repealed the Depression-era Glass-Steagall Act, originally passed in the 1930s. For nearly 60 years, this law had separated the bankers from the brokers. But in 1999, the dot-com craze was in full bloom and once-steady heads were spinning in the fragrance of easy money. Besides, Glass-Steagall was almost dead already with the 1998 merger of Citicorp and Travelers Insurance. Travelers by then had already acquired investment banking firms Solomon Brothers and Smith Barney. With the stock market continuing its downward spiral, Congress now hopes that passage of the Sarbanes-Oxley Act this summer will appease the electorate. But Sarbanes-Oxley is little more than window dressing. While some of its provisions — including increased maximum prison terms for securities fraud violations — appear tough, there is little in the statute that will alter corporate behavior or increase likelihood that an investor will be able to recover a loss of life savings due to corporate wrongdoers. The resources to the ineffectual SEC are less than doubled and the requirement that CEOs and CFOs “certify” corporate results is laughable. No certifications, no Chinese Walls, no increased maximum penalties and no mandate to preserve records will ever alter corporate behavior. It is simple psychology that the presence and availability of real rewards and punishments drive behavior in animals and humans — and corporations are nothing more than a collection of humans. To truly alter this behavior run amok, we must change the reward structure and the punishment scheme. Most obvious, on the reward side of the equation, is the continued existence of stock options. It’s not surprising that the growth of stock options coincided with the corporate wrongdoing we now see. Stock options gave corporate officers and directors every incentive to inflate their stock price because the reward was that they could — and did — become millionaires overnight. This situation was further aggravated by the fact that the U.S. Financial Accounting Standards Board (FASB) in 1993 caved in to the demands of corporate lobbyists and decided that the award of stock options did not have to be expensed. This action resulted in hiding the dilutive effect that option awards had on shareholders and making it easier for corporate executives to give to each other. With this gift came an IPO craze based on inflated earnings and a transfer of wealth from investors to option-rich executives who could then influence Washington even more handsomely. We now all know the corrupting influence of stock options. Yet Silicon Valley executives and investment bankers have made the non-expensing of stock options their highest priority year after year since 1993. Throughout the debate on Sarbanes-Oxley, they descended on Capitol Hill with the sole purpose of preserving this free money. Congress backed down, and the corrupting influence of stock options continues. Most obvious, on the punishment side of the equation, are the corporate accountability measures enacted in the 1930s and, as mentioned above, taken away in the 1990s. It is only when corporate frauds are so obvious and open, as they are now, that some kind of government action can be expected. Expect to see a few corporate executives packed off to prison for a few short years, ala Milken and Keating. But there will still be no one left to recover against. Congress must re-establish the power of the investor to pursue corporate wrongdoing and to recover losses at the earliest possible moment. Early securities fraud cases had been brought against companies like Tyco and WorldCom but were thrown out for lack of sufficient facts at the pleading stage — just months before the companies’ wrongdoings were exposed by others. Those lawsuits are now on appeal, along with the related investor claims. Had the claims been allowed to proceed in expedited fashion, how much sooner would the frauds have been exposed, how many jobs might have been saved and how many life savings preserved? The human toll from the PSLRA has been enormous. The PSLRA’s imposition of an impossible pleading burden and discovery stay must be repealed. Congress must re-establish the ability of the investor to recover his or her total losses from anyone participating in the fraudulent scheme, whether directly or as an aider and abettor. If officials at Arthur Andersen knew that the company could be fully liable for the great havoc resulting from signing off on the accounting shenanigans it condoned with respect to Enron’s books, perhaps one or two of its partners would have stopped the fraud. The temptation to cut corners or turn a blind eye was simply too great once Arthur Andersen — one of the most aggressive lobbying forces behind PSLRA — was relieved of joint and several liability. The risk/reward ratio justified the gamble. The gambles got bigger, others joined in, and everything eventually imploded under its own weight. We should not wait for any further implosions. The PSLRA’s elimination of joint and several liability must be repealed. Congress must reinstate the 60 years of case law holding aiders and abettors liable for helping to defraud investors. If lawyers and accountants had to worry about paying damages to investors, would a company like Goldman Sachs have so prostituted itself to the businesses it underwrote by not issuing a single “sell” recommendation in its analyst reports and by granting IPO shares to its executives at prices guaranteed to make them money? Probably not. The Supreme Court’s 1994 Central Bank ruling must be reversed. The refusal of Congress to reinstate aiding and abetting liability can be tolerated no longer. Even if all of these reforms occur, the battle is not over. Other changes are necessary to strengthen the ability to reward and punish corporate officials. For example, strong whistle-blower protections are needed to encourage employees, former employees and others to come forward early and often. The ability to use state law protections needs to be reinstated with the repeal of SLUSA. A single higher corporate governance standard for companies trading on the national stock exchanges needs to be created, taking the franchise away from Delaware, which usually has no relationship to the corporations it purportedly governs. The protections of the Glass-Steagall Act, separating the banks from the brokers, need to be reinstated. And new laws need to be passed that will reach those who know of the frauds but fail to report them. These laws should require all people who know about fraudulent activities to disgorge, in tripled amounts, any profits they receive by way of salary, stock sale, commission or contract that is connected to fraudulent activities. Finally, we need new moral and ethical leadership. We need corporate executives to act in the best interests of their shareholders, customers and communities. We need politicians to act in the best interests of their constituents rather than their campaign contributors. And we need a citizenry who will throw them all out of office if they don’t. The stock market crash that started the Great Depression began in 1929. The market kept falling until the first of the federal securities laws was passed in 1933. It took the stock market years to recover from that crash as investors had lost all confidence. By comparison, the dot-com bubble burst in March 2000. We are only 2 1/2 years into the fall. Unless we act now, with swift and decisive action to restore confidence in our markets, we face the same prospects that the nation faced in the early 1930s. The Sarbanes-Oxley Act is neither swift nor decisive, and the cynicism of the investing public grows daily. Talking about war while hoping that rampant corporate fraud just goes away is no longer an option. It is time that Congress got America back to making money the “old fashioned way” — the way we made money for 60 years between 1934 and 1994. It’s time to insist that Congress give us back all those laws that protected us so well. Reed R. Kathrein is a partner in the San Francisco office of Milberg Weiss Bershad Hynes & Lerach. His practice focuses on complex and class action litigation in cases involving securities or consumer fraud. His e-mail address is [email protected]

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