The Securities and Exchange Commission has taken two steps that cast doubt upon whose side it’s on: individual shareholders or corporate executives, and accountants.
Chairman Christopher Cox may lose the confidence of the investing public — and more important, Congress — if he does not tread carefully.
The New York Times reported last week that the SEC has moved to reduce the likelihood of lawsuits against corporations, and their executives and auditing firms.
In regard to corporations, the SEC filed an amicus brief in a case before the Supreme Court, arguing in favor of an interpretation of the Private Securities Litigation Reform Act of 1995 that, if adopted by the court, would make it harder for shareholder fraud suits to reach a jury.
Under the law, to prevent the dismissal of a suit, investors alleging fraud must state facts “giving rise to a strong inference that the defendant acted with the required state of mind” to commit fraud.
An appeals court interpreted the law to mean that investors had to show merely that “a reasonable person” would infer from the accusations, if true, that the executives acted with the required intent.
The SEC brief argued that the appeals court had set the bar too low and that the evidence had to show “a high likelihood” that the defendants intended to break the law.
To a certain extent, the SEC is between a rock and a hard place regarding fraud suits against corporations. Claims by former shareholders who believe they were defrauded often are paid, in effect, by current shareholders, if the company still operates, or by shareholders or policyholders of companies that issued directors’ and officers’ insurance.
If the standard is set too high, those injured may be denied fair redress. If it set too low, frivolous lawsuits may inflict unnecessary costs on companies already struggling to compete in a global economy.
And a too-low standard may hurt the U.S. financial markets. Foreign companies already reportedly are deciding not to list on U.S. stock exchanges, in part because of our reputation for frivolous lawsuits.
Nevertheless, the SEC’s first responsibility is to protect the long-term interests of shareholders and the integrity of the financial markets. In this case, its interpretation appears to lean too far toward protecting corporations and their top executives.
The SEC also is seeking ways to protect major accounting firms from large damage awards in suits brought by investors and companies.
Top SEC officials are concerned that there are only four major accounting firms, and a large damage award could reduce the number to three. The agency’s officials believe that that would be bad for the health of the accounting industry, and for accounting and auditing practices.
This is a valid concern, but once again, the SEC must walk a fine line between being too protective of the remaining accounting firms — and thus encouraging them to relax their practice standards — and not being protective enough, and encouraging costly and distracting lawsuits.
In this case, the long-term interests of shareholders would seem to require the survival of the Big Four. Some way must be found to ensure that a large damage award does not drive any of them out of business.
The solution may lie in a cap on damages, perhaps related to the revenue or profits of the offending accounting firm.
