Goldblatt Law Firm

Securities Litigation after Sarbanes-Oxley

By L. Steven Goldblatt

The Public Company Accounting Reform and Investor Protection Act of 2002, commonly known as the Sarbanes-Oxley Act of 2002, effective July 30, 2002,1 is the most comprehensive reform of the federal securities laws since the enactment of the 1933 Securities Act and the 1934 Securities Exchange Act. Spurred by widespread publicity and public outcry after the Enron, Worldcom and other corporate debacles involving accounting chicanery, Congress wanted to address the perception that earnings and other required reporting under Section 13(a) or 15(d) of the 1934 Securities Exchange Act (15 U.S.C. §78l, 15 U.S.C. §78m, 15 U.S.C. §780) were false, deceptive and misleading and to restore accuracy and transparency to the reporting of results and developments by public companies. For purposes of this article, only a selective summary of the Act is possible.

One method was to establish a Public Company Oversight Board to "further the public interest in the preparation of informative, accurate and independent audit reports."2 Another method was to add a Section 906 Certification, which requires CEO and CFO certification that periodic financial reports comply with the requirements of 13(a) or 15(d) of the Exchange Act and that the information fairly presents, in all material respects, the financial conditions and results of the issuer.3 A knowingly false certification is punishable by up to a $1,000,000 fine or up to ten years imprisonment, or both, and willfully false certifications by up to a $5,000,000 fine and/or up 20 years imprisonment or both.4 Section 404 of the Act as implemented by Exchange Act Rules 13a-15 and 15d-15 requires maintenance of disclosure controls and procedures and requires management evaluation with principal executive and financial officer participation of the effectiveness of the 36 THE ST. LOUIS BAR JOURNAL/WINTER 2004 Securities Litigation after Sarbanes-Oxley By L. Steven Goldblatt issuer's disclosure controls.5 The Act added stringent requirements for audit committees, requiring that each member be a member of the Board, have an independent director, provide for anonymous reporting of questionable accounting and audit activities, have the authority to engage independent counsel and to be appropriately funded by the issuer. The Act extended the statute of limitations for bringing securities fraud actions under the 1934 Exchange Act after the effective date of the Act to two years after discovery up to a maximum of five years, overruling prior case law.6 The new limitation period applies to all actions commenced after July 30, 2002.7 The Act explicitly created a cause of action to protect whistleblowers who have been terminated from, or discriminated against, in employment.8 Knowing retaliation against corporate informants is now a felony punishable by fine or imprisonment up to ten years.9 Finally, Section 803 of the Act amends 11 U.S.C. 523 (a) to provide that a debt is not dischargeable if incurred in violation of the federal securities laws.

I. Sarbanes and Scienter Requirement in 10(b)(5)

Sarbanes is sure to provoke a plethora of pleading practice problems in the wake of The Private Securities Litigation Reform Act of 1995 (PSLRA). PSLRA specified the pleading requirements for private actions under the various federal securities acts. Plaintiff must allege with particularity each statement alleged to be misleading and set forth in detail the "reasons why the statement is misleading."10 Plaintiffs must "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind."11 Since Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193-194 n.12, 96 S. Ct. 1375, 1381 n.12, 47 L. Ed. 2d 668 (1976) reserved the question, every United States Court of Appeals other than the Ninth Circuit has interpreted the PSLRA's pleading requirement and concluded that the statute did not overturn the well-established, preexisting law governing the mental state required to establish securities fraud. Until the Ninth Circuit decided Silicon Graphics, 183 F.3d 970, 977 (9th Cir. 1999), every circuit court that considered the issue was in agreement that under the PSLRA, as before, a showing of "recklessness" sufficed to establish § 10(b) liability. 12

Since the Silicon Graphics decision, the Eleventh Circuit explicitly rejected the panel's conclusion and followed all the other circuits. "The opinion of the Ninth Circuit in Silicon Graphics would seem to indicate that the Reform Act substantively raised the required level of scienter, while the Second, Third, and Sixth Circuits hold that fact-specific allegations of recklessness are still sufficient." 13 The Bryant court added "[e]very circuit to address the question before the passage of the Reform Act held that a showing of recklessness was sufficient to allege scienter," and discussing some of the compelling evidence that demonstrates that Congress did not intend the PSLRA to alter the scienter requirement, the Eleventh Circuit concluded: "We are persuaded that the plain text of the statute makes clear that recklessness was not eliminated as a basis for liability under the Reform Act."14 By siding with the Second, Third and Sixth Circuits, however, the Eleventh Circuit sided with the Sixth Circuit in rejecting the Second Circuit's pleading standard of "motive and opportunity" alone was sufficient under the Act.

