Securities Litigation Risks For Public Companies Arising From The Dodd-Frank Wall Street Reform and Consumer Protection Act


On Wednesday, July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act") into law. While the primary focus of the Dodd-Frank Act is on banks, financial institutions and derivative instruments, it contains important provisions that may create securities litigation risks for publicly-traded companies. The following are what we view as the most important such provisions.

1.  Expanded Aiding and Abetting Liability in SEC Cases

Section 929O of the Dodd-Frank Act will make it easier for the SEC to target those who allegedly "aid and abet" securities fraud. The new provision lowers the requisite state of mind for aiding and abetting in SEC enforcement actions. The old standard under Section 20(e) of the Exchange Act of 1934 ("Exchange Act") was "actual knowledge." Under the new standard, the SEC can bring aiding and abetting charges for "reckless" conduct. In addition, Sections 929M and 929N of the Dodd-Frank Act provide that the SEC may now bring aiding and abetting claims under the Securities Act of 1933 ("Securities Act"), the Investment Company Act of 1940 ("Investment Company Act"), and the Investment Advisers Act of 1940 ("Investment Advisers Act"). 

Importantly, however, the Dodd-Frank Act does not create a private right of action for aiding and abetting claims and leaves undisturbed the Supreme Court's bar on such claims in Central Bank.

2.  Clarification of Control Person Liability

Section 929P(c) clarifies that the SEC may charge controlling persons. This means that corporations and individuals may face joint and several SEC liability even where they were not directly involved in the underlying conduct the SEC is challenging. Congress inserted this provision to address the government's concern that Section 20(a) of the Exchange Act could have been interpreted to restrict control person claims only to private plaintiffs, and not the SEC

3.  Amendment to Regulation FD

Section 939B of the Dodd-Frank Act eliminates the exemption in Rule 100(b)(2)(iii) of Regulation FD for credit rating agencies. Therefore, public companies may not selectively disclose nonpublic material information to credit rating agencies unless the information is made pursuant to some existing exemption like a confidentiality and nondisclosure agreement. The Act requires the SEC to eliminate the exemption in Regulation FD in the next 90 days.

4.  Expanded Market Manipulation Liability

Section 929L of the Dodd-Frank Act extends market manipulation liability (arising under Sections 9, 10(a) and 15(c) of the Exchange Act) to all non-government issued securities, including options, over-the-counter securities, and short sales. Previously, only Section 10(b) and Rule 10b-5 provided remedies for such trading.

5.  Increased Powers for the SEC

A.  Jurisdiction Over Foreign Securities Transactions

Section 929 of the Dodd-Frank Act, possibly the most significant addition to the SEC's powers, overturns the Supreme Court's Morrison decision to the extent that it applies to the SEC. For more information regarding the Supreme Court's Morrison decision see Orrick's Alert entitled U.S. Supreme Court Limits Extraterritorial Application of Securities Fraud Statute. Section 929 allows the SEC to have foreign jurisdiction over a matter brought under the antifraud provisions of the Exchange Act and Investment Advisers Act if the matter involves: (1) conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors; or (2) conduct occurring outside the United States that has a foreseeable substantial effect within the United States.

B.  Penalties in Administrative Proceedings

Section 929P(a) of the Dodd-Frank Act allows the SEC to seek penalties in administrative proceedings. Previously, only a federal court could award penalties, so the SEC often chose to file civil proceedings. Going forward, the SEC may now bring more of its cases as administrative proceedings. Individuals and companies involved in such proceedings are disadvantaged by limited rights to pretrial discovery; limited evidentiary rules; no right to a jury trial; and an administrative "appeal" to the SEC commissioners themselves, who originally voted to bring the action. 

C.  Nationwide SEC Trial Subpoenas

Section 929E of the Act enables both the SEC and defendants in SEC federal court actions to issue nationwide trial subpoenas. Although this has long been the case in SEC administrative proceedings, the SEC was subject to the limits of the Federal Rules of Civil Procedure in civil cases. This broadened power to the SEC may affect strategy regarding whom the SEC and defendants choose to depose during the course of discovery, because it removes perhaps the most frequently invoked ground for unavailability of a witness to appear at trial.

D.  Sharing Information with Other Agencies 

The SEC and other government agencies have long entered into "access" or sharing agreements, although doing so created a risk of such agencies waiving privileges. Section 929K of the Dodd-Frank Act now preserves any privileges that may apply to information that the SEC exchanges with other federal agencies, the PCAOB, any self-regulatory organization, and any state or foreign agencies. This provision arguably has the potential to increase coordination and cooperation among securities enforcement agencies, although there is some doubt as to whether the waiver issue has been a significant impediment to such sharing arrangements in the past.

