Thank you for sharing!

Your article was successfully shared with the contacts you provided.
Although the new year is half over, it is not too late to offer prognostications of litigation developments we may see in the course of 2003 and beyond. Not surprisingly, given the media and governmental attention on issues surrounding corporate governance, the core of such forecasts naturally centers on the Sarbanes-Oxley Act. In the wake of corporate accounting scandals at Enron, MCI WorldCom and other companies, on July 30, 2002, Congress adopted Sarbanes-Oxley in an effort to strengthen corporate financial reporting. The act imposes now familiar stringent new requirements on corporate executives to adopt procedures to ensure the accuracy of publicly reported financial results and to certify the accuracy of those results. The act likewise seeks to improve auditor independence by adding new restrictions on the services that an auditor can provide to its client. It also requires advance approval and disclosure of other non-audit services, such as tax preparation, that auditors continue to be permitted to provide. These provisions already have been the subject of numerous articles, ranging from descriptions of the new requirements to analyses of their pros and cons. This article addresses a separate consideration — the potential impact of Sarbanes-Oxley, and new regulations adopted by the Securities and Exchange Commission pursuant thereto, on private securities litigation. Although clearly not the driving force behind the legislation, it is entirely likely that Sarbanes-Oxley will give rise to several issues in civil litigation and it potentially may be the basis of class-action plaintiffs’ attempts to expand their arsenal of weapons in securities litigation. Specifically, this article discusses three issues that may well arise in future securities litigation: (i) the statute of limitations on securities claims; (ii) the advancement of legal fees for individual defendants; and (iii) the potential attempt to bootstrap provisions of Sarbanes-Oxley to support securities claims brought under � 10(b) of the Securities Exchange Act of 1934. STATUTE OF LIMITATIONS First, Sarbanes-Oxley includes a provision that lengthens the statute of limitations applicable to � 10(b) claims. The new limitations’ period for bringing such a claim is two years from the time such claim was or should have been discovered, or five years from the alleged fraud, whichever is shorter.[FOOTNOTE 1] This is a substantial increase from the corresponding “one-year, three-year” period that applied previously under federal law. This change is unlikely to affect either the number of actions or their viability, however, because virtually all such actions typically are filed upon a substantial drop in a public company’s stock price. Rather, the increase in the limitations’ period will have its primary impact on the length of the class period. The prolongation of the class period certainly could affect the calculation of damages and the number of class participants. In turn, this could lead to subclasses and increased controversy over the selection of lead plaintiff and the coveted position of lead counsel. With the insurance world separately in crisis both in the aftermath of 9/11 and fearful of increasing securities claims, the expansion of the class period is likely to make settlement of such actions more difficult. ADVANCEMENT OF LEGAL FEES Second, Sarbanes-Oxley prohibits certain loans by companies to their officers and directors.[FOOTNOTE 2] Currently, it is an unresolved question whether this prohibition precludes companies from continuing the common practice of advancing legal fees and other expenses of defending securities litigation on behalf of their officers and directors. The predominant view followed by most companies and defense counsel that have faced this issue is that such advancement of expenses continues to be permitted and that the advancement does not constitute a loan. This argument is buttressed by reference to bylaws and state laws of incorporation that typically permit boards of directors to direct advancement of legal fees and expenses in litigation. Indeed, it is highly unlikely that Congress could have intended to prohibit an almost universally followed practice — one allowed, and in some instances mandated,[FOOTNOTE 3] by the corporate laws of every state — without directly addressing the issue. Moreover, the restriction applies only to a company’s current officers and directors; thus, interpreting the rule to prohibit such payments would lead to the perverse result that advancement could be made to a company’s former executives, but not to those officers and directors who stay with the company and work to turn it around following any bad news. This issue, however, has yet to be addressed by the courts. Class action plaintiffs have been heard to complain that the advancement of legal fees contributes to an advantage to corporate defendants who do not need to shoulder the day to day financial costs of litigation. In the typical class action, there should not be any way for a class plaintiff to challenge the advancement practice while the lawsuit is ongoing. However, were it ultimately to be decided by more than an occasional case that advancement is not allowed, the development would dramatically alter the routine course of proceedings in securities litigation. Executives would be forced to bear the substantial fees and expenses of defending such litigation on their own. This development could lead to the naming of more individual defendants and lead to pressure on the corporate defendant to attempt to settle the case more quickly. Of course, the inconvenience and burden for a director or officer to have to fund his or her individual defense, at least initially, would be a further disincentive to service in corporate government life, a truly perverse effect of the act’s stated objective to improve corporate governance. CERTIFICATION REQUIREMENTS Perhaps of greatest interest to the litigation bar is the potential that plaintiffs will attempt to scour Sarbanes-Oxley in the hope of finding new support for securities law claims. One area that can be anticipated to be a field for imaginative claims concerns the new certification requirements of the act. Indeed, class action plaintiffs in at least two recent cases have included allegations that the company and its top executives filed the certifications required by Sarbanes-Oxley, but the underlying financial data nevertheless was incorrect.