What's Not In The Bill?
But what's missing from the reform measures making their way to the President's desk? Congress has largely declined to increase the role of private litigants in deterring misconduct and encouraging accountability. In the wake of the stock market crash of 1929, Congress empowered individual investors to sue for misrepresentations and other misconduct in connection with the issuance and sale of securities. Securities fraud litigation exploded from there.
In the wake of the credit crisis, however, Congress largely has chosen not to empower private parties to enforce the rules designed to prevent a repeat of the last three years. For example, the law will create a federal regulator to protect individual consumers of financial products like mortgages. But the House bill specifies that "nothing" in the provision establishing this new consumer protection "shall be construed to create a private right of action." Similarly, the Senate failed even to vote on a proposed amendment that would have imposed aiding and abetting liability in investors' suits for securities fraud.
Exception: Private Suits Against Rating AgenciesA key exception, though, is the provision governing the credit rating agencies, such as Moody's, Standard & Poor's and Fitch. The agencies have drawn fire for assigning high ratings to structured products like mortgage-backed securities and collateralized debt obligations that were later downgraded to junk. The agencies were selected and paid by the investment banks that manufactured and marketed these products. Two highly-publicized amendments adopted by the Senate target this conflict of interest and the perceived out-sized influence of the rating agencies. One, proposed by Minnesota's Al Franken, creates a new board to select which rating agencies will rate new debt securities, so that investors will be assured that at least one rater was not selected by the party that created the product. The other strikes existing rules that require regulators like the FDIC to rely on rating agencies' assessments; instead, the FDIC and others make independent assessments of creditworthiness.
Congress has also carved out a role for private litigants to help safeguard the integrity of the rating process. Coupled with the regulatory reforms are provisions allowing investors to sue credit rating agencies for securities fraud. Today, the Securities Exchange Act of 1934 specifies that it "creates no private right of action" against the rating agencies, and allows only the SEC sue them and their employees for "fraud or deceit." The House and Senate bills, however, provide that private litigants may sue rating agencies for violations of the Exchange Act, thereby adding a new enforcement mechanism through the courts. The House bill imposes liability if the rating agency is "grossly negligent in violating the securities laws." The Senate version creates a higher standard of liability. An agency would be liable only if it knowingly or recklessly failed to conduct a reasonable investigation of the security being rated, or to obtain reasonable verification of the facts supporting its rating. While the House and Senate bills must be reconciled before the law is finalized, it appears that at least with respect to the rating agencies, Congress envisions an enforcement role for private litigants.What's Next? The next step is for House and Senate leaders to agree on a final version of legislation that can pass both chambers. The role of private litigants in financial reform may yet expand or contract during this conference process. Something else to watch for is the potential for a greater duty on broker-dealers, which could facilitate lawsuits against them. The House bill would impose a fiduciary duty on broker-dealers, requiring them to act in the "best interest" of a retail customer with regard to "personalized investment advice." This is higher than the current standard, which requires retail broker-dealers only to ensure that the transactions they perform are "suitable" for their customers. The Senate bill does not impose a fiduciary duty on broker-dealers, but instead commissions a study of the effectiveness of existing legal or regulatory standards of care of brokers, dealers and investment advisors. If the House version prevails, or if the study contemplated by the Senate eventually recommends more stringent standards of care, broker-dealers could find themselves more susceptible to litigation when investments go south.
For now, however, a salient feature of the financial reform efforts is that, with few exceptions, Congress chose not to use private litigation as a primary enforcement tool. Apparently colleagues paid little heed to the representative who said, in recommending a lower standard of liability for suits against the rating agencies: "I have a lot of trial attorneys that need the work."