Tort reform revolution.

The federal victory and the battle in the states.

On December 22, 1995, thanks to an intensive four-year effort by business, investor and professional groups and strong bipartisan support in Congress, the Private Securities Litigation Reform Act became law. The reform act is an important first step but only a first step in making the liability system less vulnerable to abuse. The next step must be state tort reform. The profession is already battling attempts to use state securities laws as vehicles for similar abuse, and it can expect legislative and legal challenges to the federal act.

This article discusses what the reform act does, and what still must be done, to achieve equity in civil liability. The companion article, "The Reform Act: What CPAs Should Know," on page 55 provides a more detailed analysis of the provisions of greatest significance to the accounting profession, including proportionate liability, the safe harbor for forward-looking information and detection and disclosure of fraud.

WHAT'S IN THE LAW?

The reform act's objectives are to discourage abusive claims of investors' losses due to fraudulent misstatements or omissions by issuers of securities (Securities and Exchange Commission rule 10b-5 suits), provide more protection against securities fraud and increase the flow of forward-looking financial information. Following is a brief summary of how the act's principal provisions will achieve its objectives.

* An end to vague pleas and fishing expeditions. It no longer will be possible to file suits based on vague claims of fraud and then subject defendants to expensive and disruptive discovery proceedings involving cartons of documents and exhaustive depositions in order to "fish" for facts to support the allegations and leverage settlements. The reform act adopts the pleading standard of the Second Circuit Court, which requires all claims to cite specific examples of a "strong inference" of the defendants' fraudulent intent. Defendants may move for dismissal or summary judgment based on the adequacy of the plea, and discovery proceedings cannot begin until the court makes a decision. This requirement will provide prompt relief for blameless defendants and encourage plaintiffs' attorneys to focus their efforts on obtaining fair recoveries for investors with legitimate claims.

* Sanctions for frivolous claims. Sanctions for frivolous claims already exist under rule 11 (b) of the Federal Rules of Civil Procedure, but they are seldom imposed. By requiring courts to evaluate lawyers' conduct under rule 11 (b), the reform act increases the likelihood that abuses will be identified and punished. The act mandates sanctions amounting to the injured party's attorney fees and costs if any party has failed to meet the rule's requirements.

It has been alleged that fear of sanctions will deter small investors from filing claims. Sanctions are intended to penalize significant abuses, not mere mistakes; and they can be reduced or eliminated if the court determines that they would be unjust or unduly burdensome or that the violation was minimal.

* Plantiff's control of class actions. In the past, the plaintiff ostensibly filing a securities fraud class action on behalf of injured investors was likely to be a so-called professional plaintiff"hired" by the attorney initiating the suit to act as lead plaintiff in name only. Members of the plaintiff class had little or no control over the resolution of the case, usually a quick settlement totally unrelated to any question of wrongdoing by the defendant. The attorney received about one-third of the settlement, leaving the plaintiffs with a recovery of 10% or less of their estimated loss. The professional plaintiff generally received a larger share of the settlement as a fee for services rendered.

Under the reform act, plaintiffs in securities fraud class actions will have greater assurance that their interests are being served. Lead plaintiffs will be selected by the court and will have to meet certain criteria intended to eliminate professional plaintiffs. Members of the plaintiff class will receive full details about proposed settlements, plus information about the potential recovery from litigation. Attorney fees should bear a logical relationship to performance and leave the plaintiffs with a reasonable recovery. The lead plaintiffs will receive the same award as all other members of the class.

* A "fair share" approach to apportioning liability. Joint and several liability--under which all defendants are fully liable for assessed damages, regardless of their degree of fault--has been both a strong incentive to extend claims to peripheral defendants, such as auditors, and a potent weapon in coercing settlements. The reform act's proportionate liability standard will help solve this problem while preserving rights of recovery in special cases. Defendants who knowingly commit fraud will remain jointly and severally liable.

* More forward-looking information for investors. Because forward-looking disclosures have been the subject of abusive claims, issuers have been unwilling to make them and auditors have been unwilling to risk association with them. Investors have thus been deprived of forward-looking information that is crucial to financial decisions. All these groups will benefit from the reform act's safe harbor for forward-looking statements. As the companion article discusses, however, the safe harbor is not risk free. Issuers may face legal challenges even though they diligently attempt to meet the act's requirements.

Some regard the safe harbor as a license for companies to lure investors with rosy projections that never will be realized. The act, however, requires balanced discussions of future prospects as a condition of imunity from liability, and the increased likelihood of auditor association with forward-looking statements will provide additional protection. Since many companies will see forward-looking disclosures and auditor association with them as a competitive advantage, the safe harbor should significantly increase the flow of useful and reliable information to the marketplace.