[FOOTNOTE 4] While those complaints do not take the next step and allege that the incorrect certification itself constituted a violation of the securities laws, it may be only a matter of time before defendants see class action complaints make such allegations. Like the prohibition on loans to officers and directors, these new rules and regulations were adopted to strengthen the corporate reporting and disclosure process, without any announced intent to affect, directly or indirectly, securities litigation that might result from announcements of past corporate disappointments. Nevertheless, in view of the creativity that can be expected of the plaintiffs’ bar in fashioning complaints to take maximum advantage of the new rules, it is important for all counsel involved in securities litigation to anticipate and understand the potential impact of the new rules. The applicable legal principles that could be affected are those contained in the Private Securities Litigation Reform Act of 1995, and longstanding Supreme Court precedent. DISCLOSURE AND INTERNAL CONTROLS Section 302 of the Sarbanes-Oxley Act requires the SEC to adopt rules under which both the principal executive officer and the principal financial officer of public companies must certify the overall accuracy of the company’s quarterly and annual reports. The certification requires the officer to state that based on his or her knowledge, the quarterly or annual report does not contain any untrue statement of material fact or omit any material fact necessary to make the other disclosures not misleading.[FOOTNOTE 5] In addition to certifying the accuracy of the public reports, the certification must also disclose the officers’ basis for making the certification; each must certify that he or she and the other officers of the company are “responsible for establishing and maintaining disclosure controls and procedures.”[FOOTNOTE 6] Specifically, the disclosures must be designed “to ensure that material information relating to the issuer … is made known to [the certifying officer].” The certifying officers must also certify that they have “evaluated the effectiveness of the issuer’s disclosure controls and procedures” within the prior 90 days and have “presented in the report their conclusions about the effectiveness of the disclosure controls and procedures.” Neither these regulations, nor � 302 of Sarbanes-Oxley, makes any reference to private securities litigation. Nor do they express any intent to affect the requirements on plaintiffs seeking to bring a securities fraud lawsuit. The disclosure requirements on their face recognize that the principal executive officer and principal financial officer of large companies who will be required to make the disclosure will not have personal knowledge of all of the facts to which they are certifying. The regulations similarly recognize that it is permitted — and expected — that such officers will rely on others within the organization in making the certification. Indeed, it has been a longstanding practice in any large public company that the officers who sign the company’s 10-Qs and 10-Ks, since well before the new certifications, relied on others in their companies for the accuracy of the information in the reports. The requirement that officers specifically certify the effectiveness of their organization’s internal controls, however, could have a significant impact on securities fraud actions. One well-known requirement of a claim under � 10(b) of the Exchange Act is the pleading of scienter, or an intent to commit fraud. In adopting the Private Securities Litigation Reform Act of 1995 (the Reform Act), Congress made it more difficult for plaintiffs to bring securities fraud actions by strengthening the scienter requirement. Under the Reform Act, a complaint alleging a 10(b) violation must contain specific factual allegations that give rise to a “strong inference” that the defendants acted with scienter. The requirements for alleging scienter under the Reform Act vary by circuit. At one end of the spectrum, the 2nd U.S. Circuit Court of Appeals permits securities fraud actions to proceed where plaintiffs allege specific facts demonstrating that the defendant either (i) had the motive and opportunity to commit fraud or (ii) engaged in conscious misconduct or recklessness.[FOOTNOTE 7] At the other end, the 9th U.S. Circuit Court of Appeals requires securities fraud plaintiffs to allege “in great detail, facts that constitute strong circumstantial evidence of deliberately reckless or conscious misconduct.”