Sarbanes-Oxley makes this melee between the circuits with respect to pleading requirements mostly immaterial. Most federal securities fraud cases involve allegations of accounting irregularities. Given the extensive audit chain and certification requirements imposed by Sarbanes, along with new standards imposed by the Financial Standards Oversight Board, any material misstatement of a firm's financial statement must be made knowingly. Reporting companies and individuals in the audit chain cannot turn a blind eye to accounting issues and escape civil, much less criminal, liability under the totality of the federal securities laws.

II. Aiding and Abetting Liability

Sarbanes-Oxley is likely to expand the target of federal securities litigation and focus litigation on officers and directors as well as attorneys and accountants. The Act and recent expanded definitions of direct liability substantially erode, if not explicitly overrule, the rules announced in Central Bank of Denver N.A. v. First Interstate Bank of Denver N.A., 511 U.S. 1164, 114 S. Ct. 1439, 128 L. Ed. 2d 119 (1994). There, the United States Supreme Court substantially limited liability of attorneys, accountants and others under any aiding and abetting theories. First Interstate Bank has been extensively distinguished and criticized. Recently, the District Court for the Southern District of Texas in Enron did an end run around Central Bank and found Enron accountants and financial officers to be subject to direct liability.

"A corporate official, acting with scienter, who on behalf of the corporation signs a document that is filed with the SEC which contains material misrepresentations, such as a fraudulent Form 10-K, regardless of whether he participated in the drafting of the document, 'makes' a statement and may be liable as a primary violator under § 10(b) for making a false statement."15 The Ninth Circuit explained that "by placing responsibility on corporate officers to ensure the validity of corporate filings, investors are further protected from misleading information." 16 Furthermore, "[k]ey corporate officers should not be allowed to make important false financial statements knowingly or recklessly, yet still shield themselves from liability to investors simply by failing to be involved in the preparation of those statements. Otherwise the securities laws would be significantly weakened. . . ."17

The SEC has attempted to make signatures on corporate documents that are filed with the SEC carry significant weight. Noting that the signature requirements for Form 10-K [in General Instruction D of Form 10-K and General *588 Instruction C of Form 10-KSB] were amended in 1980 to "enhance director awareness of and participation in the preparation of the Form 10-K information," the SEC has explained that "by signing documents filed with the Commission, board members implicitly indicate that they believe that the filing is accurate and complete."18

By imposing liability on officers and directors for direct participation even prior to Sarbanes, Enron is a harbinger of the harvest to come now that those directly involved in the audit process are so constrained by the Sarbanes mandate. Turning a blind eye and claims of ignorance now amount to an admission of culpability.

III. Breach of Fiduciary Duty

Sarbanes-Oxley will have an impact on state law claims for breach of fiduciary duty. Traditionally, directors and officers have been shielded from liability by the benign "business judgment rule." Absent conflict of interest, self-dealing or breach of loyalty, an officer's or director's actions or omissions would be shielded from liability if there was any reasonable basis for the same. In the usual case raising questions regarding discretion and business judgment, the actions of the directors and officers of a corporation, which are within their authority and are made in good faith, uninfluenced by any other consideration other than the best interest of the corporation, are not subject to challenge. The courts will not interfere with the discretion of directors so long as their discretion was exercised in a fair and honest manner.19

This long tradition of deference to directors and officers was shattered by the Delaware Chancery Court. In Caremark, officers of the health care services corporation were indicted for violations of federal law relating to prohibitions of kickbacks in awarding contracts for services. Although the officers and directors had internal controls in place for preventing such prohibited activity, derivative litigation ensued. While finding that the officers and directors had satisfied their duties, and in passing on a settlement of the litigation, the Delaware Chancery Court declaimed a new doctrine:

Obviously the level of detail that is appropriate for such an information system is a question of business judgment. And obviously too, no rationally designed information and reporting system will remove the possibility that the corporation will violate laws or regulations, or that senior officers or directors may nevertheless sometimes be misled or otherwise fail reasonably to detect acts material to the corporation's compliance with the law. But it is important that the board exercise a good faith judgment that the corporation's information and reporting system is in concept and design adequate to assure the board that appropriate information will come to its attention in a timely manner as a matter of ordinary operations, so that it may satisfy its responsibility.

