Commentary: Don't Toss This Stock-Fraud Law. Just Fix It

By Dan Carney

When Congress made it harder to sue companies for stock fraud in 1995, critics predicted catastrophe. The new law, said Senator Joseph R. Biden (D-Del.), would "give corporations a license to lie." Added Representative John D. Dingell (D-Mich.): "It would encourage the worst kind of misbehavior by people of great wealth."

Now, Biden and Dingell are leading the "I-told-you-so" caucus. Along with consumer groups, plaintiffs' attorneys, and a growing contingent of fellow legislators, they're calling for the repeal of the Private Securities Litigation Reform Act (PSLRA). While there isn't yet enough support to eliminate the law, opposition is growing with each new scandal. "We are now seeing the horrible effects that this law is having," says Representative Bart Stupak (D-Mich.), who sponsored a repeal bill in February.

But though it may be tempting to eliminate the PSLRA, the law didn't create the current mess we're in. The threat of getting sued by plaintiffs' lawyers has never been the main force keeping executives in check. And in truth, the PSLRA has hardly killed investor lawsuits. During the five years preceding the passage of the measure, shareholders filed 948 suits. In the five after, there were 935. And cases filed since the law was enacted have yielded some of history's biggest settlements, including suits against Cendant ($2.8 billion), Waste Management ($456 million), and 3Com ($259 million).

Fact is, the PSLRA has done a pretty good job of weeding out abusive lawsuits while allowing meritorious ones to go forward. One of the most controversial provisions of the law, back when it was under debate in 1995, was a provision raising the "pleading standards" for new lawsuits. It required plaintiffs' attorneys to provide much more detail about an alleged fraud before a judge would hear a case. But rather than slam the courthouse doors to innocent shareholders, as critics warned, this rule has simply forced investors' attorneys to bring better-researched cases. So the bottom line is basically that executives face just as much of a threat from securities-fraud litigation as they did before the 1995 law.

That's not to say the PSLRA is flawless. At a time when investors are suffering enormous losses, it goes too far in protecting the liability of the accountants, lawyers, and financiers who aid white-collar criminals. Under the PSLRA, these professionals are not, in most cases, on the hook for the full amount that shareholders lose. Rather, they are only "proportionately liable" for the percentage of losses directly attributable to their misconduct. That means that if a jury determined that Arthur Andersen LLP had, say, 25% of the responsibility for Enron Corp.'s collapse, the auditor would have to shell out a maximum of only one-quarter of the damages in a fraud suit--a special protection generally not afforded elsewhere in the U.S. legal system.

This provision may sound technical, but it significantly decreased the legal exposure of professionals who play a role in the commission of fraud. Prior to the PSLRA, accountants, lawyers, and investment bankers faced the prospect of holding the whole bag if a company they represented went bankrupt. Now, they face only a small fraction of that liability since the lion's share of blame for corporate failures is almost always assigned to the execs making the key decisions, not the outside advisers who help them. And don't think they're not aware of this when they give advice. "This has had an impact on their willingness to push closer to the edge," says Henry T.C. Hu, law professor at the University of Texas at Austin.

Restoring the old rule would surely make the hired hands that advise Corporate America take their watchdog roles more seriously. And given all we have learned about corporate misbehavior recently, that's a must. But Congress would draw the wrong lesson from the recent scandals--and the history of the PSLRA--if it decided to toss the legislation altogether.

Carney covers legal affairs from Washington.

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