Arbitration and reform in private securities litigation: dealing with the meritorious as well as the frivolous.

Author:Ramirez, Steven A.


An important debate is raging regarding the federal regulatory role in the securities markets. On one side of this debate are those arguing that private securities litigation is dominated by greedy attorneys who use protracted litigation to extort large settlements from legitimate business, imposing a pernicious "litigation tax" upon the cost of capital in America and flooding our courts;(1) on the other side are those arguing that private litigation is the only realistic means of enforcing federal regulation, that the American financial markets are widely perceived to be the fairest and most efficient in the world, and that there is little, if any, evidence that the system has been abused.(2) The stakes in this debate are huge.(3) American fortunes ride upon the success of our financial markets as never before because of increased international economic competition and important demographic trends.(4) Unfair financial markets are a breeding ground for panic.(5) Inefficient markets, like those that impose arbitrary costs upon capital, stunt economic growth.(6) Most importantly, the public must have confidence in the integrity of our financial markets in order to insure a stable and inexpensive source of capital for American business growth.(7)

Recently, those arguing in favor of restricting private enforcement of the federal securities laws have scored near-fatal restrictions in the scope of private remedies available under the federal securities laws. In late 1995, Congress enacted the Private Securities Litigation Reform Act of 1995 (PSLRA),(8) which restricted private claims generally and class actions in particular.(9) Congress enacted this legislation for the purpose of restricting "strike suits."(10) Congress viewed these suits as a threat to the ability of financial markets to finance start-up companies and generate jobs.(11) One notable effect of these "reforms" is that securities litigation has shifted to state courts.(12) Consequently, Congress has recently preempted state law claims when raised in class action suits involving publicly-held companies.(13) Perhaps the most critical effect of the PSLRA, however, is that it leaves private enforcement of the federal securities laws in near terminal condition.(14) This Article proposes an approach to resolving the tension between weeding out frivolous securities claims and permitting meritorious claims to proceed that neither side in this debate is likely to embrace.(15) Specifically, this Article proposes that private securities claims relating to public companies be arbitrated to the maximum extent possible.(16) Arbitration has a long and successful history in the securities broker-dealer industry, in which it is the dominant form of dispute resolution.(17)

Arbitration is capable of achieving rapid adjudications that undermine the possibility of extortionate settlements.(18) Arbitration can reduce defense costs(19) and permit meritorious claims to be resolved quickly by expert panels(20) at little or no net cost to taxpayers.(21) Most importantly, industry-sponsored arbitration in the securities broker-dealer industry under Securities and Exchange Commission (SEC) supervision provides investors with a fair process for the resolution of securities claims.(22) In short, arbitration can enhance the quality of justice available in this vital area as well as protect incipient capital formation from the costs of "strike suits." This Article recognizes that proposing an arbitration regime to resolve these claims raises a host of issues and it attempts to address the most important of these problems as well as to open a dialogue on alternative methods of resolving securities claims. This Article thus endeavors to begin a process. Indeed, one thesis of this Article is that lawmakers should proceed cautiously in addressing the proposal advanced here and implement any arbitration process in a gradual fashion in order to avoid unintended consequences. For example, the creation of a system of arbitration that becomes mired in litigation regarding its legitimacy would be counterproductive.

The Article concludes that Congress or the SEC should begin to implement an arbitration program that ultimately would require agreements to arbitrate all securities disputes involving publicly-traded companies before a SEC-sponsored forum. Under the authority and supervision of the SEC, arbitration of these disputes can be regulated and monitored to preserve substantive fairness while securing the benefits of arbitration, especially lower costs, speedier resolutions, and the elimination of frivolous claims.(23) This Article does not propose to modify the substantive law applicable to such disputes or to preempt any relevant state law. Rather, this Article posits that simply changing the way such disputes are resolved may enhance the quality of justice achieved, as well as eliminate abuses stemming from the pursuit of frivolous claims. Although no state law would be preempted, this Article does propose that an investor's ability to pursue state law remedies in state court be restricted pursuant to arbitration agreements. In other words, this Article proposes a more limited, less formal preemption than the proposal recently adopted by Congress. Investors could pursue all substantive claims, both state and federal, but only in arbitration.

Part I of this Article traces the evolution of private enforcement of the federal securities laws, including recent developments restricting private enforcement. Part I of the Article concludes that policymakers recently have given inadequate weight to the overall success of federal regulation of the securities markets and the role of private enforcement in that success. As a result, recent initiatives to restrict private enforcement expose our securities markets to unjustified risks of deregulation. On the other hand, the Article notes that frivolous lawsuits present other risks to the securities markets and should be deterred in a balanced manner.

Part II of this Article demonstrates that arbitration of securities-related claims against publicly-traded companies can be used to help extinguish frivolous suits while permitting private enforcement to function properly to remedy investor injuries and deter misconduct. First, the arbitration of securities claims in the context of broker-customer disputes provides a sound basis for concluding that arbitration can be an effective means of resolving disputes in this vital area. Second, there is now a wealth of knowledge regarding the efficacy of Alternative Dispute Resolution (ADR) that suggests that arbitration of these types of claims is a prudent policy course. Third, this mode of resolution is inimical to frivolous suits. Finally, both the SEC and Congress have broad powers to implement this kind of arbitration regime. The Article concludes that the SEC and Congress should take all necessary steps to encourage the development of a system of arbitration of securities-related claims involving publicly-held companies.


    Any discussion of the proper method of resolving private securities claims must begin with the historical basis of such litigation. Private securities litigation under federal securities laws is only a part of the overall enforcement of the federal regulatory regime.(24) This regulatory regime includes the imposition of registration requirements designed to achieve full disclosure of material facts to the financial markets,(25) the regulation of the securities brokerage industry,(26) and the prohibition of fraudulent conduct through the broad antifraud provisions of the federal securities laws.(27) Enforcement mechanisms consist of SEC civil enforcement proceedings and penalties,(28) including administrative sanctions,(29) criminal sanctions,(30) and the extension of private remedies to injured investors.(31) The broadest private remedy and antifraud provision is Rule 10b-5, which the SEC promulgated pursuant to statutory authority under the Securities Exchange Act of 1934 ("Exchange Act").(32) Although Congress has tightened this regulatory regime periodically, Congress had left its basic structure largely intact until it enacted the PSLRA.(33) Before that, this regulatory scheme had functioned successfully for over sixty years.(34)

    1. A Short History of Private Securities Litigation

      The federal role in securities regulation has its roots in the ultimate financial catastrophe--The Great Depression.(35) Shortly after taking office, as one of the earliest New Deal initiatives, President Franklin Roosevelt proposed legislation that ultimately became the Securities Act of 1933 ("Securities Act").(36) The Securities Act required the registration (and accompanying full disclosure) of initial distributions of securities.(37) The Securities Act focused only upon initial offerings of securities, therefore Congress enacted the Exchange Act, which provided for regulation of the securities industry and required periodic disclosure for publicly-held companies.(38) Roosevelt made clear that these acts were designed to heighten fiduciary obligations in securities transactions in order to restore public confidence in the nation's financial markets.(39) Congress joined the President in emphasizing the importance of investor confidence within a modern economic system.(40)

      The courts initially embraced the remedial nature of the federal securities laws and broadly interpreted their provisions to achieve those ends.(41) Further, the courts, as well as the SEC, recognized the crucial role of private securities enforcement proceedings as an essential supplement to the SEC's limited enforcement resources.(42) Indeed, in 1946, the federal courts began to imply private rights of action under the federal securities laws.(43) Since then, the Supreme Court has determined the existence of a private action under Rule 10b-5 to be "beyond peradventure,"(44)...

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