Not often in the 1990s have Republicans and Democrats come together to pass legislation of major importance to the nation's economy. A rare example is a law passed by bipartisan majorities of both houses of the Congress in December to limit frivolous lawsuits against high-growth companies. But even as the ink dries on the Private Securities Litigation Reform Act of 1995, a group of lawyers is plotting to reverse this hard-won consensus through an initiative on the California ballot in November, Proposition 211.
Last year's securities litigation reform followed years of testimony by executives of high-technology and other young, fast-growing firms that they were being harassed by a small, overzealous segment of the legal profession. These lawyers had found a way to capitalize on the inherent volatility of high-technology companies' stock prices by alleging fraud on the part of a firm's officers and directors following a stock price decline. Because of the considerable time and expense involved in fighting these suits, companies often found it in their interest to settle them irrespective of their merits.
By the 1990s, such lucrative legal tactics had begun to impede the pace of innovation, capital formation, and growth in one of the most important sectors of the U.S. economy, particularly in California. This problem was among several concerning the allocation of private capital in the U.S. economy examined by a diverse panel of experts convened by the Competitiveness Policy Council, a bipartisan federal advisory commission that focuses on improving the nation's living standards and international competitiveness. The panel of business, labor, government and public interest leaders, on which I serve, concluded that "a comparable degree of (investor) protection from fraudulent activity could be achieved at a lower net cost to the economy." The panel's report emphasized that this was "a serious problem requiring action by all three branches of the (federal) government." Little did we anticipate that such action, once achieved, might be reversed at the state level. This must not be permitted to happen.
On Nov. 5, California residents will vote on a ballot initiative that would effectively emasculate the new federal law. Since virtually all companies have some "connection" with California, the vast majority of public companies in the United States, not just those in California, would be subject to the terms of the initiative. California could become a haven for securities lawsuits.
Among the new bipartisan federal reforms that the initiative would reverse are:
The safe harbor for forward looking statements, which is designed to improve the allocation of investment capital by providing a degree of legal protection for companies making good-faith predictions about their future performance;
The restrictions on attorney's fees to a reasonable percentage of the recovery award to investors;
The limitations on the liability of defendants that have only a tangential relationship to the company being sued;
The prohibition on the payment of bonuses to "professional" plaintiffs; and
The "cooling off" period during which expensive pre-trial discovery is delayed pending an initial assessment of the merits of the allegations.
Particularly disturbing are additional proposals to reduce significantly the burden of proof in securities cases and to prohibit companies from indemnifying their officers and directors in order to protect their personal assets from lawsuit awards. The latter change would intensify pressure on companies to settle rather than fight meritless suits to avoid exposing directors and officers to the threat of personal financial ruin from punitive damage awards.
The California initiative will hamper all businesses in attracting directors, but above all will handicap the high-technology business community. A significant increase in exposure to litigation would make it much more difficult for these young, fast-growing firms to attract outside directors to their boards and hire the best qualified accounting firms. Moreover, their directors and lawyers would be placed in the awkward position of discouraging company officials from providing investors with the best possible information about future business prospects. In addition, one of the greatest international advantages of the U.S. economy - its distinctive ability to mobilize venture capital for startup and small, high-growth firms - would be placed in jeopardy.
Californians - and eventually all Americans - have much to lose if the initiative passes. It is bad for all companies. However, high-tech and high-growth companies, the biggest targets of frivolous lawsuits, form the most dynamic segment of the Golden State's economy. They drive the pace of job creation and wage increases and have played a key role in the state's recovery from the recent recession. They consensus legislation passed by Congress last year is helping to consolidate these gains. It must not be overturned by narrow, special interests in November.
Alan Patricof is chairman of Patricof & Co. Ventures Inc., New York. He is a member of the Competitive Policy Council's subcouncil on capital allocation.