Will Proposition 211 protect California investors?


by Warren S. Grimes

Warren S. Grimes is a professor at Southwestern University School of Law in Los Angeles, where he teaches corporations and antitrust law courses.

The newest tort reform initiative will protect Californians who invest their money for retirement


by Jonathan C. Dickey

Jonathan C. Dickey is a partner in the law firm of Gibson, Dunn & Crutcher LLP in Palo Alto, specializing in the defense of securities class actions in federal and state courts. Paul J. Collins of Gibson, Dunn & Crutcher LLP assisted in the preparation of this article.

Prop 211 will dramatically tip the balance in favor of plaintiffs in securities lawsuits against business


If you have read anything about Proposition 211 -- a proposition that will amend California law governing securities fraud involving retirement savings -- chances are it was highly partisan. Press accounts tell us of a well-financed struggle between big business and plaintiffs' lawyers. I am a financially disinterested observer -- I have never served in corporate office, never brokered the sale of stock, and never filed, prosecuted or defended a securities fraud suit. I intend to vote for Proposition 211. Here's why.

Thousands of Americans are victimized by securities fraud every year. Most of us recall the stories about elderly customers of Lincoln Savings and Loan who were duped into removing retirement savings from federally insured accounts to buy soon-to-be worthless securities issued by Lincoln's parent corporation. There are hundreds of other cases that we never read about, many of them involving unscrupulous brokers or insiders who take advantage of investors.

Securities fraud is not a new problem. Since its creation in 1934, the Securities and Exchange Commission has mandated increased disclosure and enforced rules that substantially reduce the incidence of fraud. The agency's success in deterring fraud has been greatly enhanced because some of its key rules are enforced through private suits brought by injured victims. The SEC and state securities regulators cannot reach more than a fraction of fraudulent incidents. Private enforcers greatly expand the law's reach (perhaps by a factor of 10), creating most of the punch behind deterrence. SEC enforcement director William McLucas has testified that privately initiated investment fraud suits are "essential" to the maintenance of investor protection.

Unfortunately, the private plaintiff's ability to maintain a securities fraud action was substantially undercut by legislation passed over President Clinton's veto in 1995. The sponsors of Proposition 211 have sought to provide Californians investing for retirement with increased protection under state law.

Provides protection

Proposition 211 provides this protection through provisions that:

(1) allow recovery for a defend-ant's fraudulent statements directed to the market, without requiring that an investor directly know of those statements (this fraud-on-the-market theory is available in suits under federal law, but so far unavailable under state law);

(2) strengthen an investor's ability to recover from those who have aided and abetted in the fraudulent act;

(3) prohibit a corporation from indemnifying executives and directors found guilty of fraud; and

(4) allow for the imposition of punitive damages for egregious fraud (the punitive damages go to the state treasury, not to the injured plaintiff).

Finally, Proposition 211 provides for tough sanctions against frivolous lawsuits, awarding attorneys' fees and costs to defendants who are the targets of such suits.

These anti-fraud provisions have drawn the support of a broad coalition of citizen and consumer groups, including investor, pension fund and senior organizations. But the opposition of business and corporate groups has been intense. The motivation for their opposition is evident -- no one wants to be sued. Because securities fraud is a white collar crime, there is perhaps an extra level of discomfort for wealthy, briefcase-toting professionals who fear being named as a defendant. But there are real victims to securities fraud, many of them relatively powerless family or elderly investors. The rights of these victims are properly given precedence over rights of those implicated in wrongdoing.

Opponents argue that Proposition 211 will bring a flood of securities litigation to California courts, much of it involving out-of-state corporations. But on average, there have been around 300 private securities cases filed each year in the United States. Almost all of these cases are settled or disposed of before trial.

Even if all 300 suits were filed in this state (many of them are already filed here), the increase in litigation would be insignificant.

As far as suits involving out-of-state corporations, they are now and would continue to be properly brought in this state if California investors are the victims of fraud and the corporation has a significant California connection.

Opponents also argue that Proposition 211, by limiting a corporation's ability to pay the expenses of executives or directors who are sued, would make it difficult for corporations to find qualified persons to serve in these offices.

