Public Policy Analysis & Opinion
By Kevin P. Hennosy
OWNERSHIP AND CONTROL AND RISK
Another spike in securities class action suits demonstrates the need to restore SEC power
In1932, Adolf Berle and Gardiner Means published a book with the sexiest of all titles: The Modern Corporation and Private Property. (Fear not, gentle readers, Rough Notes remains a family-friendly magazine!)
The book became a seminal work in American business law, and the authors published an updated edition in 1967.
Berle and Means made a startling observation about the nature of private property and the change that the corporation brought in the former. The authors observed that the modern corporation separated ownership from control of property, where traditionally private property integrated ownership with control through accepted customs and norms.
According to Berle and Means, the modern corporation created two interest holders in private enterprise where only one interest existed under sole proprietorships and partnerships. This separation of ownership and control created independent interests for those who hold ownership and those who wield control of corporate property.
A restoration of resources and fighting spirit to the SEC, along with a true modernization of its authority, would go a long way toward mitigating the risk of financial loss.
In sole proprietorships or partnerships, ownership and control remained integrated into a profit seeking union, which remained sensitive to competition, some social norms related to competition, and the risk of loss.
State legislatures originally chartered corporations to encourage private investment in a public project such as a turnpike, canal, or insurance company. The charter limited the investors’ liability for financial loss to the amount of money they invested in the enterprise, which presented significantly less risk than sole proprietorships or partnerships.
One does not find provisions in those charters stating that corporations should be run in the shareholders’ interest. The limit of liability was the only sweetener offered to the investor. In the Dartmouth College v. Woodward case (1819), the seminal Supreme Court decision in American corporate law, Chief Justice John Marshall did not impose on corporations a duty to consider shareholder interest.
Berle and Means observed that stockholders possessed an ownership interest, while the directors and officers held an interest based on control of the corporation’s property and operations. According to Berle and Means, the separation of ownership and control changed the essence of private property.
If the essence of property changed with the separation of ownership and control, then the risk of loss changed as well. Shareholders and management developed different and sometimes competing senses of risk.
Of course, when such differences exist, lawyers get involved in the relationship. Berle and Means expressed the belief that stockholder litigation was one means for “ownership” to restore control over a corporation’s management.
The arguments presented in The Modern Corporation and Private Property were highly influential as the New Deal responded to the stock market manipulations that aggravated the Great Depression.
The Securities Act of 1933 and the Securities Exchange Act of 1934 established statutory provisions aimed at inhibiting fraud-based speculation in financial markets. The 1934 law also created the Securities and Exchange Commission (SEC) to bring civil and criminal actions against those who broke the rules.
For most of the 20th century, the SEC played that role with vigor. Its actions created the kind of abyss that Berle and Means called for to provide counterincentives to fraud in the securities sector.
If an investor or whistleblowing executive wanted to correct a situation, a complaint to the SEC was an effective means to seek redress. Offenders went to prison, and SEC civil settlements provided a solid disincentive for “skating near the edge” of violations.
Since the early 1980s, administrations from both political parties have tamed the once-fearsome SEC. The kind of complaint that once brought a blizzard of enforcement actions became moot after deregulation made wrongdoing difficult to prove. New forms of trading that made oversight difficult further reduced the deterrent power of the SEC. Finally, political leaders appointed less aggressive senior personnel to the SEC because they did not want to “bite the hands” that wrote checks to campaign committees.
The withdrawal of the SEC as a vigorous enforcer left a power vacuum. Parties who felt a sense of injustice began to seek private methods to strike back at activities that caused anxiety.
In the late 1980s, private insurers saw a sharp spike in the number and size of settlements arising from Securities Class Action (SCA) lawsuits.
It is not easy to find a level-headed discussion of SCAs. People who know about SCAs tend to congregate in one of two pre-modern tribal groups. Members of one group cross a hilltop ridge and encounter members of the other group, then raucous noise and acts of intimidation precede violent outbursts.
Pursuant to the Federal Rules of Civil Procedure, aggrieved investors who bought or sold the securities issued by the offending firm can bring class actions. In instances where the violation concerns misleading statements or omissions, a “class period” begins at the time when the issuer distributes a false or misleading statement, or should have provided truthful information, and the period closes upon the release of a “corrective disclosure.”
