The People of the State of New York by Andrew M. Cuomo,, Respondent,v.Maurice R. Greenberg, et al., Appellants.BriefN.Y.May 28, 2013To be Argued: For Maurice R. Greenberg by DAVID BOIES BOIES, SCHILLER & FLEXNER LLP (Time Requested: 30 Minutes) For Howard I. Smith by VINCENT A. SAMA KAYE SCHOLER LLP (Time Requested: 30 Minutes) New York County Clerk’s Index No. 401720/05 Court of Appeals of the State of New York THE PEOPLE OF THE STATE OF NEW YORK by ANDREW M. CUOMO, Attorney General of the State of New York, Plaintiff-Respondent, – against – MAURICE R. GREENBERG and HOWARD I. SMITH, Defendants-Appellants. JOINT BRIEF FOR DEFENDANTS-APPELLANTS BOIES, SCHILLER & FLEXNER LLP 333 Main Street Armonk, New York 10504 Tel.: (914) 749-8200 Fax: (914) 749-8300 – and – 575 Lexington Avenue, 7th Floor New York, New York 10022 Tel.: (212) 446-2300 Fax: (212) 446-2350 CHARLES FRIED, ESQ. 1545 Massachusetts Avenue Cambridge, Massachusetts 02138 Tel.: (617) 495-4636 Fax: (617) 496-4865 SKADDEN, ARPS, SLATE, MEAGHER & FLOM LLP Four Times Square New York, New York 10036 Tel.: (212) 735-3000 Fax: (212) 735-2000 Attorneys for Defendant-Appellant Maurice R. Greenberg (For Continuation of Appearances See Inside Cover) Date Completed: September 24, 2012 ANDREW M. LAWLER, P.C. 641 Lexington Avenue, 27th Floor New York, New York 10022 Tel.: (212) 832-3160 Fax: (212) 832-3158 KAYE SCHOLER LLP 425 Park Avenue New York, New York 10022 Tel.: (212) 836-8000 Fax: (212) 836-7154 Attorneys for Defendant-Appellant Howard I. Smith Status Of Related Litigation Pursuant To The Rules Of The New York Court Of Appeals§ 500.13(a) l. A related federal securities class action lawsuit is currently pending before the Honorable Deborah A. Batts in the United States District Court for the Southern District of New York, captioned In re American International Group, Inc. Securities Litigation, No. 1 :04CV08141 (S.D.N. Y. filed Oct. 15, 2004 ). That federal class action includes claims brought by AIG shareholders for, inter alia, losses alJegedly caused by the two transactions at issue in the present action before this Court, which are referred to as the "GenRe Transaction" and the "CAPCO Transaction." On August l 0, 2009, the AIG shareholders entered into a class settlement that resolves their claims against Appellants. Preliminary approval of that settlement was ordered by Judge Batts on February 3, 20 12, and final approval of the class settlement with Appellants is currently pending. The New York Attorney General ("'NY AG") has acknowledged that final approval of the class settlement with Appellants will bar the NY AG's claims against Appellants in the action before this Court under People v. Applied Card Systems, Inc., 11 N.Y.3d 1 05 (2008 ). The NY AG has filed repeated objections to delay and attempt to prevent final approval of the class settlement against Appellants. See Objection of the Attorney General of the State of New York to the Proposed Starr Settlement [Dkt. 650], In re AJG Sees. Litig. (S.D. N.Y. Aug. 17, 2012); Response of the Starr Defendants to the Objections of the Office of the Attorney General of New York to the Proposed Class Settlement [Dkt. 657], In re AIG Sees. Litig. (S.D.N.Y. Sept. 18, 20 12). 2. A federal criminal trial of four GenRe employees and a former AIG employee that related to the Gen Re Transaction was held before the Honorable Christopher F. Droney in the United States District Court for the District of Connecticut in 2008, resulting in the conviction of all defendants. United States v. Ferguson, No. 3:06CR137CFD (D. Conn.). Neither Appellant was a defendant or participant in the trial. On appeal, the convictions of all five defendants were overturned and vacated by the Second Circuit. United States v. Ferguson, 6 7 6 F.3d 260 (2d Cir. 2011 ). The Department of Justice has since entered into deferred prosecution agreements with all defendants, and a retrial is not contemplated. See Consent Motion for Deferred Prosecution Continuance, Exs. A-E [Dkt. 1379], United States v. Ferguson, No. 3:06CR137 (D. Conn. June 22, 2012); Deferred Prosecution Order [Dkt. 1382], United States v. Ferguson, No. 3:06CR137 (D. Conn. June 25, 20 12). 11 Table of Contents PRELIMINARY STATEMENT ............................................................................... 1 STANDARD OF REVIEW ....................................................................................... 3 ISSUES PRESENTED ............................................................................................... 4 STATEMENT OF JURISDICTION ......................................................................... 5 STATEMENT OF FACTS ........................................................................................ 5 I. Procedural History Of This Action ....................................................... 5 II. The Parallel Federal Securities Class Actions ...................................... 8 III. The NY AG Acknowledges That It Is Pursuing This Action For Money Damages For Private Shareholders Who Already Are Members Of A Certified Federal Securities Class ................................ 9 IV. Appellants' Motions For Summary Judgment .................................... IO V. The Appellate Division's Decision ..................................................... 12 ARGUMENT ........................................................................................................... l5 I. The NY AG Lacks Standing And Authority To Pursue This Action Under The Martin Act And Executive Law Seeking To Recover Monetary Damages On Behalf Of A Class Of Private Shareholders And Its Efforts To Do So Here Also Conflict With, And Are Preempted By, The Federal Laws Governing Nationally Traded Securities ............................................................... 15 A. The NY AG Lacks Standing And Authority To Pursue Money Damages On Behalf Of An Identified Class Of Private Shareholders ................................................................. 1 7 B. The NY AG's Use Of The Martin Act And Executive Law To Advance A Claim For Money Damages On Behalf Of Private Shareholders Conflicts With Federal Securities Laws And Is Preempted ........................................... 25 lll 1. AIG's Private Investors Are The Real Parties ln Interest And This Action Is Thus Expressly Preempted By SLUSA .................................................... 27 2. This Action For Money Damages On Behalf Of Private Investors Frustrates Federal Objectives For National Standards Governing Securities Actions And Is, Therefore, Impliedly Preempted ........................ 33 II. The Courts Below Improperly Denied Appellants' Motions For Summary Judgment With Respect To The GenRe Transaction By Relying On Irremediable Hearsay Evidence ................................. 38 A. A Court Cannot Rely On Hearsay Evidence To Deny A Motion For Summary Judgment Unless The Proponent Can Demonstrate That The Hearsay Can Be Converted To Admissible Form At Trial ................................................... 38 B. The Courts Below Permitted The NY AG To Oppose Summary Judgment By Relying On Inadmissible Hearsay Evidence That Could Never Be Converted To Admissible Form At Trial. ........................................................ 41 1. Appellants Submitted Admissible Evidence Establishing That They Did Not Know Of Or Participate In The Allegedly Fraudulent Aspects Of The GenRe Transaction ............................................ 44 2. In Denying Appellants' Motions For Summary Judgment Concerning The Gen Re Transaction, The Courts Below Permitted The NY AG To Rely On Inadmissible Hearsay Evidence ................................ 52 a. Evidence From The Hartford Trial Is Not Admissible Against Appellants ............................. 54 IV b. Testimony, £mails, Notes, And Recorded Telephone Conversations OfGen Re Executives Containing Statements Speculating A bout Appellants ' Conversations With Others Is Irremediable Hearsay ............................................. , .................. 57 c. The Co-Conspirator Exception To The Hearsay Rule Does Not Apply Here .................... 58 CONCLUSION ........................................................................................................ 67 v Table of Authorities Cases Aaron v. SEC, 446 u.s. 680 ( 1980) ............................................................................................ 32 Alfred L. Snapp & Son, Inc. v. Puerto Rico, 458 u.s. 592 ( 1982) ................................................................... 19, 20, 28, 29, 30 Alvarez v. Prospect Hosp., 68 N. Y.2d 320 ( 1986) ......................................................................................... 38 American Federal Group, Ltd. v. Rothenberg, 136 F .3d 897 (2d Cir. 1998) ............................................................................... 21 Andrea v. Arnone, Hedin, Casker Kennedy & Drake, Architects & Landscape Architects, P. C., 5 N.Y.3d 514 (2005) ............................................................................................. 4 Buckley v. JA. Jones!GMO, 3 8 A.D.3d 461 (lst Dep 't 2007) .......................................................................... 40 Central States Southeast and Southwest Areas Health and Welfare Fund v. Merck-Medea Managed Care, LLC, 433 F.3d 181 (2d Cir. 2005) ............................................................................... 18 Commercia/Ins. Co. of Newark v. Popadich, 68 A.D.3d 40 I (lst Dep 't 2009) .......................................................................... 40 Commonwealth of Pennsylvania v. Mid-Atlantic Toyota Distributors, Inc., 704 F .2d 125 (4th Cir. 1983) ........................................................................ 20, 30 Community Bd. 7 of the Borough of Manhattan v. Schaffer, 84 N. Y .2d 148 ( 1994) ......................................................................................... 1 8 Dalury v. Rezinas, 183 A.D. 456 (1st Dep't 1918) ........................................................................... 62 Dalury v. Rezinas, 229 N.Y. 513 (1920) ........................................................................................... 62 VI DiGiantomasso v. City of New York., 55 A.D.3d 502 (I st Dep't 2008) ................................................................... 39, 40 Ernst & Ernst v. Hochfelder, 425 u.s. 185 ( 1976) ............................................................................................ 36 FDIC v. Philadelphia Gear Corp., 476 u.s. 426 (1986) ............................................................................................ 32 Friends of Animals, Inc. v. Associated Fur Mfrs., Inc., 46 N.Y.2d 1065 (1979) ....................................................................................... 39 Fruit & Vegetable Supreme, Inc. v. The Hartford Steam Boiler Inspection & Ins. Co., 28 Misc. 3d 1128 (Sup. Ct. Kings Cnty. 20 l 0) .................................................. 40 Garrett v. United States, 471 u.s. 773 ( 1985) ............................................................................................ 32 Graziano v. County of Albany, 3 N.Y.3d 475 (2004) ........................................................................................... 17 Guice v. Charles Schwab & Co., 89 N.Y.2d 31 (1996) ........................................................................................... 36 IDX Capital, LLC v. Phoenix Partners Group LLC, 19 N.Y.3d 850 (2012) ......................................................................................... 38 In re American International Group, Inc. Securities Litigation, No. 1:04CV08141 (S.D.N.Y. filed Oct. 15, 2004) ........................ 8, 9, 16, 17,24 In re Baldwin-United Corp., 770 F.2d 328 (2d Cir. 1985) ............................................................ 22, 28, 29, 37 in re Exxon Valdez, No. A89-095 CIV, 1993 WL 735037 (D. Alaska July 8, 1993) .................. 20, 32 In reNew York City Asbestos Litig., 7 A.D.3d 285 (1st Dep't 2004) ........................................................................... 40 Vll Jara v. Salinas-Ramirez, 65 A.D.3d 933 (1st Dep't 2009) ......................................................................... 40 Jasco Tools, Inc. v. Rogers, 13 Misc.3d 1222(A), 2006 WL 2944671 (Sup. Ct. Monroe Cnty. July 31, 2006) .............................................................. 60 Josephson v. Crane Club, Inc., 264 A.D.2d 359 (1st Dep't I 999) ....................................................................... 40 Kaszirer v. Kaszirer, 298 A.D.2d I 09 (1st Dep't 2002) ............................................................ , .......... 53 Kircher v. Putnam Funds Trust, 547 u.s. 633 (2006) ............................................................................................ 28 Lander v. Hartford Life & Annuity Ins. Co., 251 F.3d 101 (2d Cir. 2001) ......................................................................... 26, 33 LaSalle Bank Nat. Ass 'n. v. Nomura Asset Capital Corp., 424 F 3d 195 (2d Cir. 2005) ............................................................................... 39 Lent v. Shear, 160 N.Y. 462 ( 1899) ........................................................................................... 56 LG Display Co. v. Madigan, 665 F.3d 768 (7th Cir. 2011) .............................................................................. 30 Louisiana ex. rei. Caldwell v. Allstate Ins. Co., 536 F.3d 418 (5th Cir. 2008) .................................................................. 29, 30, 31 Marcus v. AT&T Corp., 138 F .3d 46 (2d Cir. 1998) ................................................................................. 36 Marine Midland Bank v. John E. Russo Produce Co., 50 N.Y.2d 31 (1980) ........................................................................................... 43 Martino v. Stolzman, 18 N.Y.3d 905 (2012) ........................................................................................... 4 Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 u.s. 71 (2006) ........................................................................... 26, 28, 33, 36 Vlll Navedo v. 250 Willis Ave. Supermarket, 290 A.D.2d 246 (1st Dep't 2002) ........................................................................ 40 New York v. General Motors Corp., 547 F. Supp. 703 (S.D.N.Y. 1982) ..................................................................... 30 New York v. Holiday Inns, Inc., 656 F. Supp. 675 (W.D.N.Y. 1984) .............................................................. 21, 24 New York v. Seneci, 817 F.2d 1015 (2d Cir. 1987) ........................................ 18, 19, 21, 22, 23, 30,32 Ohio v. GMAC Mortgage, LLC, 760 F. Supp. 2d 741 (N.D. Ohio2011) .............................................................. 29 Pennsylvania v. New Jersey, 426 u.s. 660 ( 1976) ......................................................................... 22, 23, 29, 31 People v. II Cornwell Co., 695 F.2d 34 (2d Cir. 1982) ................................................................................. 24 People v. II Cornwell Co., 718 F.2d 22 (2d Cir. 1983) ................................................................................. 24 People v. Apple Health & Sports Clubs, 80 N.Y.2d 803 (1992) ......................................................................................... 43 People v. Applied Card Systems, Inc., II N.Y.3d 105 (2008) ........................................................................................... 9 People v. Tran, 80 N.Y.2d I 70 ( 1992) ......................................................................................... 59 People v. Grasso, 54 A.D.3d 180 (1st Dep't 2008) ................................................ 18, 20, 22, 23, 25 People v. Grasso, 11 N.Y.3d 64 (2008) ..................................................................................... 25, 26 People v. Hernandez, 155 A.D.2d 342 (1st Dep't 1989) ....................................................................... 59 People v. L.B. Smith, 108 Misc. 2d 261 (Sup. Ct. Onondaga Cnty. 1981) ........................................... 59 People v. Lowe, 117 N.Y. 175 (1889) ..................................................................................... 18, 19 People v. Operation Rescue Nat'!, 80 F.3d 64 (2d Cir. 1996) ............................................................................. 23, 29 People v. Safko, 47 N.Y.2d 230 (1979) ......................................................................................... 59 People v. Sanders, 56 N.Y.2d 51 (1982) ............................................................................... 58, 62,66 People v. Singer, 193 Misc. 976 (Sup. Ct. N.Y. Cnty. 1949) ......................................................... 23 People v. Wolf, 98 N.Y.2d 105 (2002) ......................................................................................... 60 Perrin v. United States, 444 u.s. 37 (1979) .............................................................................................. 31 Polonetsky v. Better Homes Depot, Inc., 97 N.Y.2d 46 (2001 ) ........................................................................................... 43 Presbyt. Church of Sudan v. Talisman Energy, Inc., 582 F.3d 244 (2d Cir. 2009) ............................................................................... 39 Pure Power Boot Camp, Inc. v. Warrior Fitness Boot Camp, LLC, 813 F. Supp. 2d 489 (S.D.N.Y. 2011) ................................................................ 21 Raskin v. Wyatt Co., 125 F.3d 55 (2d Cir. 1997) ................................................................................. 39 Reconstruction Fin. Corp. v. Beaver County, Pa., 328 u.s. 204 (1946) ............................................................................................ 32 Sanders v. John Nuveen & Co., 554 F.2d 790 (7th Cir. 1977) .............................................................................. 36 X Schulz v. State, 86 N.Y.2d 225 (1995) ......................................................................................... 25 SECv. AIG, No. 06 Civ. 1000 (S.D.N.Y.) ................................................................................ 9 SECv. Todd, No. 03CV2230, 2006 WL 5201386 (S.D. Ca. Oct. 17, 2006) ........................... 53 Siegel v. Waldbaum, 59 A.D.2d 555 (2d Dep't 1977) .......................................................................... 56 Slater v. Gulf, M & O.R. Co., 307 N.Y. 419 (1954) ........................................................................................... 22 State v. Metz, 241 A.D.2d 192 (1st Dep't 1998) ....................................................................... 40 State v. New York City Conciliation and Appeals Bd., 123 Misc. 2d 47 (Sup. Ct. N.Y. Cnty. 1984) .......................................... 19, 23,24 Stoneridge lnv. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008) ............................................................................................ 32 United States v. Carnagie. 533 F.3d 1231 (I Oth Cir. 2008) .......................................................................... 63 United States v. Ferguson, 676 F.3d 260 (2d Cir. 20 II) ......................................................................... 16, 55 United States v. Ferguson, No. 3:06CR137CFD(D. Conn.) ................................................................... II, 55 United States v. Ferguson, 553 F. Supp. 2d 145 (D. Conn. 2008) ................................................................. 62 Verizon New York, inc. v. Garvin, 13 N.Y.3d 851 (2009) ......................................................................................... 38 West Virginia ex rel. McGraw v. Comcast Corp., 705 F. Supp. 2d 441 (E.D. Pa. 2010) .................................................................. 30 XI Zuckerman v. City of New York, 49 N.Y.2d 557 (1980) ............................................................................. 38, 39,41 Statutes 15 u.s.c. § 77h-1 .................................................................................................... 32 15 U.S.C. § 78u-1 .................................................................................................... 32 Class Action Fairness Act ........................................................................................ 30 National Securities Markets Improvement Act of 1996 Pub. L. No. 104-290, 110 Stat. 3416 ................................... 13, 27, 33, 34, 35, 37 N.Y. Gen. Bus. Law§ 353(3) .................................................................................. 22 N.Y. Executive Law§ 63 ................................................................................. passim N.Y. Insurance Law§ 31 O(a)(3) ................................................................................ 6 N.Y. Martin Act ............................................................................................... passim Private Securities Litigation Reform Act of 1995 Pub. L. No. 104-67, 109 Stat. 737 ............................................. 13, 26, 27, 33, 37 Securities Litigation Uniform Standards Act of 1998 Pub. L. No. 105-353, 112 Stat. 3227 .......................................................... passim Other Authorities Arthur Karger and Henry Cohen, The Powers of the New York Court of Appeals (3d ed. 2005) ......................................................................................................... 3 Black 's Law Dictionary (7th ed. 1999) ...................................................................................................... 36 H. Rep. No. 104-622 ( 1996) .............................................................................. 33, 35 N.Y. Constitution, Article VI ..................................................................................... 3 N.Y. Constitution, Article VII ................................................................................. 25 xu S. Rep. No. 105-182 (1998) .................................................................. 28, 33, 34, 36 Rules CPLR § 3212 ............................................................................................................ 38 CPLR§4517 ............................................................................................................ 55 CPLR § 5501 .............................................................................................................. 3 CPLR § 5602 .............................................................................................................. 5 Xlll Defendants-Appellants Maurice R. Greenberg and Howard I. Smith ("·Appellants") respectfully submit this brief in support of their appeal from the May 8, 2012 Decision and Order of the Appellate Division, First Department (the "Decision"). PRELIMINARY STATEMENT This appeal raises a critical question of nationwide importance: can the Attorney General of the State of New York C'NY AG") use the Martin Act and Executive Law to pursue money damages for alleged accounting improprieties on behalf of a worldwide class of private shareholders in a nationally-traded security here AIG stock- using lesser standards of proof than required by the federal securities laws, particularly where there is a federal class action pending on their behalf? For the following two reasons, the answer to that critical question is no. First, the NY AG lacks standing and authority under the Martin Act and Executive Law to prosecute claims for money damages on behalf of private entities. This is hardly surprising: recovering damages for securities holders does not meaningfulJy redress injury to an independent State interest separate from the interests of the class of private shareholders themselves. This is all the more so where, as here, those private shareholders are fully represented in their own parallel consolidated federal securities class action proceeding under the federal law that governs their claims, and thus have no need for the NY AG to protect their 1 individual interests. ln the circumstances of this case, the NY AG is not the rea) party in interest and, as the Appellate Division dissent found, its '-continued prosecution of these causes of action ... vindicates no public purpose.'' R. 15215 (citations and internal quotations omitted; alteration in original). Second, the NY AG's effort to hold two individuals liable for billions of dollars in damages for alleged improper accounting purportedly suffered by an identifiable class of private shareholders using significantly lesser standards of proof conflicts with and is preempted by the uniform national standards governing liability for private securities class actions. Federal law must be applied to this action as if it were brought by the real parties in interest, the AJG shareholders on whose behalf the NY AG is seeking to recover money dan1ages. lf left uncorrected, the majority's decision would permit the NY AG to pursue recovery for private investors on a quantum of proof significantly lower than required under applicable federal law. As the dissent below found, such a result would undermine Congress' determination Hthat efficient securities markets require a uniform national standard governing liability for private class actions." R. 15211 (emphasis added). ln sum, the entire action should be dismissed because (i) the NY AG does not have standing to pursue the action, and (ii) alternatively, the action seeking damages on behalf of an identifiable class of securities holders is preempted by federal law. 2 Wholly independent of the above errors, this appeal also raises a critical question concerning the administration of justice in New York: can a party defeat summary judgment without presenting any admissible evidence, re1ying instead solely on hearsay evidence that cannot be rendered admissible at trial? This Court's own precedent firmly establishes that a party may not defeat summary judgment by proffering inadmissible hearsay evidence that cannot subsequently be presented in admissible form at trial. Thus, the majority c 1early erred in accepting the proposition that ~.~in opposition to such motion for summary judgment, a court can consider hearsay evidence," without addressing the additional [act presented here that the critical hearsay evidence cannot be rendered admissible at trial. R. 15199-200. As the Appellate Division dissent concluded, Appellants' Gen Re summary judgment motions should have been granted ''due to the utter failure of the New York Atton1ey General to oppose the defendants' motion with evidence in admissible form or to put forward an excuse for the failure to do so after five years of investigation and discovery." R. 15203; see also R. 15219-23. STANDARD OF REVIEW This appeal presents solely 4'the review of questions of law." N.Y. Const., art. VI, § 3(a); see also CPLR § 5501 (b); Arthur Karger and Henry Cohen, The Powers of the New York Court of Appeals § 13:1 (3d ed. 2005). Review is thus de novo and the Court does not "defer to Supreme Court's judgment" on questions of 3 law, Andrea v. Arnone, Hedin, Casker Kennedy & Drake, Architects & Landscape Architects, P. C., 5 N. Y .3d 514, 521 (2005 ), including whether an order denying a motion for summary judgment should have been granted. See Martino v. Stolzman, 18 N.Y.3d 905,908-09 (2012). ISSUES PRESENTED 1. Does the NY AG have standing and authority to pursue this claim for money damages on behalf of an identifiable class of private shareholders where there is no legitimate, independent sovereign interest being served and those private parties are fully capable of and, in fact are, pursuing their own claims? Answer of the Appellate Division maiority and the trial court: Yes. 2. Is the NY AG's use of the Martin Act and Executive Law in this action to pursue a securities fraud class action seeking to recover money damages on behalf of a class of private shareholders preempted by federal laws intended to provide uniform national standards governing such claims for securities fraud? Answer of the Appellate Division majority and the trial court: No. 3. Can hearsay evidence be used to defeat a motion for summary judgment where that hearsay evidence cannot be converted to admissible evidence at trial (i.e. , irremediab 1 e hearsay)? Answer of the Appellate Division majority and the trial court: Yes. 4 STATEMENT OF JURISDICTION This Court has jurisdiction pursuant to CPLR § 5602(b )( l ). On October 21, 2010, the Commercial Division ofthe Supreme Court, New York County, Ramos, J., entered its decision and order denying Appellants' motions for summary judgment, and granting in part the NY AG's motion for partial summary judgment. R. 1 1-96, 119-22. Appellants timely appealed to the Appellate Division, First Department (the 4"Appellate Division"). R. 9-10, I 05-06, 1 1 7-18, 129-30. On May 8, 2012, the Appellate Division issued the Decision, which reversed the trial court's partial grant of the NY AG's motion for summary judgment and affirmed those aspects of the decision and order denying Appellants' motions for summary judgment. R. 15181-82. Appellants served respondent with the Decision on May 14, 20 12, and moved the Appellate Division for leave to appeal to this Court on the same day. The Appellate Division granted Appellants' motion for leave to appeal on July 17, 2012. R. 15179-80. STATEMENT OF FACTS I. PROCEDURAL HISTORY OF THIS ACTION At the beginning of 2005, American International Group, Inc. C"AlG") was the largest insurance company in the world. R. 1571, 6448-49, 10380-81. Defendant-Appellant Maurice R. Greenberg had been the key to the success of AIG for almost forty years. R. 8985. He served as AIG's President and Chief 5 Executive Officer from 1968 to 1989, and as its Chief Executive Officer from 1989 until his retirement from that position on March 14, 2005. /d.; R. 4259. Mr. Greenberg was a member of AIG's Board of Directors from 1967 to 1989, and served as the Chairman of the Board of Directors from 1989 to June 8, 2005. R. 3497. Defendant-Appellant Howard l. Smith similarly was a significant member of the AIG team for many years. Mr. Smith joined the company in 1984 as Vice President and Comptroller and served in that role until 1996, when he was named Chief Financial Officer, Executive Vice President and Comptroller. R. 3000-02. At the time of his departure in March 2005, he was Vice Chairman, Chief Financial Officer and Chief Administrative Officer. /d. Mr. Smith also served as a director of AIG between 1997 and his resignation from the board on June 3, 2005. R. 3002. On May 26, 2005, after Appellants ceased to be officers of AIG, the NY AG filed a complaint against AIG and Appellants alleging, inter alia, that AIG's financial statements had been materially misstated due to AIG' s accounting treatment of nine different matters while Appellants were CEO and CFO.t R. The Superintendent of Insurance of the State of New York (the ""DOl") was also a named plaintiff in the originaJ complaint in this action, which also alleged a claim for violations of New York Insurance Law§ 310(a)(3) against AIG only. R. 1410-47. In February 2006, AIG settled with the DOL R. 1515-70. The DOl voluntarily withdrew from the action by court order dated September 10, 2007. 6 1410-47. The NY AG alleged that the nine purported accounting irregularities misstated AIG's net income by over $900 million (22.39%) and AIG's shareholder equity by over $2 billion (63.35%), and that AIG investors were misled in violation of New York's Martin Act and Executive Law§ 63( 12). /d. ln February 2006, AIG settled with the NY AG, leaving Appellants as the only defendants. R. 1515- 70. On September 6, 2006, the NY AG filed an Amended Complaint that dropped all but four of the matters underlying the original complaint. R. 15 71-93. The NY AG later abandoned two of those matters, leaving only two transactions at issue in the case: these are referred to as the ''Gen Re Transaction'' and the HCAPCO Transaction." The NY AG alleges that improper accounting treatment regarding each transaction misled AIG shareholders and seeks to recover damages the NY AG claims those shareholders suffered as a result.2 R. 1572, 1592. The NY AG has recognized the evolution of this action and now describes it as follows: ''Simply put, the Attorney General brings these cases to recover damages suffered by many, sometimes tens of thousands or more, investors." R. I 4870. 2 The two remaining alleged accounting irregularities did not affect either AJG 's reported net income or its shareholder equity. R. 2304-05, 2307-08, 6454, I 0387. Accounting for the GenRe Transaction allegedly increased AJG's reported net loss reserves by 2o/o, R. 9299, 6451, 10383, and accounting for the CAPCO Transaction allegedly reclassified four years of losses totaling $163 million for a discontinued line of business, R. 2307-08. 7 Because it is relevant to one of the issues on appeal, namely whether the NY AG's reliance only on inadmissible hearsay was sufficient to defeat the Appellants' motions for summary judgment concerning the Gen Re Transaction, the Gen Re Transaction is described in some detail below .3 II. THE PARALLEL FEDERAL SECURITIES CLASS ACTIONS In October 2004, several federal securities class actions were filed against AlG, Appellants, and various others. These securities lawsuits were consolidated under the caption "In re American International Group, Inc. Securities Litigation" (the •'Federal Securities Class Action'').4 Plaintiffs in the Federal Securities Class Action allege that AlG misled investors through various purported accounting improprieties, including the GenRe and CAPCO Transactions now before this Court, R. 13885-939, and sought damages as a result. After seven years of litigation and mediation sessions involving a former federal judge, the parties in the Federal Securities Class Action entered into four partially interrelated settlements that cover, inter alia, claims relating to the Gen Re and CAPCO Transactions and resuJt in payments of over $1 billion to AIG 3 Because this appeal does not concern the CAPCO Transaction separate from the standing and preemption issues (see infra Argument~ § I)~ that transaction is not described herein. 4 See Order Consolidating Cases [Dkt. 52], In reAm. lnt 'I Group, Inc. Sees. Litig., No. 1 :04CV08141 (S.D.N. Y. Feb. 8. 2005) C"ln re AJG,~). AIG's independent auditor PricewaterhouseCoopers LLP C"PwC") was added as a defendant in the Amended Complaint. See Consolidated Amended Class Action Complaint [Dkt. 61 ], In re AJG (S.D.N. Y. April 19, 2005). 8 security holders, including the very persons on whose behalf the NY AG now seeks to recover damages in this action. 5 The NY AG has sought to defer and prevent finaJ approval of the Federal Securities Class Action settlement with Appellants primarily because of its recognition that under "the New York Court of Appeals' recent and controlling Applied Card decision,6 the broad terms of the releases ... would terminate NY AG's ... pursuit of compensation for the injured AJG shareholders."7 III. THE NY AG ACKNOWLEDGES THAT IT IS PURSUING THIS ACTION FOR MONEY DAMAGES FOR PRIVATE SHAREHOLDERS WHO ALREADY ARE MEMBERS OF A CERTIFIED FEDERAL SECURITIES CLASS Although the NY AG's Amended Complaint originally sought broad and ill- defined relief, it is uncontested that the NY AG is now pursuing this action on behalf of private shareholders of AIG based on their alleged stock losses. Indeed, the NY AG has flatly and repeatedly acknowledged that its case is now an action 5 6 See Lead Plaintiffs Memorandum of Law in Support of Its Motion for Preliminary Approval of Class Settlement with General Reinsurance Corporation [Dkt. 498], In re AJG (Feb. 25, 2009); Order and Final Judgment As To PricewaterhouseCoopers LLP [Dkt. 569], In re AIG (Dec. 2, 2010); Memorandum & Order [Dkt. 619], In re AJG (Feb. 2, 2012); Preliminary Approval Order [Dkt. 623 ], In re AJG (Feb. 3, 20 12); see also R. 13866. ln addition, AIG shareholders are entitled to an additional recovery of over $800 million from the Fair Fund established by the United States Securities and Exchange Commission as a result of AI G' s settlement payment to the SEC. See Final Judgment as to Defendant AJG at 5, SEC v. AJG, No. 06 Civ. 1000 (S.D.N. Y. Feb. 17, 2006). Thus, there are nearly $2 billion in recovered funds available to compensate AIG shareholders through the various settlements in the Federal Securities Class Action and with regulatory authorities. People v. Applied Card Systems. Inc., 11 N. Y .3d 105 (2008). 7 See Objection of the Attorney General of the State of New York to the Proposed Starr Settlen1ent [Dkt. 650] at 3, In re AJG (Aug. 17, 20 12). 9 for money damages brought on behalf of the private AIG shareholders who are part of the Federal Securities Class Action. SeeR. 14870 ("the Attorney General brings these cases to recover damages suffered by many, sometimes tens of thousands or more, investors"); R. 1486 7 (''In this case, the parties who suffered damages are the hundreds of thousands of persons who were defrauded by purchasing AIG stock at levels propped up by the dissemination of false financial statements."); R. 15173 (''the OAG can obtain damages on behalf of al1 AIG stockholders, no matter where they reside"). In short, no form of injunctive relief, disgorgement, restitution or other equitable relief is at issue- Appellants never sold any AIG stock during the relevant period; did not directly receive funds from investors; and both have entered consent judgments with the SEC covering any potentia] injunctive relief sought by the NY AG. R. 3985-96. IV. APPELLANTS' MOTIONS FOR SUMMARY JUDGMENT On September 23, 2009, Appellants fi1ed motions for summary judgment. On September 25, 2009, the NY AG filed a motion for partial summary judgment. On October 21,2010, Justice Ramos denied Appellants' motions in their entirety.8 8 Justice Ramos denied the NY A 0 's motion for partial summary judgment on liability with respect to the GenRe Transaction, but granted the NY AO's motion for partial summary judgment on liability with respect to the CAPCO Transaction. R. 14-96. On May 8, 2012, the Appellate Division reversed the trial court's grant of the NY A 0 's motion for partial summary judgment with respect to the CAPCO Transaction. R. 15200-02. 10 R. 14-96. In so doing, the trial court held that the NY AG's Martin Act and Executive Law claims were not preempted by federal law. R. 38-46. The trial court also permitted the NY AG to rely on hearsay evidence to create a triable issue of fact as to Appellants' knowledge of the alleged wrongdoing without consideration as to whether any such hearsay could be presented in proper and admissible form at trial. R. 46-61. In this regard, the trial court permitted the NY AG to rely upon testimony and other materials from United States v. Ferguson, a federal criminal trial that took place in Hartford, Connecticut (the "Hartford Trial") in which neither Appellant was a party. See, e.g., R. 18-28. The trial court also permitted the NY AG to rely on testimony, emails, notes, and recorded telephone conversations containing second-hand rumors and speculation about what Appellants supposedly said or were told. R. 16-30, 46-61 . The NY AG did not attempt to demonstrate, and the trial court made no findings, that any of this hearsay evidence could be presented in adn1issible form at trial. R. 14-96. Instead, the trial court found that testimony from the Hartford Trial could be admitted because many of the witnesses from that trial were deposed in this case and the testimony "'was being offered by the NY AG largely to substantiate the testimony that these identical witnesses have already given in this action." R. 49. The trial court also ruled that the hearsay testimony, emails, notes, and recorded telephone conversations could be admitted against Mr. Greenberg 11 under the co-conspirator exception to the hearsay rule. R. 54-58. The Department of Justice, however, stated at oral argument before the Second Circuit on an appeal from the Hartford Trial, in response to Judge Straub's question as to why Mr. Greenberg was not indicted, that it did not have evidence of wrongdoing by Mr. Greenberg: I can address what was on the pub U c record at trial with respect to Mr. Greenberg, which is that there wasn't a single e-mail that we had - that we are able to produce at trial involving Mr. Greenberg that I know of standing here. That there were no recorded phone calls to Mr. Greenberg, that there was not even a substantial witness who spoke about this to Mr. Greenberg. Nov. 1 7, 201 0 Audio Recording of United States v. Ferguson Oral Argument before United States Court of Appeals for the Second Circuit at II :58:45 A.M.