An investor buys securities that turn out to be worthless. He sues for fraud, showing that the seller omitted critical facts in describing the offer. In court, the seller says “I forgot.” With that, he escapes responsibility.
A ludicrous notion? Not at all. It will be the law if a bill that reaches the floor of the House this week wins final passage. It is the latest installment of the Newt Gingrich Contract: HR 10, to change the country’s civil damage and securities law.
Title II is called the Securities Litigation Reform Act. That sounds like a measure full of technicalities, and it is. But it demands attention, because it would weaken the world’s best system for policing securities markets. It would “reform” many victims of fraud out of court.
The idea of excusing the maker of a fraudulent statement because he “forgot” the truth seems too far out for even the most zealous advocates of ripper legislation. But it is there in black and white.
Under the law as it stands today, an investor who sues for fraud must show that the defendant made a fraudulent statement “knowingly” or “recklessly.” The bill says a defendant can be found reckless only if his conduct presented a danger of misleading people so obvious that he “must have been consciously aware of it. For example, a defendant who genuinely forgot to disclose, or to whom disclosure did not come to mind, is not reckless.”
The “I forgot” defense is one among many examples of loopholes that this legislation would carve into securities law. The bill was much criticized as originally drafted. In committee the Republican majority amended some of the criticized sections - but put in new loopholes.
A victim who sued would have to provide, in his first court filing, specific alleged facts showing that the defendant knowingly or recklessly made fraudulent statements. It is very hard, indeed often impossible, for a plaintiff to know such things about the defendant’s state of mind before his lawyer has obtained documents and testimony in discovery.
This section of the bill adds that when a suit makes such a charge as representing the plaintiff’s belief, it must “set forth with specificity all information on which that belief is formed.” That seems designed to make the plaintiffs disclose the names of whistleblowers inside the defendant’s firm.
If the suit does not meet those initial requirements, the bill says, the judge shall dismiss it. The victim could then amend his complaint - but only once. That would be a devastating limitation. Complaints are often amended many times as new facts are discovered. There were six amended complaints in the suit against the great S&L; cheat Charles Keating and his accountants.
Accountants and lawyers would get special protection from this bill. Under present law, when a defrauding firm has no money to repay victims, they can recover their full losses from accountants and lawyers who knowingly or recklessly contributed to the fraud.
HR 10 would limit full recovery to cases where the lawyers or accountants were “knowing” in their misdeeds. Otherwise they would be liable only for a share proportionate to their responsibility for the loss.
Present law allows a purchaser of securities to sue for fraud even if he did not personally read the fraudulent statement. He may, for instance, have been urged to buy by a broker who had read the false statement. This is called “fraud on the market” liability.
The house bill would deny this protection to individuals who buy municipal bonds. They could sue for fraud only if they could prove that they had personally read and relied on a fraudulent statement - which not many ordinary buyers of bonds would have done. This provision might have blocked the pending lawsuits by holders of securities issued by Orange County, California.
It is a curious time to propose weakening of legal protections against securities fraud. The Orange County disaster and last week’s collapse of Barings are among many recent indications that protection is needed more than ever.
Many House Republicans must know that it is folly to strip securities law now: folly in common sense and in politics. Will they blindly follow their leaders and vote the wish list of securities fraud defendants?