Insurance available

But Proposition 211 does nothing to prevent a corporation from buying insurance for its executives and directors. Nor is the company precluded from paying the expenses of an official who is not found guilty of fraudulent acts. Those found individually guilty of fraud are properly held personally accountable for their acts and should not be able to pass these costs on to innocent shareholders.

Even as to an individual who fears being found guilty (and whose insurance might not fully cover the liability), a settlement struck before trial could still allow the corporation to pay the individual's costs.

Opponents of the proposition tell and retell stories of company officials who were sued merely because optimistic growth projections turned out to be inaccurate. I would agree that careful and well-grounded projections of a company's future earnings can be helpful to investors and, absent fraudulent statements or omissions, should not be unlawful. On the other hand, firms have an obvious (and corrupting) incentive to make optimistic projections, but hold back bad news that will bring down the market price.

The SEC and the courts have struggled for many years with achieving the proper balance between encouraging helpful forecasts by knowledgeable officials while protecting investors from fraudulent or misleading statements or omissions. A federal safe harbor that in some circumstances would allow deliberate lies has been created by the new federal legislation. Proposition 211 merely reaffirms the state courts' ability to judge whether a statement is material and misleading on a case-by-case basis.

Proposition 211 will help prevent securities fraud. When it occurs, defrauded investors will have a realistic chance of obtaining meaningful relief.


On Tuesday, Nov. 5, California voters will decide whether to adopt Proposition 211, a ballot initiative that, if adopted, would enact sweeping new changes to the California securities law. Proposition 211 would subject corporations and their officers, directors, employees and professional advisors to liability far broader than any possible liability under the federal securities laws, either before or after adoption by Congress of the Private Securities Litigation Reform Act of 1995 (the "Reform Act"). Under Proposition 211, corporations throughout the United States could be subjected to the same abusive litigation tactics under California law that Congress overwhelmingly voted to end just last year.

Securities law reform is not, as plaintiffs' lawyers claim, simply a matter of protecting our citizens' retirement savings from unscrupulous con men (and Proposition 211 itself is only loosely tied to its stated intention of protecting "retirement savings"). To the contrary, reform is needed when a few plaintiffs' class action lawyers continually abuse the legal system. When securities "strike suits" are given a safe haven in California -- as Proposition 211 surely would do -- individual investors will be harmed by the sudden curtailment by public companies of their disclosures to the market concerning future business prospects. Such abuses also lead to higher corporate insurance premiums, lower dividends and the unwillingness of the best qualified persons to serve on corporate boards of directors.

In passing the Reform Act, Congress intended to redress securities class action lawyers' most abusive litigation tactics -- tactics which all too often resulted in expensive settlements coerced from securities class action defendants not from fear of losing on the merits, but from fear of incurring the sheer cost associated with defending these massive lawsuits.

Reform standards

Toward that end, the Reform Act created a new, uniform and higher pleading standard for all fraud allegations; created a broader, more effective safe harbor for the disclosure of valuable forward-looking information, such as projections of future financial results; codified the "bespeaks caution" doctrine; mandated a stay of discovery in almost all cases until after plaintiffs have demonstrated that their complaint has met the most basic of requirements for pleading a cause of action; created a cap on damages; apportioned liability among defendants according to degree of fault; and restricted the so-called "professional plaintiffs" while, at the same time, providing new power to investors with the most at stake to oversee and rein in the activities of the lawyers who purport to represent them in securities class actions. These are just some of the reforms that a bipartisan and overwhelming majority of Congress approved last year.

Proposition 211, if enacted, would dramatically tip the balance in favor of plaintiffs in securities lawsuits against companies and their boards of directors, and would provide an unprecedented forum in California for plaintiffs to file lawsuits whenever the price of a company's stock drops.

Consequences seen

Proposition 211, if enacted, would have at least the following adverse consequences:

Even if such cases ultimately were dismissed on the merits, plaintiffs could impose a huge discovery burden and expense on defendants prior to dismissal.

No amendments

Finally, Proposition 211, if enacted, could never be amended by the legislature. To the contrary, any amendment would require approval by California voters and, thus, no provision of Proposition 211 -- no matter how expensive or injurious to California citizens -- could be altered without an expensive, statewide political campaign.

In short, the collective and self-serving judgment of a few plaintiffs' securities lawyers could cast into stone a law that is bad for business, bad for investors, and bad for California.