- 12:03:46 P.M. With respect to Mr. Smith, the trial court found that he was not a co- conspirator because the record lacks {,'direct evidence at this stage to warrant the conclusion that Smith was a member of an illicit scheme to artificially inflate A1G's Joss reserves." R. 60. Nevertheless, and despite the lack of any admissible evidence against Mr. Smith, the court denied summary judgment as to him as well. R. 95. V. THE APPELLATE DIVISION'S DECISION Following the trial court's order denying Appellants' motions for summary judgment, Appellants appealed to the Appellate Division, arguing, among other 12 things, that ( 1 ) the trial court erred in failing to grant Appellants' motion for summary judgment as to all claims because the NY AG lacks proper authority and standing to pursue monetary damages on behalf of a class of private shareholders and its claims in this case are preempted by federal law; and (2) the trial court erred in failing to grant Appellants' n1otion for sun1n1ary judgment as to the Gen Re Transaction because the court improperly relied on inadmissible and irremediable hearsay evidence to deny summary judgment as to that transaction.9 First, the majority rejected Appellants' argument that the NY AG's use of the Martin Act and the Executive Law in this case is preempted by federal law. According to the majority, Hupon review of the cited federal legislation (NSMIA, PSLRA, SLUSA), 10 the relevant legislative history, and the governing case law, we find no evidence that Congress intended to preempt the Attorney General's Martin Act and Executive Law claims in this action." R. 15196. Second, the majority rejected Appellants' argument that summary judgment should have been granted in their favor with respect to the Gen Re Transaction Appellants also appealed the triaJ court's order granting the NY AG's motion for partial summary judgment as to the CAPCO Transaction. R. 15189-90. The Appellate Division majority agreed that there were triable issues of material fact regarding the CAPCO Transaction, and thus, reversed the triaJ court's grant of summary judgment in the NY AG's favor as to that transaction. R. 15200-02. That aspect of the Decision is not at issue in this appeal. 10 ""NSMIA" refers to the National Securities Markets lmprovement Act of 1996, Pub. L. No. 104-290, 110 Stat. 3416. '"PSLRA" refers to the Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, 109 Stat. 737. ··sLUSA" refers to the Securities Litigation Uniform Standards Act of 1998, Pub. L. No. I 05-353, 112 Stat. 3227. 13 because there is no admissible evidence demonstrating that Appellants participated in or knew about any alleged wrongdoing with respect to the transaction. In so doing, the majority held that "'in opposition to such motion for summary judgment, a court can consider hearsay evidence.'' R. 15199-200. Justice Catterson dissented as to the denial of Appellants' motions for summary judgment. He concluded that federal law preempted the Martin Act and Executive Law in this case. Contrary to the majority opinion, the dissent noted that the relevant federal statutes demonstrated Congress' intent to require a uniform national standard governing liability for private securities class actions. R. 1521 1. As the action by the NY AG was a lawsuit for "the benefit of private parties" and the relief at issue was Han award of damages for a worldwide class of AIG shareholders," the action was "indistinguishable from a private class action'' and, therefore, preempted by federal law. R. 15211-12. The dissent also found that the NY A G' s efforts to advance an action seeking monetary damages for private shareholders violated "limitations on the power of the NY AG to prosecute claims for money damages on behalf of private entities." R. 15215. Noting that the private shareholders had, in fact, litigated their own interests in the Federal Securities Class Action under the governing federal securities laws, the dissent stated that "private shareholders who have cause to complain have no need of the NY AG to protect their rights" and thus, the NY AG's 14 use of the Martin Act and Executive Law to seek monetary damages on behalf of the same class of private shareholders should be summarily rejected. R. 15216. Final1y, the dissent determined that, in all events, summary judgment with respect to the Gen Re Transaction was appropriate ""due to the utter failure of the New York Attorney General to oppose the defendants' motion with evidence in admissible form or to put forward an excuse for the failure to do so after five years of investigation and discovery." R. 15203. To the extent evidence was submitted relating to Appellants' alleged knowledge of or participation in any fraud underlying the GenRe Transaction, the dissent concluded that such evidence was irremediable hearsay that could not be made admissible at trial, and therefore was insufficient to defeat a motion for summary judgment. R. 15219-23. ARGUMENT I. THE NY AG LACKS STANDING AND AUTHORITY TO PURSUE THIS ACTION UNDER THE MARTIN ACT AND EXECUTIVE LAW SEEKING TO RECOVER MONETARY DAMAGES ON BEHALF OF A CLASS OF PRIVATE SHAREHOLDERS AND ITS EFFORTS TO DO SO HERE ALSO CONFLICT WITH, AND ARE PREEMPTED BY, THE FEDERAL LAWS GOVERNING NATIONALLY TRADED SECURITIES For more than seven years, AIG shareholders alleged to have incurred losses as a result of the conduct at issue in this action have vigorously pursued their claims in the Federal Securities Class Action in accordance with governing federal securities laws. As a result, class action settlements have been negotiated that 15 provide aggregate recoveries of more than $1 billion and resolve the shareholders' claims against AIG, Appellants, and others, relating to, among other issues, the Gen Re and CAPCO Transactions. See supra Statement of Facts, § II. Against this backdrop, the NY AG nonetheless seeks to advance this action to pursue monetary damages on behalf of those same private shareholders relating to a subset of the same transactions addressed in the Federal Securities Class Action, but attempts to invoke the lesser standards of proof it claims are available under the Martin Act and the Executive Law .11 The NY AG has gone so far as to file objections to one of the Federal Securities Class Action settlements, asserting that the NY AG's own expert has calculated Hdamages" in excess of the settlement amount agreed to by the class of private shareholders, 12 and stating: ~'The NY AG Action seeks a substantia] recovery that would inure to investors who are part of the defined class in this case." Objection of the Attorney General of the State of New York to the Proposed Starr Settlement [Dkt. 650] at 8, In re AJG (Aug. 17, 20 12). ln asserting that this action, rather than the private Federal Securities Class Action brought by 11 The NY AG readily concedes that the Federal Securities Class Action is "'brought under different statutes imposing higher standards of proof." R. 14870. 12 The Second Circuit has expressly held that the measure of damages utilized by the NY AG fails to account for confounding factors. United States v. Ferguson, 676 F.Jd 260, 274 (2d Cir. 20 II) (holding that the Gen Re Transaction ••was one of several problems besetting AIG at that time" that could cause AIG's stock price declines on the dates used by the NY AG, including '"[ u ]nrelated allegations of bid-rigging, improper self-dealing, earnings manipulations. and more .... "'). 16 the AIG sharehoJders themselves, should provide the mechanism for the recovery of damages on behalf of private investors, the NY AG expressed concern before the federal court that ""[ u ]nder the New York Court of Appeals' recent and controlling Applied Card decision," settlement of the Federal Securities Class Action in accordance with federal law ""would terminate NY AG's assiduous, seven-year pursuit o[compensation for the injured AIG shareholders." ld. at 3 (emphasis added). As shown below, the NY AG may not seek to use the lesser standards of proof under the Martin Act and Executive Law to pursue damages on behalf of a class of private shareholders in nationally traded securities. First, the NY AG lacks proper standing and authority to litigate a securities class action for monetary damages on behalf of an identified class of private shareholders. Second, use of the lesser standards of proof under the Martin Act and Executive Law to pursue such an action for damages on behalf of private investors conflicts with the federal laws enacted to ensure uniform national standards governing lawsuits for damages on behalf of investors in nationally traded securities and is thus preempted. A. The NY AG Lacks Standing And Authority To Pursue Money Damages On Behalf Of An Identified Class Of Private Shareholders This Court has made clear that 44 [ w ]ithout both capacity and standing," a party cannot sue. Graziano v. County of Albany, 3 N.Y.3d 475, 479 (2004). Moreover, statutes granting capacity to sue Hdo not abdicate the standing 17 requirements." Central States Southeast and Southwest Areas Health and Welfare Fund v. Merck-Medea Managed Care, LLC, 433 F .3d 181, 200 (2d Cir. 2005). That is, the "Legislature, consistent with the principles of separation of powers underlying the requirement of standing, cannot grant the right to sue to a plaintiff who does not have standing." People v. Grasso, 54 A.D.3d 180, 197 ( l st Dep 't 2008) (citation omitted). These principles apply with equal force to the "'Attorney General, "like all other parties to actions.'" /d. at 198 (quoting People v. Lowe, 117 N.Y. 175, 191 ( 1889) ). Regardless of whether the capacity to sue is expressed in any statute, the NY AG does not have standing to continue this suit unless it can demonstrate ""a sufficiently cognizable stake in the outcome." Community Bd. 7 of the Borough of Manhattan v. Schaffer, 84 N.Y.2d 148, 155 ( 1994). The NY AG has standing when it pursues appropriate sovereign or quasi- sovereign interests on behalf of New York or the general interests of the citizenry of New York as a whole. A substantial body of law, however, establishes that the NY AG does not have standing to use the power of the Office of the Attorney General in the "pursuit of compensation" through civil damage recoveries on behalf of an identifiable class of private interests. See New York v. Seneci, 817 F.2d 1015, 1017 (2d Cir. 1987) (dismissing suit under Executive Law§ 63(12) and RICO for lack of standing where the NY AG sought "only ... to recover money damages for injuries suffered by individuals"); see also Grasso, 54 A.D.3d at 206- 18 07; Lowe, 117 N.Y. at 191. This is because, to have standing, the NY AG ""must seek to redress an injury to an interest that is separate from the interests of particular individuals." Seneci, 81 7 F .2d at 1 01 7 (emphasis added); see also State v. New York City Conciliation and Appeals Bd., 123 Misc. 2d 47,49 (Sup. Ct. N.Y. Cnty. 1984) ("when the state does bring suit, it must be for redress of wrongs done to the interests of the people as a whole and not merely to vindicate the individual or private interests of certain citizens") (citation omitted). The doctrinal analysis requiring a State Attorney General to have a cognizable legal interest separate from those of private individuals in order to have standing to advance a civil lawsuit (whether authorized by statute or at common law) is wel1-established. 13 It is referred to as ""parens patriae" standing, and the requisite cognizable interest separate from those of private individuals is termed a Hquasi-sovereign'' interest. Seneci, 817 F .2d at 1017 (stating in suit brought under § 63( 12) and RJCO that a ~"state that sues as parens patriae must seek to redress an injury to an interest that is separate from the interests of particular individuals" and holding that the NY AG was not seeking to remedy "'any harm done to its quasi- 13 ""[A] State may, for a variety of reasons, attempt to pursue the interests of a private party, and pursue those interests only for the sake of the real party in interest." See Alfred L. Snapp & Son, Inc. v. Puerto Rico, 458 U.S. 592, 602 (1982). Where it does so, however, ""the State is no more than a nominal party." /d. 19 sovereign interests"); see also Grasso, 54 A.D.3d at 198-99. 14 But as has been recognized: ~ 4 [n]o state has a legitimate quasi-sovereign interest in seeing that consumers or any other group of persons receive a given sum ofn1oney.,' Commonwealth of Pennsylvania v. Mid-Atlantic Toyota Distributors, Inc., 704 F.2d 125, 129 n.8 (4th Cir. 1983) (internal quotation marks and citation omitted; aJteration in original); see also In re Exxon Valdez, No. A89-095 CIV, 1993 WL 735037, at *2 (D. Alaska July 8, 1993) e'Without a doubt, '[p]arens patriae has received no judicial recognition in this country as a basis for recovery of money damages for injuries suffered by individuals.'") (citation omitted) (emphasis added). 15 As shown above, the NY AG has made crystal clear that through the continued prosecution of this action it seeks to recover money damages on behalf of specific private parties- i.e., shareholders holding shares of AIG' s publicly traded stock on specified dates. See Grasso, 54 A.D.3d at 197 (standing 44must exist at all stages of a proceeding"). It is undisputed that injunctive relief is no longer at issue in this case. 16 The NY AG at times blithely describes the monetary 14 See also Snapp, 458 U.S. at 601 (explaining the •·quasi-sovereign" interests necessary for a State to have ''parens patriae" standing). 15 Consistent with this fundamental principle, we have found no authority ever before allowing the NY AG to advance an action solely for money damages on behalf of an identified class of private individuals under either the Martin Act or Executive Law. 16 As noted above, the NY AG cannot have a cognizable interest in pursuing injunctive relief here given that Appellants have each entered into a consent judgment with the SEC in the 20 remedy it is pursuing as ""restitution," but it is clear that its express efforts to "'recover damages suffered by tens of thousands or more, investors,'' see R. 14870 (emphasis added), do not constitute "'restitution" under the Martin Act or any recognized definition of that term. The recoveries sought by the NY AG qualify as --damages" because they "'focus on the plaintiff and provide "make whole,' con1pensatory n1onetary relief; restitution, by contrast, concentrates on the defendant-preventing unjust enrichment, disgorging wrongfully held gains, and restoring them to the plaintiff." Pure Power Boot Camp, Inc. v. Warrior Fitness Boot Camp, LLC, 813 F. Supp. 2d 489,534 (S.D.N.Y. 2011) (applying New York law) (citation omitted); see American Federal Group, Ltd. v. Rothenberg, 136 F.3d 897,907 n.7 (2d Cir. 1998) (explaining that under New York law, ""damages ... con1pensate for a claimant's loss" while a ""restitutionary" remedy prevents a defendant's "'unjust enrichment as measured by his ill-gotten gain."). Further, the NY AG cannot seek restitution from Appellants as it is undisputed that they did not sell any AJG stock during the relevant period and United States District Court for the Southern District of New York that imposes broader injunctive relief than that sought by the NY AG. R. 3985-96, 13999-140 13; see Seneci, 817 F.2d at I 017 (holding NY AG had no cognizable interest in pursuing injunctive relief in federaJ court where injunction on same subject matter had been entered by state court); see also New York v. Holiday Inns. Inc., 656 F. Supp. 675,678 (W.D.N.Y. 1984) (holding NY AG had no cognizable interest in seeking injunction where private litigants were attempting to obtain injunction covering same subject matter). ln their consent judgments, Appellants neither admitted nor denied wrongdoing. R. 3985-96, 13999-14013. The consent judgment entered into by Mr. Greenberg resolved a Complaint by the SEC for claims based on control person liability, not fraud claims. R. 3985-96. 21 never received any monies from the investors at issue. See Gen. Bus. Law § 353(3) (stating NY AG may seek "restitution of any moneys or property obtained' as a result of the alleged fraudulent practice) (emphasis added); see also Slater v. Gulf, M. & O.R. Co., 307 N.Y. 419,421 (1954) (holding that where there is 4'no factual basis for unjust enrichn1ent, there is no basis for restitution."). 17 Moreover, the NY AG cannot manufacture its own standing by claiming, as it previously has, that it has an interest in protecting the integrity of the securities market. Where, as here, only money damages for the benefit of an identifiable class of private shareholders are sought, the mere assertion that the action is intended 44to protect the integrity of the securities marketplace in New York" does not confer standing. To the contrary, such efforts have been repeatedly rejected. See Seneci, 817 F .2d at 1 0 1 7-18 (protection of "the integrity of the state's marketplace'' insufficient to confer standing on NY AG ); see also Grasso, 54 A.D.3d at 198-99 (same, except that restitution- rather than damages- was sought). That is exactly why this action is barred by settled precedent, including New York v. Seneci. "The state cannot merely litigate as a volunteer the personal claims of its competent citizens." Seneci, 817 F.2d at 1017 (citing Pennsylvania v. New 17 Regardless of the characterization of the relief as either .. damages'· or .. restitution,,. where, as here, n[ a ]ny recovery would not go to the state but ultimately to the [] investors in the federal action, who are the real parties in interest" the state functions as a nominal party acting in a ··representative" capacity. in re Baldwin-United Corp., 770 F.2d 328, 341-42 (2d Cir. 1985). 22 Jersey, 426 U.S. 660, 665 ( 1976)); see People v. Singer, 193 Misc. 976, 980 (Sup. Ct. N.Y. Cnty. 1949) ("'The matters set forth, if they are wrongs, are wrongs to individual citizens and not to the state and are remediable at the suit of the parties injured only.'') (citation omitted); see also People v. Operation Rescue Nat '1, 80 F .3d 64, 71 (2d Cir. 1996) ("'New York's standing does not extend to the vindication of the private interests of third parties.") (citation omitted). Here, as in Seneci, because the NY AG "seeks to recover money damages for injuries suffered by individuals, the award of money damages will not compensate the state for any harm done to its quasi-sovereign interests.'' 817 F.2d at 1017. The NY AG's assertion that it is seeking monetary relief to protect ~'the integrity of the state's marketplace'' fails to qualify as a quasi-sovereign interest because "the monetary relief sought by the complaint is not designed to compensate the state for those damages." !d.; see Grasso, 54 A.D.3d at 198 (rejecting assertion that ~,~,the continued prosecution of this action somehow is relevant to the integrity of trading"). "Thus, the state as parens patriae lacks standing to prosecute [this] suit." Seneci, 817 F.2d at 1017 (citation omitted). The NY AG's lack of standing is also independently established by the fact that the private shareholders at issue are fully capable of obtaining appropriate relief on their own behalf. See New York City Conciliation and Appeals Bd., 123 Misc. 2d at 50 ("arguments for standing become less compelling when private suits 23 by the aggrieved parties are feasible and would provide complete relief') (citation omitted); People v. II Cornwell Co., 695 F.2d 34, 40 (2d Cir. I 982) (state lacks standing unless it can show ~'that individuals could not obtain complete relief through a private suit"), vacated, in part, on other grounds, 718 F .2d 22 (2d Cir. 1983 ). "If the aggrieved individual has an adequate ren1edy at law, then the state is merely a nominal party with no real interest of its own. As a nominal party the state would not have capacity to sue as parens patriae." New York City Conciliation and Appeals Bd., 123 Misc. 2d at 49. 18 Here, there can be no doubt that AI G' s investors, on whose behalf the NY AG readily admits it is seeking damages, have an adequate remedy at law. Not only are AI G 's shareholders capable of obtaining relief through a private suit, but also a consolidated securities class action on behalf of a11 such investors has, in fact, been litigated in the United States District Court for the Southern District of New York. See In reAm. lnt 'I Group Sec. Litig., No. l :04CV08141 (S.D.N.Y. filed Oct. 15, 2004). The NY AG, however, seeks to obstruct the resolution of that action and the approval of the pending settlement entered into by six defendants, including Appellants, in order to preserve its own action brought on behalf of those same shareholders. Because the al1egedly aggrieved parties not onJy can obtain 18 Indeed, even where the NYAG has sought equitable remedies under Executive Law§ 63(12), including broad injunctive relief, its action has been dismissed for lack of standing where the affected individuals could obtain such relief themselves. See Holiday Inns, 656 F. Supp. at 678. 24 relief themselves- but are actually doing so- as a matter of law, the NY AG has no rea] interest of its own in pursuing this action. See, e.g., Holiday Inns, 656 F. Supp. at 678. Finally, the NY AG's effort to recover on behalf of private shareholders, despite having no cognizable interest on behalf of New York, raises "serious constitutional questions" regarding the NY AG's authority. Grasso, 54 A.D.3d at 209. As the Appellate Division explained in Grasso, Artic1e VII, § 8 ( 1) of the New York Constitution has been held to bar the ''use of public funds'' to further the interests of private organizations and individuals. Grasso, 54 A.D.3d at 195-96; see also Schulz v. State, 86 N. Y .2d 225, 234 ( 1995). Here, the constitutionaJ concern is more squarely at issue because the NY AG is using public resources to seek the recovery not of restitution (i.e., the return of il1-gotten gains), but solely of money damages for certain individuals. These constitutiona] questions, however, can be properly avoided by adherence to the deep-rooted principles of standing set forth above. B. The NY AG's Use Of The Martin Act And Executive Law To Advance A Claim For Money Damages On Behalf Of Private Shareholders Conflicts With Federal Securities Laws And Is Preempted This Court has previously recognized that the NY AG should not be permitted to use its authority to effect recoveries under weakened standards of proof inconsistent with fault-based statutory schemes. People v. Grasso, 11 25 N.Y.3d 64, 70-72 (2008). Grasso dealt with an effort to use common law parens patriae authority to "circumvent" the ''fault-based'' standards that otherwise applied to the relevant statutory causes of action under New York law. The same fundamental concern arises in the present context. Here, the NY AG has invoked the Martin Act and Executive Law to seek private recoveries for AIG shareholders using lesser standards of proof that circumvent the scienter and reliance standards critical to the uniformity sought by the federal legislation governing securities actions. Congress has determined that efficient securities markets require uniform national standards governing liability to investors for alleged misrepresentations with respect to nationally traded securities. Lander v. Hartford Life & Annuity Ins. Co., 251 F.3d 101, 111 (2d Cir. 2001 ). As the United States Supreme Court has held: "The magnitude of the federal interest in protecting the integrity and efficient operation of the market for nationally traded securities cannot be overstated." Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 U.S. 71,78 (2006). As set forth above, it is the private individual investors who are the real parties in interest on whose behalf the NY AG is seeking to recover damages. As such, this action, as with any other suit under state law seeking to recover damages on behalf of more than fifty persons for alleged misrepresentations relating to nationally listed and traded securities, is expressly precluded by the Securities 26 Litigation Uniform Standards Act of 1998 C'SLUSA''), Pub. L. No. 105-353, 112 Stat. 3227. Further, because this action seeks to apply state laws that impose far less stringent legal standards than federal securities laws specifically enacted to ensure legal "'uniformity" for shareholder suits seeking recoveries for alleged misrepresentations relating to nationally listed and traded securities, this action is also impliedly preempted by the uniform standards for securities litigation Congress fashioned through its enactment of SLUSA, the National Securities Markets Improvement Act of 1996 ("NSMIA''), Pub. L. No. 104-290, I 10 Stat. 3416, and the Private Securities Litigation Reform Act of 1995 C'PSLRA''), Pub. L. No. I 04-67, 109 Stat. 737. 1. AIG 's Private Investors Are The Real Parties In Interest And This Action Is Thus Expressly Preempted By SLUSA SLUSA provides: No covered class action based upon the statutory or common law of any State or subdivision thereof may be maintained in any State or Federal court by any private party alleging ... a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security . . . . 15 U.S.C. § 78bb(f)( 1 )(A). The term "'covered class action" is not limited to cases styled as class actions, but includes any lawsuit in which ''damages are sought on behalf of more than 50 persons" or "one or more named parties seek to recover damages on a representative basis." /d. § 78bb(t)(5)(B)(i)(II); see also S. 27 Rep. No. 1 05-182, at 8 ( 1998) (''it remains the Committee's intent that the bill be interpreted broadly to reach mass actions and all other procedural devices that might be used to circumvent the class action definition"). As explained by the U.S. Supreme Court, a H'covered class action' is a lawsuit in which damages are sought on behalf of more than 50 people." Dab it, 54 7 U.S. at 83 (citation and footnote omitted). The U.S. Supreme Court has directed state courts that the failure to dismiss actions in which damages are sought on behalf of more than 50 investors is subject to review by the U.S. Supreme Court. Kircher v. Putnam Funds Trust, 547 U.S. 633,646-48 (2006). The mere fact that a State entity, such as the NY AG, has filed a lawsuh does not mean that the State is the real party in interest, rather than the private party citizens on whose behalf it is suing. To the contrary, as the U.S. Supreme Court has explained, when a State acts to 44pursue the interests of a private party,'' courts recognize that "the State is no more than a nominal party" and the ''real party in interest" is the "private party." Snapp, 458 U.S. at 602. Thus, when a question regarding the application of federal law to an action brought by the State requires a determination as to the identity of the real party in interest, courts look past the caption to examine the nature of the relief at issue. See, e.g., In re Baldwin-United Corp., 770 F .2d 328, 340 ... 42 (2d Cir. 1985) (holding that the Eleventh 28 Amendment's bar against suits in federal court against one of the United States did not prohibit an injunction restraining the NY AG and other State Attorneys General from pursuing restitution because the real parties in interest were the ~·plaintiffs investors in the federal action"); Operation Rescue Nat'/, 80 F.3d at 71-72; accord Pennsylvania, 426 U.S. at 665-66. Where the private parties on whose behalf the State is seeking relief are the reaJ parties in interest, courts apply the relevant federal law as if the suit had been brought by those private parties. See Louisiana ex. rei. Caldwell v. Allstate Ins. Co., 536 F .3d 418, 428-29 (5th Cir. 2008) (holding that the real party in interest was not the Attorney General of Louisiana, but the private parties on whose behalf suit had been brought); see also Ohio v. GMAC Mortgage, LLC, 760 F. Supp. 2d 741, 750 (N.D. Ohio 2011 ). The test for whether a State Attorney General is the real party in interest is a familiar one. As with standing, "'when the state merely asserts the personal claims of its citizens, it is not the real party in interest." In re Baldwin-United Corp., 770 F.2d at 341; Caldwell, 536 F.3d at 426 rHtnterests of private parties are obviously not in themselves sovereign interests, and they do not become such simply by virtue of the State's aiding in their achievement."') (quoting Snapp, 458 U.S. at 29 602). 19 Thus, to qualify as the real party in interest, a State Attorney General must have 4'a quasi-sovereign interest in the controversy independent of the interests of individual citizens." New York v. General Motors Corp., 547 F. Supp. 703, 705 n.5 (S.D.N.Y. 1982) (citation omitted). As noted above, the NY AG has no quasi- sovereign interest in this action separate and distinct from those of the private shareholders for whom it is seeking money damages. See Seneci, 817 F .2d at 10 17; see also Mid-Atlantic Toyota Distributors, Inc., 704 F.2d at 129-30.20 As such, the real party in interest is not the NY AG, but the private shareholders to whom the money damages would be paid. 19 Here, the NY AG does not even seek to vindicate the interests of the citizens of the State of New York, but rather seeks a damages recovery on behalf of a worldwide class of A1G investors, most of whom are not citizens of New York. See R. 15173 (""the OAG can obtain damages on behalf of all AIG stockholders, no matter where they reside"). 20 This does not mean that the standing and rea] party in interest analyses are entirely coextensive. In the Class Action Fairness Act C"CAFA") context, in particular, while some courts utilize a '"whole complaint" approach to the real party in interest analysis in which the courts consider ""the essential nature and effect of the proceeding"- other courts apply a ""claim-by-claim approach." LG Display Co. v. Madigan, 665 F.3d 768, 773 (7th Cir. 20 ll) (citation omitted). Those courts that apply the claim-by-claim approach sometimes determine that a State Attorney General is not the real party in interest even though it may have standing. See. e.g., Caldwell, 536 F.3d at 429-30 (assuming that Attorney General had standing to bring purported enforcement action seeking injunctive relief but holding that the real parties in interest were the private parties on whose behalf the Attorney General was seeking treble damages). rationale for the claim-by-claim approach is that it '"prevents a state from wearing two in an attempt to disguise itself as the real party in interest for clain1s for which the true real parties in interest are individual consumers." WesT Virginia ex rei. McGraw v. Comcast Corp .. 705 F. Supp. 2d 441.449 (E.D. Pa. 2010). It does not matter whether the ·"wholesale'' or .. claim-by-claim" analysis is used here. Under either approach, as set forth above, the NY AG has no quasi-sovereign interest in this action separate from those of the private parties for whom it is seeking money damages. 30 SLUSA therefore applies to this action as if this suit had been brought by the AIG private shareholders, the real parties in interest. See, e.g., Pennsylvania, 426 U.S. at 665-66; see also Caldwell, 536 F.3d at 428-29. This similarly means that, as a matter of federal law, this suit cannot be viewed as an ~.'enforcement action'' excluded from SLUSA under I 5 U.S.C. § 77p( e). The statute and the governing precedents compel the conclusion that the real parties in interest here are private shareholders and that this action accordingly falls within SLUSA as a suit "by any private party." 15 U.S.C. § 77p(b). lndeed, to consider this suit for solely money damages an ''enforcement action" would violate the "fundamental canon of statutory construction ... that, unless otherwise defined, words will be interpreted by taking their ordinary, (emphasis added; citation omitted). ln the nearly one hundred year history of the Martin Act and the more than sixty year history of Executive Law § 63, the NY AG has never been allowed to advance an action under either statute where only money damages was sought on behalf of an identifiable group of private citizens.21 21 Here, the NY AG acknowledges: Defendants ... argu[ e] that equitable relief would be unnecessary, since there is no ongoing fraud, and that since they did not personally profit from the fraud there are no monies for them to disgorge. As defendants point out, the principaJ monetary relief by the Attorney General is the payment of damages .... R. 14867-68. 31 Moreover, in the rare instance where that was attempted, the NY AG was prohibited from going forward for the specific reason that: HWhere the complaint only seeks to recover money damages for injuries suffered by individuals, the award of money damages will not compensate the state for any harm done to its quasi-sovereign interests." Seneci, 817 F.2d at 1017; see In re Exxon Valdez, 1993 WL 735037, at *2. This unprecedented action under the Martin Act and Executive Law § 63( 12) seeking to recover money damages on behalf of private parties does not fall within the ordinary or common meaning of''enforcement action," as that term was understood, either when SLUSA was passed in 1998 or today. Moreover, the meaning of words used in federal statutes are determined by reference to federal law. See, e.g., Reconstruction Fin. Corp. v. Beaver County, Pa., 328 U.S. 204, 208 ( 1946); FDIC v. Philadelphia Gear Corp., 476 U.S. 426, 431 ( 1986}.22 Under federal law, SEC enforcement actions include actions for injunctive relief and civil penalties, but not actions for damages on behalf of private shareholders. See, e.g., 15 U.S.C. §§ 77h-1, 78u-1; Stoneridge lnv. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 166 (2008 ); Aaron v. SEC, 446 U.S. 680, 685-86 & n.3 ( 1980). 22 Congress is presumed to know the law. See GarretT v. United States, 471 U.S. 773, 793 (I 985) (""as we have previously noted, Congress is predominantly a lawyer's body ... and it is appropriate for us to assume that our elected representatives ... know the law'') (citation and quotation marks omitted). 32 Because this action is one seeking to recover damages on behalf of more than fifty people based on allegations concerning a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security, it is expressly precluded by SLUSA. See 15 U .S.C. § 78bb( f)( 1 ). 2. This Action For Money Damages On Behalf Of Private lnvestors Frustrates Federal Objectives For National Standards Governing Securities Actions And ls, Therefore, Impliedly Preempted Given the paramount federal interest "-in protecting the integrity and efficient operation of the market for nationally traded securities," Dabit, 547 U.S. at 78, Congress enacted "SLUSA, NSMIA, and PSLRA ... to provide national, uniform standards for the securities markets and nationally marketed securities," Lander, 251 F .3d at 1 1 1. "'Through these statutes, Congress erected uniform standards for registration of, and litigation concerning, a defined class of covered securities." /d.; see also Dabit, 547 U.S. at 87 (noting that Congress intended to create -"national standards for securities class action lawsuits involving nationally traded securities''' (citation omitted)). By this legislative scheme, Congress acknowledged ""designating the Federal government as the exclusive regulator" of national securities markets. H.R. Rep. No. 1 04-622, at 16 ( 1996) (emphasis added). Congress did this to eliminate the "dangers of maintaining differing federal and state standards of liability for nationally-traded securities." S. Rep. No. 1 05-1 82, at 3. 33 More pointedly, Congress sought to ensure that no single State could 44impose the risks and costs of its peculiar litigation system on all national issuers." /d. (citation omitted). Aware that ''fragmentation of investor remedies potentially imposes costs that outweigh the benefits," Congress enacted SLUSA and other securities laws expressly to eliminate "[ d]isparate, and shifting, state litigation procedures" with the potential for 44Significant liability that cannot easily be evaluated in advance, or assessed when a statement is made." !d. (citation omitted). The NY AG should not be allowed to upset the judgment of Congress that Hthe benefits flowing to investors from a uniform national approach" to securities litigation were superior to state-level litigation that would "foster fragmentation of our national system of securities litigation." /d. (citation omitted). Congressional intent to establish a national system of securities litigation will be obstructed if this action is allowed to move forward. The NY AG expressly acknowledges this action seeks to invoke the lesser legal standards of the Martin Act and the Executive Law in order to pursue monetary damages on behalf of AlG's private shareholders. R. 14870. As a result, the NY AG seeks to recover money damages for a worldwide class of AIG's private investors while avoiding the imposition o[the federal requirements of scienter and reliance, which are 34 applicable in the parallel suit advanced bv those same investors in the United States District Court for the Southern District o[New York. 23 Actions like this action were expressly contemplated by Congress when enacting NSMIA and SLUSA, and Congress decided that such actions should not be allowed. The legislative history of NSMIA states plainly: ""The legislation preempts authority that would allow the States to employ the regulatory authority they retain to reconstruct in a different form the regulatory regime for covered securities that [NSMIA] has preempted." H. Rep. No. l 04-662, at 34. Accordingly, NSMIA preempts state Blue Sky Laws, except for (,(,enforcement actions'' ~'with respect to fraud or deceit.'' 15 U.S.C. § 77r(c)( l ). As noted above, the NY AG's action for money damages does not constitute an ~'enforcement action" within the 440rdinary'' and "common'' meaning of that term or as that term is understood under the federal securities laws. See supra at pp. 31-32. Further, the n1anner in which the Martin Act and Executive Law have been invoked in this case i.e., to seek a damages award for investors without any showing of scienter or reliance, see R. 92-93 - does not constitute a claim for 23 If this Court finds that this action is not preempted because, contrary to the NY AG's position, the Martin Act and Executive Law require a showing of scienter and reliance, (I) summary judgment for Appellants still should be granted because the NY A G lacks and authority to pursue this action and the action is expressly preempted by S L USA as shown above~ and (2) summary judgment for Appellants with respect to the GenRe Transaction still should be granted because the NY AG proffers no admissible evidence of scienter as shown in Section II below. 35 {,'fraud and deceit" as those terms are used in federal law. Under both federal and common law, it is well-settled that actions for "fraud" and "'deceit" require proof of scienter. See Marcus v. AT&T Corp., 138 F.3d 46,63 (2d Cir. 1998); Sanders v. John Nuveen & Co., 554 F.2d 790, 795 (7th Cir. 1977); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 214-15 ( 1976); Black's Law Dictionary 1347 (7th ed. 1999). Likewise, one of the factors driving Congress to pass SLUSA two years later was a ""substitution effect'' whereby state court complaints were being filed {,'when the under1ying facts appear not to satisfy new, more stringent federal pleading requirements, or otherwise seek to avoid the substantive or procedural provisions of the Act." S. Rep. No. 105- I 82, at 3 (citation omitted). In the same manner, this action "squarely conflicts" with the uniform securities litigation standards Congress designed: The prospect is raised, then, of parallel class actions proceeding in state and federal court, with different standards governing claims asserted on identical facts. That prospect, which exists to some extent in this very case, squarely conflicts with the congressional preference for "national standards for securities class action lawsuits involving nationally traded securities." Dabit, 547 U.S. at 86-87 (citation omitted); accord Guice v. Charles Schwab & Co., 89 N.Y.2d 31, 48 (1996). In the face of these conflicts, this action 36 should be dismissed pursuant to preemption in deference to the federal legislative scheme. See, e.g., Guice, 89 N.Y.2d at 48. Against this backdrop, the flaw in the majority's preemption ruling below is apparent. The majority relied on the fact that, as pled, the NY AG's prayer for relief sought injunctive relief and disgorgement, remedies that might give the NY AG a sovereign interest in the action. SeeR. 15194 (stating that the NY AG brought this action 44tO enjoin allegedly fraudulent practices, and to direct restitution and damages"); seeR. 15195 (stating that this action 4'seeks remedies broader than the restitution sought in Baldwin."). However, while the Amended Complaint may contain such a prayer for relief, the NY AG itself has made crystal clear that the case is not about- and, as set forth above, could not be about those pled remedies. By the NY AG's own adn1ission, this action is now about the pursuit of money damages on behalf of a worldwide class of private shareholders: 44Simply put, the Attorney General brings these cases to recover damages suffered by many, sometimes tens ofthousands or more, investors." R. 14870. As such, this action is expressly precluded by SLUSA and is impliedly preempted by the uniform securities litigation standards set forth by Congress in SLUSA, NSMIA, and the PSLRA. 