* Detection and disclosure of fraud. It is best to nip fraud in the bud before it causes losses that give rise to litigation. To help achieve this objective, the reform act codifies auditors' existing responsibilities to search for and disclose fraud. It also requires auditors to promptly notify the SEC when a client's management fails to take appropriate action in response to reports of material fraud. In addition to supporting this measure, the accounting profession is taking other significant steps to increase auditors' effectiveness in preventing and detecting fraud. One example is the American Institute of CPAs (AICPA) auditing standards board's current exposure draft that would require auditors to develop plans to reduce the risk of fraud (For more about the AICPA exposure draft, see the special report, "Auditing Standards Board Adresses Fraud," JofA, p17, June 1996).

REFORM AT HOME

The reform act corrected abuses that hurt investors as well as those that harmed public companies and the accounting profession, making the federal liability system fairer and more effective for all. This balanced approach must now be applied at the state level, where the profession's greatest liability exposure still exists. The federal act covers only federal securities fraud suits. CPAs remain vulnerable to litigation and related abuses under state securities laws, Racketeer Influenced and Corrupt Organizations Act laws (RICO), tort systems based on statute and case law and laws providing for private rights of action, such as state environmental statutes. In the past two years, there has been enormous progress on organizational reforms that will protect partners' personal assets if catastrophic litigation bankrupts their firms (see box on page 58). Organizational reform, however, is not a substitute for tort reform.

Tort reform momentum is building m many states (see exhibit, page 56). High on the profession's list of state priorities is proportionate liability. A number of states already have adopted proportionality in recognition that joint and several liability may be fair in theory but is an open invitation to abuse in practice. But the profession still has its work cut out for it because many of these changes apply to product liability rather than professional negligence claims.

The profession and other supporters of the Private Securities Litigation Reform Act also must combat attempts by perpetrators of abusive securities litigation to shift their activities to the state level. One serious threat is in California, where a ballot initiative (Proposition 211) masquerading as pro-investor and pro-consumer is up for voter consideration in November. Not only would this proposition nullify the federal reforms but it would also overturn the U.S. Supreme Court's decisions on statute of limitations and aiding and abetting, and it would weaken state protections against abusive litigation. Worst of all, since the proposition would permit any California resident to file a claim with respect to the sale or purchase of securities, its reach would extend to virtually every public company.

The business, shareholder and professional groups that united to stop abusive securities fraud litigation at the federal level must now get out the message that the California initiative would not benefit investors. Investors should refuse to accept this initiative and others like it if they want to reduce the risks of abusive litigation. Instead, they should help protect the Private Securities Litigation Reform Act from efforts to weaken or overturn it and work for state tort reforms.

Congress voted to override President Clinton's veto of the Private Securities Litigation Reform Act of 1995. It was the first--and so far only-- veto override for Clinton.

  House of Representatives                  Senate

  Ayes        Nays                  Ayes        Nays
  319         100                   68          30

The Private Securities Litigation Reform Act of 1995

LESS AND MORE

LESS abusive securities fraud litigation.

MORE relief for investors with legitimate claims.

LESS fraud leading to investor losses and litigation.

MORE forward-looking financial information.

EXECUTIVE SUMMARY

* THANKS TO AN INTENSIVE FOUR-YEAR effort by business, investor and professional groups and strong bipartisan support in Congress, the Private Securities Litigation Reform Act of 1995 became law. The next steps are to preserve the federal victory at the state level, challenge legal and legislative efforts to amend or overturn the federal act and focus on state tort reforms.

* THE REFORM ACT'S OBJECTIVES are to discourage abusive claims of investors' losses due to fraudulent misstatements or omissions by issuers of securities, provide more protection against securities fraud and increase the flow of forward-looking financial information.

* THE REFORM ACT SHOULD MEET its objectives by imposing specific pleading requirements; reducing the effectiveness of discovery, in coercing settlements; mandating sanctions for frivolous claims; giving the plaintiff class more control of class actions; providing for proportionate liability, except in cases of knowing fraud; creating a safe harbor for forward-looking information; and codifying the auditors' responsibilities to search for and disclose fraud.

* THE PROFESSION AND THE ACT'S OTHER supporters must combat attempts by perpetrators of abusive securities litigation to shift their activities to the state level, such as in California, where a ballot proposition masquerading as pro-investor and pro-consumer is up for voter consideration in November.

* THE COMPANION ARTICLE, "The Reform Act: What CPAs Should Know" provides an in-depth look at the three provisions of the reform act that directly affect CPAs, and it explains how the provisions will change the way auditors do their work. ANDREA R. ANDREWS is a senior manager with Price Waterhouse and director of public affairs for its Washington liaison office. GILBERT SIMONETTI, JR., a principal of price Waterhouse, is managing director of the firm's Office of Washington Liaison in Washington, D.C., with responsibility for coordinating the firm's government relations and public affairs activities. He was formerly chairman of the American Institute of CPAs federal legislative task force. ANDREW J. PINCUS is a partner in the Washington, D.C., office of the law firm of Mayer, Brown & Platt. He represented the American Institute of Certified Public Accountants and the six largest international accounting firms in the legislative process that culminated in the enactment of the Private Securities Litigation Reform Act of 1995.