Thus, I am of the view that a director's obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by non-compliance with applicable legal standards.

In re Caremark Litigation, 698 A.2d 959, 972 (Del. Chancery 1996).

Sarbanes, in effect, imposed Caremark duties on all reporting corporations as a matter of federal securities law. Internal controls are core compliance issues under the Act. It remains to be seen whether state courts in Missouri and throughout America will impose Caremark duties on the officers and directors of private corporations. On the one hand, it is axiomatic that promoting respect and compliance with the law is an essential aspect of not just our system of law, but our civilization. To impose a fiduciary duty upon officers and directors to take reasonable steps to ensure corporate activities conform to law seems a minimal requirement for those who choose to do business in a corporate entity. However, imposing the same duties on the officers and directors of private corporations as on public corporations with access to the public capital market may discourage small business formation and job creation. The corporate entity has been and will continue to be a vital component of our industrial engine, from the first industrial revolution to the technology boom. Reconciling the rule of law with the free market both in public corporations and private has been, and will continue to be, a flashpoint of public policy and litigation. Already the availability and cost of insurance of officers and directors has skyrocketed.

IV. Whistle Blower Liability

Sarbanes-Oxley will impact the traditional termination at will doctrine followed by many states, including Missouri, under which non-contract employees may be terminated at any time. Sarbanes- Oxley explicitly created a private right of action. Section 806 of the Act. No company registered under Section 12 or reporting under Section 15 (d) of the Securities Exchange Act "may discharge, demote, suspend, threaten, harass or in any manner discriminate against any employee when the employee provides information to or otherwise assists in an investigation by a federal regulatory or law enforcement agency, any Member of Congress or any committee of Congress or any person with supervisory authority over that employee."20 An aggrieved employee may seek relief by filing a complaint with the Department of Labor. If the secretary has not issued a final decision within 180 days, the employee may file an action in law or equity in the United States District Court seeking reinstatement, back pay with interest and compensation for any "special damages," including costs, expert witness fees and reasonable attorneys fees.21 Further, knowing retaliation against whistleblowers for providing truthful information to law enforcement authorities may be fined and/or imprisoned for not more than ten years.

Obviously the creation of a private right of action trumps Missouri's general rule that an employee may be discharged at will and adds significant quiver in the arrow of an advocate representing the discharged employee of a public corporation.

V. Conclusion

Sarbanes-Oxley significantly changes the superstructure of the federal securities laws and the rules of engagement for litigation under both the 1933 Securities Act and the 1934 Securities Exchange Act. However, no United States Circuit Court of Appeals has ruled on a case involving the Act. While this article has touched on some of the litigation implications of the Act, no one can delineate all the consequences which only practical experience and common law jurisprudence will illuminate.