37 II. THE COURTS BELOW IMPROPERLY DENIED APPELLANTS' MOTIONS FOR SUMMARY JUDGMENT WITH RESPECT TO THE GENRE TRANSACTION BY RELYING ON IRREMEDIABLE HEARSAY EVIDENCE A. A Court Cannot Rely On Hearsay Evidence To Deny A Motion For Summary Judgment Unless The Proponent Can Demonstrate That The Hearsay Can Be Converted To Admissible Form At Trial Summary judgment ~.'shall be granted'' if a "defense shall be established sufficiently to warrant the court as a matter of law in directing judgment in favor of any party.'' CPLR § 3212(b) (emphasis added). The movant must first n1ake a prima facie showing of entitlement to judgment as a matter of law. Alvarez v. Prospect Hosp., 68 N.Y.2d 320,324 (1986). However, once that showing is made, "the burden shifts to the party opposing the motion for summary judgment to produce evidentiary proof in admissible form sufficient to establish the existence of material issues of fact which require a trial of the action.'' /d. (emphasis added; citation omitted); see also IDX Capitalt LLC v. Phoenix Partners Group LLC, 19 N.Y.3d 850,851 (2012); Verizon New York, Inc. v. Garvin, 13 N.Y.3d 851,852 (2009); Zuckerman v. City of New York, 49 N.Y.2d 557, 562 ( 1980). As this Court explained in Zuckerman: Normally if the opponent is to succeed in defeating a summary judgment motion he, too, must make his showing by producing evidentiary proof in admissible form. The rule with respect to defeating a motion for summary judgment, however, is more flexible, for the opposing party, as contrasted with the movant, may be permitted to demonstrate acceptable excuse for his failure to meet the strict requirement of tender in admissible fom1. We have repeated]y 38 held that one opposing a motion for summary judgment must produce evidentiary proof in admissible form sufficient to require a trial of material questions of fact on which he rests his claim or must demonstrate acceptable excuse for his failure to meet the requirement of tender in admissible form .... /d. at 562 (en1phasis added); see also Friends of Animals, Inc. v. Associated Fur Mfrs., Inc., 46 N.Y.2d 1065, 1067-1068 (1979). Thus, at a minimum, a party seeking to avoid summary judgment by relying on hearsay evidence must make an appropriate showing that such inadmissible evidence can be presented in an admissible form at trial. That is, the opposing party must demonstrate an acceptable excuse for its failure to meet the requirement of tender in admissible form when opposing a motion for summary judgment. 24 Departing from these basic principles, the majority opinion held that 44in opposition to such motion for summary judgment, a court can consider hearsay evidence." R. 15199-200. However, a closer examination of the cases relied upon by the majority- DiGiantomasso v. City of New York, 55 A.D.3d 502 (I st Dep 't 2008) and In re New York City Asbestos Litig., 7 A.D.3d 285 (I st Dep 't 2004)- demonstrates that even those Appellate Division decisions do not support such a 24 Not surprisingly, federal courts, including the Second Circuit, also recognize this basic principle and prohibit consideration of hearsay evidence on summary judgment unless there is a sufficient explanation for how that evidence will become admissible at trial. See. e.g., Presbyt. Church of Sudan v. Talisman Energy, Inc., 582 F.3d 244, 264 (2d Cir. 2009) (' .. Because the purpose of summary judgment is to weed out cases in which there is no genuine issue as to any material fact ... it is appropriate for district courts to decide questions regarding the admissibility of evidence on summary judgment.'') (citation and internal quotations omitted); see also Raskin v. Wyatt Co., 125 F.3d 55,66 (2d Cir. 1997); LaSalle Bank Nat. Ass 'n v. Nomura Asset Capital Corp., 424 F 3d 195, 205 (2d Cir. 2005 ). 39 broad statement. In DiGiantomasso, the court considered the prior testimony gf the plainti(fin a related proceeding, who obviously could testify as to the same facts at trial on a non-hearsay basis. 55 A.D.3d at 502. In In reNew York City Asbestos Litigation, 7 A.D.3d at 286, the court considered depositions from a related matter, where the defendant was a party to that matter, had participated in the deposition at issue, and elicited some of the disputed testimony on cross- examination. 2004 WL 5471937, at *28 (Brief for Plaintiff-Respondent).25 The other "hearsay" evidence at issue in Asbestos consisted merely of unauthenticated documents, which evidentiary disability could be cured at trial. ld. at *33. This Court has never authorized the use of irremediable hearsay to defeat a motion for summary judgment. See R. 15219 ("No court in New York has ever allowed hearsay to be sufficient to defeat a summary judgment motion where that hearsay evidence cannot ultimately be converted to admissible evidence at trial"). To the contrary, this Court has repeatedly recognized that one opposing a motion 25 The cases cited by the trial court, R. 51, are similarly inapplicable. See, e.g.. Naveda v. 250 Willis Ave. Supermarket, 290 A.D.2d 246. 247 (1st Dep't 2002) (principal/agent exception to hearsay rule applicable, curing hearsay); Josephson v. Crane Club, Inc., 264 A.D.2d 359, 360 (1st Dep 't 1999) (hearsay testimony from witness who could testify on non-hearsay basis to same facts at trial); Jara v. Salinas-Ramirez, 65 A.D.3d 933, 934 (I st Dep't 2009) (present sense exception to hearsay rule applicable); Commercial ins. Co. ofNewark v. Popadich, 68 A.D.3d 401,402 (lst Dep't 2009) (declaration against interest exception to hearsay rule applicable); Buckley v. JA. Jones!GMO, 38 A.D.3d 461, 462-63 (lst Dep't 2007) (business record exception to hearsay rule applicable); Fruit & Vegetable Supreme. inc. v. The Hartford Steam Boiler Inspection & Ins. Co., 28 Misc. 3d 1128, 1133-34 (Sup. Ct. Kings Cnty. 201 0) (public documents exception to hearsay rule applicable); State v. Metz, 241 A.D.2d 192, 199-201 (lst Dep't 1998) (party admissions exception to hearsay rule). 40 for summary judgment "must produce evidentiary proof in admissible form ... or must demonstrate acceptable excuse for his failure to meet the requirement of tender in admissible form ... " Zuckerman, 49 N.Y.2d at 562. The courts below did not require the NY AG to do either. B. The Courts Below Permitted The NY AG To Oppose Summary Judgment By Relying On Inadmissible Hearsay Evidence That Could Never Be Converted To Admissible Form At Trial The Gen Re Transaction was a (,(,finite reinsurance" transaction known as a ''loss portfolio transfer" or "LPT." Finite reinsurance transactions such as this, while not familiar to the general investing public, were well known and recognized as legitimate in the world of insurance and reinsurance accounting.26 Here, Mr. Greenberg asked GenRe's CEO ifGen Re would be willing to enter into an LPT that would increase AIG's premiums and loss reserves by the transfer of specified risk from GenRe to AIG. Such a transaction may be accounted for as reinsurance 26 ·"Finite reinsurance'' is widely accepted and recognized in the world of insurance and reinsurance accounting. R. 4179-80, 611 17, 7955-56. Finite reinsurance is common in the insurance industry, and it is undisputed that a correctly structured LPT transaction even if involving minimal risk transfer and undertaken to achieve balance sheet objectives is not illegal or improper. See. e.g., R. 7953-56 (Warren Buffet testifying that finite reinsurance is an established form of reinsurance that has its proper uses and regularly is used by his Berkshire Hathaway companies, and that ' .. sometimes people enter into finance [sic] - insurance because of the balance sheet or income statement effect''); see also R. 4176-82, 611 17,6742-44,6942-43,7790,7806-09,7868. 41 so long as a defined minimum (I%) of risk is actually transferred to the reinsurer. 27 As executed, this particular LPT transaction consisted of two finite reinsurance contracts between subsidiaries of AIG and GenRe that together required Gen Re to pay $500 n1illion in premiums to AIG in exchange for AIG providing $600 million of reinsurance coverage with respect to claims made on existing GenRe insurance policies. R. 6702-6724. The NY AG alleges that, despite the facial transfer of $100 million of reinsurance risk to AIG, there was not enough risk actually transferred from Gen Re to AIG for AIG to have accounted for the transaction as reinsurance under generally accepted accounting principles C'GAAP"). R. 1572, 1577, 1581. Thus, the NY AG alleges that transaction "falsely inflated AIG's loss reserves'' by approximately 2%- i.e., by $500 n1illion out of AIG's nearly $25 billion in net loss reserves. As noted at pp. 44-46, the admissible evidence unequivocally shows that Mr. Greenberg at the outset sought a properly structured deal and set in motion the appropriate machinery in both companies to execute such a properly structured deal. However, even assuming arguendo that, unknown to Appellants, the 27 Accounting standards require that a minimaJ amount of risk be present in a transaction in order for it to be accounted for as ""reinsurance," rather than as a ""deposit." If the transaction transfers sufficient minimal risk, the accounting for the transaction will reflect an increase in .. premiums'' and "'loss reserves" by the reinsurer (here AlG). The amount of risk transfer required is at least a I 0°/o chance of a I 0% loss, or a 1 o/o risk of loss. R. 4179-80 42 transaction as actually structured did not meet the applicable Hrisk transfer" criterion/8 there is no admissible evidence establishing that Appellants participated in or knew about the lack of sufficient risk transfer. 29 There is no admissible evidence that the Appellants were ever inforn1ed that anything other than a proper finite reinsurance transaction had been implemented. The admissible evidence is clear and uncontradicted on that score and there is no admissible testimony to the contrary. Nor is the hearsay objection some technical evidentiary objection. The hearsay relied on by the NY AG consisted of self-serving statements by the lower ]evel individuals directly involved in the details of structuring the deals and who were seeking understandably - to shift or at ]east share the responsibility for any defects to the Appellants. Instead of granting summary judgment in Appellants' favor as they should have done, the courts below permitted the NY AG to defeat summary judgment by relying on hearsay, double hearsay, and triple hearsay statements by persons involved in working out the details of the deal and who now seek to associate 28 There is, in fact, a serious dispute regarding this proposition. The Appellate Division dissent found that the NY AG ••failed to offer any admissible evidence that the transaction was without risk." R. 15218. 29 As the Appellate Division concluded, even under the lesser standards of the Martin Act, in order to hold Appellants personally liable in this case, the NY AG must demonstrate that Appellants ''knew of, or participated in the fraudulent aspects" of the alleged fraud. R. 15197-98, 15200 (citing Marine Midland Bank v. John E. Russo Produce Co., 50 N.Y.2d 31. 44 (1980)~ People v Apple Health & Sports Clubs, 80 N. Y .2d 803, 807 ( 1992)~ Polonetsky v. Better Homes Depot, Inc., 97 N. Y.2d 46. 54 (200 1 )) (emphasis added). 43 Appellants with what may have turned out to be a riskless and therefore improperly accounted for deal. The trial court and Appellate Division did so without requiring the NY AG to make any showing of acceptable excuse for its failure to meet the requirement of tendering evidence in admissible form or addressing the fact that the hearsay evidence at issue could never be presented in admissible fom1 at trial. All that the evidence properly shows is that Mr. Greenberg sought a lawful transaction transferring the requisite minimum amount of risk. There is no admissible evidence that Appellants' subordinates at AIG (and their counterparts at GenRe) ever informed Appellants that anything other than a proper transaction was consummated and properly accounted for. The NY A G' s attempt to implicate Appellants with testimony from witnesses who never dealt with Appellants is unfair to Appellants and is improper as a matter of law. With this in mind, Appellants will set out the evidence where the courts below attempted to in1plicate Appellants in the impropriety by relying solely on evidence that is not inculpatory or did not originate in inculpatory statements made by or to the Appellants. 1. Appellants Submitted Admissible Evidence Establishing That They Did Not Know Of Or Participate In The Allegedly Fraudulent Aspects Of The GenRe Transaction The admissible evidence submitted by Appellants demonstrates that they did not participate in or know about any alleged improprieties relating to the Gen Re Transaction. To the contrary, the admissible evidence shows that on October 31, 44 2000, Mr. Greenberg called Mr. Ronald Ferguson, then CEO ofGen Re, to inquire about the possibility of a legitimate LPT transaction. R. 635-37, 643-45.30 Mr. Ferguson did not know whether Gen Re had a suitable Joss portfolio availab1e, and thus had to get back to Mr. Greenberg. R. 6058, 6062, 6746-47. It is also undisputed that at no time during this conversation did Mr. Greenberg ask for, nor did Mr. Ferguson suggest, a reinsurance transaction without risk transfer. R. 6114- 15. Shortly thereafter, Mr. Greenberg appointed Christian M. Milton, an Executive Vice President and head of AIG's reinsurance department, to handle the transaction going forward for AIG. R. 6061-62. Likewise, Mr. Ferguson designated Richard Napier, a Senior Vice President of Gen Re, to explore whether Gen Re could provide AIG with a sufficient loss portfolio and to handle the transaction for GenRe going forward. See, e.g., R. 584-87, 6082-83. Uncontroverted evidence establishes that for the next two weeks, from October 31 51 to November 13rh, Mr. Napier and numerous other GenRe 30 The NY AG argues that Mr. Greenberg telephoned Mr. Ferguson because, on October 26, 2000, AIG's stock price temporarily dropped following the release of AIG's third quarter 2000 financial results in which it reported that loss reserves declined by less than a quarter of a percent, i.e., a $59 million reduction from its then-existing loss reserves of $24.5 billion. However, it is undisputed that the possibility of an LPT was first raised at a meeting in early October 2000, R. 6065-66,6127-29, well before AIG's third quarter 2000 earnings release and that by the time Mr. Greenberg called Mr. Ferguson, the stock already had returned to its pre-October 26th price, see R. 7904-05. 45 executives31 sought to structure a legitimate, risk-bearing finite reinsurance transaction with AIG.32 Those GenRe executives testified that they understood that the transaction AIG requested would contain adequate risk transfer to be accounted for as reinsurance and none believed there was anything improper about the transaction requested.33 At his deposition in this action, Mr. Napier testified that it was not until November 13th, when Christopher Garand, GenRe's Chief Underwriter of Finite Reinsurance, became involved in the transaction that the possibility of a ' 4no-risk'' deal first was raised internally at GenRe. R. 1926-29,4133-35. According to Mr. Napier, by that time, i.e., two weeks after Mr. Greenberg's telephone call to Mr. Ferguson, Gen Re had not been able to find a suitable loss portfolio that transferred sufficient risk to AlG. /d. As a result, Gen Re unilaterally decided to explore a 31 Those executives included Mr. Ferguson (CEO}, Elizabeth Monrad (CFO), Lee Steeneck (Chief Actuary), Joseph Brandon (President), Thomas Kellogg (COO), Tad Montross (Chief Underwriting Officer), Annette Morrill (Senior Staff Accountant) and James Sabella (Director of Domestic Tax). 32 See. e.g., R. 584-87, 4151-59, 4169-75, 6733-34, 6746-48, 6750-66, 6769-74, 6782-83, 7806- 15, 12405-07, 12424, 12427, 12433, 12437, 14161, 14427. 33 For example, Sabella, one of the GenRe tasked with identifying an appropriate loss portfolio, testified that he approached the proposed transaction .. with the understanding that there would be risk transfer," he ""never believed [he] was working on an improper transaction,'' nor did he have any concerns that there was anything improper with the LPT that had been requested. R. 4169-75. Even Mr. Napier, upon whom the NYAG's case heavily relies, did not believe he was involved in structuring a risk-free transaction during these initial stages. R. 6746, 12405-10. It is undisputed that if Gen Re had provided the risk-shifting LPT requested by Mr. Greenberg, AIG could have properly accounted for the transaction as reinsurance. SeeR. 584-87, 4151-59, 4169-75, 6746-48, 6750-66, 6769- 73,6782-83,7806-15,12405-07. 46 no-risk structure instead of the proper LPT that had been requested by AJG. R. 1926-32, 4133-35, 4138-40. While Mr. Napier claims to have discussed the new no-risk concept with Mr. Milton at AIG, see id., Mr. Greenberg testified that neither Mr. Milton, nor anyone else, ever discussed with him the possibility of AIG engaging in a no-risk transaction. See, e.g., R. 6080-82, 6114-15. The NY AG presented no non-hearsay evidence to the contrary. See, e.g., R. 657, 5963, 5941, 6 1 1 4- 1 5' 12 1 12. According to Mr. Napier, and unbeknownst to Appellants, GenRe enlisted John Houldsworth, the CEO of Cologne Re Dublin ("CRD"), a subsidiary of Gen Re, to construct the proposed transaction. R. 4143, 6823-24. Mr. Houldsworth identified a portfolio of $500 million in loss reserves and drafted a proposed term sheet under which CRD would pay $500 million of premium, on a funds withheld basis,34 in exchange for $600 million of reinsurance coverage. R. 2008-12, 4143, 6 793-94.35 On the face of this term sheet, AIG undertook a risk of loss of up to $100 million. R. 2008-12. Mr. Greenberg never knew about or saw that term sheet. SeeR. 6820-21 ('4As to this point [November 15, 2000], AJG didn't even 34 A funds withheld deal is one in which the company obtaining reinsurance does not physical1y transfer premiums to the reinsurer, but retains the premium and takes on the responsibility of paying claims. R. 4181. The risk of loss under the policies, however, still shifts to the reinsurer. ld. is a common mechanism for this type of reinsurance. ld 35 As noted in the Appellate Division's dissent, the actual loss portfolio that was ceded to AJG is not part of the record nor has there been any direct testimony about it or expert analysis it. Thus, there is no evidence in the record as to whether or not the portfolio at issue did, in fact, have sufficient risk to be accounted for as reinsurance. See R. 15218. 47 know that the transaction existed. They had nothing presented to them in any sort of way."); see also R. 6089-90. On or about November 161h, Mr. Ferguson telephoned Mr. Greenberg to advise him that GenRe would be able to cede an LPT to AIG in two parts, each part consisting of $250 million in premiun1s for $300 million of maximum loss exposure, and proposed that AIG pay a fee36 of $5 million or I%. R. 6082-85. lf he knew it, Mr. Ferguson did not tell Mr. Greenberg that the loss portfolio being transferred did not have sufficient risk to be accounted for as reinsurance under applicable accounting standards. R. 6114-15. The executives left implementation of the transaction to Mr. Milton and Mr. Napier. R. 58-87, 6083-84. The various AIG and Gen Re personnel to whom the transaction had been delegated, including Mr. Milton and Mr. Napier, executed the transaction. See, e.g., R. 2047-58,6381-403, 12405-10. There is no evidence that Appellants were involved in, or aware of, any issues relating to the implementation of the LPT or any problems concerning the accounting for the LPT. See, e.g., R. 693, 4093, 4096,6092-98,6127-35,6152,6255,6838-43,6846-53,6859,6861,6869,6874- 36 Such fees, known as commissions," are commonly used and accepted the industry. See, e.g., R. 4094-95,4147-48, 4156-57, 4182,4880, 4909, 6439, 11265. 48 79,6889,6893,6895-96,6934-41,6946,6959-62,6977-81,6997,7018-19,7022- 24, 7027-28, 7033-34, 12568, 14222.37 AIG accounted for the transaction as reinsurance under GAAP, and thus recorded additional reserves and premiun1s in the fourth quarter of 2000 and in the first quarter of 2001. R. 6424-25, 6828-34, 12800. The accounting for the transaction was addressed by personnel in the accounting department for AI G' s Domestic Brokerage Group ("DBG")38 who reviewed the documents relating to the LPT, made the accounting determinations, drafted the supporting documentation, and ultimately booked the transaction as reinsurance. R. 12922-23. The DBG accountants specifically charged with evaluating the transaction (Lawrence Golodner and David Wessel) never spoke with Appellants regarding those accounting detern1inations, see R. 12599, 12740, and Appellants' approval was not necessary to book the Gen Re Transaction, see R. 14188.39 37 Mr. Smith was not a party to either of Mr. Greenberg's two telephone conversations with Mr. Ferguson nor was Mr. Smith involved with any of the negotiations or discussions regarding the transaction with GenRe. See, e.g., R. 14222-23. Although Mr. Smith did later receive a copy of Mr. Houldsworth's term sheet, R. 11217-22, on its face, the term sheet indicates that AIG was assuming risk, and Mr. Smith testified that it was his belief at all times that the Gen Re Transaction contained sufficient risk to be accounted for as reinsurance. R. 6155-57, 6255, 6271-72. 38 DBG was AIG"s largest division. It was comprised of multiple entities and had its own CFO, other financial executives. and accounting personnel. R. 6142-43, 9022, 9260. 39 The trial court and the Appellate Division majority erroneously relied on the deposition testimony of Jay Morrow, an AIG actuary, and two DBG accountants to conclude that the accounting for the GenRe Transaction was Mr. Smith's responsibility. First, Mr. Morrow never said that he had ever spoken with Mr. Smith, or that Mr. Milton ever said that he had spoken with Mr. Smith regarding the accounting for the GenRe Transaction; Mr. Morrow 49 Every AJG accounting and actuarial professional deposed in this case who was involved in the Gen Re Transaction uniformly testified that he: ( 1) understood that senior management relied on him to perforn1 his accounting and actuarial duties in connection with the Gen Re Transaction accurately and with integrity; (2) had no concerns regarding the propriety ofGen Re Transaction or its accounting; (3) was never asked to do anything improper in connection with the GenRe Transaction or to keep the transaction secret; ( 4) performed his accounting and actuarial duties in the manner that he thought was appropriate; and (5) was never prevented from doing anything he felt wouJd be necessary to ensure that the transaction was booked properly. R. 6838-43, 6846-53, 6861, 6869, 6874-79, 6889, 6893, 6895-96 (Douglas); R. 4093, 4096, 6934-41, 6946, 6959-62 (Morrow); R. 6977-81 (Beier); R. 7018-29, 7022-24, 7027-28 (Golodner); 7033-35 (WesseJ). ln December 200 I, AI G paid Gen Re $5 million as the previously agreed upon fee- i.e., the 1% ceding commission - for providing the loss portfolio and merely stated that he suggested to Mr. Milton that Mr. Milton discuss the accounting for the transaction with M.r. Smith. R. I 0512. The adn1issible evidence establishes, however, that Mr. Milton never actually spoke to Mr. Smith about the accounting for the GenRe Transaction. R. 6261, 12568. Second, neither of the DBG accountants at ever testified that Mr. Smith ··was responsible for booking the Gen Re transaction as insurance for GAAP purposes," R. 86; '"was responsible for recording the transaction,'' R. 151 84; or instructed them on how to account for the transaction. Rather, these senior DBG accountants, who were not directJy involved in accounting for the transaction, merely testified that they generally •·relied on" the accountants at DBG's parent company, A1G, and that Mr. Smith, as CFO of the parent company, was ultimately responsible for the accounting, as he is for every one of the millions oftransactions effected by AIG or any of its dozens of subsidiaries. ld; see also R. 104 76, I 0502-04. Moreover. neither of the accountants who actually booked the transaction ever spoke with Mr. Smith about the transaction. R. 12740, 12599. 50 rescinded the $10 million in premiums owed to AJG pursuant to arrangements made between Gen Re, AJG and Hartford Steam Boiler, a newly acquired AIG subsidiary. R. 27, 6794, 6822. AJthough Appellants were aware that AIG would be paying a 1 o/o ceding commission, see R. 6086, 14197-98, they testified that they neither were aware of nor authorized any return of premium. See, e.g., R. 6086-87, 6280. The NY AG did not present any admissible evidence to the contrary. Appellants' next involvement with the transaction was years later, in 2003 and 2004, when they and other AIG executives40 participated in conversations about commuting various contracts, including the GenRe contracts, as part of a study of AIG 's adverse loss developments.41 R. 2267-68, 3251-52. During the 2003 discussion, Mr. Douglas raised potential disclosure issues if AJ 0 commuted the LPT at the same time it commuted other portfolios, but neither he nor any of the other participants ever expressed concerns to Appellants about the legitimacy of the LPT or the propriety of its accounting. R. 2272-76,4229. GenRe commuted the first tranche of the loss portfolio in late 2004 and commuted the 40 Those other executives included Frank Douglas (Chief Actuary), Robert Jacobson (Vice President, CFO, Domestic Generallnsurance), Michael Castelli (Chief Administrative Officer), and Joseph Umansky (Senior Vice President). 41 Commutation is unique to reinsurance contracts. The concept is contained in most reinsurance contracts and permits either the reinsured or the reinsurer to cancel the contract and reverse the liability or recognize the profit. See, e.g., R. 2047-58, 2059-69, 2253-54. Historically, it was designed to avoid one from taking the full brunt of unexpected consequences. It maintains the future relationship between the parties by sharing losses from unforeseen events. 51 other tranche on August 1, 2005. R. 2276, 2297, 2304. Finally, Appellants presented direct evidence that they personally were not aware that the GenRe Transaction failed to meet GAAP requirements. See, e.g., R. 655-56, 2047-58, 2059-69, 6114-15, 6155-57, 6271-72, 12200 at~ 5. In sum, it is undisputed that Mr. Greenberg requested a legitimate LPT transaction; that GenRe understood Mr. Greenberg to be requesting a legitimate LPT transaction; that for at least two weeks GenRe attempted to structure a legitimate LPT transaction; and that GenRe unilateral1y decided to structure a no- risk deal for its own reasons. There is no admissible evidence that Appellants participated in or knew about the allegedly riskless nature of the transaction. lndeed, no witnesses that spoke to Appellants and no document sent to or authored by Appellants indicates that either Appellant was ever told that Gen Re may have structured a no-risk deal that was contrary to the legitimate LPT requested by Mr. Greenberg. 2. In Denying Appellants' Motions For Summary Judgment Concerning The Gen Re Transaction, The Courts Below Permitted The NY AG To Rely On Inadmissible Hearsay Evidence Despite the failure of the NY AG to present admissible evidence demonstrating Appellants' participation in or knowledge of the allegedly fraudulent aspects of the Gen Re Transaction, the courts below relied upon two categories of hearsay evidence to allow the NY AG to defeat summary judgment: 52 ( 1) testimony and findings from the subsequently reversed Hartford Trial to which Appellants were not parties; and (2) testimony, emails, notes, and recorded telephone conversations involving Mr. Napier and other GenRe executives containing classic hearsay, i.e., second-hand or third-hand accounts of conversations to which the individual was not a participant. R. 16-30, 46-61; R. 15199-201.42 Indeed, the sole evidence relied on by the NY AG to assert that Mr. Greenberg knew that GenRe was structuring a no-risk transaction was the double- hearsay testimony and notes of Mr. Napier that recount a conversation he claims to have had with Mr. Ferguson about a conversation Mr. Ferguson supposedly had with Mr. Greenberg. All of this evidence is unfair, deeply suspect, unreliable inadmissible hearsay, and the NY AG never disputed that it could not be converted to admissible form at trial. Similarly, there is absolutely no admissible evidence that Mr. Smith was aware of the allegedly riskless nature of the transaction. The NY AG has failed to 42 The trial court also improperly considered hearsay evidence relating to AI 0 's 2005 Restatement, which it found .. will be treated as a business record for purposes of the NYAG's motion for summary judgment." R. 54. The Restatement does not fall within the business record exception because the NYAG made no effort to establish a foundation for the exception. see, e.g., Kaszirer v. Kaszirer, 298 A.D.2d 109 (1st Dep't 2002), nor could it, given that the Restatement was created under questionable circumstances, see SEC v. Todd, No. 03CV2230, 2006 WL 5201386, at *5 (S.D. Ca. Oct. 17, 2006). As explained in the Appellate Division dissent: .. There is no evidence of record as to how the Restatement was created, how the facts that it was purportedly based on were established, or even that it was created from evidence that is generally considered reliable. Most significantly, it was after Greenberg left Al G and at a time when then Attorney General Spitzer was threatening AIG with criminal prosecution.'' R. 15218-19. 53 offer any evidence to show that Mr. Smith was aware of the alleged side deal or that the Gen Re Transaction did not contain sufficient risk to qualify for reinsurance. There is also no admissible evidence to suggest that Mr. Smith directed, took part in, or had any knowledge of the allegedly improper payment structure of the GenRe Transaction. As the dissent recognized: "No court in New York has ever allowed hearsay to be sufficient to defeat a summary judgment motion where that hearsay evidence cannot ultimately be converted to admissible evidence at trial" because "'[ t ]here would be no reason to deny summary judgment to a party where the only evidence in opposition to the motion could never be admitted at a subsequent trial.'' R. 15219 (emphasis added). Because the record does not contain any admissible, inculpatory evidence that can sustain the NY AG, s fraud allegations with respect to the GenRe transaction, Appellants' summary judgment motions should have been granted. a. Evidence From The Hartford Tria/Is Not Admissible Against Appellants The Hartford Trial was a federal crimina] prosecution of four Gen Re executives and Mr. Milton in connection with the Gen Re Transaction. Neither Appellant was a defendant or participant in the Hartford TriaL (As discussed supra at p.12, the Department of Justice stated at oral argument before the Second Circuit on appeal of the Hartford Trial convictions that it did not have evidence of 54 wrongdoing by Mr. Greenberg.) Thus, Appellants had no opportunity to cross- examine witnesses or challenge evidence submitted at that trial. Although the trial initially resulted in convictions, those convictions were overturned on appeal. See United States v. Ferguson, 676 F.3d 260 (2d Cir. 2011 ). The govemn1ent since has entered into deferred prosecution agreements with all defendants, and a retrial is not contemplated. 43 The Appellate Division majority purported to confine its review to facts submitted independent of the Hartford TriaL SeeR. 15199 n. 3. Nonetheless, the majority noted that "there was no error in the motion court's consideration of the criminal trial testimony in its ruling" because at the time the trial court issued its decision the judgment issued by the federa] court convicting the Hartford defendants had not been overturned. !d. 44 New York law admits prior testimony from another proceeding only where the testimony is of a witness "at a prior trial involving the same parties or their representatives and arising from the same subject matter." CPLR § 4517(a). This settled rule is not only codified in the CPLR, but also has long been the common law requirement: 43 See Consent Motion for Deferred Prosecution Continuance, Exs. A-E [Dkt. 1379], United States v. Ferguson, No. 3:06CR137 (D. Conn. June 22, 2012); Deferred Prosecution Order [Dkt. 1382], United States v. Ferguson, No. 3:06CR137 (D. Conn. June 25, 2012). 44 For its part, the trial court extensively (and erroneously) relied upon evidence from the Hartford Trial, as well as Judge Droney's written opinions, R. 50, 67, 81, and the trial testimony of six witnesses, R. 16, 18, 20, 24-25, 29-30. 49, 55-59, 61. 65-68, 83-87. 55 Coexistent with the statutory rule for the admission of prior testimony [CPLR § 4517] is a common-law rule which provides that the prime and essential requirement for the use of former testimony is that it was given under oath, referred to the same subject matter, and was heard in a tribunal where the other side was represented and allowed to cross-examine. Siegel v. Waldbaum, 59 A.D.2d 555, 555 (2d Dep't 1977) (emphasis added; citation omitted); see also Lent v. Shear, 160 N.Y. 462,470 (1899). The NY AG has argued that testimony from the Hartford Trial is admissible here because cettain of the witnesses who testified in the Hartford Trial were deposed in this case and thus Appellants had the opportunity to cross-examine them. But the mere existence of deposition testimony in this action does not render testimony from another proceeding in which neither Appellant was a party independently admissible. No precedent or rule of evidence supports such a conclusion. More fundamentally, as plaintiff, the NY AG had the burden of developing a factual record in this action as to Appellants' alleged culpable participation. Appellants had no burden to preemptively rebut testimony from other litigations concerning issues upon which the NY AG did not attempt to elicit similar testimony in this case. The NY AG does not offer any explanation to justify its failure to elicit the necessary testimony from such witnesses in this case. 56 b. Testimony, £mails, Notes, And Recorded Telephone Conversations Of Gen Re Executives Containing Statements Speculating About Appellants ' Conversations With Others Is Irremediable Hearsay The primary source of the inadmissible hearsay relied upon below was testimony and documents involving out-of-court conversations Mr. Napier claims to have had with various Gen Re employees and Mr. Milton about the transaction. Significantly, Mr. Napier, by his own admission had no direct contact or communications with either Appellant. R. 597-601, 1908, 1926-29,4149,5991, 6731, 6746, 124 I 7, 14222-23. Yet the courts below relied on testimony, notes, and emails from Mr. Napier to establish what Appellants did, said, and were told in connection with this transaction. 45 For example, the trial court relied on the testimony and notes of Mr. Napier regarding an October 31st conversation Mr. Napier claims to have had with Mr. Ferguson as an evidentiary basis for establishing what took place during a conversation between Mr. Ferguson and Mr. Greenberg. R. 586-87, 630, 12405. The trial court similarly relied on testimony and notes from Mr. Napier regarding a November 17th conversation which Mr. Napier claims to have had with Mr. Ferguson as the evidentiary basis for Mr. Napier's testimony that Mr. Greenberg and Mr. Ferguson spoke on November 16th. 45 With respect to Mr. Napier's testimony in the Hartford Trial, the Second Circuit observed that, .. [c]ertain factuaJ inconsistencies are sufficiently obvious to raise an eyebrow," 676 F.3d at 281, and ""[ c ]ompelling inconsistencies suggest that Napier may well have testified falsely," id. 57 R. 19, 625, 628-29. Mr. Napier (who was not on the call) contends Mr. Ferguson and Mr. Greenberg purportedly ••orally agreed at this time AlG would not bear any "rea] risk' 46 in the transaction.'' /d. It is hornbook law that such third-hand accounts of conversations engaged in by others are hearsay. The NY AG did not present the required explanation in opposition to Appellants' summary judgment n1otions of how such hearsay could be presented in admissible form at trial, and sought only to rely on the co- conspirator exception to the hearsay rule. c. The Co-Conspirator Exception To The Hearsay Rule Does Not Apply Here Under the co-conspirator exception to the hearsay rule, hearsay statements of one conspirator are admissible against other members of the conspiracy. People v. Sanders, 56 N.Y.2d 51, 62 ( 1982). Before one can be considered a co-conspirator, however, there must be independent, non-hearsay evidence establishing that the declarant joined the conspiracy with knowledge of its purpose. !d. at 62 r·the People must establish, by prima facie proof, the existence of a conspiracy between 46 The record contains expert evidence that ""reaJ risk" is a term of art in the insurance industry and that its absence does not imply the absence of the minimal or finite risk required to book finite insurance as reinsurance. R. 4180. The trial court's decision, and that of the Appellate Division majority, simply ignored this unrebuned evidence establishing that even if Mr. Napier's testimony were to be credited, it still would not establish culpability of the Appellants. R. 4176-91. 58 the declarant and the defendant "without recourse to the declarations sought to be introduced.'") (citation omitted). To satisfy the co-conspirator hearsay exception: H( 1) there must be an independent showing of the existence of the conspiracy and (2) of the declarant's and the alleged defendant conspirator's participation therein; and (3) the statement itself must have been made in furtherance of and ( 4) during the conspiracy." People v. L.B. Smith, 108 Misc. 2d 261, 264 (Sup. Ct. Onondaga Cnty. 1981 ); see also People v. Hernandez, 155 A.D.2d 342, 343-44 (I st Dep't 1989). As this Court has made clear, "the determination whether a prima facie case of conspiracy has been established must be made without recourse to the declarations sought to be introduced.'' People v. Tran, 80 N.Y.2d 170, 179 ( 1992) (quoting People v. Safko. 47 N.Y.2d 230, 238 ( 1979)). The prerequisite of independent, admissible evidence to show membership in the conspiracy prevents a proponent from ~.'bootstrapping" disputed hearsay declarations into evidence by using the declarations themselves in the admissibility analysis. This has long been the law in New York: New York cases had always followed the rule that a precondition to admissibility of co-conspirator declarations was independent proof of the conspiracy and the participation in it of the person against whom the declaration is sought to be introduced quite without reference to the declaration itself. 59 Jasco Tools, Inc. v. Rogers. 