[FOOTNOTE 8] In every circuit, it is clear that a securities fraud lawsuit cannot survive based on allegations that amount to nothing more than negligent, or even grossly negligent, misrepresentations by the defendants. The certification requirements, however, could be argued to change that standard, even unintentionally. Corporate officers must now certify not only the accuracy of the financial statements, but also the adequacy of the company’s internal controls in bringing misstatements or omissions to the attention of senior management. Although we have yet to see a complaint based on such allegations (the two securities class actions that mention Sarbanes-Oxley do so in passing and do not focus on this issue), it is possible that eager securities plaintiffs will focus on the certification itself — rather than the underlying control failure — as a basis for bringing a � 10(b) claim. Such a claim would likely require plaintiffs to make factual allegations that would support the inference that corporate officers made the internal control certification in reckless disregard of the company’s actual lack of internal controls. The attraction of such a claim for a plaintiff would be that such factual circumstances may well prove easier to allege and sustain than complex allegations that corporate officers knew or were reckless in not knowing that difficult accounting judgments made by experienced accountants and approved by well-respected outside auditors were incorrect. Naturally, there are answers to such claims. Apart from the need to have a strong factual basis for internal control allegations, it is dubious that a control failure itself could constitute a violation of the securities laws. One would have to posit that the filing itself was false and misleading because the certification was recklessly false. However, it would appear to be a classic bootstrap to contend that the absence of diligence in making the certification could supply a claim where none otherwise existed. ATTORNEY CONDUCT RULES On Jan. 23, 2003, the Securities and Exchange Commission adopted new rules of attorney conduct, pursuant to � 307 of Sarbanes-Oxley. As a result of the notice and comment period, the SEC modified some of the proposed rules announced in November 2002. The new rules of conduct will supersede any conflicting state rule, and will apply to attorneys who represent the issuer (i.e., the company, as opposed to its officers or directors) in connection with the preparation of any document that will be submitted to or filed with the SEC.[FOOTNOTE 9] The rules require an attorney to report objective “evidence of a material violation” of the SEC rules “up-the-ladder” to the chief legal officer or chief executive officer of the company. If that officer does not respond appropriately to the evidence, the rules require the attorney to report the suspected misconduct to the audit committee, another committee of independent directors or the full board of directors. The new rules also permit — but do not require — the attorney to reveal client confidences, without the client’s consent, “(1) to prevent the issuer from committing a material violation likely to cause financial injury to the financial interests or property of the issuer or investors; (2) to prevent the issuer from committing an illegal act; or (3) to rectify the consequences of a material violation or illegal act in which the attorney’s services have been used.”[FOOTNOTE 10] The SEC has not yet decided whether to adopt its proposed requirement that an attorney make a “noisy withdrawal” — a withdrawal coupled with notification to the SEC that the withdrawal was for professional reasons — in the event his or her concerns are not adequately addressed by the company.[FOOTNOTE 11] Instead, the SEC is considering shifting the burden of notifying the commission to the company, rather than the attorney. As a practical matter, however, it would appear to make little difference whether the attorney or the client was required to give the notice, since under either rule the SEC would be notified of the attorney’s withdrawal and the attorney’s withdrawal could trigger such disclosure to the SEC. The final rules affirmatively provide that they do not create a private cause of action, and that enforcement authority is vested exclusively with the commission.[FOOTNOTE 12] The new rules nevertheless have the potential to change significantly the legal landscape for securities fraud claims against attorneys. Under longstanding Supreme Court precedent, there is no liability under � 10(b) for aiding and abetting securities fraud. Rather, Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A.[FOOTNOTE 13] limits securities fraud claims to those who are primary actors in the alleged fraud. Thus, after Central Bank, a person violates the federal securities laws only by making a false or misleading statement himself or herself or by specifically acquiescing in or adopting the statements made by others.[FOOTNOTE 14] Even though the new rules do not give rise to a private cause of action against an attorney who violates the SEC rules, the rules may affect the determination of whether a lawyer is a primary actor or a secondary actor in a � 10(b) violation. Specifically, the application of the rules only to attorneys who provide legal services to issuers in connection with the preparation of documents filed with or submitted to the commission suggests that an attorney “speaks” by permitting his or her services to be used in the filing of such documents. In that regard, the attorney may be viewed to have adopted or acquiesced in the statements made by the company. Previously, such conduct would have been deemed, at most, “aiding and abetting” the statements made by the issuer, and would not have subjected the attorney to liability for any material misstatements or omissions in the documents. Now, however, the attorney might be claimed to be a primary violator of the securities laws in this circumstance