In 1995, Congress passed the Private Securities Litigation Reform Act (PSLRA) over a presidential veto. The act established preference for investors who suffered the largest losses in a scheme to assume the role of lead plaintiff in federal class action suits—usually institutional investors. This law reduced the number and size of class action settlements. In most instances of violation-driven losses, institutional investors used portfolio monitoring to identify problems and seek redress.
In 2018 the U.S. Supreme Court decision in Cyan Inc. v. Beaver County Employees Retirement Fund opened a litigation door to state courts. Of course, state jurisdictions are outside the jurisdiction of the PSLRA framework.
Readers may be interested in a report titled From Nuisance to Menace: The Rising Tide of Securities Class Action Litigation, published in 2018 by the Chubb Group.
With access to state courts and state juries, investors, aided by plaintiffs’ lawyers, have caused a rapid increase in the number of suits brought and the size of settlements granted.
Where’s the beast?
From this commentator’s perspective, the Chubb report spends a “wee dram” too much time berating plaintiffs’ lawyers. I think the report writers fell into a rhetorical trap that is all too common in the insurance sector.
After working in and around insurance for more than 35 years, I have never met a plaintiffs’ lawyer who could be described as “fire-breathing,” “blood-sucking,” or a “savage beast.” I have read about these brutes in many pieces of legislative testimony. I have heard these giants denounced from convention discussion panels and political platforms. Yet, like Bigfoot, no one has ever captured one.
If a candidate or consumer group asks a plaintiffs’ lawyer for a contribution, or a dissatisfied consumer asks for representation, often the answer is, “no.” Plaintiffs’ lawyers prefer to operate in packs. They enjoy a reputation for being powerful fundraising sources, but they are slow to reach for their checkbooks. They usually wait for the local trial lawyers’ association to target a campaign or cause for giving before they contribute, so they can get some association credit for their contribution.
In fact, most plaintiffs’ lawyers I have met seem downright lazy. They tend to take cases that meet their pre-drawn blueprints. In my experience, the last thing a plaintiffs’ lawyer wants to do is break new ground, which would require research, creativity, and devotion to a cause. One can see the plaintiffs’ bar as preferring to gather windfall harvests off the ground rather than to climb a ladder and pick fruit from the tree.
That said, when plaintiffs’ lawyers find a legal strategy or tactic that can harvest settlement money and legal fees, they will use it as many times as they can until the “machine stops opaying.”
Here I am on one of those tangents again!
The insurance sector and the plaintiffs’ bar remind me of conjoined twins who share internal organs but hate each other. Without plaintiffs’ lawyers, fewer insurance policies would be sold. Without insurance companies, fewer vacation homes at the shore would be built. In the words of Rodney King, “Can’t we all just get along?”
What’s the risk?
As a young employee of Nationwide Insurance, I heard a presentation made to the government relations staff that explained the need for state laws prohibiting the use of gasoline-powered heaters. The presentation showed how the heaters presented a fire risk to residences and small businesses. The presenter argued that the company should reduce fire risk by lobbying for a ban on those furnaces. We focused on the risk of financial loss.
Too often, even steely-eyed commentators look past the ways to mitigate the risk of loss: in this case, the shenanigans that pass for business practice in the investment sector. The great game of finance is so rotten with “leverage” (i.e., debt) that securities issuers are hard-pressed to give investors accurate descriptions of securities in order to please creditors.
A restoration of resources and fighting spirit to the SEC, along with a true modernization of its authority, would go a long way toward mitigating the risk of financial loss. When fraudsters know they face likely prosecution, they might leave Wall Street and seek an exciting career in the arms trafficking sector.
The absence of the real bad guys would reduce the motivation of others to skate near the edge of violations. We could harmonize the separate interests of management and investors.
Kevin P. Hennosy is an insurance writer who specializes in the history and politics of insurance regulation. He began his insurance career in the regulatory compliance office of Nationwide and then served as public affairs manager for the National Association of Insurance Commissioners (NAIC). Since leaving the NAIC staff, he has written extensively on insurance regulation and testified before the NAIC as a consumer advocate.