13 Misc.3d 1222(A), 2006 WL 2944671, at *3 (Sup. Ct. Monroe Cnty. July 3 1, 2006) (citation omitted). Although the trial court acknowledged that it could not consider the declarations of the alleged co-conspirators in determining whether either Appellant joined a conspiracy regarding the GenRe Transaction, R. 55, it nonetheless held that "New York permits the testimony of admitted coconspirators, and other witnesses or participants regarding defendant's invo1vement in establishing a prima facie case of conspiracy." R. 57; see also R. 18-19, 55-58, 61, 81 (relying on Mr. Napier's statements, notes, emails, and testimony about Mr. Greenberg's alleged conduct despite the fact that Mr. Napier never had a single interaction with either Appellant). However, the court failed to distinguish between direct testimony and the hearsay declarations themse1ves. The sole case cited by the trial court, People v. Wolf, 98 N. Y .2d 105 (2002 ), does not permit reliance on otherwise inadmissible hearsay to establish a conspiracy. To the contrary, in Wolf, this Court held that the conspiracy must be proved "without recourse to the declarations sought to be introduced," and went on to find, in that case, that the conspiracy was established by direct testimony of co-conspirators that the defendant participated in the conspiracy. /d. at 118. The trial court attempted to justify its finding of Mr. Greenberg's involvement in a conspiracy by identifying what it said was independent evidence 60 of his membership in the conspiracy. R. 55-58. In that regard, the trial court relied upon the following: • Mr. Greenberg called Mr. Ferguson on October 3 1 ; • Mr. Greenberg called Mr. Ferguson on November 16; • Mr. Greenberg appointed Mr. Milton to be the ~~point person" to execute the loss portfolio transaction; • Mr. Greenberg made public statements regarding increases in AIG's reserve levels; • Mr. Napier made hearsay declarations; • Mr. Morrow testified that Mr. Milton allegedly did not request actuarial review of the Gen Re Transaction; • Mr. Douglas testified that he attended meetings where the possibility of commuting the Gen Re Transaction was discussed; and • Mr. Winograd testified that Mr. Greenberg allegedly downplayed the GenRe Transaction to PwC in 2005. R. 57, 59. None of this evidence, alone or in the aggregate, is sufficient to establish that Mr. Greenberg was a member of any conspiracy. By all accounts, including Mr. Napier's own testimony in this case, the transaction requested by Mr. Greenberg on October 31, 2000, was a proper one. It is undisputed that for the first two weeks, everyone who worked on the transaction attempted to structure a legitimate risk-transferring LPT transaction. See, e.g., R. 584-87, 4151-59,4169-75,6733-34,6746-48,6750-66,6769-74,6782-83,12405- 07, 12424, 12427, 12433, 12437, 14161. During that time, no one involved, 61 including Mr. Napier, believed there to be anything improper about the transaction requested by Mr. Greenberg. Accordingly, a conspiracy could not have existed before November 13, 2000.47 Moreover, excluding Mr. Napier's hearsay statements and documents, the sum total of the information in the record is that the Mr. Greenberg and Mr. Ferguson had two conversations regarding the transaction requested by Mr. Greenberg: one conversation in which Mr. Greenberg asked ifGen Re could cede loss reserves to AJG in the form of an LPT, and, several weeks later, a second conversation in which Mr. Ferguson called back to advise Mr. Greenberg that Gen Re could do so. R. 658, 6076, 6462. Nothing therein is indicative of improper conduct by Mr. Greenberg. There can be no conspiracy to enter into a lawful transaction. Dalury v. Rezinas, 183 A.D. 456, 459 (1st Dep't 1918) ("'A conspiracy is an agreement between two or more persons to do an unlawful act"), aff'd, 229 N.Y. 513 (1920). 47 The NY AG claims that this argument should be rejected because the court in the Hartford Trial rejected a similar by Mr. Ferguson there. See v. Ferguson, 553 F. Supp. 2d 145 (D. Conn. 2008). The NY AG's argument is meritless. Evidence and findings from the Ferguson case are not admissible in this action, because M.r. Greenberg was not a party to and is not bound by the outcome of that proceeding. More importantly, the findings in the Hartford Trial were based on evidence against defendants in that trial that is inadmissible against Appellants. Thus. the Hartford court relied almost exclusively on Mr. Napier's testimony and e-mail correspondence about interactions he had with Mr. Ferguson and Mr. l'vfilton, who were defendants in the Hartford TriaL See id. at 158. There is no similar evidence against Mr. Greenberg here and therefore no independent evidence to support a prima facie case of conspiracy. Sanders, 56 N. Y .2d at 62. 62 Accordingly, the co-conspirator exception cannot apply without properly admissible evidence that Mr. Greenberg changed his lawful intention with respect to the transaction at some point after his initial discussion with Mr. Ferguson. See generally United States v. Carnagie, 533 F.3d 1231, 1239 n.5 (1Oth Cir. 2008) (''because the underlying transaction is generally lawful, one cannot infer an illegal common purpose in the same way that a common purpose could be found in a drug conspiracy"). No independent, admissible evidence supports any such construction. Each of the items of evidence noted by the courts below falls well short of the evidentiary predicates necessary to support a finding of conspiratorial agreement. For instance, Mr. Greenberg appropriately appointed a subordinate reinsurance specialist, Mr. Milton, who was more familiar with the area, to negotiate the details of and execute the LPT. As CEO, Mr. Greenberg's day-to- day tasks were far broader than approving the details of a finite reinsurance transaction. AIG was a company of 92,000 employees in 130 countries world- wide that engaged in 40 million transactions per year. R. 8974-9259. As in every multifaceted, large corporation the size of AIG, the CEO must delegate such tasks to the proper division or unit.48 48 The trial court appears to have adopted the NY AG's position that it is inconceivable that Mr. Milton would not have reported his alleged misdeeds to his superior. SeeR. 84. This 63 So too, Mr. Greenberg's public statements at the time of quarterly earnings reports are not evidence of any conspiratorial agreement or intent. AIG (as it did every quarter) issued press releases in the first and second quarters of 2001. R. 2083-85, 2 I 68-70. Among other issues referenced therein, as was customary, it announced the level of loss reserves and the change in net loss reserves since the previous quarter. The press releases represent standard quarterly business practices engaged in by virtualJy all publicly traded companies. R. 2083-92, 2168-75. Nothing in the release or in Mr. Greenberg's statements gives rise to any inference that he knew that the net loss reserves had been improperly inflated through inclusion of a transaction that did not contain sufficient levels of risk to be considered reinsurance for accounting purposes. The trial court's reliance on Mr. Morrow's testimony that Mr. Mi1ton did not seek actuarial analysis of the portfolios (and thereby purportedly failed to perform his job responsibilities correctly), R. 58, is not an appropriate basis to infer Mr. Greenberg's actions or state of mind. No one who testified in this action provided any testimony suggesting that Mr. Greenberg desired, instructed, participated in or even knew that no actuary analyzed the Joss portfolios. To the contrary, as noted above, all AIG personnel deposed in this action involved in the GenRe speculative assessment does not constitute or have any probative value to the issue of Mr. Greenberg's alleged membership in any conspiracy. 64 Transaction and accounting for the transaction testified that it was their clear understanding that Mr. Greenberg wanted and expected them to undertake their responsibilities properly and to account for the transaction correctly. Moreover, Mr. Douglas and Mr. Morrow were advised that AIG's actuarial personnel couJd review underwriting data for the transaction, if necessary, to address any accounting issues. 49 R. 6953-54. Nor do any of the issues concerning the possible commutation of the Gen Re Joss portfolio in 2003 and 2004 evidence a conspiracy. Mr. Douglas unequivocally testified that no issues raised in the commutation meetings had anything to do with any concerns regarding the propriety of the original transaction or of its accounting treatment, and that he did not believe at that time that the LPT was improper. R. 2267-68, 6838-43, 6846-47. Finally, Mr. Greenberg's March 2005 conversation with PwC audit partner, Barry Winograd, is not evidence that Mr. Greenberg was in a conspiracy regarding the GenRe Transaction. Mr. Greenberg's suggestion to PwC that disproportionate attention being paid to the transaction is consistent not only with Mr. Greenberg's belief that the transaction was lawful, but also with the de minimis amounts at issue 49 As explained above, see supra at p. 50, every accounting and actuarial professional responsible for the booking of the Gen Re Transaction testified that he performed his duties with respect to the GenRe Transaction in the manner he believed to be appropriate and did not believe there was anything improper about the GenRe Transaction. R 6838-43, 6846-53, 6803,6861,6869,6874-79,6889,6893,6895-96,6934-41.6946,6959-62,6977-80,6990. 6997, 7018-9,7022-24, 7027-28, 7033-35. 65 in relation to AIG 's overall financials and the massive amounts of loss reserves held by AIG. 50 In sum, none of the items cited by the trial court as supporting application of the co-conspirator exception are probative of the issue of whether Mr. Greenberg, with knowledge of its purpose, joined a conspiracy to engage in a fraudulent transaction. These facts - whether taken together or separately - do not rise to the level of proper prima facie evidence that Mr. Greenberg knowingly agreed to enter into a conspiracy to engage in unlawful activity. Thus, it is clear that without the improper use of hearsay statements, there is no 44prima facie proof [of] the existence of a conspiracy between the declarant and the defendant." Sanders, 56 N.Y.2d at 62. With respect to Mr. Smith, the trial court specifically held that there was insufficient record evidence presented to find that Mr. Smith was a member of any 44illicit scheme to artificially inflate AIG's loss reserves." R. 60. Thus, it is clear that inadmissible hearsay may not be relied on by the NY AG to support its 50 AIO's 2005 Restatement concluded that the GenRe Transaction ""had virtually no effect on net income or consolidated shareholders' equity" and ""virtually no impact on AI 0 's financial condition." R. 6829-30, 9286-87. The lead architect of AIG's Restatement, Steven Bensinger, described the GenRe Transaction as ·•totally immaterial to net income and consolidated shareholders' equity.'' R. 9284-85. While the transaction was allegedly executed to fraudulently inflate AJO's loss reserves, the transaction represented only 2o/o of the company's almost $25 billion in net loss reserves and had only a negligible effect on AJO's loss reserves, as several AJO executives testified. R. 6892. 6898-99, 6955-56, 9292. Securities analysts covering AI 0 at the tin1e conceded that they did not consider the transaction material. R. 7880-81, 7916-1 7. 66 allegations against Mr. Smith and certainly cannot be considered under the co- conspirator exception to the hearsay rule. CONCLUSION Based on the foregoing, Appellants respectfully request that this Court hold that ( 1) the NY AG lacks standing and authority to pursue the claims now being advanced in his case; (2) the NYAG's claims in this case are preempted by federal law; and (3) a court cannot rely on inadmissible hearsay evidence that cannot be converted to admissible form at trial, in order to deny summary judgment. Accordingly, summary judgment should be entered in Appellants' favor and this action dismissed. Dated: New York, NY September 24, 2012 BOIES, SCHILLER & FLEXNER LLP Nicholas A. Gravante, Jr. Robert J. Dwyer 575 Lexington A venue New York, New York 10022 Telephone: (212) 446-2300 67 SKADDEN, ARPS, SLATE, MEAGHER & FLOM LLP John L. Gardiner Four Times Square New York, NY 10036 Telephone: (212) 735-3000 CHARLES FRIED (of the bar of the State of Massachusetts) By Permission of the Court 1 545 Massachusetts A venue Cambridge, MA 02138 Telephone: (617) 495-4636 Attorneys for Appellant Maurice R. Greenberg Vincent A. Sarna Catherine B. Schumacher 425 Park A venue New York, New York l 0022 Telephone: (212) 836-8000 ANDREW M. LAWLER, P.C. Andrew M. Lawler 641 Lexington Avenue, 27th Floor New York, New York, 10022 Telephone: (212) 832-3160 Attorneys for Appellant Howard I. Smith 68 ADDENDUM 29–006 104TH CONGRESS REPORT " !HOUSE OF REPRESENTATIVES2d Session 104–622 SECURITIES AMENDMENTS OF 1996 JUNE 17, 1996.—Committed to the Committee of the Whole House on the State of the Union and ordered to be printed Mr. BLILEY, from the Committee on Commerce, submitted the following R E P O R T [To accompany H.R. 3005] [Including cost estimate of the Congressional Budget Office] The Committee on Commerce, to whom was referred the bill (H.R. 3005) to amend the Federal securities laws in order to pro- mote efficiency and capital formation in the financial markets, and to amend the Investment Company Act of 1940 to promote more ef- ficient management of mutual funds, protect investors, and provide more effective and less burdensome regulation, having considered the same, report favorably thereon with an amendment and rec- ommend that the bill as amended do pass. CONTENTS Page The Amendment ...................................................................................................... 2 Purpose and Summary ............................................................................................ 16 Background and Need for Legislation .................................................................... 16 Hearings ................................................................................................................... 20 Committee Consideration ........................................................................................ 20 Rollcall Votes ............................................................................................................ 21 Committee Oversight Findings ............................................................................... 21 Committee on Government Reform and Oversight ............................................... 21 New Budget Authority and Tax Expenditures ...................................................... 21 Committee Cost Estimate ....................................................................................... 21 Congressional Budget Office Estimate ................................................................... 22 Inflationary Impact Statement ............................................................................... 29 Advisory Committee Statement .............................................................................. 29 Section-by-Section Analysis of the Legislation ...................................................... 29 Committee Correspondence .................................................................................... 54 Agency Views ........................................................................................................... 55 Changes in Existing Law Made by the Bill, as Reported ..................................... 56 2 THE AMENDMENT The amendment is as follows: Strike out all after the enacting clause and insert in lieu thereof the following: SECTION 1. SHORT TITLE; TABLE OF CONTENTS. (a) SHORT TITLE.—This Act may be cited as the ‘‘Securities Amendments of 1996’’. (b) TABLE OF CONTENTS.—The table of contents of this Act is as follows: Sec. 1. Short title; table of contents. TITLE I—CAPITAL MARKETS DEREGULATION AND LIBERALIZATION Sec. 101. Short title. Sec. 102. Creation of national securities markets. Sec. 103. Margin requirements. Sec. 104. Prospectus delivery. Sec. 105. Exemptive authority. Sec. 106. Promotion of efficiency, competition, and capital formation. Sec. 107. Privatization of EDGAR. Sec. 108. Coordination of Examining Authorities. Sec. 109. Foreign press conferences. Sec. 110. Report on Trust Indenture Act of 1939. TITLE II—INVESTMENT COMPANY ACT AMENDMENTS Sec. 201. Short title. Sec. 202. Funds of funds. Sec. 203. Registration of securities. Sec. 204. Investment company advertising prospectus. Sec. 205. Variable insurance contracts. Sec. 206. Reports to the Commission and shareholders. Sec. 207. Books, records and inspections. Sec. 208. Investment company names. Sec. 209. Exceptions from definition of investment company. TITLE I—CAPITAL MARKETS DEREGULATION AND LIBERALIZATION SEC. 101. SHORT TITLE. This title may be cited as the ‘‘Capital Markets Deregulation and Liberalization Act of 1996’’. SEC. 102. CREATION OF NATIONAL SECURITIES MARKETS. (a) SECURITIES ACT OF 1933.— (1) AMENDMENT.—Section 18 of the Securities Act of 1933 (15 U.S.C. 77r) is amended to read as follows: ‘‘SEC. 18. EXEMPTION FROM STATE REGULATION OF SECURITIES OFFERINGS. ‘‘(a) SCOPE OF EXEMPTION.—Except as otherwise provided in this section, no law, rule, regulation, or order, or other administrative action of any State or Territory of the United States, or the District of Columbia, or any political subdivision there- of— ‘‘(1) requiring, or with respect to, registration or qualification of securities, or registration or qualification of securities transactions, shall directly or indirectly apply to a security that— ‘‘(A) is a covered security; or ‘‘(B) will be a covered security upon completion of the transaction; ‘‘(2) shall directly or indirectly prohibit, limit, or impose conditions upon the use of— ‘‘(A) with respect to a covered security described in subsection (b)(1) or (c)(1)— ‘‘(i) any offering document that is prepared by the issuer; or ‘‘(ii) any offering document that is not prepared by the issuer if such offering document is required to be and is filed with the Commission or any national securities organization registered under section 15A of the Securities Exchange Act of 1934 (15 U.S.C. 78o–3); ‘‘(B) with respect to a covered security described in paragraph (2), (3), or (4) of subsection (b), any offering document; or ‘‘(C) any proxy statement, report to shareholders, or other disclosure doc- ument relating to a covered security or the issuer thereof that is required to be and is filed with the Commission or any national securities organiza- 3 tion registered under section 15A of the Securities Exchange Act of 1934 (15 U.S.C. 78o–3); or ‘‘(3) shall directly or indirectly prohibit, limit, or impose conditions, based on the merits of such offering or issuer, upon the offer or sale of any security de- scribed in paragraph (1). ‘‘(b) COVERED SECURITIES.—For purposes of this section, the following are covered securities: ‘‘(1) EXCLUSIVE FEDERAL REGISTRATION OF NATIONALLY TRADED SECURITIES.— A security is a covered security if such security is— ‘‘(A) listed, or authorized for listing, on the New York Stock Exchange or the American Stock Exchange, or included or qualified for inclusion in the National Market System of the National Association of Securities Dealers Automated Quotation System (or any successor to such entities); ‘‘(B) listed, or authorized for listing, on a national securities exchange (or tier or segment thereof) that has listing standards that the Commission de- termines by rule (on its own initiative or on the basis of a petition) are sub- stantially similar to the listing standards applicable to securities described in subparagraph (A); or ‘‘(C) is a security of the same issuer that is equal in seniority or senior to a security described in subparagraph (A) or (B). ‘‘(2) EXCLUSIVE FEDERAL REGISTRATION OF INVESTMENT COMPANIES.—A secu- rity is a covered security if such security is a security issued by an investment company that is registered under the Investment Company Act of 1940 (15 U.S.C. 80a et seq.). ‘‘(3) SALES TO QUALIFIED PURCHASERS.—A security is a covered security with respect to the offer or sale of the security to qualified purchasers, as defined by the Commission by rule. In prescribing such rule, the Commission may de- fine qualified purchaser differently with respect to different categories of securi- ties, consistent with the public interest and the protection of investors. ‘‘(4) EXEMPTION IN CONNECTION WITH CERTAIN EXEMPT OFFERINGS.—A security is a covered security if— ‘‘(A) the offer or sale of such security is exempt from registration under this title pursuant to section 4(1) or 4(3), and— ‘‘(i) the issuer of such security files reports with the Commission pur- suant to section 13 or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m, 78o(d)); or ‘‘(ii) the issuer is exempt from filing such reports; ‘‘(B) such security is exempt from registration under this title pursuant to section 4(4); ‘‘(C) the offer or sale of such security is exempt from registration under this title pursuant to section 3(a), other than the offer or sale of a security that is exempt from such registration pursuant to paragraph (4) or (11) of such section, except that a municipal security that is exempt from such reg- istration pursuant to paragraph (2) of such section is not a covered security with respect to the offer or sale of such security in the State in which such security is issued; or ‘‘(D) the offer or sale of such security is exempt from registration under this title pursuant to Commission rule or regulation under section 4(2) of this title. ‘‘(c) CONDITIONALLY COVERED SECURITIES.— ‘‘(1) FEDERALLY REGISTERED OFFERINGS.—Subject to the limitations contained in paragraphs (2) and (3), a security is a covered security if— ‘‘(A) the issuer of such security has (or will have upon conclusion of the transaction) total assets exceeding $10,000,000; ‘‘(B) such security is the subject of a registration statement that is filed with the Commission pursuant to this title; and ‘‘(C) the issuer files with such registration statement audited financial statements for each of the two most recent fiscal years of its operations end- ing before the filing of the registration statement. ‘‘(2) LIMITATIONS FOR CERTAIN OFFERINGS.—Notwithstanding paragraph (1), a security is not a covered security if such security is— ‘‘(A) a security of an issuer which is a blank check company (as defined in section 7(b) of this title), a partnership, a limited liability company, or a direct participation investment program; ‘‘(B) a penny stock (as such term is defined in section 3(a)(51) of the Secu- rities Exchange Act of 1934 (15 U.S.C. 78c(a)(51)); or 4 ‘‘(C) a security issued in an offering relating to a rollup transaction (as such term is defined in paragraphs (4) and (5) of section 14(h) of such Act (15 U.S.C. 78n(h)(4), (5)). ‘‘(3) LIMITATIONS BASED ON MISCONDUCT.—Notwithstanding paragraph (1), a security is not a covered security— ‘‘(A) with respect to any State, if the issuer, or a principal officer or prin- cipal shareholder thereof— ‘‘(i) is subject to a statutory disqualification, as defined in subpara- graph (A), (B), (C), or (D) of section 3(a)(39) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(39)); ‘‘(ii) has been convicted within 5 years prior to the offering of any fel- ony under Federal or State law in connection with the offer, purchase, or sale of any security, or any felony under Federal or State law involv- ing fraud or deceit; or ‘‘(iii) is currently named in and subject to any order, judgment, or de- cree of any court of competent jurisdiction acting pursuant to Federal or State law temporarily or permanently restraining or enjoining such issuer, officer, or shareholder from engaging in or continuing any con- duct or practice in connection with a security; or ‘‘(B) with respect to a particular State, if the issuer, or a principal officer or principal shareholder thereof— ‘‘(i) has filed a registration statement which is the subject of a cur- rently effective stop order entered pursuant to that State’s securities laws within 5 years prior to the offering; ‘‘(ii) is currently named in and subject to any administrative enforce- ment order or judgment of that State’s securities commission (or any agency or office performing like functions) entered within 5 years prior to the offering, or is currently named in and subject to any other ad- ministrative enforcement order or judgment of that State entered with- in 5 years prior to the offering that finds fraud or deceit; or ‘‘(iii) is currently named in and subject to any administrative enforce- ment order or judgment of that State which prohibits or denies reg- istration, or revokes the use of any exemption from registration, in con- nection with the offer, purchase, or sale of securities. ‘‘(4) EXCEPTIONS TO LIMITATIONS.— ‘‘(A) EXEMPTIONS.—The limitations in paragraph (3)(A) shall not apply if the Commission has exempted the subject person from the application of such paragraph by rule or order, and the limitations in paragraph (3)(B) shall not apply if the securities commission (or any agency or office per- forming like functions) of the affected State has exempted the subject per- son from the application of such paragraph by rule or order. ‘‘(B) REASONABLE STEPS.—The provisions of paragraph (3) shall not apply if the issuer has taken reasonable steps to ascertain whether any principal officer or principal shareholder is subject to such paragraph, and such steps do not reveal a person who is subject to such paragraph. An issuer shall be considered to have taken reasonable steps if such issuer or its agent has conducted a search of any centralized data bases that the Commission may designate by rule, and has received an affidavit under oath by each such principal officer or principal shareholder stating that such officer or share- holder is not subject to the provisions of paragraph (3). ‘‘(C) EFFECT OF LIMITATIONS ON REMEDIES.—Notwithstanding paragraph (3), an issuer shall not be subject to a right of rescission under State securi- ties laws solely as a result of the operation of such paragraph. ‘‘(5) NO EFFECT UNDER SUBSECTION (B).—No limitation under this subsection shall affect the treatment of a security that qualifies as a covered security under subsection (b). ‘‘(d) PRESERVATION OF AUTHORITY.— ‘‘(1) FRAUD AUTHORITY.—Consistent with this section, the securities commis- sion (or any agency or office performing like functions) of any State or Territory of the United States, or the District of Columbia, shall retain jurisdiction under the laws of such State, Territory, or District to investigate and bring enforce- ment actions with respect to fraud or deceit in connection with securities or se- curities transactions. ‘‘(2) PRESERVATION OF FILING REQUIREMENTS.— ‘‘(A) NOTICE FILINGS PERMITTED.—Nothing contained in this section shall prohibit the securities commission (or any agency or office performing like functions) of any State or Territory of the United States, or the District of Columbia, from requiring the filing of any documents filed with the Com- 5 mission pursuant to this title solely for notice purposes, together with any required fee. ‘‘(B) PRESERVATION OF FEES.—Until otherwise provided by State law en- acted after the date of enactment of the Securities Amendments of 1996, filing or registration fees with respect to securities or securities trans- actions may continue to be collected in amounts determined pursuant to State law as in effect on the day before such date. ‘‘(C) FEES NOT PERMITTED ON LISTED SECURITIES.—Notwithstanding sub- paragraphs (A) and (B), no filing or fee may be required with respect to any security that is a covered security pursuant to subsection (b)(1) of this sec- tion, or will be such a covered security upon completion of the transaction, or is a security of the same issuer that is equal in seniority or senior to a security that is a covered security pursuant to such subsection. ‘‘(3) ENFORCEMENT OF REQUIREMENTS.—Nothing in this section shall prohibit the securities commission (or any agency or office performing like functions) of any State or Territory of the United States, or the District of Columbia, from suspending the offer or sale of securities within such State, Territory, or Dis- trict as a result of the failure to submit any filing or fee required under law and permitted under this section. ‘‘(e) DEFINITIONS.—For purposes of this section: ‘‘(1) PRINCIPAL OFFICER.—The term ‘principal officer’ means a director, chief executive officer, or chief financial officer of an issuer, or any other officer per- forming like functions. ‘‘(2) PRINCIPAL SHAREHOLDER.—The term ‘principal shareholder’ means any person who is directly or indirectly the beneficial owner of more than 20 percent of any class of equity security of an issuer. When two or more persons act as a partnership, limited partnership, syndicate, or other group for the purpose of acquiring, holding, or disposing of securities of an issuer, such syndicate or group shall be deemed a ‘person’ for purposes of this paragraph. In determining, for purposes of this paragraph, any percentage of a class of any security, such class shall be deemed to consist of the amount of the outstanding securities of such class, exclusive of any securities of such class held by or for the account of the issuer or a subsidiary of the issuer. ‘‘(3) OFFERING DOCUMENT.—The term ‘offering document’ has the meaning given the term ‘prospectus’ by section 2(10), but without regard to the provi- sions of clauses (a) and (b) of such section, except that, with respect to a secu- rity described in subsection (b)(2) of this section, such term also includes a com- munication that is not deemed to offer such a security pursuant to a rule of the Commission. ‘‘(4) PREPARED BY THE ISSUER.—Within 6 months after the date of enactment of the Securities Amendments of 1996, the Commission shall, by rule, define the term ‘prepared by the issuer’ for purposes of this section.’’. (2) STUDY OF UNIFORMITY.—The Securities Exchange Commission shall con- duct a study after consultation with States, issuers, brokers, and dealers on the extent to which uniformity of State regulatory requirements for securities or se- curities transactions has been achieved for securities that are not covered secu- rities (within the meaning of section 18 of the Securities Act of 1933 as amend- ed by paragraph (1) of this subsection). Such study shall specifically focus on the impact of such uniformity or lack thereof on the cost of capital, innovation and technological development in securities markets, and duplicative regulation with respect to securities issuers (including small business), brokers, and deal- ers and the effect on investor protection. The Commission shall submit to the Congress a report on the results of such study within one year after the date of enactment of this Act. (b) BROKER/DEALER REGULATION.— (1) AMENDMENT.—Section 15 of the Securities Exchange Act of 1934 (15 U.S.C. 78o) is amended by adding at the end the following new subsection: ‘‘(h) LIMITATIONS ON STATE LAW.— ‘‘(1) CAPITAL, MARGIN, BOOKS AND RECORDS, BONDING, AND REPORTS.—No law, rule, regulation, or order, or other administrative action of any State or political subdivision thereof shall establish capital, custody, margin, financial respon- sibility, making and keeping records, bonding, or financial or operational report- ing requirements for brokers, dealers, municipal securities dealers, government securities brokers, or government securities dealers that differ from, or are in addition to, the requirements in those areas established under this title. The Commission shall consult periodically the securities commissions (or any agency or office performing like functions) of the States concerning the adequacy of such requirements as established under this title. 6 ‘‘(2) EXEMPTION TO PERMIT SERVICE TO CUSTOMERS.—No law, rule, regulation, or order, or other administrative action of any State or political subdivision thereof shall prohibit an associated person from effecting a transaction de- scribed in paragraph (3) for a customer in such State if— ‘‘(A) such associated person is not ineligible to register with such State for any reason other than such a transaction; ‘‘(B) such associated person is registered with a registered securities asso- ciation and at least one State; and ‘‘(C) the broker or dealer with which such person is associated is reg- istered with such State. ‘‘(3) DESCRIBED TRANSACTIONS.—A transaction is described in this paragraph if— ‘‘(A) such transaction is effected— ‘‘(i) on behalf of a customer that, for 30 days prior to the day of the transaction, maintains an account with the broker or dealer; and ‘‘(ii) by an associated person (I) to which the customer was assigned for 14 days prior to the day of the transaction, and (II) who is reg- istered with a State in which the customer was a resident or was present for at least 30 consecutive days during the one-year period prior to the transaction; except that, if the customer is present in another State for 30 or more con- secutive days or has permanently changed his or her residence to another State, such transaction is not described in this subparagraph unless the as- sociated person files with such State an application for registration within 10 business days of the later of the date of the transaction or the date of the discovery of the presence of the customer in the State for 30 or more consecutive days or the change in the customer’s residence; ‘‘(B) the transaction is effected— ‘‘(i) on behalf of a customer that, for 30 days prior to the day of the transaction, maintains an account with the broker or dealer; and ‘‘(ii) within the period beginning on the date on which such associated person files with the State in which the transaction is effected an appli- cation for registration and ending on the earlier of (I) 60 days after the date the application is filed, or (II) the time at which such State noti- fies the associated person that it has denied the application for reg- istration or has stayed the pendency of the application for cause; or ‘‘(C) the transaction is one of 10 or fewer transactions in a calendar year (excluding any transactions described in subparagraph (A) or (B)) which the associated person effects in the States in which the associated person is not registered. ‘‘(4) ALTERNATE ASSOCIATED PERSONS.—For purposes of paragraph (3)(A)(ii), each of up to 3 associated persons who are designated to effect transactions dur- ing the absence or unavailability of the principal associated person for a cus- tomer may be treated as an associated person to which such customer is as- signed for purposes of such paragraph.’’. (2) STUDY.—Within 6 months after the date of enactment of this Act, the Commission, after consultation with registered securities associations, national securities exchanges, and States, shall conduct a study of— (A) the impact of disparate State licensing requirements on associated persons of registered brokers or dealers; and (B) methods for States to attain uniform licensing requirements for such persons. (3) REPORT.—Within one year after the date of enactment of this Act, the Commission shall submit to the Congress a report on the study conducted under paragraph (2). Such report shall include recommendations concerning appro- priate methods described in paragraph (2)(B), including any necessary legisla- tive changes to implement such recommendations. (4) TECHNICAL AMENDMENT.—Section 28(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78bb(a)) is amended by striking ‘‘Nothing’’ and inserting ‘‘Ex- cept as otherwise specifically provided elsewhere in this title, nothing’’. SEC. 103. MARGIN REQUIREMENTS. (a) MARGIN REQUIREMENTS.— (1) EXTENSIONS OF CREDIT BY BROKER-DEALERS.—Section 7(c) of the Securities Exchange Act of 1934 (15 U.S.C. 78g(c)) is amended to read as follows: ‘‘(c) UNLAWFUL CREDIT EXTENSION TO CUSTOMERS.— ‘‘(1) PROHIBITION.—It shall be unlawful for any member of a national securi- ties exchange or any broker or dealer, directly or indirectly, to extend or main- 7 tain credit or arrange for the extension or maintenance of credit to or for any customer— ‘‘(A) on any security (other than an exempted security), in contravention of the rules and regulations which the Board of Governors of the Federal Reserve System shall prescribe under subsections (a) and (b) of this section; ‘‘(B) without collateral or on any collateral other than securities, except in accordance with such rules and regulations as the Board of Governors of the Federal Reserve System may prescribe— ‘‘(i) to permit under specified conditions and for a limited period any such member, broker, or dealer to maintain a credit initially extended in conformity with the rules and regulations of the Board of governors of the Federal Reserve System; and ‘‘(ii) to permit the extension or maintenance of credit in cases where the extension or maintenance of credit is not for the purpose of pur- chasing or carrying securities or of evading or circumventing the provi- sions of subparagraph (A) of this paragraph. ‘‘(2) EXCEPTION.—This subsection and the rules and regulations thereunder shall not apply to any credit extended, maintained, or arranged by a member of a national securities exchange or a broker or dealer to or for a member of a national securities exchange or a registered broker or dealer— ‘‘(A) a substantial portion of whose business consists of transactions with persons other than brokers or dealers; or ‘‘(B) to finance its activities as a market maker or an underwriter; except that the Board of Governors of the Federal Reserve System may impose such rules and regulations, in whole or in part, on any credit otherwise exempt- ed by this paragraph if it determines that such action is necessary or appro- priate in the public interest or for the protection of investors.’’. (2) EXTENSIONS OF CREDIT BY OTHER LENDERS.—Section 7(d) of the Securities Exchange Act of 1934 (78 U.S.C. 78g(d)) is amended to read as follows: ‘‘(d) UNLAWFUL CREDIT EXTENSION IN VIOLATION OF RULES AND REGULATIONS; EX- CEPTION TO APPLICATION OF RULES, ETC.— ‘‘(1) PROHIBITION.—It shall be unlawful for any person not subject to sub- section (c) of this section to extend or maintain credit or to arrange for the ex- tension or maintenance of credit for the purpose of purchasing or carrying any security, in contravention of such rules and regulations as the Board of Gov- ernors of the Federal Reserve System shall prescribe to prevent the excessive use of credit for the purchasing or carrying of or trading in securities in cir- cumvention of the other provisions of this section. Such rules and regulations may impose upon all loans made for the purpose of purchasing or carrying secu- rities limitations similar to those imposed upon members, brokers, or dealers by subsection (c) of this section and the rules and regulations thereunder. ‘‘(2) EXCEPTIONS.—This subsection and the rules and regulations thereunder shall not apply to any credit extended, maintained, or arranged— ‘‘(A) by a person not in the ordinary course of business; ‘‘(B) on an exempted security; ‘‘(C) to or for a member of a national securities exchange or a registered broker or dealer— ‘‘(i) a substantial portion of whose business consists of transactions with persons other than brokers or dealers; or ‘‘(ii) to finance its activities as a market maker or an underwriter; ‘‘(D) by a bank on a security other than an equity security; or ‘‘(E) as the Board of Governors of the Federal Reserve System shall, by such rules, regulations, or orders as it may deem necessary or appropriate in the public interest or for the protection of investors, exempt, either un- conditionally or upon specified terms and conditions or for stated periods, from the operation of this subsection and the rules and regulations there- under; except that the Board of Governors of the Federal Reserve System may impose such rules and regulations, in whole or in part, on any credit otherwise exempt- ed by subparagraph (C) of this paragraph if it determines that such action is necessary or appropriate in the public interest or for the protection of inves- tors.’’. (b) BORROWING BY MEMBERS, BROKERS, AND DEALERS.—Section 8 of the Securities Exchange Act of 1934 (15 U.S.C. 78h) is amended— (1) by striking subsection (a), and (2) by redesignating subsections (b) and (c) as subsections (a) and (b), respec- tively. 8 SEC. 104. PROSPECTUS DELIVERY. (a) REPORT ON ELECTRONIC DELIVERY.—Within six months after the date of enact- ment of this Act, the Commission shall report to Congress on the steps the Commis- sion has taken, or anticipates taking, to facilitate the electronic delivery of prospectuses to institutional and other investors. (b) REPORT ON ADVISORY COMMITTEE RECOMMENDATIONS.—Within one year after the date of enactment of this Act, the Commission shall report to Congress on the Commission’s views on the recommendations of the Advisory Committee on Capital Formation, including any actions taken to implement the recommendations of the Advisory Committee. SEC. 105. EXEMPTIVE AUTHORITY. (a) GENERAL EXEMPTIVE AUTHORITY UNDER THE SECURITIES ACT OF 1933.—Title I of the Securities Act of 1933 (15 U.S.C. 77a et seq.) is amended by adding at the end the following new section: ‘‘SEC. 28. GENERAL EXEMPTIVE AUTHORITY. ‘‘The Commission, by rules and regulations, may conditionally or unconditionally exempt any person, security, or transaction, or any class or classes of persons, secu- rities, or transactions, from any provision or provisions of this title or of any rule or regulation thereunder, to the extent that such exemption is necessary or appro- priate in the public interest, and is consistent with the protection of investors.’’