Sarbanes-Oxley Section 501(a): No Implied Private Right of Action, and a Call to Congress for an Express Private Right of Action to Enhance Analyst Disclosure

• Author: Louis E. Ebinger
• Position: J.D., The University of Iowa College of Law, 2008
• Pages: 02

J.D., The University of Iowa College of Law, 2008; M.B.A., The University of Iowa Tippie School of Management, 2008; B.A., Georgetown University, 1998. I give a special thanks to Professor Hillary Sale for her suggestions about the subject matter of this Note and for providing guidance throughout my law school career. I am grateful as well for the efforts of the editors and writers of Volumes 92 and 93 of the Iowa Law Review. Finally, I thank my wife, Rebecca, for her love and support throughout this endeavor. Page 1921

I Introduction

Crystal Ball is a securities analyst for Bulge Bracket, Inc., a large investment bank. Ball specializes in evaluating technology stocks. One company that Ball covers is ZipChip, a semiconductor company whose stock is publicly traded. In the course of her recent evaluation of ZipChip, Ball determines that the market for semiconductor business is becoming quite crowded; price competition is intensifying. While ZipChip was once a promising buy, the window for big profits and new clients has long since closed for the company. In short, ZipChip is a dog of a stock.

As a result, Ball is fully prepared to downgrade ZipChip from her current "hold" recommendation and issue a "sell" recommendation for the stock. But Ball pauses momentarily: if she were to issue this recommendation, would she be damaging Bulge Bracket's attempts to win ZipChip's business if ZipChip were to receive buyout offers in the future? What are Bulge Bracket's current trading positions in ZipChip stock? Does she or a member of her family own stock in ZipChip? What are Ball's chances of getting a return phone call from an officer or director of ZipChip in the future if the company's fortunes change? What about her relationship with officers of the other companies who read her report?

This hypothetical situation demonstrates the different sources of pressure that a "sell-side" securities analyst faces, particularly when that analyst finds herself in the position of being the messenger of bad news about a stock.¹ Congress, the Securities and Exchange Commission ("SEC"), Self-Regulatory Organizations ("SROs"), and Bulge Bracket itself all require Ball to disclose any interest that she has in the outcome of her recommendations. This Note discusses the current state of those analyst disclosure requirements, and whether they effectively deter the analyst from misleading the investor. This Note proposes that Congress expressly include individual investors in the enforcement of those requirements.

Section 501(a) of the Public Accounting Reform and Investor Protection Act of 2002 ("Sarbanes-Oxley") requires the SEC to enact rules to help prevent securities analysts from publishing false research reports.²Sarbanes-Oxley also encourages rulemaking designed to enhance analyst Page 1922 disclosure by the two SROs-the New York Stock Exchange ("NYSE") and the National Association of Securities Dealers ("NASD").³

The SEC subsequently adopted Regulation Analyst Certification ("Regulation AC").⁴ Among other requirements, Regulation AC demands that a securities analyst like Ball certify that she did not receive any compensation linked to her recommendations in the research report.⁵Alternatively, if Ball is being paid to recommend a stock, Regulation AC requires her to document the details of that compensation in her report.⁶The SROs also made or amended rules of their own; for example, the NASD adopted Rule 2711, which included similar disclosure requirements for analysts.⁷ The NASD also went a step further by preventing any member broker-dealer from paying "any bonus, salary or other form of compensation to a research analyst that is based upon a specific investment banking services transaction."⁸ Similarly, the NYSE amended its Rule 472 to require analysts to disclose the nature of their financial interest in their reports, "including whether the interest consists of any option, right, warrant, futures contract, or long or short position, etc."⁹

How shall these rules be enforced? Section 501(a) of Sarbanes-Oxley is silent as to the question of whether investors can sue securities analysts for damages stemming from false certifications.¹⁰ This congressional silence raises the question: Will courts imply a private right of action in section 501(a), allowing investors to institute class-action lawsuits against offending analysts and their employers? The lack of congressional intent in section 501(a) to create a separate, implied private right of action makes this unlikely. Additionally, courts have interpreted a separate section of Page 1923 Sarbanes-Oxley as lacking an implied private right of action, thus making section 501(a) ripe for analogy.¹¹

Like Sarbanes-Oxley, Regulation AC does not provide any new methods for sanctioning untruthful analysts.¹² Academics have criticized both Regulation AC and Sarbanes-Oxley for not effecting any meaningful reform, in spite of Sarbanes-Oxley's creation of the Public Company Accounting Oversight Board and provisions to increase funding for the SEC.¹³ It seems that the only option available to private investors both before and after the enactment of Sarbanes-Oxley and its progeny is suing under the fraud provisions of the federal securities laws.¹⁴ One prominent commentator has suggested, however, that fraud claims would be difficult to prove in this context.¹⁵ The SEC also punishes fraudulent behavior by issuers and broker-dealers, just as it did before Sarbanes-Oxley.¹⁶

This set of rulemaking arose from a wave of public frustration toward analysts who covered stocks dishonestly.¹⁷ But do these rules represent systemic changes that will persist beyond the sense of dissatisfaction that led to the creation of the rules? This Note argues that they do not, and in turn asks Congress to adopt an express private right of action for investor clients who are misled by an analyst's nondisclosure. This Note does not argue that the SEC should impose liability for substantive buy/sell recommendation errors,¹⁸ nor does it argue that analysts cannot ever be interested in the Page 1924 outcome of their recommendations; rather, in keeping with the SEC's disclosure-focused approach,¹⁹ analysts and their employers should be directly accountable to their investor clients for failing to disclose material interests in the outcome of their recommendations.

Admittedly, giving individual investors the right to sue analysts for nondisclosure is an aggressive solution. But congressional action to further incentivize analyst disclosure is proper because disclosure is far less difficult than defending a lawsuit, while the effect of nondisclosure can be extremely damaging to the firm's clients.

While many commentators place the securities analyst in a dispassionate role, others have suggested that rather than attempting to de-conflict every aspect of the analyst's job, it is sometimes better to view analyst research as sales material.²⁰ However, equity salespeople already perform the proper function of selling stocks to benefit the business of the firm; the role of the analyst is to be a professional market-watcher.²¹ But unlike lawyers, who exist in an adversarial system and whose clients risk suffering a zero-sum loss if their counsel is conflicted, securities analysts square off against a market that can discount an analyst's recommendation to the extent that the analyst is conflicted.²² one empirical study has shown this market-discounting effect.²³Because markets function efficiently to discount for analyst conflicts, the most important enforcement mechanism to protect investors should be disclosure. Analysts and their employers, then, should be subjected to individual lawsuits for nondisclosure about where the analysts stand in relation to their recommendations.

Part II of this Note provides a brief background of the role of the securities analyst, Sarbanes-oxley, and the implied private right of action doctrine. Part III tracks the history of the implied private right of action Page 1925 doctrine in the "era of contraction."²⁴ Part IV examines a recent decision denying an implied right of action in another section of Sarbanes-oxley and concludes by analogy that courts likely will not imply a private right of action in section 501(a) of the Act. Lastly, Part V proposes that Congress should enact an express private right of action to incentivize analyst disclosure and to more effectively enforce the regulatory changes in Sarbanes-oxley, Regulation AC, and the SRO rules.

II Background

A The Role of the Analyst

For a student of the legal system, the securities analyst's job is peculiar. Lawyers are trained to ensure that protected information from previous clients does not give them unfair advantages in the representation of current clients.²⁵ Conflicts of interest poison the system, and serve as the basis for malpractice lawsuits. Conversely, the securities analyst best serves his...