E.  Increased Budget

Section 991 of the Dodd-Frank Act effectively doubles the SEC's budget over the next five years from $1.3 billion in fiscal 2011 to $2.25 billion in 2015. Additionally, the Dodd-Frank Act creates a reserve fund for use by the SEC of up to $100 million that will be funded by registration fees collected by the SEC under the Securities Act and the Investment Company Act. Presumably, the budget increase and reserve fund will bolster the Enforcement Division and, combined with the array of new rules, will lead to a significant increase in SEC investigations, examinations and lawsuits. 

6.  New Executive Compensation "Clawback" Rules

Section 954 of Dodd-Frank Act adds new Section 10D to the Exchange Act requiring all companies listed with national securities exchanges and associations to enact "clawback" policies. Such policies must recover any incentive-based compensation (including stock options) from current or former executive officers for the prior three years in the event of a financial restatement due to material noncompliance with any financial reporting requirement under the securities laws. The amount of the recovery is the difference between the amount of incentive-based compensation received and the amount that should have been received under the restated financial results.

Section 954 is different from Section 304 of the Sarbanes-Oxley Act of 2002 ("SOX") in four significant respects. First, the new provision is enforceable, not just by the SEC, but by plaintiffs' attorneys in derivative cases if companies fail to seek such relief. Such plaintiffs may initiate litigation regarding restatements that did not occur, yet which allegedly would have, but for some claimed conflict of interest by management. At the very least, the new rules will make a company's restatement decisions even more arduous. Second, while Section 304 only allows disgorgement from the company's CEO and CFO, the Dodd-Frank Act covers the company's current and former "executive officers," which arguably means all Section 16 officers. Third, the Dodd-Frank Act lowers the trigger for clawbacks to instances of "material noncompliance with applicable accounting principles," whereas Section 304 of SOX requires a restatement resulting from "misconduct." Fourth, the Dodd-Frank Act expands the look-back period in SOX Section 304 from one year to three years. Section 954 also raises thorny state law issues if a current or former executive chooses to fight the clawback. This is because the legislation appears to conflict with a board's business judgment authority to forego such actions where the costs of litigation may outweigh the recovery. The Dodd-Frank Act does not contain a deadline for the SEC to issue rules to the national securities exchanges pursuant to Section 954 or a deadline for the national exchanges to pass such rules.

7.  Independent Counsel Requirements for Compensation Committees

Section 952 of the Dodd-Frank Act requires the SEC to issue rules within one year requiring all publicly traded corporations to establish independent compensation committees to the extent they have not done so already. The Dodd-Frank Act further requires those independent committees to select independent advisors, including legal counsel. While the national securities exchanges currently have independence rules in place, the Dodd-Frank Act requires the SEC to issue rules to require the compensation committee to consider the independence of their advisors when selecting them. Such advisors include consultants, legal counsel or other advisors, and the SEC rules will identify factors affecting independence such as the other work the advisor performs for the corporation. The compensation committees will be solely responsible for retaining advisors and determining their independence. This provision may increase challenges to the independence of compensation committee decisions and their advisors, and could force many companies and their boards to hire additional counsel.

8.  Non-Binding Vote on Pay and Golden Parachutes

Section 951 of the Dodd-Frank Act requires that, within six months after the date of enactment, companies must (1) provide their shareholders with additional disclosure on executive compensation, (2) conduct a non-binding vote on executive compensation, and (3) conduct a vote to determine whether a say on pay vote must be held annually or every two or three years. Similarly, companies must provide shareholders with a non-binding vote on golden parachutes in all M&A transactions. While the votes are non-binding, the results of the votes and added disclosure obligations will likely provide material for plaintiffs in fiduciary duty and M&A litigation. For more information regarding Section 951 of the Dodd-Frank Act see Orrick's Alert entitled Dodd-Frank Provisions Relating to Corporate Governance, Executive Compensation and Disclosure posted here.

9.  Whistleblower Provisions

Section 922 provides a whistleblower shall be entitled to a bounty of 10%-30% of a monetary recovery if their tip leads to an SEC enforcement action resulting in sanctions of more than $1 million in a successful enforcement action or proceeding. To qualify for a bounty, the whistleblower must provide the SEC with information that it did not already know from another source. Section 922 also provides that the whistleblower can submit anonymous tips and need not identify themselves until the government pays the bounty.

Oftentimes, securities class action plaintiffs will rely on information from confidential witnesses to support the allegations in their complaints and some courts have considered such witness statements at the motion to dismiss stage.  Section 922 of the Dodd-Frank Act will likely increase the number of "confidential witnesses" at the disposal of the plaintiffs' bar because it provides monetary incentives for such individuals. In addition, Section 922 creates significant new protections for such persons such as confidentiality provisions. For more information regarding Section 922 of the Dodd-Frank Act see Orrick's Alert entitled Whistleblower Provisions in the Dodd-Frank Act posted here.

The full text of Dodd-Frank is available here.