. (b) GENERAL EXEMPTIVE AUTHORITY UNDER THE SECURITIES EXCHANGE ACT OF 1934.—Title I of the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.) is amended by adding at the end the following new section: ‘‘SEC. 36. GENERAL EXEMPTIVE AUTHORITY. ‘‘Notwithstanding any other provision of this title, the Commission, by rule, regu- lation, or order, may conditionally or unconditionally exempt any person, security, or transaction, or any class or classes of persons, securities, or transactions, from any provision or provisions of this title or of any rule or regulation thereunder, to the extent that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors. The Commission shall by rules and regulations determine the procedures under which an exemptive order under this section shall be granted and may, in its sole discretion, decline to entertain any application for an order of exemption under this section.’’. SEC. 106. PROMOTION OF EFFICIENCY, COMPETITION, AND CAPITAL FORMATION. (a) SECURITIES ACT OF 1933.—Section 2 of the Securities Act of 1933 (15 U.S.C. 77b) is amended— (1) by inserting ‘‘(a) DEFINITIONS.—’’ after ‘‘SEC. 2.’’; and (2) by adding at the end the following new subsection: ‘‘(b) CONSIDERATION OF PROMOTION OF EFFICIENCY, COMPETITION, AND CAPITAL FORMATION.—Whenever pursuant to this title the Commission is engaged in rule- making and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission shall also consider, in addition to the protection of investors, whether the action will promote efficiency, competi- tion, and capital formation.’’. (b) SECURITIES EXCHANGE ACT of 1934.—Section 3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c) is amended by adding at the end the following new sub- section: ‘‘(f) CONSIDERATION OF PROMOTION OF EFFICIENCY, COMPETITION, AND CAPITAL FORMATION.—Whenever pursuant to this title the Commission is engaged in rule- making, or in the review of a rule of a self-regulatory organization, and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission shall also consider, in addition to the protection of inves- tors, whether the action will promote efficiency, competition, and capital formation.’’. (c) INVESTMENT COMPANY ACT of 1940.—Section 2 of the Investment Company Act of 1940 (15 U.S.C. 80a–2) is amended by adding at the end the following new sub- section: ‘‘(c) CONSIDERATION OF PROMOTION OF EFFICIENCY, COMPETITION, AND CAPITAL FORMATION.—Whenever pursuant to this title the Commission is engaged in rule- making and is required to consider or determine whether an action is consistent with the public interest, the Commission shall also consider, in addition to the pro- tection of investors, whether the action will promote efficiency, competition, and cap- ital formation.’’. SEC. 107. PRIVATIZATION OF EDGAR. (a) EXAMINATION.—The Securities and Exchange Commission shall examine pro- posals for the privatization of the EDGAR system. Such examination shall promote 9 competition in the automation and rapid collection and dissemination of information required to be disclosed. Such examination shall include proposals that maintain free public access to data filings in the EDGAR system. (b) REVIEW AND REPORT.—Within 180 days after the date of enactment of this Act, the Commission shall submit to the Congress a report on the examination under subsection (a). Such report shall include such recommendations for such legislative action as may be necessary to implement the proposal that the Commission deter- mines most effectively achieves the objectives described in subsection (a). SEC. 108. COORDINATION OF EXAMINING AUTHORITIES. (a) AMENDMENTS.—Section 17 of the Securities Exchange Act of 1934 (15 U.S.C. 78q) is amended by adding at the end the following new subsection: ‘‘(i) COORDINATION OF EXAMINING AUTHORITIES.— ‘‘(1) ELIMINATION OF DUPLICATION.—The Commission and the examining au- thorities, through cooperation and coordination of examination and oversight as required by this subsection, shall eliminate any unnecessary and burdensome duplication in the examination process. ‘‘(2) PLANNING CONFERENCES.— ‘‘(A) The Commission and the examining authorities shall meet at least annually for a national general planning conference to discuss coordination of examination schedules and priorities and other areas of interest relevant to examination coordination and cooperation. ‘‘(B) Within each geographic region designated by the Commission, the Commission and the relevant examining authorities shall meet at least an- nually for a regional planning conference to discuss examination schedules and priorities and other areas of related interest, and to encourage informa- tion-sharing and to avoid unnecessary duplication of examinations. ‘‘(3) COORDINATION TRACKING SYSTEM FOR BROKER-DEALER EXAMINATIONS.— ‘‘(A) The Commission and the examining authorities shall prepare, on a periodic basis in a uniform computerized format, information on registered broker and dealer examinations and shall submit such information to the Commission. ‘‘(B) The Commission shall maintain a computerized database of consoli- dated examination information to be used for examination planning and scheduling and for monitoring coordination of registered broker and dealer examinations under this section. ‘‘(4) COORDINATION OF EXAMINATIONS.— ‘‘(A) The examining authorities shall share among themselves such infor- mation, including reports of examinations, customer complaint information, and other non-public regulatory information, as appropriate to foster a co- ordinated approach to regulatory oversight of registered brokers and deal- ers subject to examination by more than one examining authority. ‘‘(B) To the extent practicable, the examining authorities shall assure that each registered broker and dealer subject to examination by more than one examining authority that requests a coordinated examination shall have all requested aspects of the examination conducted simultaneously and without duplication of the areas covered. The examining authorities shall also prepare an advance schedule of all such coordinated examina- tions. ‘‘(5) PROHIBITED NON-COORDINATED EXAMINATIONS.—Any examining authority that does not participate in a coordinated examination pursuant to paragraph (4) of this subsection shall not conduct a routine examination other than a co- ordinated examination of that broker or dealer within 9 months of the conclu- sion of a scheduled coordinated examination. ‘‘(6) EXAMINATIONS FOR CAUSE.—At any time, any examining authority may conduct an examination for cause of any broker or dealer subject to its jurisdic- tion. ‘‘(7) BROKER-DEALER EXAMINATION EVALUATION PANEL.—The Commission shall establish an examination evaluation panel composed of representatives of registered brokers and dealers that are members of more than one self-regu- latory organization that conducts routine examinations. Prior to each national general planning conference required by paragraph (2)(A) of this subsection, the Commission shall convene the examination evaluation panel to review consoli- dated and statistical information on the coordination of examinations and infor- mation on examinations that are not coordinated, including the findings of Com- mission examiners on the effectiveness of the examining authorities in achiev- ing coordinated examinations. The Commission shall present any findings and recommendations of the examination evaluation panel to the next meeting of 10 the national general planning conference, and shall report back to the examina- tion evaluation panel on the actions taken by the examining authorities regard- ing those findings and recommendations. The examination evaluation panel shall not be subject to the Federal Advisory Committee Act (5 U.S.C. App.). ‘‘(8) REPORT TO CONGRESS.—Within one year after the date of enactment of this Act, the Commission shall report to the Congress on the progress it and the examining authorities have made in reducing duplication and improving co- ordination in registered broker and dealer examinations, and on the activities of the examination evaluation panel. Such report shall also indicate whether the Commission has identified additional redundancies that have failed to be ad- dressed in the coordination of examining authorities, or any recommendations of the examination evaluation panel established under paragraph (7) of this subsection that have not been addressed by the examining authorities or the Commission.’’. (b) DEFINITION.—Section 3(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78e) is amended by adding at the end the following paragraph: ‘‘(54) The term ‘examining authority’ means any self-regulatory organization registered with the Commission under this title (other than registered clearing agencies) with the authority to examine, inspect, and otherwise oversee the ac- tivities of a registered broker or dealer.’’. SEC. 109. FOREIGN PRESS CONFERENCES. No later than one year after the date of enactment of this Act, the Commission shall adopt rules under the Securities Act of 1933 concerning the status under the registration provisions of the Securities Act of 1933 of foreign press conferences and foreign press releases by persons engaged in the offer and sale of securities. SEC. 110. REPORT ON TRUST INDENTURE ACT OF 1939. Within 6 months after the date of enactment of this Act, the Securities and Ex- change Commission shall submit to the Congress a report on the benefits of, the continuing need for, and, if necessary, options for the modification or elimination of, the Trust Indenture Act of 1939 (15 U.S.C. 77aaa et seq.). TITLE II—INVESTMENT COMPANY ACT AMENDMENTS SEC. 201. SHORT TITLE. This title may be cited as the ‘‘Investment Company Act Amendments of 1996’’. SEC. 202. FUNDS OF FUNDS. Section 12(d)(1) of the Investment Company Act of 1940 (15 U.S.C. 80a–12(d)(1)) is amended— (1) in subparagraph (E)(iii)— (A) by striking ‘‘in the event such investment company is not a registered investment company,’’; and (B) by inserting ‘‘in the event such investment company is not a reg- istered investment company’’ after ‘‘(bb)’’; (2) by redesignating existing subparagraphs (G) and (H) as subparagraphs (H) and (I), respectively; (3) by inserting after subparagraph (F) the following new subparagraph: ‘‘(G) The provisions of this paragraph (1) shall not apply to securities of a reg- istered open-end company (the ‘acquired company’) purchased or otherwise acquired by a registered open-end company (the ‘acquiring company’) if— ‘‘(i) the acquired company and the acquiring company are part of the same group of investment companies; ‘‘(ii) the securities of the acquired company, securities of other registered open-end companies that are part of the same group of investment companies, Government securities, and short-term paper are the only investments held by the acquiring company; ‘‘(iii)(I) the acquiring company does not pay and is not assessed any charges or fees for distribution-related activities with respect to securities of the ac- quired company unless the acquiring company does not charge a sales load or other fees or charges for distribution-related activities; or ‘‘(II) any sales loads and other distribution-related fees charged with respect to securities of the acquiring company, when aggregated with any sales load and distribution-related fees paid by the acquiring company with respect to se- curities of the acquired company, are not excessive under rules adopted pursu- 11 ant to either section 22(b) or section 22(c) of this title by a securities association registered under section 15A of the Securities Exchange Act of 1934 or the Com- mission; ‘‘(iv) the acquired company shall have a fundamental policy that prohibits it from acquiring any securities of registered open-end companies in reliance on this subparagraph or subparagraph (F) of this subsection; and ‘‘(v) such acquisition is not in contravention of such rules and regulations as the Commission may from time to time prescribe with respect to acquisitions in accordance with this subparagraph as necessary and appropriate for the pro- tection of investors. For purposes of this subparagraph, a ‘group of investment companies’ shall mean any two or more registered investment companies that hold themselves out to inves- tors as related companies for purposes of investment and investor services.’’; and (4) adding at the end the following new subparagraph: ‘‘(J) The Commission, by rules and regulations upon its own motion or by order upon application, may conditionally or unconditionally exempt any person, security, or transaction, or any class or classes of persons, securities, or transactions from any provisions of this subsection, if and to the extent such exemption is consistent with the public interest and the protection of investors.’’. SEC. 203. REGISTRATION OF SECURITIES. (a) AMENDMENTS TO REGISTRATION STATEMENTS.—Section 24(e) of the Investment Company Act of 1940 (15 U.S.C. 80a–24(e)) is amended— (1) by striking paragraphs (1) and (2); (2) by redesignating paragraph (3) as subsection (e); and (3) in subsection (e) (as so redesignated) by striking ‘‘pursuant to this sub- section or otherwise’’. (b) REGISTRATION OF INDEFINITE AMOUNT OF SECURITIES.—Section 24(f) of the In- vestment Company Act of 1940 (15 U.S.C. 80a–24(f)) is amended to read as follows: ‘‘(f) REGISTRATION OF INDEFINITE AMOUNT OF SECURITIES.— ‘‘(1) INDEFINITE REGISTRATION OF SECURITIES.—Upon the effectiveness of its registration statement under the Securities Act of 1933, a face-amount certifi- cate company, open-end management company, or unit investment trust shall be deemed to have registered an indefinite amount of securities. ‘‘(2) PAYMENT OF REGISTRATION FEES.—Within 90 days after the end of the company’s fiscal year, the company shall pay a registration fee to the Commis- sion, calculated in the manner specified in section 6(b) of the Securities Act of 1933, based on the aggregate sales price for which its securities (including, for this purpose, all securities issued pursuant to a dividend reinvestment plan) were sold pursuant to a registration of an indefinite amount of securities under this subsection during the company’s previous fiscal year reduced by— ‘‘(A) the aggregate redemption or repurchase price of the securities of the company during that year, and ‘‘(B) the aggregate redemption or repurchase price of the securities of the company during any prior fiscal year ending not more than 1 year before the date of enactment of the Investment Company Act Amendments of 1996 that were not used previously by the company to reduce fees payable under this section. ‘‘(3) INTEREST DUE ON LATE PAYMENT.—A company paying the fee or any por- tion thereof more than 90 days after the end of the company’s fiscal year shall pay to the Commission interest on unpaid amounts, compounded daily, at the underpayment rate established by the Secretary of the Treasury pursuant to section 3717(a) of title 31, United States Code. The payment of interest pursu- ant to the requirement of this paragraph shall not preclude the Commission from bringing an action to enforce the requirements of paragraph (2) of this subsection. ‘‘(4) RULEMAKING AUTHORITY.—The Commission may adopt rules and regula- tions to implement the provisions of this subsection.’’. (c) EFFECTIVE DATE.—The amendments made by this section shall be effective 6 months after the date of enactment of this Act or on such earlier date as the Com- mission may specify by rule. SEC. 204. INVESTMENT COMPANY ADVERTISING PROSPECTUS. Section 24 of the Investment Company Act of 1940 (15 U.S.C. 80a–24) is amended by adding at the end the following new subsection: ‘‘(g) In addition to the prospectuses permitted or required in section 10 of the Se- curities Act of 1933, the Commission shall permit, by rules or regulations deemed necessary or appropriate in the public interest or for the protection of investors, the use of a prospectus for the purposes of section 5(b)(1) of such Act with respect to 12 securities issued by a registered investment company. Such a prospectus, which may include information the substance of which is not included in the prospectus speci- fied in section 10(a) of the Securities Act of 1933, shall be deemed to be permitted by section 10(b) of such Act.’’. SEC. 205. VARIABLE INSURANCE CONTRACTS. (a) UNIT INVESTMENT TRUST TREATMENT.—Section 26 of the Investment Company Act of 1940 (15 U.S.C. 80a–26) is amended by adding at the end the following new subsection: ‘‘(e)(1) Subsection (a) shall not apply to any registered separate account funding variable insurance contracts, or to the sponsoring insurance company and principal underwriter of such account. ‘‘(2) It shall be unlawful for any registered separate account funding variable in- surance contracts, or for the sponsoring insurance company of such account, to sell any such contract, unless— ‘‘(A) the fees and charges deducted under the contract in the aggregate are reasonable in relation to the services rendered, the expenses expected to be in- curred, and the risks assumed by the insurance company, and the insurance company so represents in the registration statement for the contract; and ‘‘(B) the insurance company (i) complies with all other applicable provisions of this section as if it were a trustee or custodian of the registered separate ac- count; (ii) files with the insurance regulatory authority of a State an annual statement of its financial condition, which most recent statement indicates that it has a combined capital and surplus, if a stock company, or an unassigned sur- plus, if a mutual company, of not less than $1,000,000, or such other amount as the Commission may from time to time prescribe by rule as necessary or ap- propriate in the public interest or for the protection of investors; and (iii) to- gether with its registered separate accounts, is supervised and examined peri- odically by the insurance authority of such State. ‘‘(3) The Commission may adopt such rules and regulations under paragraph (2)(A) as it determines are necessary or appropriate in the public interest or for the protection of investors. For the purposes of such paragraph, the fees and charges deducted under the contract shall include all fees and charges imposed for any pur- pose and in any manner.’’. (b) PERIODIC PAYMENT PLAN TREATMENT.—Section 27 of such Act (15 U.S.C. 80a– 27) is amended by adding at the end the following new subsection: ‘‘(i)(1) This section shall not apply to any registered separate account funding vari- able insurance contracts, or to the sponsoring insurance company and principal un- derwriter of such account, except as provided in paragraph (2). ‘‘(2) It shall be unlawful for any registered separate account funding variable in- surance contracts, or for the sponsoring insurance company of such account, to sell any such contract unless (A) such contract is a redeemable security, and (B) the in- surance company complies with section 26(e) and any rules or regulations adopted by the Commission thereunder.’’. SEC. 206. REPORTS TO THE COMMISSION AND SHAREHOLDERS. Section 30 of the Investment Company Act of 1940 (15 U.S.C. 80a–29) is amend- ed— (1) by striking paragraph (1) of subsection (b) and inserting the following: ‘‘(1) such information, documents, and reports (other than financial state- ments), as the Commission may require to keep reasonably current the informa- tion and documents contained in the registration statement of such company filed under this title; and’’; (2) by redesignating subsections (c), (d), (e), and (f) as subsections (d), (e), (g), and (h), respectively; (3) by inserting after subsection (b) the following new subsection: ‘‘(c) In exercising its authority under subsection (b)(1) to require the filing of infor- mation, documents, and reports on a basis more frequently than semi-annually, the Commission shall take such steps as it deems necessary or appropriate, consistent with the public interest and the protection of investors, to avoid unnecessary report- ing by, and minimize the compliance burdens on, registered investment companies and their affiliated persons. Such steps shall include considering and requesting public comment on— ‘‘(1) feasible alternatives that minimize the reporting burdens on registered investment companies; and ‘‘(2) the utility of such information, documents, and reports to the Commission in relation to the costs to registered investment companies and their affiliated persons of providing such information, documents, and reports.’’; 13 (4) by inserting after subsection (e) (as redesignated by paragraph (2) of this section) the following new subsection: ‘‘(f) The Commission may by rule require that semi-annual reports containing the information set forth in subsection (e) include such other information as the Com- mission deems necessary or appropriate in the public interest or for the protection of investors. In exercising its authority under this subsection, the Commission shall take such steps as it deems necessary or appropriate, consistent with the public in- terest and the protection of investors, to avoid unnecessary reporting by, and mini- mize the compliance burdens on, registered investment companies and their affili- ated persons. Such steps shall include considering and requesting public comment on— ‘‘(1) feasible alternatives that minimize the reporting burdens on registered investment companies; and ‘‘(2) the utility of such information to shareholders in relation to the costs to registered investment companies and their affiliated persons of providing such information to shareholders.’’; and (5) in subsection (g) (as so redesignated) by striking ‘‘subsections (a) and (d)’’ and inserting ‘‘subsections (a) and (e)’’. SEC. 207. BOOKS, RECORDS AND INSPECTIONS. Section 31 of the Investment Company Act of 1940 (15 U.S.C. 80a–30) is amend- ed— (1) by striking subsections (a) and (b) and inserting the following: ‘‘(a) Every registered investment company, and every underwriter, broker, dealer, or investment adviser that is a majority-owned subsidiary of such a company, shall maintain and preserve such records (as defined in section 3(a)(37) of the Securities Exchange Act of 1934) for such period or periods as the Commission, by rules and regulations, may prescribe as necessary or appropriate in the public interest or for the protection of investors. Every investment adviser not a majority-owned subsidi- ary of, and every depositor of any registered investment company, and every prin- cipal underwriter for any registered investment company other than a closed-end company, shall maintain and preserve for such period or periods as the Commission shall prescribe by rules and regulations, such records as are necessary or appro- priate to record such person’s transactions with such registered company. In exercis- ing its authority under this subsection, the Commission shall take such steps as it deems necessary or appropriate, consistent with the public interest and for the pro- tection of investors, to avoid unnecessary recordkeeping by, and minimize the com- pliance burden on, persons required to maintain records under this subsection (here- inafter in this section referred to as ‘subject persons’). Such steps shall include con- sidering, and requesting public comment on— ‘‘(1) feasible alternatives that minimize the recordkeeping burdens on subject persons; ‘‘(2) the necessity of such records in view of the public benefits derived from the independent scrutiny of such records through Commission examination; ‘‘(3) the costs associated with maintaining the information that would be re- quired to be reflected in such records; and ‘‘(4) the effects that a proposed recordkeeping requirement would have on in- ternal compliance policies and procedures. ‘‘(b) All records required to be maintained and preserved in accordance with sub- section (a) of this section shall be subject at any time and from time to time to such reasonable periodic, special, and other examinations by the Commission, or any member or representative thereof, as the Commission may prescribe. For purposes of such examinations, any subject person shall make available to the Commission or its representatives any copies or extracts from such records as may be prepared without undue effort, expense, or delay as the Commission or its representatives may reasonably request. The Commission shall exercise its authority under this subsection with due regard for the benefits of internal compliance policies and pro- cedures and the effective implementation and operation thereof.’’; (2) by redesignating existing subsections (c) and (d) as subsections (e) and (f), respectively; and (3) by inserting after subsection (b) the following new subsections: ‘‘(c) Notwithstanding any other provision of law, the Commission shall not be com- pelled to disclose any internal compliance or audit records, or information contained therein, provided to the Commission under this section. Nothing in this subsection shall authorize the Commission to withhold information from Congress or prevent the Commission from complying with a request for information from any other Fed- eral department or agency requesting the information for purposes within the scope of its jurisdiction, or complying with an order of a court of the United States in an 14 action brought by the United States or the Commission. For purposes of section 552 of title 5, United States Code, this section shall be considered a statute described in subsection (b)(3)(B) of such section 552. ‘‘(d) For purposes of this section— ‘‘(1) ‘internal compliance policies and procedures’ means policies and proce- dures designed by subject persons to promote compliance with the Federal secu- rities laws; and ‘‘(2) ‘internal compliance and audit record’ means any record prepared by a subject person in accordance with internal compliance policies and procedures.’’. SEC. 208. INVESTMENT COMPANY NAMES. Section 35(d) of the Investment Company Act of 1940 (15 U.S.C. 80a–34(d)) is amended to read as follows: ‘‘(d) It shall be unlawful for any registered investment company to adopt as a part of the name or title of such company, or of any securities of which it is the issuer, any word or words that the Commission finds are materially deceptive or mislead- ing. The Commission is authorized, by rule, regulation, or order, to define such names or titles as are materially deceptive or misleading.’’. SEC. 209. EXCEPTIONS FROM DEFINITION OF INVESTMENT COMPANY. (a) AMENDMENTS.—Section 3(c) of the Investment Company Act of 1940 (15 U.S.C. 80a–3(c)) is amended— (1) in paragraph (1), by inserting after the first sentence the following new sentence: ‘‘Such issuer nonetheless is deemed to be an investment company for purposes of the limitations set forth in section 12(d)(1)(A)(i) and (B)(i) governing the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any reg- istered open-end company to any such issuer.’’; (2) in subparagraph (A) of paragraph (1)— (A) by inserting after ‘‘issuer,’’ the first place it appears the following: ‘‘and is or, but for the exception in this paragraph or paragraph (7), would be an investment company,’’; and (B) by striking all that follows ‘‘(other than short-term paper)’’ and insert- ing a period; (3) in paragraph (2)— (A) by striking ‘‘and acting as broker,’’ and inserting ‘‘acting as broker, and acting as market intermediary,’’; and (B) by adding at the end of such paragraph the following new sentences: ‘‘For the purposes of this paragraph, the term ‘market intermediary’ means any person that regularly holds itself out as being willing contempora- neously to engage in, and is regularly engaged in the business of entering into, transactions on both sides of the market for a financial contract or one or more such financial contracts. For purposes of the preceding sentence, the term ‘financial contract’ means any arrangement that (A) takes the form of an individually negotiated contract, agreement, or option to buy, sell, lend, swap, or repurchase, or other similar individually negotiated transaction commonly entered into by participants in the financial markets; (B) is in respect of securities, commodities, currencies, interest or other rates, other measures of value, or any other financial or economic interest similar in purpose or function to any of the foregoing; and (C) is entered into in response to a request from a counterparty for a quotation or is oth- erwise entered into and structured to accommodate the objectives of the counterparty to such arrangement.’’; and (4) by striking paragraph (7) and inserting the following: ‘‘(7)(A) Any issuer (i) whose outstanding securities are owned exclusively by persons who, at the time of acquisition of such securities, are qualified pur- chasers, and (ii) who is not making and does not presently propose to make a public offering of such securities. Securities that are owned by persons who re- ceived the securities from a qualified purchaser as a gift or bequest, or where the transfer was caused by legal separation, divorce, death, or other involuntary event, shall be deemed to be owned by a qualified purchaser, subject to such rules, regulations, and orders as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors. ‘‘(B) Notwithstanding subparagraph (A), an issuer is within the exception pro- vided by this paragraph if— ‘‘(i) in addition to qualified purchasers, its outstanding securities are ben- eficially owned by not more than 100 persons who are not qualified pur- chasers if (I) such persons acquired such securities on or before December 15 31, 1995, and (II) at the time such securities were acquired by such per- sons, the issuer was excepted by paragraph (1) of this subsection; and ‘‘(ii) prior to availing itself of the exception provided by this paragraph— ‘‘(I) such issuer has disclosed to such persons that future investors will be limited to qualified purchasers, and that ownership in such is- suer is no longer limited to not more than 100 persons, and ‘‘(II) concurrently with or after such disclosure, such issuer has pro- vided such persons with a reasonable opportunity to redeem any part or all of their interests in the issuer for their proportionate share of the issuer’s current net assets, or the cash equivalent thereof. ‘‘(C) An issuer that is excepted under this paragraph shall nonetheless be deemed to be an investment company for purposes of the limitations set forth in section 12(d)(1)(A)(i) and (B)(i) governing the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end company to any such issuer. ‘‘(D) For purposes of determining compliance with this paragraph and para- graph (1) of this subsection, an issuer that is otherwise excepted under this paragraph and an issuer that is otherwise excepted under paragraph (1) shall not be treated by the Commission as being a single issuer for purposes of deter- mining whether the outstanding securities of the issuer excepted under para- graph (1) are beneficially owned by not more than 100 persons or whether the outstanding securities of the issuer excepted under this paragraph are owned by persons that are not qualified purchasers. Nothing in this provision shall be deemed to establish that a person is a bona fide qualified purchaser for pur- poses of this paragraph or a bona fide beneficial owner for purposes of para- graph (1) of this subsection.’’. (b) DEFINITION OF QUALIFIED PURCHASER.—Section 2(a) of the Investment Com- pany Act of 1940 (15 U.S.C. 80a–2(a)) is amended by inserting after paragraph (50) the following new paragraph: ‘‘(51) ‘Qualified purchaser’ means— ‘‘(A) any natural person who owns at least $10,000,000 in securities of is- suers that are not controlled by such person, except that securities of such a controlled issuer may be counted toward such amount if such issuer is, or but for the exception in paragraph (1) or (7) of section 3(c) would be, an investment company; ‘‘(B) any trust not formed for the specific purpose of acquiring the securi- ties offered, as to which the trustee or other person authorized to make de- cisions with respect to the trust, and each settlor or other person who has contributed assets to the trust, is a person described in subparagraph (A) or (C); or ‘‘(C) any person, acting for its own account or the accounts of other quali- fied purchasers, who in the aggregate owns and invests on a discretionary basis, not less than $100,000,000 in securities of issuers that are not affili- ated persons (as defined in paragraph (3)(C) of this subsection) of such per- son, except that securities of such an affiliated person issuer may be count- ed toward such amount if such issuer is, or but for the exception in para- graph (1) or (7) of section 3(c) would be, an investment company. The Commission may adopt such rules and regulations governing the persons and trusts specified in subparagraphs (A), (B), and (C) of this paragraph as it determines are necessary or appropriate in the public interest and for the pro- tection of investors.’’. (c) CONFORMING AMENDMENT.—The last sentence of section 3(a) of the Investment Company Act of 1940 (15 U.S.C. 80a–3(a)) is amended— (1) by inserting ‘‘(i)’’ after ‘‘of the owner’’; and (2) by inserting before the period the following: ‘‘, and (ii) which are not rely- ing on the exception from the definition of investment company in subsection (c)(1) or (c)(7) of this section’’. (d) RULEMAKING REQUIRED.— (1) IMPLEMENTATION OF SECTION 3(c)(1)(B).—Within one year after the date of enactment of this Act, the Commission shall prescribe rules to implement the requirements of section 3(c)(1)(B) of the Investment Company Act of 1940 (15 U.S.C. 80a–3(c)(1)(B)). (2) EMPLOYEE EXCEPTION.—Within one year after the date of enactment of this Act, the Commission shall prescribe rules pursuant to its authority under section 6 of the Investment Company Act of 1940 (15 U.S.C. 80a–6) to permit the ownership by knowledgeable employees of an issuer or an affiliated person of the issuer of the securities of that issuer or affiliated person without loss of 16 the issuer’s exception under section 3(c)(1) or 3(c)(7) of such Act from treatment as an investment company under such Act. PURPOSE AND SUMMARY The purpose of this legislation is to modernize and rationalize certain important aspects of the regulatory scheme governing our capital markets, including the respective responsibilities of Federal and State governmental authorities over the securities markets. The legislation seeks to further advance the development of na- tional securities markets and eliminate the costs and burdens of duplicative and unnecessary regulation by, as a general rule, des- ignating the Federal government as the exclusive regulator of na- tional offerings of securities. State governments generally retain authority to regulate small, regional, or intrastate securities offer- ings, and to bring actions pursuant to State laws and regulations prohibiting fraud and deceit, including broker-dealer sales practices abuses. The legislation also seeks to promote efficiency, competition, and capital formation in the capital markets without compromising in- vestor protection by repealing anti-competitive restrictions on enti- ties from whom brokers may borrow; requiring the consideration of efficiency, competition, and capital formation whenever the Securi- ties and Exchange Commission (Commission) makes a public inter- est determination in its rulemaking; providing for streamlining and coordinating of examinations of broker-dealers by self-regulatory organizations; significantly reducing regulatory burdens on the mu- tual fund industry; simplifying and reducing ineffective and anti- competitive restrictions imposed by the Investment Company Act; and establishing a new exception from the Investment Company Act for private investment pools (such as hedge funds, as well as venture capital firms raising capital for new and growing busi- nesses) that will eliminate certain regulatory impediments on these investment pools by permitting interests in these pools to be sold to an unlimited number of qualified purchasers. BACKGROUND AND NEED FOR LEGISLATION The Subcommittee on Telecommunications and Finance held a series of hearings in 1995 to examine the need for legislation mod- ernizing and rationalizing our scheme of securities regulation. Sev- eral themes recurred throughout the testimony of the majority of witnesses. One was the need to rethink the system of dual Federal and State securities regulation. Testimony demonstrated a clear need for modernization and indicated that, notwithstanding past reform efforts, there continues to be a substantial degree of dupli- cation between Federal and State securities regulation, and that this duplication tends to raise the cost of capital to American issu- ers of securities without providing commensurate protection to in- vestors or our markets. Testimony also indicated that technological change has transformed the capital raising process, necessitating changes in the regulatory scheme to facilitate the flow of informa- tion to potential investors and reduce the marginal cost of capital to firms. The explosive growth of the investment company industry dra- matically illustrates the transformation that our nation’s capital 17 raising process has undergone in recent years. In the 56 years since the Investment Company Act became law, the mutual fund industry has grown from 68 funds with assets of about $400 million to over 5,500 funds with over $3 trillion in assets. Americans are relying on mutual fund investments with increasing frequency for purposes of investing and saving for retirement, college education, and other fundamental financial needs. Today, nearly one in every three American households owns mutual fund shares. The Investment Company Act has not, however, undergone sig- nificant change in response to the developments in the industry; the Act has been amended significantly only once, in 1970. Accord- ingly, certain of the Act’s provisions have become outdated and un- duly burdensome, imposing unnecessary costs on funds and imped- ing innovation in the industry. The costs borne by the industry are passed on to shareholders in the form of lower returns on their in- vestments and reduced flexibility in investment options. The Securities Amendments of 1996 eliminate many of these bur- dens and enhance innovation and efficiency for investment compa- nies. The legislation facilitates the creation of funds of funds, which can be simple and economical asset allocation devices for investors. The legislation simplifies and streamlines the registration process that investment companies must undertake to sell their shares con- tinuously. This change in the registration process eliminates the risk under current law that can cause investment companies to pay inordinately large penalties for a technical or clerical error that re- sults in missing a filing deadline. And the legislation facilitates more flexible and useful investment company advertising by creat- ing a new type of advertising document. Investment companies may use this new document to advertise performance data and other up-to-date information without having to limit the advertise- ment to information ‘‘the substance of which’’ is contained in the statutory prospectus. The growth of the industry has also raised questions with respect to industry regulation that were not anticipated by the authors of the Investment Company Act. To help maintain the strong record of investor protection that has characterized the regulation of the mutual fund industry, the legislation grants the Commission spe- cific additional authority regarding investment company books and records, and the preparation of shareholder reports. In exercising this authority, the legislation directs the Commission to take ap- propriate steps to avoid unnecessary reporting by, and to minimize the compliance burdens on, investment companies and to consider the effects of new recordkeeping requirements on the integrity and continued effectiveness of internal compliance programs of invest- ment companies. The legislation also grants the Commission new authority to adopt rules that will help ensure that an investment company’s name is consistent with its investment objectives and policies, rather than having to seek to have the use of such a name enjoined by a Federal court. The legislation also clarifies and refines the regulation of vari- able insurance products, which are currently subject to anomalous regulatory requirements arising from the application of principles in the Investment Company Act that are not suited to these prod- ucts, which did not exist at the time the Act was enacted. 