Friday Editorial: SOX, Stoneridge and the Assault on Shareholder Rights

As we leave our commentary on Stoneridge, we ought to take one more effort to put it into context. 

Maybe two years ago, and one reason for the creation of this Blog, there was a relentless attack on Sarbanes-Oxley, with commentators and academics alleging that the Act was more harmful than beneficial.  One commentator labeled it "quack corporate governance."  SOX was bad for governance and bad for US competitiveness.  It was too expensive and yielded too few benefits.  My paper rebutting these attacks is here.  The criticisms largely came from those who had little interest in seeing the rights of shareholders enhanced. 

As the market rose (indicating renewed investor confidence), the number  of fraud suits fell (indicating that provisions of SOX were working), and the Commission took steps to soften the impact of SOX on smaller companies, and the criticisms largely abated (the incorrigible Larry Ribstein the exception, although he has been reduced to alleging that SOX fixed "yesterday's problems," hardly the withering criticism of yore).   

But the criticism didn't stop.  Instead, it shifted.  The same group largely shifted to the issue of shareholder litigation.  It was bad for governance and bad for US competitiveness.  Exhibit A was the poorly reasoned, unquestionably biased report issued by the Committee on Capital Markets Regulation (under the tutelage of Hal Scott at Harvard).  The report identifies litigation as harming US competitiveness but ignores data indicating a decline in the number of suits and the impact of existing restrictions (namely the PSLRA).  The result oriented nature of the report can be seen from some of the conclusions that now border on laughable (how about "The dramatic increase in the use of private U.S. markets is important evidence that regulation and litigation are keeping them out of the public market."). It purports to be balanced, but under the category of shareholder rights approves of steps either already underway or useless, adding no proposal that would significantly improve the rights of shareholders. 

In other words, like the attacks on SOX, the attacks on shareholder litigation are coming from critics who, on the whole, have little patience with shareholder rights.  The one thing that can be said about the US is that the system of litigation here allows for greater vindication of shareholder rights, a direction, incidentally, other countries are slowly adopting.  Restricting litigation has the collateral consequence of reducing this ability, without any concomitant increase in the rights of shareholders.  Thus, while it is harder to sue in Great Britain, shareholders have access and say on pay. 

Stoneridge fits into this scheme.  Justice Kennedy may as well have a seat on the Committee on Capital Markets Regulation.  The opinion provides as a justification for cutting back on shareholder rights the possibility that "[o]verseas firms with no other exposure to our securities laws could be deterred from doing business here. . . This, in turn, may raise the cost of being a publicly traded company under our law and shift securities offerings away from the domestic capital markets."  For the former, the only authority was the amicus brief written by the Organization for International Investment and for the latter the brief written by Nasdaq and the NYSE.  Both briefs are, by the way, posted on the DU Corporate Governance website.

Suffice it to say that the claims are unproven and the Court was careful to contend that litigation against vendors "could" shift business away and "may" shift securities offerings away.  One could just as easily say that the failure to protect the integrity of the financial markets by ensuring accurate disclosure "could" discourage foreign investors from investing in US markets and "may" cause a shift in offerings away from domestic markets. 

It is the belief of this Blog that this harsh, anti-shareholder attitude among regulators (including the Supreme Court) is something that ultimately will cause long term harm to the US capital markets.  With overseas capital markets becoming more efficient, the US must compete through a race to the top, not a race to the bottom.  The Supreme Court is promoting a race to the bottom.

Comments

[Herrick Lidstone]

Jay:

As one who has twice before posted comments on the Stoneridge case (October 5, 2007 and September 7, 2007), I cannot let your Friday editorial go by. First, I think that the decision in Stoneridge is consistent with the current state of the law as identified in the majority opinion, relying especially on the Central Bank case and Chiarella. As the Supreme Court said in Chiarella v. United States, 445 U.S. 222, 234 (1980), “When an allegation of fraud is based upon nondisclosure, there can be no fraud absent a duty to speak.”

I am not arguing that the Stoneridge defendants were clean. Assuming the facts in the complaint, they knew just what they were doing in helping Charter communications manipulate their financial statements, as did (according to the complaints) the defendants in the Enron barges case (University of California, et al. v. Credit Suisse First Boston (USA), Inc.) and in the Homestore.com case (Simpson v. AOL Time Warner, Inc.). If the complaints are true, the defendants knowingly participated in a significant scheme to defraud investors.

Not every wrong has a litigation remedy. The Supreme Court has previously struck a balance between litigants in 70 years of Rule 10b-5 litigation. The Court has been (with varying degrees of care) refining that balance since Ernst & Ernst v. Hochfelder in 1976. I think that the balance as it currently exists in 10b-5 litigation is an appropriate balance.

I think that the 10b-5 balance has nothing to do with a perception that the SEC may be anti-shareholder, or perhaps not sufficiently pro-shareholder. That, itself, is a balance, and different people can reach different conclusions on where the balance should be. (And Race to the Bottom has made persuasive arguments on that score.)

Ultimately in my 30 years of watching corporate law and corporate governance, the pendulum keeps swinging. The balance is always shifting, and I predict it will continue to shift. Perhaps in big jumps (witness 2002), and perhaps in minor modifications or clarifications (Stoneridge). I look forward to it continuing.

[Harry Gerla]

In response to Herrick Lidstone's comment one can certainly argue with his conclusions that the current balance in 10b-5 litigation is appropriate and that the pendulum will continue to swing. I have reached different conclusions, but that is of little matter. One thing I cannot let pass, however, is the claim that Stoneridge was somehow compelled by Central Bank or Chiarella. The language in Chiarella that fraud based on nondisclosure must be premised on a duty to speak is simply irrelevant. The defendants in Stoneridge and similar cases did choose to "speak" in the form of communicative behavior. Even Justice Kennedy's majority opinion recognized this when it rejected "one reading" of the 8th Circuit's rationale for dismissing the plaintiffs' case. As far as Central Bank itself is concerned Justice Steven's point in dissent is never really rebutted in the majority opinion. Specifically, in Central Bank the defendant never committed a deceptive act--an act designed to create an impression in the minds of investors that diverged from reality. As Mr. Lidstone's comment acknowledges, plaintiffs in Stoneridge and the other cases alleged that the defendants "knew exactly what they were doing." They were alleged to have engaged in sham transactions specifically designed to mislead participants in the securities markets. One can argue whether the outcome in Stoneridge embodies good law or policy. One cannot make an honest argument that Chiarella and Central Bank somehow compelled that outcome.

[Herrick Lidstone]

I appreciate Harry Gerla's clarification, but I don't think I said that Stoneridge was somehow compelled by Central Bank or Chiarella, merely that, in my opinion, it is consistent with the approaches taken in those cases.