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A recent commentary by Stanford Law Professor Joseph A. Grundfest in the Wall Street Journal provided fresh evidence of a broad backlash by some business and academic leaders against the Sarbanes-Oxley Act reforms, enhanced U.S. Securities and Exchange Commission (SEC) enforcement in the post-Enron era and the vital fraud deterrent and investor safety net provided by securities litigation. Specifically, securities fraud class actions are under attack, with some, in effect, calling for their abolition, even though the number of such suits has declined from approximately 193 per year from 1996 to midyear 2005 to 90 from mid-2005 through 2006. The decline in securities fraud litigation reflects a reduction in the incidence of securities fraud since the “Enron era.” This is because of critically important changes that were made by the Sarbanes-Oxley Act and the SEC to business disclosure, corporate governance, the roles of gatekeepers (like accountants and lawyers) and enforcement. Nevertheless, given the dual threat to SEC enforcement created by flat budgets and the business backlash, it would be a tragic error to eliminate private securities fraud class actions. They remain, in the SEC’s traditional words, “a necessary supplement to the Commission’s efforts.” Quite simply, these suits provide the primary method for defrauded investors to recover their losses. Go back about five years. This country was in the midst of the largest securities fraud wave in its history. Daily news stories highlighted the alleged misconduct of major corporations, including Enron Corp. and WorldCom Inc. As significant were several other lesser known trends. Financial restatements had grown linearly between 1997, when there were 116 restatements, and 2001, when there were 305. Not all of the restatements should be attributed to fraud, but a significant number fairly could be. The staff of the SEC had not grown by a single position between 1995 and 1998. Deterrence, as we entered the new century, had been grievously weakened. Significant areas of concern, such as research analysts, were largely unaddressed by the commission. In the months running up to the enactment of the Sarbanes-Oxley Act, aggregate stock market values declined by more than $7 trillion between selected dates in March 2000 and July 2002. These developments led Congress (by a vote of 99-0 in the Senate and 423-3 in the House), the SEC, the New York Stock Exchange and the National Association of Securities Dealers to respond vigorously with the Sarbanes-Oxley Act and other important reforms. Conflicts of interest in the auditing profession and in corporate board practice have been systematically reduced. Internal auditing controls have been effectively strengthened through executive certification and the much-criticized � 404 of Sarbanes-Oxley. The SEC’s budget was dramatically increased, and the SEC and Justice Department devoted much greater resources to enforcement. And private securities class actions have played an important role in deterring corporate misconduct. Not perfect, but working Is the system perfect today? Of course not. It is nearly universally recognized that compliance costs with respect to � 404 of Sarbanes-Oxley have been too high, particularly for small and medium- sized firms. But the system is working. The Public Company Accounting Oversight Board has recently proposed revising its most expensive Audit Standard No. 2 (the basis for most complaints about � 404) and replacing it with a streamlined Audit Standard No. 5. The SEC itself has offered constructive guidance that should further reduce compliance costs. But to abruptly end the class action remedy to securities fraud, as some recommend, would be to throw out the baby with the bath water. These suits provide a vital deterrence and safety net. Only yesterday, as historian Frederick Lewis Allen wrote in similar circumstances, the enforcement agencies seemed to be weakened to an extent that they could not effectively deter fraud. Given federal budgetary and political realities, these times can easily return. Moreover, even in a period of robust enforcement, the government relies upon private litigation to help police the markets and recover money otherwise lost to wrongdoing. Investors have little other recourse than private suits because the SEC’s disgorgement and monetary penalty powers are limited and will generally cover only a fraction of the damage done to investors by serious securities fraud. In the recent Charter Communications Securities case, for example, the SEC settled with the company without seeking disgorgement or other damages, while private litigants subsequently recovered $146 million. In another dramatic example, consider the Enron case, in which approximately $40 billion in shareholder losses have been attributed to fraud. News reports indicate that the SEC was able to either collect or receive promises to pay approximately $435 million from individuals and banks held accountable in federal civil and criminal Enron prosecutions. Compare that with the $7 billion in settlements agreed to thus far by defendants in the ongoing securities fraud class action led by the California Board of Regents pension fund on behalf of all Enron investors. The challenge of a wise system of securities regulation is neither to “overdeter” and chill legitimate corporate activity nor to “underdeter” and encourage corporate misbehavior. Two important ways to get the balance right is to reduce the wide pendulum swings in SEC budgets and to leave unhobbled the vital safety net provided by private litigation. Joel Seligman is president of the University of Rochester and has written several books about securities regulation. Harvey J. Goldschmid is Dwight Professor of Law at Columbia Law School and served as a commissioner of the SEC from 2002 to 2005, and general counsel of the SEC in 1998 and 1999.

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