18 The legislation also provides a new exception from the definition of ‘‘investment company’’ to permit investment pools that sell their securities only to ‘‘qualified purchasers’’ who are deemed to be so- phisticated investors to sell to an unlimited number of these inves- tors. These pools, which include not only hedge funds but also fi- nancing vehicles such as venture capital funds that provide capital directly to start-up companies or businesses, currently operate pur- suant to an exception in the Investment Company Act that limits the number of investors that can invest in these pools. Although there is no exact accounting of the total number and size of these private investment partnerships, estimates indicate that the total number may be as high as 3,000, with assets estimated between $75 and $160 billion. The Committee recognizes the important role that these pools can play in facilitating capital formation for U.S. companies. The Committee expects that the legislation will signifi- cantly reduce regulatory restrictions that have affected these pools, and will remove incentives that have caused some Americans to in- vest in unregulated offshore markets. During the course of the hearings on this bill, the Subcommittee on Telecommunications and Finance received written and oral tes- timony from witnesses representing the managed futures industry regarding the need for an explicit exception from both the Invest- ment Company Act and the Investment Advisers Act of 1940 for commodity pools and commodity trading advisers whose business it is to trade, or give advice with respect to trading, commodity inter- ests. Such persons are otherwise subject to regulation by an inde- pendent Federal agency, the Commodity Futures Trading Commis- sion (‘‘CFTC’’), pursuant to a separate Federal statute, the Com- modity Exchange Act, as amended (‘‘CEA’’) and the regulations thereunder, and are also subject to oversight by the National Fu- tures Association, a self-regulatory organization. Commodity pool offering documents are subject to review by the CFTC. These documents are also subject to review by the Commis- sion in a manner similar to offerings under the Securities Act. To some extent, this extensive regulatory system evolved in response to the volatility and risk associated with commodity pool invest- ments. The Committee is concerned, however, that aspects of the regulations of commodity pools and commodity trading advisers under the Investment Company and Investment Advisers Acts may constitute unnecessarily burdensome regulation which does not en- hance the protection of investors. The Commission staff has recognized a distinction between com- modity pools and investment companies. The Committee, however, has been informed that the relief that the Commission staff has provided from the Investment Company and Investment Advisers Acts with respect to commodity pools and commodity trading advis- ers has proven to be unnecessarily restrictive to these entities. The Commission staff has represented to the Committee that it is willing to take appropriate action, pursuant to the Commission’s authority under the Investment Company Act, to provide adminis- trative relief from the provisions of that Act to issuers that are pri- marily engaged in the business of operating a commodity pool or investing in interests of such pools, operated by a person subject to regulation as a commodity pool operator under the CEA, and are 19 held out as being primarily engaged in such business. The Commis- sion staff has also represented that it is willing to consider rec- ommending that the Commission take appropriate action pursuant to its authority under the Investment Advisers Act to provide ad- ministrative relief from the provisions of the Act to any commodity pool operator or commodity trading adviser registered as such with the CFTC pursuant to the CEA whose advice, analyses or reports concerning securities is solely related to (a) the securities issued by commodity pools that are the subject of any administrative relief by the Commission under the Investment Company Act, or (b) se- curities investments by such commodity pools. The Committee expects the Commission to take appropriate ac- tion to effect the administrative relief discussed above as soon as practicable following the date of enactment of this legislation. In addition, the Committee supports appropriate administrative action by the Commission to prevent the Investment Company Act from having unintended and adverse consequences to U.S. compa- nies in the business of developing or acquiring and operating for- eign infrastructure projects. The Committee has been informed that some of these companies face regulatory impediments under the Investment Company Act in connection with the acquisition of minority ownership interests in the foreign subsidiaries they establish in connection with these projects. Under current law, if the minority interest constitutes an investment security for purposes of the Investment Company Act, the company holding such an interest may meet the definition of an investment company set out in section 3(a)(3) of the Investment Company Act. Because registration and regulation under the Act can be inconsistent with the intended operations of the company, such a company may determine to avoid participation in such a project in order to avoid becoming subject to the Act. The Investment Company Act may therefore place U.S. compa- nies at a competitive disadvantage vis-a-vis their foreign competi- tors, who are not subject to its requirements in developing or ac- quiring foreign infrastructure projects. These projects include roads, bridges, airports, schools, housing, and hospitals, among many other types of infrastructure projects. The activities of U.S. companies involved in foreign infrastructure projects are not the sort of activities the Investment Company Act was designed to reg- ulate. The Committee is not suggesting that exemptive relief from the Commission is necessarily required in order for investments in these projects to proceed. However, where such relief is necessary, the Committee expects the Commission to take administrative ac- tion expeditiously, either on a case-by-case basis through exemptive orders or through rule making, to exempt from regulations as in- vestment companies U.S. companies that own substantial interests in foreign infrastructure companies and that are (directly or through affiliates) actively involved in foreign infrastructure projects. Any such exemption or rulemaking should be subject to such conditions as the Commission deems necessary and appro- priate in the public interest and consistent with the protection of investors and the purposes fairly intended by the Investment Com- pany Act. 20 HEARINGS The Subcommittee on Telecommunications and Finance held three days of hearings on H.R. 2131, the Capital Markets Deregu- lation and Liberalization Act of 1995, on November 14, 1995, No- vember 30, 1995, and December 5, 1995. Testifying before the Subcommittee on November 14, 1995, were: Dr. Charles Cox, Chief Executive Officer, Lexecon; Mr. J. Carter Beese, Jr., Chairman, Capital Markets Regulatory Reform Project, Center for Strategic and International Studies; Mr. Saul S. Cohen, Rosenman & Colin LLP; Professor John C. Coffee, Jr., Adolphe Berle Professor of Law, Columbia University; and Mr. A.A. Sommer, Jr., Morgan, Lewis & Bockius, LLP. Testifying before the Subcommittee on November 30, 1995, were: The Honorable Arthur Levitt, Chairman, Securities and Exchange Commission; and The Honorable Alan Greenspan, Chairman, Board of Governors, Federal Reserve System. Testifying before the Subcommittee on December 5, 1995, were: Mr. A.B. Krongard, Chairman, Securities Industry Association; Ms. Elaine LaRoche, Vice-Chair, Public Securities Association; Mr. John Gaine, General Counsel, Managed Futures Association; Mr. Matthew P. Fink, President, Investment Company Institute; Mr. R. Charles Shufeldt, representing the American Bankers Association; Mr. Stephen J. Friedman, Partner, Debevoise & Plimpton; Profes- sor Mark A. Sargent, University of Maryland School of Law; Pro- fessor Rutherford B. Campbell, Jr., University of Kentucky College of Law; Mr. Morey W. McDaniel; Mr. Bradley D. Belt, Director of Capital Markets and Domestic Policy Issues, Center for Strategic and International Studies; Mr. Dee Harris, President, North Amer- ican Securities Administrators Association; and Mr. Mark Saladino, representing the Government Finance Officers Association. The Subcommittee on Telecommunications and Finance also held a hearing on H.R. 1495, the Investment Company Act Amendments of 1995, on October 31, 1995. Testifying before the Subcommittee on October 31, 1995, were: Mr. Barry P. Barbash, Director, Divi- sion of Investment Management, Securities and Exchange Commis- sion; Mr. Matthew P. Fink, President, Investment Company Insti- tute; Mr. James S. Riepe, Managing Director, T. Rowe Price Associ- ates, Inc.; Mr. Don G. Powell, Chief Executive Officer, Van Kampen American Capital, Inc.; Ms. Marianne Smythe, Partner, Wilmer, Cutler & Pickering; and Mr. Paul G. Haaga, Director and Senior Vice President, Capital Research & Management Company. COMMITTEE CONSIDERATION On March 7, 1996, the Subcommittee on Telecommunications and Finance met in open markup session and approved H.R. 3005, the Securities Amendments of 1996, as amended, for Full Commit- tee consideration, by a roll call vote of 25 yeas to 0 nays, in lieu of H.R. 2131 and H.R. 1495. On May 15, 1996, the Full Committee met in open markup session and ordered H.R. 3005 reported to the House, as amended, by a voice vote, a quorum being present. 21 ROLLCALL VOTES Clause 2(l)2(B) of rule XI of the Rules of the House requires the Committee to list the recorded votes on the motion to report legis- lation and amendments thereto. There were no recorded votes taken in connection with ordering H.R. 3005 reported or in adopt- ing the amendment. The voice votes taken in Committee are as fol- lows: COMMITTEE ON COMMERCE—104TH CONGRESS VOICE VOTES—MAY 15, 1996 Bill: H.R. 3005, Securities Amendments of 1996. Amendment: Amendment in the Nature of a Substitute offered by Mr. Bliley. Disposition: Agreed to, by a voice vote. Motion: Motion by Mr. Bliley to order H.R. 3005, as amended, re- ported to the House. Disposition: Agreed to, by a voice vote. COMMITTEE OVERSIGHT FINDINGS Pursuant to clause 2(l)(3)(A) of rule XI of the Rules of the House of Representatives, the Committee held legislative hearings and made findings that are reflected in this report. COMMITTEE ON GOVERNMENT REFORM AND OVERSIGHT Pursuant to clause 2(l)(3)(D) of rule XI of the Rules of the House of Representatives, no oversight findings have been submitted to the Committee by the Committee on Government Reform and Oversight. NEW BUDGET AUTHORITY AND TAX EXPENDITURES In compliance with clause 2(l)(3)(B) of rule XI of the Rules of the House of Representatives, the Committee states that H.R. 3005 would result in no new or increased budget authority or tax ex- penditures or revenues. COMMITTEE COST ESTIMATE The Committee adopts as its own, with the reservation described below, the cost estimate prepared by the Director of the Congres- sional Budget Office (CBO) pursuant to section 403 of the Congres- sional Budget Act of 1974. The Committee notes that in the Estimated Cost of Intergovern- mental Mandates, the CBO states that the provision of H.R. 3005 entitled ‘‘exemption to permit service to customers’’ could result in a loss of revenue to States of as much as $10 million. In reaching that conclusion, the CBO assumes that under current law, reg- istered representatives will routinely register in States in which their customers temporarily reside, if such customers seek to con- duct transactions while out of their own State of residence. The Committee believes that under current law, transactions for such customers may be delayed until such customers return to their State of residence, or may be effected by the registered representa- 22 tive without knowledge of the location of the customer. As a result of the transactions permitted under the legislation’s exemption, there will be minimal (if any) loss of revenue to States. The Com- mittee further believes that the current volume of brokerage trans- actions of traveling clients is indeterminate, and thus any loss of revenue resulting from this provision is not able to be quantified with any degree of precision. CONGRESSIONAL BUDGET OFFICE ESTIMATE Pursuant to clause 2(l)(3)(C) of rule XI of the Rules of the House of Representatives, the following is the cost estimate provided by the Congressional Budget Office pursuant to section 403 of the Congressional Budget Act of 1974: U.S. CONGRESS, CONGRESSIONAL BUDGET OFFICE, Washington, DC, June 12, 1996. Hon. THOMAS J. BLILEY, Jr. Chairman, Committee on Commerce, House of Representatives, Washington, DC. DEAR MR. CHAIRMAN: The Congressional Budget Office has pre- pared the enclosed cost estimates for H.R. 3005, the Securities Amendments of 1996. The estimates encompass costs to the federal government, private-sector impacts (incorporated in the federal costs estimate), and costs to state and local governments (discussed in a separate intergovernmental mandate statement). The intergov- ernmental mandate statement supersedes the statement we pre- pared on June 6, 1996, and reflects a technical and conforming change to the base text of H.R. 3005 regarding the scope of the pre- emption of state registration requirements. Enactment of H.R. 3005 would affect receipts. Therefore, pay-as- you-go procedures would apply to the bill. If you wish further details on this estimate, we will be pleased to provide them. Sincerely, JUNE E. O’NEILL, Director. CONGRESSIONAL BUDGET OFFICE COST ESTIMATE 1. Bill number: H.R. 3005. 2. Bill title: Securities Amendments of 1996. 3. Bill status: As ordered reported by the House Committee on Commerce on May 15, 1996. 4. Bill purpose: H.R. 3005 would amend federal laws that regu- late securities. The bill would streamline the securities laws and decrease the regulation of certain products offered by the capital markets. Title I of H.R. 3005 would preempt state law with respect to the following types of capital offerings: (1) securities issued by invest- ment companies, (2) securities listed on the New York Stock Ex- change and the American Stock Exchange, or included on the Na- tional Market System of the National Association of Securities Dealers Automated Quotation System (NASDAQ), (3) off-exchange securities that meet certain threshold requirements, and (4) offers 23 or sales of securities to ‘‘qualified purchasers’’ as defined by the Se- curities and Exchange Commission (SEC) in later rulemaking. In addition, the bill would preempt state law regarding the registra- tion of most debt securities. The bill would preserve the ability of states to require certain filings and fees and would allow states to pursue instances of fraud. Title I would require the SEC to study the following issues: privatization of the Electronic Data Gathering and Retrieval (EDGAR) system; the impact of disparate state licensing requirements on broker-dealers; the uniformity of state securities laws not preempted by H.R. 3005; the feasibility of transmitting prospectuses electronically; and possible modifications to the Trust Indenture Act. The bill also would require the SEC to promulgate a number of rules to consider the impact of such rules on the efficiency of the capital markets. Finally, Title I would exempt most broker-dealers and members of a national exchange from the margin requirements set by the Federal Reserve System, thus enabling sellers of securi- ties to extend more credit to buyers. Title II would amend the Investment Company Act of 1940 to es- tablish rules governing investment companies that wish to offer mutual funds comprised of other mutual funds. In addition, the title would authorize investment companies to include data related to the performance of mutual funds in a fund’s prospectus and would exempt certain types of investment companies from the secu- rities laws. The bill also would ease the regulations on the amount of fees that insurance companies could charge to customers who buy variable annuities. Title II would provide the SEC with more flexibility in determin- ing which records are necessary for the agency to monitor invest- ment companies. The SEC would be required to consider the costs and benefits of requiring additional filings and recordkeeping from the investment companies. Title II also would require the SEC to promulgate a number of rules concerning companies exempted from the Investment Company Act and suitable names for investment company products. Current law requires investment companies to file a registration statement with the SEC before offering shares of a mutual fund to the public. At the time of registration most mutual funds register an ‘‘indefinite’’ number of shares and pay a $500 regulatory fee. At the end of a company’s fiscal year, the firm must pay a registration fee to the SEC based upon the net number of shares sold. H.R. 3005 would simplify the calculations needed to determine the amount owed to the SEC and would extend the window during which the investment companies must pay the registration fee from 60 days to 90 days after the end of a company’s fiscal year. 5. Estimated cost to the Federal Government: CBO estimates that enacting H.R. 3005 would result in a loss of revenues of about $9 million in fiscal year 1997, and new discretionary spending to- taling about $1 million over fiscal years 1997 and 1998, assuming 24 appropriation of the necessary funds. The estimated budgetary im- pact of the bill is summarized in the following table. [By fiscal year, in million of dollars] 1996 1997 1998 1999 2000 2001 2002 SPENDING SUBJECT TO APPROPRIATIONS Spending under current law: Estimated authorization level 1 .......................................... 103 103 103 103 103 103 103 Estimated outlays ............................................................... 102 105 103 103 103 103 103 Proposed changes: Estimated authorization level ............................................ .......... 1 (2) .......... .......... .......... .......... Estimated outlays ............................................................... .......... 1 (2) .......... .......... .......... .......... Estimated spending under H.R. 3005: Estimated authorization level 1 .......................................... 103 104 103 103 103 103 103 Estimated outlays ............................................................... 102 106 103 103 103 103 103 CHANGES IN REVENUES Registration fees: Estimated revenues .............................. .......... ¥9 .......... .......... .......... .......... .......... 1 The 1996 level is the amount appropriated for that year. The estimated authorization levels for 1997 through 2002 reflect CBO baseline estimates for the SEC, assuming no adjustment for inflation. 2 Less than $500,000. The costs of this bill fall within budget function 370. 6. Basis of estimate: Spending subject to appropriations.—Based on information from the SEC, CBO estimates that enacting H.R. 3005 would result in additional discretionary spending of about $1 million in 1997 and less than $500,000 in 1998, assuming appropriations of the nec- essary funds. This additional funding would be used to conduct the rulemakings and studies required by H.R. 3005. The bill also would require the SEC to consider the burden of regulations or rules on capital formation, efficiency, and competition. Because the SEC currently conducts cost-benefit analyses in conjunction with its rulemakings, CBO would not expect this provision to result in any additional costs to the federal government. Many other provisions of the bill would affect those who engage in securities; transactions but would not significantly affect spending by the SEC. Revenues.—H.R. 3005 would extend the deadline for investment companies to file registration fees on the net value of mutual funds sold to the public from 60 days to 90 days after the end of a compa- ny’s fiscal year. CBO estimates that this delay in payments to the SEC would result in a one-time reduction in governmental receipts of about $9 million in fiscal year 1997, because it would shift pay- ments by some companies from fiscal year 1997 into 1998. Similar shifts would occur in subsequent years. Thus, while total receipts from registration fees would remain largely unchanged, there would be a budgetary effect in 1997. Because companies filing beyond the deadline are subject to higher fees, extending the filing period also could reduce total fee collections. However, the bill would authorize the SEC to collect in- terest on late payments, and such interest would partially offset any reduction in the amount of delinquent fees. In addition, the bill would simplify the procedures by which registration fees are cal- culated; that simplification could increase fee collections through greater compliance. CBO estimates that these provisions taken to- gether would not significantly affect the amount of fees collected by the SEC. 25 7. Pay-as-you-go considerations: Section 252 of the Balanced Budget and Emergency Deficit Control Act of 1985 sets up pay-as- you-go procedures for legislation affecting direct spending or re- ceipts through 1998. CBO estimates that enactment of H.R. 3005 would affect receipts by extending the due date for certain registra- tion fees. Therefore, pay-as-you-go procedures would apply to the bill. The following table summarizes the estimated pay-as-you-go impact of H.R. 3005. [By fiscal year, in millions of dollars] 1996 1997 1998 Change in outlays ..................................................................................................................... 1 1 1 Change in receipts .................................................................................................................... 0 ¥9 0 1 Not applicable. 8. Estimated impact on State, local, and tribal governments: The bill would impose mandates on state governments (see the attached intergovernmental mandate cost statement). 9. Estimated impact on the private sector: CBO has identified three private-sector mandates in this bill. We expect that these mandates would not impose any significant costs on the private sector. The first mandate would impose requirements on examining authorities, also referred to as self-regulating organizations (SROs), such as the National Association of Securities Dealers, the New York Stock Exchange, and the American Stock Exchange. The other two mandates would impose requirements on investment companies and certain related entities. The bill would require that the SROs meet annually to discuss the coordination of examination schedules for brokers and dealers, to develop a computerized tracking system for these examinations, and to coordinate the examination process to eliminate duplicate and overlapping examinations. The SROs currently conduct these activities and, therefore, would not incur any additional costs. The bill would give the SEC the authority to require investment companies to file information, documents, and reports more fre- quently and to include additional information in their semi-annual reports. In addition, the bill would allow the SEC to require invest- ment companies to maintain additional record that are similar to those that the commission currently requires of investment advis- ers, brokers, and dealers. The SEC does not anticipate changing current filing and recordkeeping requirements as a result of these provisions. Therefore, CBO estimates that investment companies’ costs would not be affected. 10. Previous CBO estimate: None. 11. Estimate prepared by: Federal cost estimate: Rachel Forward and Stephanie Weiner; Private sector impact: Jean Wooster. 12. Estimate approved by: Robert A. Sunshine for Paul N. Van de Water, Assistant Director for Budget Analysis. CONGRESSIONAL BUDGET OFFICE ESTIMATED COST OF INTERGOVERNMENTAL MANDATES 1. Bill number: H.R. 3005. 2. Bill title: Securities Amendments of 1996. 26 3. Bill status: As ordered reported by the House Committee on Commerce on May 15, 1996, and including a technical and con- forming change to the base text. 4. Bill purpose: H.R. 3005 would amend or repeal sections of the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940. In doing so, the bill would preempt state laws and regulations regarding certain types of secu- rities and transactions. The legislation would preserve the ability of states to require certain filings and fees and would allow states to pursue instances of fraud. H.R. 3005 would also create a uniform exemption from state registration for securities salespersons. The bill would require the Securities and Exchange Commission (SEC) to conduct several studies, would exempt most broker-deal- ers and members of a national exchange from the margin require- ments set by the Federal Reserve System, and would amend cer- tain federal restrictions on investment companies. 5. Intergovernmental mandates contained in bill: H.R. 3005 would preempt, with certain limitations, state laws, rules, and reg- ulations that require the registration or qualification of the follow- ing securities or transactions: securities listed or authorized for listing on the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), or included on the National Market System (NMS) of the National Association of Securities Dealers Automatic Quotation System (NASDAQ); debt securities issued by companies that have securities list- ed on the above-mentioned exchanges; securities issued by investment companies registered under the Investment Company Act of 1940; securities issued by companies that have (or will have upon conclusion of the transaction) more than $10 million in total assets, subject to certain conditions; offers or sales of securities to ‘‘qualified purchasers’’ as de- fined by the SEC in later rulemaking; and certain offers or sales of securities that are already exempt from federal registration requirements. The bill would also preempt state laws that: prohibit, limit, or impose conditions on the offering docu- ments, shareholder reports, or other disclosure documents re- lated to certain kinds of securities; prohibit, limit, or impose conditions on offers of the securi- ties listed above based on the merits of the offer or the issuer; and establish capital, margin, books and records, bonding, or re- porting requirements for securities brokers and dealers. Finally, H.R. 3005 would partially preempt state laws that re- quire securities salespersons to register and pay a fee in order to conduct business in a state. Currently, most state laws contain some kind of ‘‘de minimis’’ exemption that allows a salesperson to conduct certain transactions in the state without registering there. The bill would create a national uniform exemption that is broader than most state laws, and would thus allow a salesperson to con- duct business with pre-existing customers who are temporarily re- siding in states even though the salesperson is not registered there. 27 The exemption would also allow a salesperson to conduct a total of ten other transactions annually in those states in which the sales- person is not registered. 6. Estimated direct costs of mandates to State, local, and tribal governments: (a) Is the $50 million threshold exceeded? No. (b) Total direct costs of mandates: The Unfunded Mandates Re- form Act of 1995 (Public Law 104–4) defines the direct costs of an intergovernmental mandate as ‘‘the aggregate estimated amounts that all state, local, and tribal governments would be required to spend or would be prohibited from raising in revenues in order to comply with the Federal intergovernmental mandate.’’ CBO esti- mates that the mandates in this bill—particularly the preemption of state requirements for securities listed on the national exchanges and the partial preemption of state registration requirements for se- curities salesperson—would prohibit states from collecting fees total- ing about $15 million annually that they otherwise would collect. (c) Estimate of necessary budget authority: Not applicable. 7. Basis of estimate: For the purposes of preparing this estimate, CBO contacted state securities regulators in twenty-seven states to understand how state securities laws would be affected by H.R. 3005, and to request data about states’ collections from fees that would be preempted by this bill. CBO also contacted securities in- dustry associations for information about how the industry would likely react to provisions of the bill. Preemption of State requirements for exchange-listed securities CBO estimates that the bill would lower state fee revenues by about $5 million annually by preempting state registration and fil- ing requirements for securities listed or authorized for listing on the NYSE or the AMEX, or included on the NASDAQ NMS. While most states currently exempt these securities form any state re- quirements, CBO identified a few states that do not. We estimate that revenue losses in those states would total about $5 million an- nually. Partial preemption of State registration requirements for securities salespersons The bill would partially preempt state laws to create a uniform exemption from registration for securities salespersons. Because the exemption in the bill is broader than most of the exemptions in current state laws, the bill would likely result in fewer registra- tions by salespersons and thus a reduction in revenues from associ- ated fees. States’ annual registration fees for salespersons cur- rently range from $15 to $235 per agent. CBO estimates that states collect a total of $150 million to $250 million annually from these fees. None of the states we surveyed collect data about the number of transactions that registered salespersons conduct in their states, but based on conversations with state regulators, CBO estimates that state fee collections would decrease by as much as $10 million per year. Revenue losses would be concentrated in those states that do not currently have an exemption, especially those that have a large number of seasonal residents. State enforcement costs could increase as a result of the uniform exemption, but CBO cannot estimate the extent of the increase. A 28 state that does not currently offer an exemption need only prove that a salesperson who is conducting business in the state does not have a license in order to take action against the salesperson. If H.R. 3005 were enacted into law, however, the state would have to prove that the transactions conducted by the salesperson were not covered by the exclusion. Preemption of State registration requirements The bill would preempt state laws requiring the registration or qualification of certain categories of securities and certain securi- ties transactions. The bill provides, however, that states may re- quire the filing of documents filed with the SEC together with any required fee. It further provides that states may continue to collect filing or registration fees pursuant to state laws in effect prior to the enactment of H.R. 3005. CBO estimates that these fees cur- rently generate revenues for the states totaling $210 million to $240 million annually, and that this bill would not preclude the col- lection of such fees. There is, however, some uncertainty as to whether these fee col- lections would continue uninterrupted in all states if H.R. 3005 is enacted. The North American Securities Administrators Associa- tion and several states securities regulators have expressed concern that if H.R. 3005 were enacted, some states, because of the con- struction of their own statutes, would not be able to withstand legal challenges to their right to collect current fees. However, CBO believes that because the scope of the federal preemption in H.R. 3005 is limited, any loss of revenues would not be a direct cost of a federal mandate as defined in Public Law 104–4. By prohibiting states from registering investment company offer- ing or reviewing disclosure documents, the bill would produce ad- ministrative savings for those states that currently devote staff re- sources to those tasks. In our survey of state securities regulators, however, CBO found that only about a dozen states actively review and comment on disclosure documents, and that only a few staff members in each state were assigned those tasks. Therefore, we es- timate that the administrative savings to states would not signifi- cantly offset revenue losses from other mandates in the bill. Other preemptions of State laws CBO estimates that the other preemptions of state law contained in the bill would not impose direct costs on state, local, or tribal governments. 8. Appropriation or other Federal financial assistance provided in bill to cover mandate costs: None. 9. Other impacts on State, local, and tribal governments: None. 10. Previous CBO estimate: On June 6, 1996, CBO provided a cost estimate for H.R. 3005, the Securities Amendments of 1996, as ordered reported by the House Committee on Commerce on May 15, 1996. At that time, CBO estimated that H.R. 3005 contained intergovernmental mandates that would prohibit states from col- lecting certain fees totaling over $125 million annually that they otherwise would collect. Based on a technical and conforming change to the base text of H.R. 3005 regarding the scope of the pre- emption of state registration requirements, CBO now estimates 29 that the mandate costs in H.R. 3005 would total about $15 million annually. 11. Estimate prepared by: Pepper Santalucia. 12. Estimate approved by: Robert A. Sunshine for Paul N. Van de Water, Assistant Director for Budget Analysis. INFLATIONARY IMPACT STATEMENT Pursuant to clause 2(l)(4) of rule XI of the Rules of the House of Representatives, the Committee finds that the bill would have no inflationary impact. ADVISORY COMMITTEE STATEMENT No advisory committees within the meaning of section 5(b) of the Federal Advisory Committee Act are created by this legislation. SECTION-BY-SECTION ANALYSIS OF THE LEGISLATION SECTION 1.—SHORT TITLE; TABLE OF CONTENTS Section 1 states that this Act may be cited as the ‘‘Securities Amendments of 1996’’. Section 1 also provides a table of contents for Titles I and II of the Act. TITLE I.—CAPITAL MARKETS DEREGULATION AND LIBERALIZATION SECTION 101—SHORT TITLE Section 101 provides that Title I may be cited as the ‘‘Capital Markets Deregulation and Liberalization Act of 1996’’. SECTION 102—CREATION OF NATIONAL SECURITIES MARKETS Section 102(a)—Exemption from State Regulation of Securities Offerings. This provision replaces existing section 18 of the Securi- ties Act of 1933 (‘‘Securities Act’’). Section 18 currently provides that the authority of State governments to regulate securities offer- ings is not limited or restricted by the Securities Act. This provi- sion adds a new Section 18 to the Securities Act in order to realign the respective responsibilities of Federal and State governmental authorities over certain aspects of the securities markets. Section 18(a) prohibits State governments from requiring the reg- istration of, or otherwise imposing conditions on, offerings of ‘‘cov- ered securities’’ as defined in Section 18(b), subject to Section 18(d), which preserves State authority to investigate and bring enforce- ment actions with respect to fraud or deceit (including broker-deal- er sales practices) in connection with securities or securities trans- actions. Section 18(d) also preserves the authority of States to re- quire notice filings and fees with respect to certain offerings, and to suspend the offer or sale of securities within a State as a result of the failure to submit a filing or fee. Section 18(a) also limits State governments from requiring the regulation or otherwise im- posing conditions on offerings of ‘‘conditionally covered securities’’ as defined in Section 18(c). Section 18(a) specifically provides that States may not conduct merit reviews of these offerings. In addi- tion, Section 18(a) prohibits States from placing limits or imposing 30 conditions upon (including outright prohibition of) the use of offer- ing documents with respect to such ‘‘covered securities’’ offerings, including advertising or sales literature used in connection with such offerings. It further preempts State regulation of other disclo- sure documents such as proxy statements and annual reports. In each case, the prohibition applies both to direct and indirect State action, thus precluding States from exercising indirect authority to regulate the matters preempted by Section 18(a). Also, in each case, the prohibitions are subject to the provisions of subsection (d). By extending the prohibition to indirect State action, the Commit- tee specifically intends to prevent State regulators from cir- cumventing the provisions of section 18(a) that expressly prohibit them from requiring the registration of, or otherwise imposing con- ditions or limitations upon, offerings of covered securities. The Committee does not intend, however, that the extension of the pro- hibition to indirect actions by State regulators restrict or limit their ability to investigate, bring actions, or enforce orders, injunctions, judgments or remedies based on alleged violations of State laws that prohibit fraud and deceit or that govern broker-dealer sales practices in connection with securities or securities transactions. Section 18(b) defines ‘‘covered securities’’ for the purposes of the provisions of the bill that limit the securities regulatory authority of State governmental bodies. The following four categories of secu- rities are set forth as ‘‘covered securities.’’ Paragraph 18(b)(1) includes as ‘‘covered securities’’ those securi- ties listed, or authorized for listing, on the New York Stock Ex- change (NYSE) or the American Stock Exchange (AMEX) as well as those that are included, or qualify for inclusion, in the National Market System of the National Association of Securities Dealers Automated Quotation System (NASDAQ–NMS). This paragraph codifies in the Securities Act of 1933 an exemption from State reg- istration requirements similar to existing State statutes excepting from State registration requirements securities traded in such mar- kets. In order to avoid competitive disparities, the Commission is given discretionary authority to extend similar preemption treat- ment to other national securities exchanges (or tiers or segments thereof) that have substantially similar listing standards. Some of the regional exchanges have developed tiers that have listing standards similar to NASDAQ–NMS and it is anticipated that other regional exchanges (or new exchanges) may seek to develop such tiers or segments of their markets. The Committee intends that the Commission use this authority to facilitate listings on such qualifying exchanges or tiers or segments thereof. The Committee expects the Commission to monitor the listing requirements of these exchanges, consistent with its supervisory authority under the Exchange Act, to ensure the continued integrity of these mar- kets and the protection of investors. Finally, securities of the same issuer that are equal in seniority or senior to such listed or qualified securities are also ‘‘covered se- curities’’ for the purposes of Section 18(a). This provision is in- tended to afford to issuers of debt securities the same benefits of preemption as are enjoyed by issuers of equity securities. Paragraph 18(b)(2) includes as ‘‘covered securities’’ those securi- ties issued by investment companies regulated under the Invest- 31 ment Company Act of 1940. In recent years, the Commission has directed an increasing percentage of its resources to overseeing the regulation of registered investment companies. The National Asso- ciation of Securities Dealers (NASD) also maintains an effective program of reviewing the sales materials and advertising of reg- istered investment companies that are also broker-dealers, account- ing for approximately 90% of the industry. Registered investment companies themselves often maintain strong internal compliance departments, and the industry has a laudable record of maintain- ing a strong and genuine commitment to the principle of investor protection. The Committee expects that rather than being bur- dened with the time-consuming task of conducting a second review of investment company offering and sales materials, State regu- latory authorities will be freed to spend more time investigating customer complaints, broker-dealer sales practice problems, and re- lated issues. Paragraph 18(b)(3) includes as ‘‘covered securities’’ sales to quali- fied purchasers. This has the effect of preempting State regulation of offers and sales of securities to qualified purchasers. This para- graph anticipates that the Commission will adopt by rule or regula- tion a definition of qualified purchaser that would be used for de- termining the scope of this provision. The Committee intends that the Commission move promptly to adopt such a rule or regulation to give effect to the provision. The Committee believes that securities offered or sold to quali- fied purchasers generally should be included as ‘‘covered securities’’ for three reasons. First, many States currently exempt such securi- ties from registration requirements, but the qualification standard can vary from State to State. This provision will result in a uni- form national rule for qualified purchasers, which should greatly facilitate the ability of issuers to use it. Second, the Committee expects that the securities to be included will be fundamentally national in character and generally (though not always) subject to regulation at the Federal level. Thus, the Committee expects the Commission to craft and construe the defi- nition so that, for example, purchasers of mortgaged-backed, asset- backed and other structured securities, as well as securities issued in connection with project financings, are generally included as qualified purchasers. The Committee notes that structured securi- ties are routinely issued by special purpose vehicles or by trusts that are not listed on an exchange, and will often not have two years of audited financial statements needed to qualify for the list- ing exemption created by paragraph 18(b)(1). As such, it is essen- tial that the Commission craft regulations for qualified purchasers that will implement Congress’s intention that such structured of- ferings be regulated exclusively by the Federal government. Third, the Commission is given flexible authority to establish various definitions of qualified purchasers. In all cases, however, the Committee intends that the Commission’s definition be rooted in the belief that ‘‘qualified’’ purchasers are sophisticated investors, capable of protecting themselves in a manner that renders regula- tion by State authorities unnecessary. For guidance, the Committee suggests that the Commission consider a definition of qualified pur- chaser not more restrictive than that provided in Title II of this 32 legislation under Section 3(c) of the Investment Company Act. The Committee further intends that the qualified purchaser exemption apply to all offerings of securities, whether registered or exempt under the Securities Act. In prescribing any such rule, the Commis- sion may define the term ‘‘qualified purchaser’’ differently with re- spect to different categories of securities, consistent with the public interest (including consideration of efficiency, competition and cap- ital formation) and the protection of investors. Finally, the qualified purchaser provision allows State preemp- tion, State exemptions and State registrations to be tacked to- gether to comply with State requirements. Thus, sales to qualified purchasers would qualify for preemption without regard to wheth- er, in the same offering, offers and sales are also made to non- qualified purchasers. Paragraph 18(b)(4) defines as ‘‘covered securities’’ certain offer- ings and transactions that are exempted from registration under the Securities Act of 1933. Specifically, a ‘‘covered security’’ would include secondary market trading transactions exempt from Fed- eral registration pursuant to sections 4(1) or 4(3) of the Securities Act (provided that the issuer is reporting under the Securities Ex- change Act of 1934 (‘‘Exchange Act’’) or is exempt from filing such reports), as well as similar transactions exempt from registration pursuant to section 4(4) of the Securities Act. ‘‘Exempted securi- ties’’ under section 3(a) of the Securities Act also would be ‘‘covered securities’’ and thus preempted from State registration, with three exceptions: (i) securities of non-profit and similar entities set forth in Section 3(a)(4); (ii) intrastate offerings under section 3(a)(11)(i); and (iii) municipal securities as defined in section 3(a)(2) (which would be preempted in every State but the State in which the is- suer of such municipal securities is located). Finally, securities sold in private transactions under section 4(2) of the Securities Act would be ‘‘covered securities,’’ and thus preempted, if offered or sold pursuant to a Commission rule or regulation adopted under such section 4(2). The Committee intends that the section 4(2) ex- emption from State regulation facilitate private placement of secu- rities consistent with the public interest and the protection of in- vestors. Section 18(c) defines ‘‘conditionally covered securities,’’ which will not be subject to registration requirements and routine review by State securities regulators, subject to certain conditions, and sub- ject to 18(d). Paragraph 18(c)(1) states that, subject to the conditions set forth in paragraphs (2) and (3), certain Federally registered offerings also will be ‘‘covered securities’’ for the purpose of this legislation. Such offerings are defined as: registered securities offerings by is- suers with total assets exceeding $10 million (which may be meas- ured upon conclusion of the transaction) and two years of audited financial statements ending before the filing of the registration statement. The Committee intends that an issuer qualifying under this provision would have at least two years of actual operating history. Paragraph 18(c)(2) provides that certain offerings—those involv- ing securities issued by blank check companies, partnerships, lim- ited liability companies, direct participation investment programs, 33 penny stock companies, and roll-up transactions, are excluded from the operation of paragraph 18(c)(1). Thus, certain, categories of of- ferings that have been a disproportionate source of fraudulent prac- tices and disclosure abuse would continue to be subject to State regulation (as well as Federal regulation), unless they are ‘‘covered securities’’ pursuant to Section 18(b). Paragraph 18(c)(3) would preserve State review of offerings oth- erwise covered by paragraph 18(c)(1) that involve a person subject to a specified disqualification. Certain persons associated with the issuer—the issuer itself, its principal financial officers, and prin- cipal shareholders—must not be subject to previous action for mis- conduct in order for the securities offering to be a ‘‘covered secu- rity’’ and for the requisite State preemption to apply. The disquali- fying conduct consists of statutory disqualifications, as defined in subparagraphs (A), (B), (C), and (D) of Section 39(a)(39) of the Ex- change Act, as well as a range of other specified Federal and State offenses, generally relevant to the securities business. The para- graph provides that certain of These specified State offenses, gen- erally relating to administrative or largely technical violations of State law, will give rise to disqualification of an offering only in the particular State in which the conduct occurred. The paragraph also provides that an issuer of securities that cease to be ‘‘covered securities’’ pursuant to the operation of para- graph 18(c)(3) will not be subject to a right of rescission under State securities law solely as a result of the operation of paragraph 18(c)(3) Paragraph 18(c)(4) provides the Commission with discretionary authority to exempt a person subject to a specified disqualification by rule or order, similar to the process currently in effect in connec- tion with Commission Regulation A offerings. An issuer may avoid the operation of the conduct disqualification provision by taking reasonable steps to ascertain where any of its principal officers or shareholders is subject to any of the specified disqualifying con- duct. The paragraph also provides that the limitations of para- graph 3(B) may be waived by a securities commission in the rel- evant State that has exempted the affected person from the appli- cation of the paragraph. The paragraph establishes a non-exclusive safe harbor for the de- termination of reasonable steps. An issuer shall be conclusively deemed to have taken reasonable steps if it searches centralized data bases specified by the Commission to ascertain the discipli- nary background of its principal officers and shareholders and re- veals no person subject to the disqualification provisions of para- graph 18(c)(4), and receives sworn affidavits from such persons stating that they are not subject to the conduct disqualifications set forth in paragraph (3). Conclusive proof of such reasonable steps shall constitute appending the results of such search to the affida- vits, or to some other duly executed certificate. This safe harbor is not subject to any qualification. Section 18(d) preserves State authority in certain defined areas. Paragraph 18(d)(1) preserves specified State authority, pursuant to State law, consistent with Section 18. The relationship between Section 18(d) and Section 18(a) is especially important. The Com- mittee intends to preserve the ability of the States to investigate 34 and bring enforcement actions under the laws of their own State with respect to fraud and deceit (including broker-dealer sales practices) in connection with any securities or any securities trans- actions, whether or not such securities or transactions are other- wise preempted from State regulation by Section 18. It is the Com- mittee’s intent that the limitations on State law established by Sec- tion 18 apply to State law registration and regulation of securities offerings, and do not affect existing State laws governing broker- dealers, including broker-dealer sales practices. In preserving State laws against fraud and deceit, (including broker-dealer sales prac- tice abuse), however, the Committee intends to prevent the States from indirectly doing what they have been prohibited from doing directly. The Committee intends that the authority that States re- tain over broker-dealers to allow the States to impose conditions on, or otherwise to regulate, offerings of securities. The legislation preempts authority that would allow the States to employ the regu- latory authority they retain to reconstruct in a different form the regulatory regime for covered securities that Section 18 has pre- empted. Thus, for example, Section 18 precludes State regulators from, among other things, citing a State law against fraud or deceit or regarding broker-dealer sales practices as its justification for pro- hibiting the circulation of a prospectus or other offering document or advertisement for a covered security that does not include a leg- end or disclosure that the States believes is necessary or that in- cludes information that a State regulator criticizes based on the format or content thereof. The Committee intends to eliminate States’ authority to require or otherwise impose conditions on the disclosure of any information for covered securities. If, however, a State had undertaken an enforcement action that alleged, for ex- ample, that the prospectus contained fraudulent financial data or failed to disclose that principals in the offering had previously been convicted of securities fraud, it is conceivable that State laws re- garding fraud and deceit could serve as the basis of a judgment or remedial order that could include a restriction or prohibition on the use of the prospectus or other offering document or advertisement within that State. The Committee does not intend Section 18 to be interpreted in a manner that would prohibit such judgments or re- medial orders. It is also the Committee’s intention not to alter, limit, expand, or otherwise affect in any way any State statutory or common law with respect to fraud or deceit, including broker-dealer sales prac- tices, in connection with securities or securities transactions. Paragraph 18(d)(2) retains for the States the authority to require notice filings and require and collect fees with respect to certain se- curities offerings. This section is intended to accomplish two things: first, it is intended to ensure that States can continue to receive filings for notice purposes from issuers selling their securities with- in the jurisdiction, notwithstanding the fact that States will no longer be permitted to require the issuers’ covered securities to be registered. Second, it is intended to ensure that States can con- tinue to receive fees from issuers selling securities within the juris- diction, notwithstanding the fact that States will no longer be per- mitted to require the issuers’ covered securities to be registered. 35 In this regard, paragraph 18(d)(2)(B) specifies that, until other- wise provided by State law, each State may continue to collect fees in connection with securities or securities transactions in amounts determined pursuant to that State’s law in effect prior to enact- ment of the legislation. The Committee notes that some commenta- tors expressed concern that the legislation’s preemption of State registration authority over covered securities would prevent a State that links a securities issuer’s obligation to pay fees to registration of those securities from collecting such fees. These commentators suggested that, in order to continue to require that a securities is- suer pay fees to a State notwithstanding the preemption of the is- suer’s obligation to register the securities, a State might have to re- vise its statutes to provide for a fee requirement in connection with the notice filings the legislation permits States to require. Para- graph 18(d)(2)(B) permits a State that currently requires securities issuers to pay fees in connection with registration to continue to re- ceive such fees during any interim period between enactment of this legislation and such time as the State may revise its statutes. Thus, the preemptive effect of the legislation with respect to State registration authority does not extend to a State’s ability to con- tinue to collect registration fees, but does extend to all other as- pects of State registration authority over covered securities. Para- graph 18(d)(2)(C) follows the practice under the securities laws of most States in not permitting such notice filing or fees in connec- tion with securities listed or eligible for listing on the New York Stock Exchange, American Stock Exchange, or the NASDAQ Na- tional Market System, or any securities of the same class as or sen- ior to such securities. Paragraph 18(d)(3) preserves the authority of the States to sus- pend the offer or sale of securities within a State as a result of the failure to submit a filing or fee permitted under paragraph 18(d)(2). It is the Committee’s intent that the States retain authority to take actions permitted under this section in order to enforce any filing and fee requirements permitted under this section and to calculate accurately any applicable fees. In addition, for any State that wish- es to assess fees based upon the amount of sales within that State within a given period of time (e.g., true indefinite registration), this section is intended to preserve the State’s right to receive the sales information necessary to compute the amount of the fee. However, the Committee does not intend that this provision will allow States to regulate indirectly offerings or sales of securities or transactions preempted under this title. Section 18(e) defines the terms ‘‘principal officer’’ and ‘‘principal shareholder’’ for the purpose of Section 18, and directs the Commis- sion to define by rule, for the purpose of Section 18, the term ‘‘pre- pared by the issuer.’’ In addition, Section 18(e) defines the term ‘‘of- fering document’’ for the purpose of Section 18 by reference to the definition of ‘‘prospectus’’ contained in Section 2(10) of the Securi- ties Act, without regard to exceptions (a) and (b) in Section 2(10). Specifically, the term ‘‘offering document’’ would include any pro- spectus, notice, circular, advertisement, letter, or communication, written or by radio or television, which offers any security for sale or confirms the sale of any security. Notably, materials that the Commission determines not to be a prospectus by Commission rule 36 also are offering documents for the purpose of Section 18, as are materials that accompany or follow the final prospectus. With re- spect to securities of registered investment companies, the term ‘‘of- fering document’’ also is defined to include materials that the Com- mission has defined not to be offers, such as Rule 135a advertise- ments. Section 102(a)(2) requires the Commission to conduct a study, within one year of enactment, on the extent to which uniformity of State regulatory requirements for securities or securities trans- actions has been achieved for securities that are not ‘‘covered secu- rities.’’ In conducting the study, the Commission shall review the impact of such uniformity or lack thereof on the cost of capital, in- novation and technological development in securities markets, on securities issuers, including small businesses, and on the protection of investors. Section 102(b)—Broker-Dealer Regulation. This section requires the Commission, after consultation with the self-regulatory organi- zations (‘‘SROs’’) and the States, to conduct a study of the effect of disparate state licensing requirements on associated persons of reg- istered broker-dealers and methods for the States to establish uni- form licensing requirements. The Commission, within one year, is required to submit to Congress a report on the study that includes recommendations for establishing uniform requirements. This sec- tion amends Section 15 of the Securities Exchange Act of 1934 by adding a new section 15(h). Section 15(h) addresses issues of duplicative or inconsistent regu- lation of associated persons of broker-dealers by State and Federal government. Paragraph 15(h)(1) preempts State laws that impose financial re- sponsibility and reporting requirements inconsistent with or ex- ceeding requirements established under the Exchange Act. This preemption extends to any regulation of capital, margin, books and records, bonding, record making and record keeping. Paragraph 15(h)(2) establishes a uniform national exemption for associated persons effecting transactions for existing customers. It permits associated persons to effect certain transactions with exist- ing customers in States in which they are not licensed. For pur- poses of this provision, a customer is an existing customer if he or she maintained an account with the broker-dealer for at least 30 days. In order to be exempt from a State’s licensing requirements, the associated person (1) must not be ineligible to register in the State for any reason, (2) must be registered with the NASD and with at least one State, and (3) must be associated with a broker-dealer that is registered in the State in which the transaction is effected. In addition, the transaction effected in a State in which the associ- ated person is not licensed must fall into one of the following cat- egories. The first type of permitted transaction is one effected on behalf of an existing customer assigned to the associated person while that customer is temporarily away from home, for example on vaca- tion or business. If, however, the customer is present in a State for 30 or more days or permanently changes residence, the associated person must file an application for registration. This application 37 must be filed within 10 calendar days of the later of the date of the transaction or of discovering that the customer has been present in the State for 30 or more days or has permanently changed his or her address. The second type of permitted transaction is one effected on behalf of an existing customer during the pendency of the associated per- son’s application for licensing in the State. The associated person, however, must cease effecting transactions in the State on the ear- lier of 60 days after the application is filed, or when the State noti- fies the associated person that it has denied the application or stayed the pendency of the application for cause. Finally, 10 or fewer total transactions with any person are per- mitted in States in which the associated person is not licensed. Any transaction that falls within one of the other two above categories does not count toward the 10 transactions permitted in this cat- egory. The Committee intends that these provisions be construed so as not to permit cold calling of potential customers by unlicensed brokers. SECTION 103—MARGIN Section 103 repeals statutory restrictions under section 7 and section 8(a) of the Exchange Act on the sources from which broker- dealers may borrow. It also exempts from Federal margin require- ments, adopted under section 7, credit extended, maintained, or ar- ranged to or for a member of a national securities exchange or reg- istered broker or dealer (1) a substantial portion of whose business consists of transactions with persons other than brokers or dealers, or (2) to finance market making or underwriting activities. SECTION 104—PROSPECTUS DELIVERY Section 104(a). This section requires the Commission to report to the Congress on the steps the Commission has taken, or antici- pates taking, to facilitate the electronic delivery of prospectuses to institutional and other investors. Such report is to be delivered within 6 months of enactment of the Act. Section 104(b). The provision requires the Commission to report to the Congress its views and recommendations concerning the Ad- visory Committee on Capital Formation. The Advisory Committee is preparing a report to the Commission, which is expected to rec- ommend a shift in the traditional Securities Act approach of reg- istering offerings to a ‘‘company’’ registration approach. The report required by section 104(b) should also describe any actions taken to implement the recommendations of the Advisory Committee and is to be delivered within 1 year of the enactment of the Act. The Committee notes that an alternative to the existing registra- tion approach, such as one that relies on company disclosure, could streamline both registration and disclosure requirements, while ac- tually enhancing information flow and protection to investors. In that context, the Commission should consider whether an alter- native vehicle to the prospectus can more efficiently and effectively delivery information to investors. 38 SECTION 105—EXEMPTIVE AUTHORITY Section 105 provides the Commission with broad and general ex- emptive authority under both the Securities Act and the Exchange Act, similar to the authority provided to the Commission under other securities statutes. Both the Investment Company Act and the Investment Advisers Act provide the Commission with author- ity to exempt any persons, securities, or transactions from any pro- vision of the statute or the rules thereunder. Moreover, the Trust Indenture Act of 1939 (‘‘Trust Indenture Act’’) provides the Com- mission with similar broad exemptive authority with respect to the provisions of that Act. Section 105(a). This section adds a new Section 28 to the Securi- ties Act to provide the Commission with the authority, by rule or by regulation, to conditionally or unconditionally exempt any per- son, security, or transaction, or any class of the same, from any provision or provisions of the Act or any rule or regulation there- under. Section 28 allows the Commission enhanced flexibility to more easily adopt new approaches to registration, disclosure, and related issues, such as are being considered by the Commission’s Advisory Committee on Capital Formation. The Committee expects that the Commission will use this authority to promote efficiency, competition and capital formation in the marketplace, consistent with the public interest and investor protection. The Committee also intends that the Commission at an early date raise the ceilings on various exemptions adopted pursuant to Section 3(b) of the Se- curities Act, the small offering exemption under the Securities Act, from $5,000,000 to not less than $10,000,000, including increasing the exemption amount of offerings for certain employee benefit plans, pursuant to Rule 701 under the Securities Act, and small public offerings, pursuant to Regulation A under the Securities Act. Section 105(b). The legislation adds a new Section 36 to the Ex- change Act to provide the Commission with authority under the Exchange Act similar to that contained in new Section 28 of the Se- curities Act. Unlike its Securities Act counterpart, however, Section 36 of the Exchange Act also allows the Commission to act by order. To assist the Commission in handling individual exemptive re- quests, Section 36 permits the Commission to determine the proce- dures and circumstances under which an exemptive order may be granted. The Committee expects that the Commission will use this authority to promote efficiency, competition and capital formation in the marketplace, consistent with the public interest and investor protection. The Department of Treasury has authority under Section 15C of the Exchange Act to regulate government securities broker-dealers. The Government Securities Act Amendments of 1993, which en- acted Section 15C, prescribed a consultative process for both Treas- ury and Commission rulemaking under that section. The legislation provides that the broad grant of exemptive authority to the Com- mission in new Section 36 of the Exchange Act does not extend to Section 15C of the Exchange Act or to the definitions in Sections 3(a)(42) through (45) as used in that section. 39 SECTION 106—PROMOTION OF EFFICIENCY, COMPETITION, AND CAPITAL FORMATION Section 106 requires the Commission to consider efficiency, com- petition, and capital formation when it engages in rulemaking or reviews SRO-proposed rules pursuant to the Securities Act, the Ex- change Act, or the Investment Company Act under a ‘‘public inter- est’’ standard. The new section makes clear that matters relating to efficiency, competition, and capital formation are only part of the public interest determination, which also includes, among other things, consideration of the protection of investors. For 62 years, the foremost mission of the Commission has been investor protec- tion, and this section does not alter the Commission’s mission. In considering efficiency, competition, and capital formation, the Com- mission shall analyze the potential costs and benefits of any rule- making initiative, including, whenever practicable, specific analysis of such costs and benefits. The Committee expects that the Com- mission will engage in rigorous analysis pursuant to this section. Such analysis will be necessary to the Congress in connection with the Congress’ review of major rules pursuant to the terms of the Small Business Regulatory Enforcement Fairness Act of 1996. SECTION 107—PRIVATIZATION OF EDGAR Section 107 requires the Commission to examine proposals for the privatization of the EDGAR system in ways that would pro- mote competition in the automation and rapid dissemination of in- formation. The section also requires the Commission to report to Congress regarding its examination of those issues within 180 days of enactment of this legislation. SECTION 108—COORDINATION OF EXAMINING AUTHORITIES Section 108 adds a new subsection to Section 17 of the Exchange Act designed to facilitate coordination of examination of broker- dealers by self-regulatory organizations (SROs). Section 17(i) requires examining authorities (defined as SROs with the authority to examine the activities of a registered broker- dealer) to determine whether each broker-dealer subject to exam- ination by more than one SRO requests coordination of its regu- latory examinations by all SROs. The examining authorities are re- quired to prepare an advance schedule of all coordinated examina- tions and to ensure, to the maximum extent practicable, that every brokerage firm that so requests shall have all requested aspects of its examination conducted simultaneously and without duplication of the areas covered. Any examining authority that does not par- ticipate in a scheduled coordinated examination would not be able to conduct its own routine examination (other than a coordinated examination of that broker or dealer) within nine months of the conclusion of the scheduled coordinated exam. The Committee notes that, under some circumstances, an SRO primarily respon- sible for the financial and operational examination of a broker-deal- er might miss a scheduled exam and be precluded from routinely examining that broker-dealer for nine months because of the oper- ation of subsection (i)(5). The Securities Investor Protection Cor- poration (‘‘SIPC’’) expressed concerns to the Committee that the im- 40 position of this limitation or penalty could leave SIPC, which must rely on the results of Commission and SRO examination, without important information on the financial condition of its members. The Committee expects that, to avoid such a situation, the SROs will attempt to reschedule the examination in consultation with the broker, or failing that, that other reasonable steps are taken to make sure that the financial and operational examination is con- ducted in a timely manner. Such other steps may include designa- tion of a participating SRO to conduct the financial and operational examination. Examinations ‘‘for cause’’ (which are conducted when indications of possible wrongdoing exist) may be conducted at any time. The Committee expects that SROs that fail to coordinate will not use the ‘‘for cause’’ exception exclusively to conduct a routine exam that was missed. Section 17(i) also requires the Commission to create a broker- dealer advisory committee comprised of representatives of broker- dealers that are subject to examinations by more than one SRO. Because the advisory committee created by this provision is likely to be involved in discussing examination strategies and related matters that may bear on enforcement, this committee is specifi- cally exempted from the Federal Advisory Committee Act. The Commission would be required to report to Congress, within one year after enactment of the Act, pursuant to Section 17(i) on the progress it and the examining authorities have made in reduc- ing duplication and improving coordination, on the activities of the advisory committee, and on any redundancies that have not been addressed by the coordination of examining authorities. SECTION 109—FOREIGN PRESS CONFERENCES Section 109 requires the Commission to adopt rules under the Securities Act concerning the status under the registration provi- sions of the Securities Act of foreign press conferences and foreign press releases by persons engaged in the offer and sale of securi- ties. The Commission would be required to adopt these rules within one year of the enactment of the Act. The Committee intends that journalists disseminating information in the U.S. be given appro- priate access to foreign press conferences involving offerings of se- curities in order to ensure that information is made available in the U.S. and instructs the Commission to adopt a rule that will achieve this goal consistent with the protection of U.S. investors. SECTION 110—REPORT ON TRUST INDENTURE ACT OF 1939 Section 110 requires the Commission to report to Congress on the benefits of, the continuing need for, and, if necessary, options for the modification or elimination of the Trust Indenture Act. Such report is to be delivered within six months of enactment of the Act. The Trust Indenture Act generally requires that all publicly is- sued debt securities be issued pursuant to an indenture which con- tains specified mandatory provisions and requires the presence of an independent trustee. The Commission shall consult with the Treasury Department on the impact of the study’s recommenda- tions on the bond market and on insured depository institutions. In the context of the Subcommittee hearings on H.R. 2131 (Serial No. 104–50), the Committee notes that three witnesses testified on 41 the proposal to repeal the Trust Indenture Act. Morey W. McDaniel, Esq., an indenture practitioner, questioned the Act’s con- tinued utility and supported its repeal, while SunTrust Capital Markets President and CEO R. Charles Shufeldt, testifying on be- half of the ABA Securities Association, argued that the Act still served a useful purpose and opposed repeal. Columbia University Professor of Law John C. Coffee, Jr. testified that there was a ‘‘plausible case for repealing much of the statute’’ but cautioned Congress to retain necessary protections for bondholders in some form. Finally, the Committee notes that it approved legislation in 1990, the Trust Indenture Reform Act (P.L. 101–550, Nov. 15, 1990), to modernize the Act and streamline its requirements to re- flect evolving industry practice and market conditions. The Com- mittee expects the Commission will consider the issues raised in the testimony and the effect of the 1990 Act. TITLE II—INVESTMENT COMPANY ACT AMENDMENTS SECTION 201—SHORT TITLE Section 201 provides that Title II may be cited as the Investment Company Act Amendments of 1996. SECTION 202—FUNDS OF FUNDS Currently, subject to certain exceptions, Section 12(d)(1) of the Investment Company Act of 1940 (the ‘‘Investment Company Act’’) imposes three restrictions on the ability of one investment company to invest in another: (1) an investment company may not acquire more than 3% of another investment company’s voting stock; (2) an investment company may not hold more than 5% of its assets in securities of another single investment company; and (3) an invest- ment company may not hold more than 10% of its assets in securi- ties of all other investment companies. One of the exceptions to these restrictions is an arrangement in which a fund invests solely in the shares of another fund. The ex- emption is often used by so-called ‘‘master-feeder’’ funds, where one or more funds (‘‘feeder funds’’) invest all of their assets in another fund (‘‘master fund’’). These arrangements are often used to facili- tate the master fund’s access to alternative distribution channels to sell its shares. Section 202(1)(A). This section effects a change regarding the vot- ing rights of shareholders in ‘‘master-feeder’’ arrangements. It re- quires all feeder funds—rather than only those that are not reg- istered under the Investment Company Act, as is the case under current law—to vote the master fund shares that they own propor- tionately in accordance with the votes cast by the feeder fund’s own shareholders. This will give feeder fund shareholders effectively the same voting rights they would have as direct security holders of the master fund. Current law imposes this voting requirement only on unregis- tered feeder funds because it was enacted to address abusive prac- tices of the 1970s involving off-shore (and therefore unregistered) funds that invested in U.S. funds. Today, the development of mas- ter-feeder arrangements has led to a proliferation of U.S. feeder 42 funds, which are generally registered. In practice, registered feeder funds generally comply voluntarily with this voting requirement. Section 202(1)(B). This section preserves the statute’s limitation on the ability of unregistered investment companies to substitute securities in their portfolio. It does not effect a change in current law. The new language of this section is necessary, given the change in Section 202(1)(A) above, to preserve the status quo with respect to unregistered investment companies. Section 202(3). This section creates a new provision, subpara- graph (G) under Section 12(d)(1) of the Investment Company Act, to codify the permissibility of certain ‘‘fund of funds’’ arrangements if five conditions are met. These conditions, which are similar to the conditions generally imposed by the SEC on companies that are currently permitted to operate funds of funds pursuant to SEC or- ders, are as follows: 1. Clause (i) of new subparagraph (G) requires the ac- quired company and the acquiring company to be part of the same ‘‘group of investment companies.’’ The final sen- tence of subparagraph (G) would define a ‘‘group of invest- ment companies’’ as any two or more registered invest- ment companies that hold themselves out to investors as related companies for purposes of investment and investor services. 2. Clause (ii) of new subparagraph (G) limits the oper- ation of subparagraph (G) to bona fide fund of funds ar- rangements. The provision limits the acquiring company to investing in securities of the acquired company, securities of other registered open-end investment companies that are part of the same group of investment companies, U.S. government securities, and short-term paper. The provi- sion for U.S. government securities and short-term paper is designed to allow the acquiring company to make short- term investments, including repurchase agreements (which often involve U.S. government securities), that provide suf- ficient liquidity to meet redemption requests. In the ab- sence of such flexibility, the acquiring company might oth- erwise be forced to redeem securities of acquired compa- nies to meet redemption requests when it would not other- wise be in the best interests of investors in either the ac- quiring or acquired company to do so. 3. Clause (iii) of new subparagraph (G) addresses the as- sessment of sales loads and other distribution-related fees. This clause is intended to prevent the abuses that may be associated with the layering of sales charges. It accom- plishes this by providing that any sales loads and other distribution-related fees charged with respect to the ac- quiring company’s securities (such as sales loads or rule 12b–1 fees), when aggregated with any sales load and dis- tribution-related fees paid by the acquiring company with respect to securities of the acquired company, cannot be excessive under rules adopted pursuant to either Section 22(b) or Section 22(c) of the Act by a securities association registered under Section 15A of the Exchange Act (i.e., the National Association of Securities Dealers) or the Commis- 43 sion. Thus, sales charges and distribution-related fees could be assessed by both the acquiring company and the acquired company provided that, taken together, such fees are not excessive. 4. Clause (iv) of new subparagraph (G) requires the ac- quired company to have a fundamental policy that pro- hibits it from acquiring any securities of registered open- end investment companies in reliance on new subpara- graph (G) or subparagraph (F) of Section 12(d)(1) (which contains an additional exception to Section 12(d)(1)). This provision will prevent a fund of funds from investing in other funds of funds. The provision is intended to avoid overly complex inter-corporate structures that may present issues that have not been presented in the types of fund of funds arrangements previously considered by the Com- mission. 