Corporate Governance

Restoring American Financial Stability Act of 2009: Repealing the PSLRA

By J. Robert Brown

The Private Securities Litigation Reform Act was a severe response to congressional dislike for securities class action fraud suits.  Congress sought to restrict the suits in part by imposing exceedingly tough pleading standards.  Thus, a complaint would be dismissed unless plaintiffs alleged a "strong inference" of scienter.  See 15 USC 78u-4. 

The problem of course was that tougher pleading standards had little to do with the merits.  They simply resulted in the dismissal of cases where plaintiffs could not meet the pleading standards prior to discovery, irrespective of the merits of the fraud allegation.  Plaintiffs would bring fraud actions not whenever fraud occurred but whenever they could meet the toughened pleading standard.  Thus, for example, fraud actions were easier to bring if accompanied by suspicious trading by insiders.  Absent such facts, the fraud might escape recourse. 

In the American Financial Stability Act, Section 932 shifts the pendulem back, at least for private actions against rating agencies.  The legislation would define a "strong inference" of fraud where a rating agency: 

• knowingly or recklessly failed—(i) to conduct a reasonable investigation of the rated security with respect to the factual elements relied upon by its own methodology for evaluating credit risk; or (ii) to obtain reasonable verification of such factual elements (which verification may be based on a sampling technique that does not amount to an audit) from other sources that it considered to be competent and that were independent of the issuer and underwriter.

First, the provision would effectively codify the reckless standard for fraud actions, something that all circuits have held but the Supreme Court has left open.  Adoption of this provision would make it harder for the Court to find recklessness insufficient.

Second, the provision looks to weaken the "strong inference" standard.  It would likely not be hard to find someone inside a rating agency who knew that the investigation was inadequate, meeting the state of mind requirement for a fraud action against the agency.  Moreover, to the extent repeated by the CEO/CFO, he or she could easily be considered reckless for not knowing about the inadequacy of the inspection. 

This can be contrasted with those courts that have held that the certification of internal controls by the CEO/CFO will not automatically be deemed to be evidence of scienter where the controls are later shown to be inadequate. See, e.g. Horizon Asset Mgmt. v. H&R Block, Inc., 580 F.3d 755, 765-66 (8th Cir. 2009).  In other words, the fact that controls are inadequate is not attributed to the company or its officers as a means of showing scienter.  In Section 932, however, Congress seems to be allowing the inadequacy of the investigation of itself to be sufficient to establish scienter.  That would be a change in the law. 

In the meantime, the bill and a summary are posted at the DU Corporate Governance web site.

SEC. 932. STATE OF MIND IN PRIVATE ACTIONS.

Section 21D(b)(2) of the Securities Exchange Act of 1934 (15 U.S.C. 78u–4(b)(2)) is amended—

(1) by striking ‘‘In any'' and inserting the following:
(A) IN GENERAL.—Except as provided in subparagraph (B), in any''; and

(2) by adding at the end the following:
(B) EXCEPTION.—In the case of an action for money damages brought against a nationally recognized statistical rating organization under this title, it shall be sufficient, for purposes of pleading any required state of mind in relation to such action, that the complaint state with particularity facts giving rise to a
strong inference that the nationally recognized statistical rating organization knowingly or recklessly failed—
(i) to conduct a reasonable investigation of the rated security with respect to the factual elements relied upon by its own methodology for evaluating credit risk; or
(ii) to obtain reasonable verification of such factual elements (which verification may be based on a sampling technique that does not amount to an audit) from other sources that it considered to be competent and that were independent of the issuer and underwriter.

Full post as published by The Race to the Bottom on November 28, 2009 (boomark / email).