ENDNOTES

1. This Act, referred to in text, means the Sarbanes-Oxley Act of 2002, Pub. L. 107-204, July 30, 2002, 116 Stat. 745, which enacted this chapter [15 U.S.C.A. § 7201 et seq.], 15 U.S.C.A. §§ 78d-3, 78o-6, and 78kk, and 18 U.S.C.A. §§ 1348 to 1350, 1514A, 1519, and 1520, amended 11 U.S.C.A. § 523, 15 U.S.C.A. §§ 77h-1, 77a, 77t, 78c, 78j-1, 781, 78mm, 78o, 78o-4, 78o-5, 78p, 78q, 78q-1, 78u, 78u-1, 78u-2, 78u-3, 78ff, 80a-41, 80b-3, and 80b-9, 18 U.S.C.A. §§ 1341, 1343, 1512, and 1513, 28 U.S.C.A. § 1658, and 29 U.S.C.A. §§ 1021, 1131, and 1132, enacted provisions set out as notes under 15 U.S.C.A. §§ 78a, 78o-6, 78p, and 7201, 18 U.S.C.A. §§ 1341 and 1501, and 28 U.S.C.A. § 1658, and amended provisions set out as notes under 28 U.S.C.A. § 994.
2. 15 U.S.C. 7211(a).
3. 18 U.S.C. 1350(a).
4. 18 U.S.C. 1350 (b).
5. 15 U.S.C. 7262.
6. 28 U.S.C. 1658 (a).
7. 28 U.S.C 1658 (b).
8. 18 U.S.C. 1514A.
9. 18 U.S.C. 1513.10. 15 U.S.C. 78u-4 (b)(1).
11. 15 U.S.C. 78u-4 (b) (2).
12. See Hoffman v. Comshare, Inc. (In re Comshare, Inc. Sec. Litig.), 183 F.3d 542, 550 (6th Cir. 1999) (holding that evidence of "recklessness" still suffices to prove scienter); In re Advanta Corp. Sec. Litig., 180 F.3d 525, 535 (3rd Cir. 1999) (holding that evidence of "recklessness" still suffices to prove scienter); Press v. Chemical Inv. Serv. Corp., 166 F.3d 529, 538 (2nd Cir. 1999) (holding that evidence of "recklessness" still suffices to prove scienter).
13. Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1283 (11th Cir. 1999).
14. Bryant, 187 F.3d at 1284.
15. Howard v. Everex Systems, Inc., 228 F.3d 1057, 1061 (9th Cir. 2000), citing AUSA Life Ins. Co. v. Dwyer (In re JWP Inc., Sec. Litig.), 928 F. Supp. 1239, 1255-56 (S.D.N.Y. 1996) (holding that a director who signs a fraudulent Form 10-K with scienter can be liable as a primary violator for making a false statement under § 10 (b)), and F.N. Wolf & Co., Inc. v. Estate of Neal, No. 89 Civ. 1223(CSH), 1991 WL 34186, at 8 (S.D.N.Y. Feb. 25, 1991) (holding that a "director signing a document filed with the SEC ... 'makes or causes to be made' the statements contained therein" under § 18(a) of the 1934 Act). See also, In re Cabletron Systems, Inc., 311 F. 3d 11, 40 (1st Cir. 2002); In re Reliance Sec. Litig., 135 F. Supp.2d 480, 503 (D. Del. 2001); In re Indep. Energy Holdings PLC Sec. Litig., 154 F. Supp.2d 741, 767 (S.D.N.Y. 2001), abrogated on other grounds, In re Initial Public Offering Sec. Litig., 241 F. Supp.2d 281 (S.D.N.Y. 2003); In re Lernout & Hauspie Sec. Litig., 286 B.R. 33, 37 (D. Mass. 2002) (signatures of three members of the Audit Committee on statements filed with the SEC "satisfy the requirement that defendants make a fraudulent statement" for liability under § 10(b)); In re Lernout & Hauspie Sec. Litig., 230 F. Supp.2d 152, 163 (D. Mass. 2002) ("It is well established in this Circuit that each defendant may be held responsible for the false and misleading statements contained in the financial statements he signed [under § 10(b) ]," citing Serabian v. Amoskeag Bank Shares, Inc., 24 F.3d 357, 367- 68 (1st Cir. 1994)).
16. Howard, 228 F.3d at 1061.
17. Id. at 1062.
18. "Audit Committee Disclosure" (S.E.C. Release No. 41987), 1999 WL 955908 at *29 n. 57, *9 (Oct. 7, 1999). In re: Enron Corporation Securities, Derivative, & ERISA Litigation, 285 F. Supp. 586-588 (S.D. Tex. 2003).
19. Iron Product Company v. Samuel, 17 S.W.3d 566, 573 (Mo. Ct. App. 2000).

ABOUT THE AUTHOR

L. Steven Goldblatt is the principal of the Goldblatt Law Firm in Clayton. Mr. Goldblatt is licensed in all the state and federal courts in Missouri, Illinois and California. He is also licensed as a Series 24 Securities Principal with the NASD. Mr. Goldblatt has represented customers, broker-dealers and issuers in federal court litigation and arbitrations throughout the United States. He received the Bar Association of St. Louis President's Outstanding Service Award for 2001-2002. Mr. Goldblatt is a 1979 graduate of Stanford University Law School and clerked for Judge Rendlen of the Missouri Supreme Court from 1979 to 1980.