Congress should not repeal the Private Securities Litigation Reform Act.

• Author: Pritchard, Adam C.
• Position: Law & Justice

THE ENACTMENT of the Private Securities Litigation Reform Act of 1995 (PSLRA) was a victory for accountants, securities firms, and the high-technology industry, who were frequent targets of securities fraud class actions. Subsequent events have substantially diminished the lobbying clout of these industries. Arthur Andersen's involvement in the accounting legerdemain at Enron and its subsequent criminal conviction have discredited the accounting industry as a whole. Incriminating emails from Merrill Lynch, Credit Suisse First Boston, and Salomon Smith Barney suggest that the stock picks that brokers offer their clients may be little more credible than the pitch of the average used-car salesman. The collapse of the high-tech bubble erased 4.3 trillion dollars in market capitalization from the NASDAQ. Those developments have left multitudes of angry investors in their wake.

Opponents of securities fraud class action reform--i.e., the class action bar--see Enron, Worldcom, and the host of lesser scandals that have followed as their great chance to undo securities litigation reform. The Enron fiasco, the plaintiffs' lawyers claim, shows that the curbs on abusive lawsuits created by the PSLRA give corporations carte blanche to engage in fraud. William Lerach, dean of the class action bar, labels PSLRA the "Corporate License to Lie Act." Bills have been introduced in Congress that would repeal its critical provisions.

Evidence does not support repealing PSLRA. In fact, securities class actions are getting filed at a record pace. Although a higher percentage of these lawsuits are being dismissed than prior to the act, the ones that survive lead to larger settlements. The combination of higher settlements in a smaller percentage of cases suggests that the class action lawsuits under PSLRA deterring corporate fraud are more cost effective. This conclusion is bolstered by the fact that post-PSLRA complaints have more delineated allegations that are more highly correlated with factors related to fraud.

Why do we worry about corporate fraud? Most conspicuously, fraud may influence how investors direct their capital. Firms selling securities disclose more information in an effort to attract investors. If those disclosures are fraudulent, investors will pay an inflated price for those securities and companies will invest in projects that are not cost-justified. That risk of fraud will lead investors to discount the value of securities, thus raising the cost of capital for publicly traded firms.

The U.S. scheme of securities regulation deploys a variety of countermeasures to discourage fraud, Reputable accounting firms audit financial statements. Audit committees of outside directors oversee company disclosures. Analysts rate them for credibility and completeness. In addition to those market mechanisms, fraud is further monitored by Securities and Exchange Commission (SEC) enforcement and criminal prosecutions by the Justice Department. Class actions promise additional deterrence as well as compensation to the victims of fraud. That promise of compensation--and the enormous damages necessary to fulfill that promise--strikes genuine fear into the hearts of corporate executives. Yet, the potential for large damages undermines the regulatory value of securities fraud class actions.

Compensation is important when the corporation has been selling securities through fraud, correcting fraud's distortions in two ways. First, requiring compensation to the victim discourages the corporation from committing the fraud. Second, compensation discourages investors from expending resources trying to avoid fraud. Expenditures by both the perpetrator and the victim due to fraud are a social waste, so compensation makes sense in that context. The Federal securities laws encourage such fraud suits with a generous standard for recovery. Despite that encouragement, claims asserting a misrepresentation made by a company in connection with an offering of securities are just a small percentage of securities class actions.

The overwhelming majority of securities fraud class actions do not...