Guest column by Adam Pritchard, the Frances and George Skestos Professor of Law at the University of Michigan Law School. On Thursday, November 20, Prof. Pritchard will be speaking on the topic of “Reforming Securities Class Actions” at the University of Chicago.
I recently wrote about the power of shareholders to waive the FOTM presumption of reliance (see the op-ed here and the fuller explication here) through the Rule 14a-8 process. The proposal is relatively straightforward: companies could amend their articles of incorporation to effect a partial waiver of the FOTM presumption of reliance in Rule 10b-5 cases. The waiver would be partial because shareholder-plaintiffs could still collect disgorgement damages from officers and others who violated Rule 10b-5. And shareholder-plaintiffs who could allege actual reliance on a material misstatement would be unaffected. They would still be allowed to collect compensatory, “out of pocket” damages. Nonetheless, the potential damages available in securities class actions would be substantially scaled back. The proposal’s targeted scaling back of damages has two virtues: (1) it eliminates the “pocket shifting” problem of shareholders compensating shareholders in securities class actions; and (2) it focuses deterrence on the actual wrongdoers. No one has seriously questioned these two advantages. Instead, the question I get most frequently is: Does § 29 of the Exchange Act allow shareholders to do this?
Section 29 voids “[a]ny condition, stipulation, or provision binding any person to waive compliance with any provision of this title or of any rule or regulation thereunder.” What does it mean to “waive compliance” with the Exchange Act? Read broadly, any provision affecting the enforcement of a right under the Exchange Act could be deemed as waiving compliance. The Supreme Court, however, has not read § 29 that way. The Supreme Court, rejecting a challenge to mandatory arbitration in Shearson/American Express, Inc. v. McMahon, 482 U.S. 220, 228 (1987), said: “By its terms, § 29(a) only prohibits waiver of the substantive obligations imposed by the Exchange Act.” The Court concluded that § 27 of the Exchange Act, which gives federal courts jurisdiction over Exchange Act claims, was not a substantive obligation.
It is hard to see my proposal as waiving the substantive obligation of Rule 10b-5. The corporation would still be subject to the enforcement mechanisms established by Congress in the Exchange Act: SEC enforcement actions and Justice Department criminal prosecutions. The government does not need to prove reliance, so those suits would be unaffected. In addition, the corporation would continue to face civil liability for compensatory damages to shareholder-plaintiffs who allege actual reliance. In addition to these government actions and private cases alleging actual reliance, officers who make material misstatements would also face FOTM lawsuits for disgorgement of their benefits from the fraud.
Moreover, it is difficult to see the private right of action that courts have implied under Rule 10b-5 as a substantive obligation of the Exchange Act. In § 29, Congress barred waiver of “any provision of [the Exchange Act] or of any rule or regulation thereunder.” The Rule 10b-5 private cause of action is not found in the Exchange Act, or any rule adopted by the SEC. It has been conjured up by the judiciary as a remedy for violations of the substantive obligation of the Act, which is the antifraud duty imposed by § 10(b). By contrast, an amendment that attempted to limit damages for §§ 11 or 12 of the Securities Act would be much more problematic. In those provisions, Congress not only created an explicit private cause of action, it specified the measure of damages. As it happens, the measure that Congress specified there – depriving the wrongdoer of the benefit from the fraud – tracks the disgorgement measure of my proposal.
Still more remote from the obligations created by the Exchange Act is the FOTM presumption created by the Supreme Court in Basic, Inc. v. Levinson, 485 U.S. 224 (1988). The Court was relatively modest in its claims for the presumption: “The presumption of reliance employed in this case is consistent with, and, by facilitating Rule 10b-5 litigation, supports the congressional policy embodied in the 1934 Act.” Note that the Court did not pretend that the FOTM presumption was in any way mandated by the Exchange Act; such an argument would have been specious when dealing with an implied right of action. So at most, the argument would have to be that my proposed partial waiver is inconsistent with the purposes of the Exchange Act. This is pretty thin; the current pocket shifting regime does little to deter officers from violating Rule 10b-5, and my proposal promises to add some real teeth to private causes of action by putting officers on the hook for damages in a practical, rather than theoretical, way.
Perhaps the best way of understanding the proposal is as a means of ex ante rebutting the presumption of reliance. The Basic Court took pains to stress that the presumption could be rebutted by “[a]ny showing that severs the link between the alleged misrepresentation and … his decision to trade at a fair market price, will be sufficient to rebut the presumption of reliance.” My proposal severs that link. By waiving the FOTM presumption of reliance in the articles of incorporation, shareholders will be putting future purchasers of the company’s stock on notice that they cannot rely on that presumption to collect out-of-pocket damages. If courts are to be faithful to Basic, they have to faithful not only to its presumption, but also the means that it provided for rebutting that presumption.
It is quite possible, as some have suggested, that the SEC will oppose my proposal. But for that opposition to be effective, it has to have some basis in law. If the SEC allows companies to exclude my shareholder proposal from their proxy statements, shareholders are still entitled to have a court decide the question. In that forum, the SEC’s views will not be dispositive. The Supreme Court left little doubt last term in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 128 S.Ct. 761 (2008), that it viewed the implication of the private right of action under Rule 10b-5 as a mistake. The Court showed a willingness to mitigate the effects of its reliance decisions in Stoneridge. The question that remains after Stoneridge is who has the power to undo the most costly damage flowing from the judicial invention of a private right of action under Rule 10b-5. The SEC has that power – it could amend Rule 10b-5 to fix the damages measure – but it has declined to exercise it. Will the courts allow the SEC to use § 29 to block shareholders’ efforts to fix the problem? Those of us hoping for change in securities class actions are optimistic that the courts will side with shareholders over the SEC and its allies in the plaintiffs’ bar.