if the act is stretched to fit such a contention. Moreover, the rules specifically permit the attorney to disclose client confidences to prevent financial injury to investors. Lawyers and law firms that determine not to make such permissive disclosure may find themselves defending claims by investors that the use of the lawyers’ services, followed by the lawyers’ silence when faced with the option of correcting any alleged misstatement or violation by the client, constitutes a direct violation by the attorney rather than aiding and abetting the client’s alleged violation of � 10(b). Once again, the use of such arrangements to support expanded claims appears to be a significant distortion of the act and its intended purpose. In fact, it seems almost inconceivable that the courts would permit the use of Sarbanes-Oxley to provide the basis for indirect liability under the securities laws. Nonetheless, the possibility for such attempts cannot be entirely discounted. Indeed, even before the formal adoption of the new attorney conduct rules by the SEC, the seeds of such an argument appear to be the basis for Judge Melinda Harmon’s decision in the Enron securities litigation to permit investors’ claims against the law firm of Vinson & Elkins to proceed.[FOOTNOTE 15] The court concluded that the complaint’s allegations that Vinson & Elkins routinely drafted, reviewed and commented on Enron’s public statements and that Vinson & Elkins knew that it was being used by Enron to further Enron’s fraudulent scheme were sufficient to plead primary violations of the federal securities laws by Vinson & Elkins. [FOOTNOTE 16] The allegations against Kirkland & Ellis, another of Enron’s outside counsel, however, amounted only to claims that Kirkland & Ellis “aided and abetted” Enron’s fraud because they did not allege direct participation by Kirkland & Ellis in making public statements.[FOOTNOTE 17] Thus, the court denied Vinson & Elkins’ motion to dismiss, but granted the motion to dismiss of Kirkland & Ellis. CONCLUSION The new certification requirements and attorney conduct rules could have a profound impact on private securities litigation. Although neither the Sarbanes-Oxley Act nor the regulations adopted by the Securities and Exchange Commission pursuant thereto were the result of an expressed intent to change the legal requirements applicable to private securities litigation, the new regulations could, as a practical matter, have such an effect. Not until courts address these important issues will the full impact of Sarbanes-Oxley be known. Robert J. Jossen is the co-chair of the litigation department of Swidler Berlin Shereff Friedman (www.swidlaw.com) and is a Fellow of the American College of Trial Lawyers. Neil A. Steiner is a litigation associate with the firm. ::::FOOTNOTES:::: FN1 See 28 U.S.C. � 1658. FN2 See 15 U.S.C. � 78m(k). FN3 See, e.g., Reddy v. Electronic Data Systems Corp., C.A. No. 19467, 2002 Del. Ch. 69 (June 18, 2002). FN4 See Buthker v. VoiceFlash Networks, Inc., Case No. 03-80196-CV-PAINE (S.D. Fla.) (filed Feb. 18, 2003); United Brotherhood of Carpenters Pension Trust v. Michaels Stores, Inc., Case No. 3-03CV0246-M (N.D. Tex.) (filed Feb. 5, 2003). FN5 See 17 C.F.R. � 240.13a-14(b)(2). FN6 See 17 C.F.R. � 240.13a-14(b)(4). FN7 See, e.g., Kalnit v. Eichler, 264 F.3d 131, 138-39 (2d Cir. 2001). FN8 See In re Silicon Graphics, Inc. Sec. Litig., 183 F.3d 970, 974 (9th Cir. 1999). FN9 See SEC Release No. 2003-13, “SEC Adopts Attorney Conduct Rules Under Sarbanes-Oxley Act,” Jan. 23, 2003. FN10 See id. FN11 See id. FN12 See id. FN13 511 U.S. 164 (1994) FN14 See, e.g., Dinco v. Dylex Ltd., 111 F.3d 964, 968 (1st Cir. 1997); In re Fidelity/Micron Sec. Litig., 964 F. Supp. 539, 544 (D. Mass. 1997); In re The Prudential Ins. Co. Sales Practices Litig., 975 F.Supp. 584, 612 (D.N.J. 1996); Converse, Inc. v. Norwood Venture Corp., No. 96 Civ. 3745 (HB), 1997 WL 742534, at *3 n.5 (S.D.N.Y. Dec. 1, 1997). FN15 See In re Enron Corp. Sec., Deriv. & ERISA Litig., 235 F.Supp.2d 549 (S.D. Tex. 2002). FN17 See id. at 704-05. FN17 See id. at 706. If you are interested in submitting an article to law.com, please click here for our submission guidelines.

This content has been archived. It is available exclusively through our partner LexisNexis®.

To view this content, please continue to Lexis Advance®.

Not a Lexis Advance® Subscriber? Subscribe Now

Why am I seeing this?

LexisNexis® is now the exclusive third party online distributor of the broad collection of current and archived versions of ALM's legal news publications. LexisNexis® customers will be able to access and use ALM's content by subscribing to the LexisNexis® services via Lexis Advance®. This includes content from the National Law Journal®, The American Lawyer®, Law Technology News®, The New York Law Journal® and Corporate Counsel®, as well as ALM's other newspapers, directories, legal treatises, published and unpublished court opinions, and other sources of legal information.

ALM's content plays a significant role in your work and research, and now through this alliance LexisNexis® will bring you access to an even more comprehensive collection of legal content.

For questions call 1-877-256-2472 or contact us at [email protected]


ALM Legal Publication Newsletters

Sign Up Today and Never Miss Another Story.

As part of your digital membership, you can sign up for an unlimited number of a wide range of complimentary newsletters. Visit your My Account page to make your selections. Get the timely legal news and critical analysis you cannot afford to miss. Tailored just for you. In your inbox. Every day.

Copyright © 2020 ALM Media Properties, LLC. All Rights Reserved.