5. Clause (i) of new subparagraph (G) requires that any acquisition of securities under new subparagraph (G) may not be in contravention of such rules and regulations as the Commission may prescribe as necessary and appro- priate for the protection of investors. This provision is de- signed to permit the Commission, based on its experience with the operation of subparagraph (G), to adopt rules to address any perceived problems and abuses. For example, the Commission may conclude that it is necessary to adopt rules that require acquiring companies to implement pro- cedures designed to assure that redemptions of securities of acquired companies be effected in a manner designed to limit disruptions in the portfolio management of the ac- quired company. Section 202(4). This section adds a new subparagraph (J) to Sec- tion 12(d)(1) that gives the Commission the additional authority to exempt any person, security or transaction from Section 12(d)(1) of the Investment Company Act. The Commission currently has au- thority under Section 6(c) of the Act to exempt investment compa- nies from Section 12(d)(1). The new subparagraph makes explicit the authority of the Commission to grant exemptions for funds of funds that might not meet the conditions of new subparagraph 12(d)(1)(G), for example, fund of fund arrangements that involve in- vestment companies that are not part of the same group of invest- ment companies, or fund of funds arrangements that involve a group of investment companies but do not satisfy other conditions of new subpargraph (G). The Committee notes that many invest- ment company fund complexes may not include a sufficient number or variety of fund types to permit the creation of a workable affili- ated fund of funds. The Committee intends the rulemaking and ex- emptive authority in new Section 12(d)(1)(J) to be used by the Commission so that the benefits of funds are not limited only to in- vestors in the largest fund complexes, but, in appropriate cir- cumstances, are available to investors through a variety of different types and sizes of investment company complexes. The Committee expects that the Commission will use this au- thority to adopt rules and process exemptive applications in the fund of funds area in a progressive way as the fund of funds con- 44 cept continues to evolve over time. In exercising the exemptive au- thority, the Commission shall also consider factors that relate to the protection of investors. These factors may include the extent to which a proposed arrangement is subject to conditions that are de- signed to address conflicts of interest and overreaching by a partici- pant in the arrangement, so that the abuses that gave rise to the initial adoption of the Act’s restrictions against investment compa- nies investing in other investment companies are not repeated. Section 202 of the legislation redesignates current subparagraphs (G) and (H) of Section 12(d)(1) as subparagraphs (H) and (1), re- spectively. SECTION 203—REGISTRATION OF SECURITIES Section 203 of the legislation adds new Section 24(f) to the In- vestment Company Act. The new provision provides that upon the effectiveness of the registration statement of an investment com- pany, the investment company will be deemed to have registered an indefinite quantity of securities. The investment company must then pay a fee to the Commission within 90 days after the end of its fiscal year, based upon the net sales of the company for that fis- cal year. The amendment specifically provides that the fee will be based on the aggregate sales price for which the company’s securi- ties were sold (including securities issued pursuant to a dividend reinvestment plan) during the fiscal year, reduced by the aggregate redemption or repurchase price of the securities during that year and the aggregate redemption or repurchase price of the securities during any prior fiscal year ending not more than one year before the enactment of this legislation that were not used previously by the company to reduce the fees payable under the section. An investment company that misses the filing deadline must pay interest based on the amount due at the rate established by the Secretary of Treasury under the Debt Collection Act of 1982, 31 U.S.C. 3701 et seq. This provision encourages timely filing and will compensate the U.S. Treasury for any delay in the receipt of reve- nues by requiring interest to be paid on past due amounts. Al- though the new provision incorporates the rate established pursu- ant to section 11 of the Debt Collection Act, the other provision of that section do no apply. This section gives the Commission rulemaking authority to im- plement new Section 24(f). it also effects a conforming amendment to Section 24(e) of the Investment Company Act to eliminate para- graphs (1) and (2) of that section relating to the registration of a definite amount of a company’s securities. Despite the elimination of Section 24(e)(1), open-end management investment companies and unit investment trusts that have registered shares in accord- ance with Section 24(e) (as in effect prior to enactment of this legis- lation) may sell those shares without the payment of any additional registration fees. The amendments made by this section will be ef- fective 6 months after the date of enactment of this legislation or on such earlier date as the Commission may specify by rule. SECTION 204—INVESTMENT COMPANY ADVERTISING PROSPECTUS This section adds subsection (g) to Section 24 of the Investment Company Act to direct the Commission to permit the use of a new 45 ‘‘investment company advertising prospectus’’ for purposes of Sec- tion 5(b)(1) of the Securities Act. Unlike the ‘‘omitting’’ prospectus that is permitted pursuant to rules promulgated by the Commis- sion under section 10(b) of the Securities Act, the advertising pro- spectus authorized by new Section 24(g) is not restricted to infor- mation ‘‘the substance of which’’ is included in the fund’s statutory prospectus (the prospectus mandated by Section 10(a) of the Securi- ties Act). The investment company advertising prospectus may con- tain performance data, and could be subject to the same standard- ized calculation requirements as Commission rules currently apply to performance data used by investment companies. The investment company advertising prospectus is deemed to be permitted by Section 10(b) of the Securities Act. As a result, the advertising prospectus will be subject to prospectus liability under Section 12(2) of the Securities Act; it need not be filed as part of the registration statement, and will not be a part of the registra- tion statement for purposes of Section 11 of the Securities Act. In addition, the Commission may prevent or suspend the use of an in- vestment company advertising prospectus pursuant to the stand- ards and procedures set forth in Section 10(b). This is not a new grant of authority but rather an incorporation by reference of the standards and procedures in section 10(b). SECTION 205—VARIABLE INSURANCE CONTRACTS Section 205(a). This section amends the Investment Company Act to exempt variable insurance contracts from the charge restrictions in Sections 26 and 27, and instead requires aggregate charges under variable contracts to be reasonable. Currently, insurance companies selling variable insurance are treated as periodic pay- ment plan sponsors and are, therefore, limited by Section 26 of the Act in the types of fees that may be deducted under the contracts and to the assessment of ‘‘reasonable’’ fees for performing adminis- trative services. In addition, variable insurance contracts are treat- ed as periodic payment plan certificates and, thus, the issuers of the contracts must comply with Section 27 of the Act, which limits the amount, manner, and timing of sales load deductions and pre- scribes certain refund rights for surrendering contract owners. The legislation recognizes that variable insurance contracts and peri- odic payment plan certificates are different products that should not be treated identically under the Act, and subjects variable in- surance separate accounts to more general prohibitions against ex- cessive fees, similar to the way mutual funds are treated under the Act. This section adds a new subsection (e) to Section 26. New para- graph (1) of Section 26(e) exempts a registered separate account, its sponsor, and its principal underwriter from Section 26(a), which limits the types of charges that may be deducted from separate ac- count assets and imposes custodial requirements. New paragraph (2)(A) of Section 26(e) establishes a reasonableness standard for evaluating aggregate contract charges and requires insurers to rep- resent that such charges are reasonable. Under this new provision, an issuer must establish aggregate charges that are reasonable in relation to the services rendered under the contract, the expenses expected to be incurred, and the risks assumed by the insurance 46 company. New paragraph 26(e)(3) explicitly authorizes the Com- mission to adopt rules under subparagraph 26(e)(2)(A). New para- graph (3) also clarifies that the aggregate charges covered by para- graph (2)(A) include all fees and charges imposed for any purpose and in any manner, including, without limitation, marketing, sales, and distribution charges, compensation for investment advisory, administrative, custodial, transfer agent, or other services; insur- ance charges; and charges related to taxes imposed on the sponsor- ing insurance company; and including, without limitation, charges imposed directly on the contract holder or on the assets of the reg- istered separate account. This section also adds subparagraph (B) to Section 26(e)(2), in order to codify certain provisions of Commission rules that permit an insurance company rather than a bank to maintain custody of separate account assets without a trust indenture. The legislation does not change current regulation of insurance companies or their separate account operations, but simply preserves the current cus- todial provisions in conjunction with the exemption provided by Section 26(e)(1). To serve as custodian, an insurer must file with its domiciliary State an annual statement of financial condition that shows it has a combined capital and surplus (if a stock com- pany) or an unassigned surplus (if a mutual company) of not less than $1,000,000 or such other amount prescribed by the Commis- sion. In addition, the company and its separate account operations must be supervised and examined periodically by State insurance officials. Section 205(b). This section amends Section 27 of the Investment Company Act by adding a new subsection (i), which exempts a reg- istered separate account, its sponsor, and its principal underwriter from the sales load restrictions of Section 27. In conjunction with this exemption, new subparagraph 27(i)(2) requires separate ac- counts organized as management companies to comply with the provisions of new subparagraph 26(e). Currently, Section 27(c)(2) links the regulation of periodic payment plans to procedures estab- lished in Section 26 for unit investment trusts even if the issuer is organized as a management investment company. New Section 27(i)(2), in effect, preserves that cross-reference to ensure that the charges under variable contracts funded by unit investment trusts and managed separate accounts are treated alike. New Section 27(i)(2) also makes the provisions of new Section 26(e)(2)(B) con- cerning custody applicable to variable contracts funded by managed separate accounts. The new subparagraph also preserves the re- quirement that variable contracts be redeemable securities. SECTION 206—REPORTS TO THE COMMISSION AND SHAREHOLDERS Section 206. This section amends Section 30(b)(1) of the Invest- ment Company Act to grant the Commission authority to require more frequent filing with the Commission of information by invest- ment companies. Specifically, new Section 30(b)(1) allows the Com- mission to require investment companies to file such information, documents and reports as the Commission deems necessary to keep reasonably current the information and documents contained in an investment company’s registration statement, eliminating the re- striction in current law that such information need only be filed on 47 a semi-annual or quarterly basis. However, in order to limit unnec- essary regulatory burdens on investment companies, the section adds new Section 30(c), which requires the Commission, in exercis- ing its authority to require that this information be filed more fre- quently than semi-annually or quarterly, to take such steps as it deems necessary and appropriate, consistent with the public inter- est and the protection of investors, to avoid unnecessary reporting by, and minimize compliance burdens on, investment companies and their affiliated persons. These steps include considering and requesting public comment on feasible alternatives that minimize reporting burdens on investment companies and on the utility to the Commission of the information included in the reports in rela- tion to the costs to investment companies and their affiliated per- sons of providing such information. The section also inserts a new Section 30(f), expanding the Com- mission’s authority to require additional information to be included in an investment company’s reports to shareholders. Currently, Section 30(d) limits the Commission’s authority to prescribing the content of financial statements. The new subsection gives the Com- mission authority to require that investment companies include in annual and semi-annual reports such other information as the Commission deems necessary or appropriate in the public interest or for the protection of investors. Again, in order to limit unneces- sary regulatory burdens on investment companies, the section re- quires the Commission, in exercising this new authority, to take such steps as it deems necessary and appropriate, consistent with the public interest and the protection of investors, to avoid unnec- essary reporting, and minimize the compliance burdens on, invest- ment companies and their affiliated persons. These steps include considering and requesting public comment on feasible alternatives that minimize reporting burdens on investment companies and on the utility to shareholders of the information provided in relation to the costs to investment companies and their affiliated persons of providing such information. SECTION 207—BOOKS, RECORDS AND INSPECTIONS Section 207(1). This section expands the Commission’s record- keeping authority under the Investment Company Act. Currently, Section 31(a) of the Act authorizes the Commission to require in- vestment companies to maintain only records that relate to the company’s financial statement. This section amends Section 31(a) to authorize the commission to require registered investment com- panies and certain of their related entities to keep any records the Commission prescribes as ‘‘necessary or appropriate in the public interest or for the protection of investors.’’ This authority will en- able the Commission to require investment companies to maintain the records necessary for examiners to conduct a thorough exam- ination of a company’s operations and thereby ensure that the in- vestment company and its related entities are in compliance with all applicable statues and regulations (whether or not records con- cerning these matters are needed to support financial statements). The legislation does not change the Commission’s recordkeeping authority with respect to investment company advisers that are not majority-owned subsidiaries of an investment company, depositors 48 for, or principal underwriters of registered investment companies. These entities would continue to be required to keep only those records necessary to record their transactions with investment com- panies. This section also incorporates in Section 31(a) the definition of ‘‘records’’ contained in Section 3(a)(37) of the Exchange Act, which is currently incorporated in section 204 of the Investment Advisers Act. Section 3(a)(37) provides that the term ‘‘records’’ means ac- count, correspondence, memorandums, tapes, discs, papers, books, and other documents or transcribed information of any type, whether expressed in ordinary or machine language. Thus, the in- clusion of this definition, which encompasses both paper and elec- tronic records, would ensure uniformity between the parallel provi- sions of the two Acts. In order to prevent the grant of authority under new Section 31(a) from resulting in unnecessarily burdensome regulation of in- vestment companies and their affiliates, the legislation requires that the Commission, in exercising its authority under this new provision, to take such steps as it deems necessary and appro- priate, consistent with the public interest and the protection of in- vestors, to avoid unnecessary recordkeeping by, and minimize the compliance burdens on, investment companies and their affiliated persons. These steps include considering and requesting public comment on (1) feasible alternatives that would minimize record- keeping burdens, (2) the necessity of such records in view of the public benefits derived from the independent scrutiny of such records through the Commission’s examinations program, (3) the costs to investment companies and their affiliates of maintaining the information that would be required, and (4) the effects that a proposed recordkeeping requirement would have on internal com- pliance policies and procedures. This section also amends Section 31(b) of the Investment Com- pany Act, which relates to the Commission’s authority to inspect the books and records of investment companies. The first sentence of amended Section 31(b) would authorize the Commission or its representatives to examine records that relate to the operations of, or transactions with, a registered investment company. This provi- sion refers only to ‘‘records’’ because, as defined, this term encom- passes the ‘‘accounts’’ and ‘‘books’’ referred to in the existing stat- ute, as well as other forms of non-written records. This section expands current Commission authority by permit- ting examiners to inspect records that may not be required by Commission rules, but that already exist and are relevant to the operations of the investment company and transactions between the investment company and other persons required to keep records with respect to the investment company—the investment company’s investment adviser and principal underwriters. In addi- tion, as under the current provision, the Commission would have the authority to inspect such other records as the Commission may require to be maintained and preserved in accordance with sub- section (a). The section also amends Section 31(b) to authorize the Commis- sion to request copies of records. The provision differs from the cur- 49 rent language in Section 31(b) by eliminating the requirement for examiners to seek a formal order to obtain copies of these records. The authority granted to the Commission under the amendments may result in its having broader access to, among other things, records that a fund may keep related to the fund’s internal policies and procedures for compliance with securities laws. The Committee recognizes the vital significance of effective internal compliance systems, which are essential to helping investment companies pre- vent problems before they become statutory violations. The Com- mittee believes that voluntary compliance efforts by investment companies to prevent, detect, and correct violations should be strongly encouraged. Internal control systems, in turn, generally function most effectively when they operate in an atmosphere of openness and candor, which is best fostered when internal audit re- ports are utilized by, and maintained within, the investment com- pany organization, and are not routinely made public to third par- ties or requested by regulatory authorities. Amended Section 31(b) addresses these issues by requiring the Commission, in exercising its authority under that section, to give ‘‘due regard’’ to the effective implementation, operation, and bene- fits of internal compliance policies and procedures. The Commis- sion expects that, in exercising ‘‘due regard,’’ the Commission would review fund internal audit and similar compliance-related reports on a selective basis. Specifically, the Committee expects the Commission to request and review internal audit and similar re- ports only insofar as necessary to determine whether the internal compliance policies of the fund or other examined persons are in place, whether procedures to effect and enforce those policies have been implemented, and whether the compliance policies and proce- dures are reasonably designed to detect compliance problems and address them in an appropriate fashion. Thus, the Committee an- ticipates that, in a routine examination, the Commission staff would seek to review a sample of an examined person’s internal audit reports adequate to form a basis for concluding that the com- pliance policies and procedures are achieving these objectives. The Committee believes that the goal of examinations effected by the Commission staff should not be simply to duplicate the role played by a fund’s internal compliance staff. If a fund has a well-function- ing system of internal controls, the Commission’s limited resources could be directed to other areas of fund operations, or to other funds. In addition, recognizing that the information obtained by the Commission pursuant to this expanded inspection authority may be sensitive, the legislation adds new Section 31(c), which provides that the Commission may not be compelled to disclose any internal compliance or audit records, or information contained therein under amended Section 31. The section provides that this limita- tion on disclosure of information by the Commission shall not au- thorize the Commission to withhold information from Congress or prevent the Commission from complying with a request for infor- mation from a U.S. department, agency, or court. Finally, the section adds new Section 31(d), defining ‘‘internal compliance policies and procedures’’ as policies and procedures de- signed to promote compliance with the Federal securities laws, and 50 defining ‘‘internal compliance and audit record’’ as any record pre- pared by an investment company or affiliate in accordance with in- ternal compliance policies and procedures. SECTION 208—INVESTMENT COMPANY NAMES Section 208. This section amends Section 35(d) of the Investment Company Act to grant the Commission rulemaking authority to de- fine investment company names or the title of the securities they issue as materially deceptive or misleading. Currently, Section 35(d) requires the Commission to find and by order declare the name to be deceptive or misleading and then to bring an action in the proper court to enjoin use of the name. This process is rarely used and is extremely cumbersome. This section would enhance the Commission’s ability to prevent the use by investment companies of materially misleading names. SECTION 209—EXCEPTED INVESTMENT COMPANIES Section 209(a). This section amends Section 3(c)(1) of the Invest- ment Company Act, which excepts from the Act’s regulation invest- ment pools that have no more than 100 investors and do not en- gage in public offerings (‘‘Section 3(c)(1) funds’’). Section 209(a)(2) of the legislation simplifies the way the 100 investor limit of Sec- tion 3(c)(1) is calculated by no longer requiring Section 3(c)(1) funds to count the underlying shareholders of their corporate, non-invest- ment company investors under any circumstances. As amended, Section 3(c)(1) treats beneficial ownership by a company, for pur- poses of the 100 investor limit, as beneficial ownership by one per- son, unless the company (i) owns ten percent or more of the Section 3(c)(1) issuer and (ii) is a registered investment company, a Section 3(c)(1) fund, or an excepted investment company relying on the ex- ceptions of new Section 3(c)(7) (‘‘Section 3(c)(7) fund’’). Section 209(a)(1) of the legislation applies Section 12(d)(1)(A)(i) of the Investment Company Act to Section 3(c)(1) funds. As a result, Section 3(c)(1) funds may not purchase more than three percent of any registered investment company’s securities. To cover the other side of the transaction involving open-end investment companies, registered investment companies selling their securities to Section 3(c)(1) funds also are subject to the three percent limitation in Sec- tion 12(d)(1)(B)(i). Section 209(a)(3) of the legislation amends Section 3(c)(2) of the Investment Company Act to add a new type of entity, a ‘‘market intermediary,’’ to those that the section currently excepts from the definition of ‘‘investment company’’ for purposes of the Act. The amendment addresses the type of intermediary, commonly referred to as a ‘‘swap dealer,’’ that is in the business of acting as a counterparty with respect to various financial products, such as in- terest rate and currency swaps. Market intermediary is defined as any person that regularly holds itself out as being willing contem- poraneously to engage in, and is regularly engaged in the business of entering into, transactions on both sides of the market for finan- cial contracts. As defined, ‘‘market intermediary’’ may, in some in- stances, encompass persons that are otherwise excluded from the definition of investment company, such as brokers. 51 The term ‘‘financial contract’’ has been drafted in a manner that is designed to be sufficiently flexible to encompass the wide variety of financial contracts that currently exist and that will continue to develop in the evolving financial markets: it is defined as an indi- vidually negotiated transaction in respect of securities, commod- ities, currencies, interest rates or other functionally similar finan- cial or economic interests, that is entered into and structured to ac- commodate the objectives of the counterparty. The amendment to Section 3(c)(2) addresses the status of market intermediaries under the Investment Company Act only, and not under any other Federal securities laws. Section 209(a)(4) of the legislation adds Section 3(c)(7) to the In- vestment Company Act to create a new exception from the defini- tion of investment company for investment pools whose securities are held exclusively by ‘‘qualified purchasers,’’ as defined under Section 209(b) of the legislation (‘‘Section 3(c)(7) funds’’). Under new subsection 3(c)(7)(A), there is no limit on the number of ‘‘qualified purchasers’’ participating in a Section 3(c)(7) fund, but the Section 3(c)(7) fund is prohibited from making a public offering of its securities. In addition, this section provides that securities that are owned by persons who received the securities from a quali- fied purchaser as a gift or bequest, or through legal separation, di- vorce, death, or other involuntary event, shall be deemed to be owned by a qualified purchaser for purposes of Section 3(c)(7). The section grants the Commission rulemaking authority with respect to such transfers. This section adds new subsection 3(c)(7)(B) to the Act, which pro- vides a ‘‘grandfather clause’’ for existing companies that currently operate under the 100-person exception of Section 3(c)(1) but wish to convert to Section 3(c)(7) status. Subsection 3(c)(7)(B) provides that, notwithstanding the requirements of subsection 3(c)(7)(A), an issuer shall qualify for the Section 3(c)(7) exception if, in addition to qualified purchasers, the issuer’s outstanding securities are ben- eficially owned by not more than 100 persons who are not qualified persons (the ‘‘original investors’’) if (1) the original investors ac- quired the securities on or before the date of enactment of the leg- islation, and (2) at the time the securities were acquired by the original investors, the issuer was excepted under Section 3(c)(1) of the Act (in other words, the issuer had 100 or fewer investors), and (3) prior to availing itself of the new exception in proposed Section 3(c)(7), the issuer (a) disclosed to the original investors who are not qualified purchasers that future investors will be limited to quali- fied purchasers but will not be limited in number, and (b) the is- suer provided the original investors who are not qualified pur- chasers with a reasonable opportunity to redeem their interests in the company. This section also adds new subsection 3(c)(7)(C) to the Act, which applies Section 12(d)(1)(A)(i) of the Investment Company Act to Section 3(c)(7) issuers (similar to the provision in relating to Sec- tion 3(c)(1) issuers, discussed above). As a result, Section 3(c)(7) is- suers may not purchase more than three percent of any registered investment company’s securities. To cover the other side of the transaction involving open-end investment companies, registered investment companies selling their securities to Section 3(c)(7) is- 52 suers also are subject to the three percent limitation in Section 12(d)(1)(B)(i). This section also adds new subsection 3(c)(7)(D) to the Act, which clarifies that a Section 3(c)(1) fund and a Section 3(c)(7) fund will not be treated as a single issuer by the Commission for purposes of determining whether investors in the Section 3(c)(7) fund will be counted toward the 100 investor limit of the Section 3(c)(1) fund, or that investors in the Section 3(c)(1) fund that are not qualified purchasers will be treated as investors in the Section 3(c)(7) fund. This provision seeks to clarify that sponsors have the flexibility to form Section 3(c)(1) and Section 3(c)(7) funds without running afoul of the integration doctrine developed under Section 3(c)(1). This section also provides that this non-integration provision shall not be deemed to establish whether a person is a bona fide qualified purchaser for purposes of Section 3(c)(7) or a bona fide beneficial owner for purposes of Section 3(c)(1). For example, a pro- moter of a Section 3(c)(7) fund could not organize a ‘‘sham’’ Section 3(c)(1) fund to facilitate investment by non-qualified purchasers in the Section 3(c)(7) fund. Section 209(b). This section amends Section 2(a) of the Invest- ment Company Act to add a new paragraph (51), defining the term ‘‘qualified purchaser.’’ The section creates three categories of quali- fied purchasers. First, under new subparagraph 2(a)(51)(A), a qualified purchaser may be a natural person who owns at least $10 million in securities (a ‘‘natural person purchaser’’). Securities of an issuer that is controlled by the putative qualified purchaser could not be used to satisfy the $10 million securities test unless the is- suer that is controlled by the qualified purchaser is an investment company, a Section 3(c)(1) fund or a Section 3(c)(7) fund. Under those circumstances, the securities of that issuer may be counted toward the $10 million requirement. The purpose of this exception to the ‘‘no control’’ rule is to ensure that purchasers who own or control securities of companies such as investment companies or excepted companies under Section 3(c)(1) of Section 3(c)(7) are not excluded from the definition of ‘‘qualified purchasers.’’ Second, under new subparagraph 2(a)(51)(B), a qualified pur- chaser may be a trust, so long as the trustee or other person au- thorized to make decisions with respect to the trust and each set- tlor or other person contributing assets to the trust is a ‘‘qualified purchaser’’ under subparagraphs 2(a)(51(A) or 2(a)(51(C). Third, under subparagraph 2(a)(51)(C), a qualified purchaser may be any person who in the aggregate owns and invests on a dis- cretionary basis at least $100 million in securities (an ‘‘institutional purchaser’’). Securities issued by any person that is an affiliated person, as defined in Section 2(a)(3(C) of the Investment Company Act, of a putative qualified purchaser could not be used to satisfy the $100 million securities test unless the issuer is affiliated with the qualified purchaser but the issuer is an investment company, a Section 3(c)(1) fund or a Section 3(c)(7) fund. Under those cir- cumstances, the securities of that issuer may be counted toward the $100 million requirement. Section 2(a)(51)(C) would permit the aggregation of an institutional purchaser’s proprietary securities holdings with those under discretionary management for purposes of the $100 million securities test. An institutional purchaser, how- 53 ever, could invest in a Section 3(c)(7) fund only for its own account or for the accounts of other qualified purchasers. While new Sections 2(a)(51)(A), (B), and (C) are self-operative, the legislation gives the Commission the authority to adopt addi- tional rules relating to the objective standards. This authority would enable the Commission to develop reasonable care defenses when an issuer relying on the qualified purchaser exception in good faith sells securities to a purchaser that does not meet the qualified purchaser definition, to develop additional conditions governing qualified purchaser trusts, or to develop rules deeming a ‘‘natural person’’ to include a person and his or her spouse, for example. Section 209(c). This section amends Section 3(a)(3) of the Invest- ment Company Act to include within that section’s definition of in- vestment securities, securities of majority-owned subsidiaries that would be investment companies but for the exclusion under Section 3(c)(1) or Section 3(c)(7). This section precludes a company from avoiding regulation under the Investment Company Act by estab- lishing a Section 3(c)(1) or Section 3(c)(7) subsidiary. Section 209(d). This section directs the Commission to promul- gate certain rules. First, under subsection 209(d)(1) of the legisla- tion, the Commission must promulgate rules, within one year after the date of enactment of the legislation, to implement the require- ments of Section 3(c)(1)(B) of the Investment Company Act. That section provides that, subject to rules adopted by the Commission, ownership of an interest in a Section 3(c)(1) fund, where the owner- ship is the result of an involuntary transfer (through legal separa- tion, divorce, death, or other involuntary event), is deemed to be ownership by one person. This would have the effect of permitting an investor in a Section 3(c)(1) fund that is owned by the maximum number of investors, 100, to transfer his or her interest to more than one person (through a bequeathal, for example), without caus- ing the Section 3(c)(1) fund to lose its Section 3(c)(1) exception. While Section 3(c)(1)(B) was enacted fifteen years ago, the Commis- sion has never issued rules pursuant to its authority. Second, under subsection 209(d)(2) of the legislation, the Com- mission must promulgate rules, within one year after the date of enactment of the legislation, to permit ownership by knowledgeable employees of an issuer (or its affiliate) of the securities of that is- suer (or affiliate) without loss of the issuer’s exception under Sec- tions 3(c)(1) or 3(c)(7). Pursuant to such a rule, an excepted com- pany under Section 3(c)(1) would be permitted to sell its shares to employees deemed ‘‘knowledgeable’’ pursuant to Commission rules even if such employees caused the total number of investors in the fund to exceed 100. Similarly, pursuant to such a rule, an excepted company under Section 3(c)(7) (or an affiliate of such an excepted company, such as the company’s adviser, for example) would be permitted to sell its shares to employees who are not ‘‘qualified in- vestors’’ under Section 3(c)(7) but who are deemed ‘‘knowledgeable’’ pursuant to Commission rules. 54 COMMITTEE CORRESPONDENCE U.S. HOUSE OF REPRESENTATIVES, COMMITTEE ON BANKING AND FINANCIAL SERVICES, Washington, DC, May 22, 1996. Hon. THOMAS J. BLILEY, Jr., Chairman, Committee on Commerce, Washington, DC. DEAR TOM: I am writing concerning H.R. 3005, the Securities Amendments of 1996, which was recently marked-up by the House Commerce Committee. There are two provisions of H.R. 3005, as approved by the Com- merce Committee, which fall within the jurisdiction of the Banking Committee. One of these provisions relates to the margin authority of the Federal Reserve Board. In addition, the House Banking Committee staff has been discussing with the Commerce Commit- tee staff during the past two months the potential impact of a pro- vision in H.R. 3005 on the use of common names by banks and af- filiated mutual funds. The Commerce Committee staff has agreed to address the concern of the Banking Committee staff by including an amendment that eliminates this concern. I appreciate your willingness to address this issue. In view of your desire to move H.R. 3005 to the Floor in an expeditious man- ner, I do not intend to seek a sequential referral of H.R. 3005. I would appreciate, however, your commitment that the agreement worked out between our staffs will be effected without the need for separate amendments by the Banking Committee on the House Floor. Please be advised that my agreement not to seek a sequential re- ferral is based on an understanding that this waiver will be with- out prejudice to the Banking Committee’s jurisdictional claims with regard to H.R. 3005 and similar bills that may be offered in the fu- ture. I appreciate your cooperation in this matter and would further appreciate the inclusion of this letter in the Commerce Committee’s report on H.R. 3005. Sincerely, JAMES A. LEACH, Chairman. U.S. HOUSE OF REPRESENTATIVES, COMMITTEE ON COMMERCE, Washington, DC, June 5, 1996. Hon. JAMES LEACH, Chairman Committee on Banking and Financial Services, Rayburn House Office Building, Washington, DC. DEAR JIM: I am writing in response to your letter dated May 22, 1996, concerning H.R. 3005, the Securities Amendments of 1996. I appreciate your willingness to expedite passage of this legisla- tion by agreeing not to seek a sequential referral thereof. We have been able to address your concern regarding the impact on banks of a provision of the legislation dealing with investment company names. It is far more constructive for committees to work coopera- tively on issues, and in this Congress we have a record between our two committees of which we can be justifiably proud. 55 With respect to your analysis of the bill, I respectfully disagree with your assertion that the provision of the legislation regarding regulation of investment company names falls under the jurisdic- tion of the Committee on Banking and Financial Services. Under Rule X of the Rules of the House, the Commerce Committee is vest- ed with jurisdiction over securities and exchanges. Under the same rule, the Banking Committee has supervisory jurisdiction over the entry by depository institutions into securities activities in connec- tion with its jurisdiction over the safety and soundness of such in- stitutions. It does not have jurisdiction over functional regulation of applicable securities laws not involving safety and soundness. Under the relevant provision of H.R. 3005, the Securities and Ex- change Commission is given express authority to regulate fraudu- lent or misleading names of investment companies by rule or by order pursuant to the Investment Company Act of 1940. Such ac- tion by the Commission constitutes an example of functional regu- lation of investment companies and the securities that they issue. The determination of what constitutes a fraudulent or misleading name for an investment company is a question of securities regula- tion, wholly independent of what entity may be advising or distrib- uting those securities. although you point out that such regulation could have an impact on the business practices of banks that ad- vise investment companies, such impact is not conceptually dif- ferent from the impact of such regulation on any other entity that happens to advise an investment company. I thank you again for your consideration. Sincerely, THOMAS J. BLILEY, Jr., Chairman. AGENCY VIEWS U.S. SECURITIES AND EXCHANGE COMMISSION, Washington, DC, May 14, 1996. Hon. THOMAS J. BLILEY, Jr., Chairman, Committee on Commerce, House of Representatives, Ray- burn House Office Building, Washington, DC. Hon. JACK FIELDS, Chairman, Subcommittee on Telecommunications and Finance, Committee on Commerce, House of Representatives, Rayburn House Office Building, Washington, DC. DEAR CHAIRMEN BLILEY AND FIELDS: On behalf of the U.S. Secu- rities and Exchange Commission, I offer our support and endorse- ment for the Amendment in the Nature of a Substitute to H.R. 3005 to be offered by Mr. Bliley, ‘‘Securities Act Amendments of 1996.’’ You and your colleagues, Congressmen Dingell and Markey, have risen above the fray of partisan politics to produce a consen- sus bill that could well provide the regulatory framework for our markets as we enter the twenty-first century. Chairman Fields’ introduction of the predecessor bill last July challenged the securities industry, its regulators, and all market participants to confront serious issues that must be addressed in order for the U.S. capital markets to remain preeminent. Your leadership inspired a constructive debate on issues such as coordi- nation of state and federal securities laws and margin require- 56 ments. We will shortly forward to you the Commission’s section-by- section analysis that expresses our understanding of the Bliley Amendment and how it would impact the Commission’s work. We commend your efforts on this important initiative. In addi- tion, I compliment the superb staff work on both sides of the aisle—without which this effort would not have been achieved. Sincerely, ARTHUR LEVITT, Chairman. CHANGES IN EXISTING LAW MADE BY THE BILL, AS REPORTED In compliance with clause 3 of rule XIII of the Rules of the House of Representatives, changes in existing law made by the bill, as re- ported, are shown as follows (existing law proposed to be omitted is enclosed in black brackets, new matter is printed in italic, exist- ing law in which no change is proposed is shown in roman): SECURITIES ACT OF 1933 TITLE I SHORT TITLE SECTION 1. This title may be cited as the ‘‘Securities Act of 1933’’. DEFINITIONS SEC. 2. (a) DEFINITIONS.—When used in this title, unless the con- text otherwise requires— (1) * * * * * * * * * * (b) CONSIDERATION OF PROMOTION OF EFFICIENCY, COMPETITION, AND CAPITAL FORMATION.—Whenever pursuant to this title the Commission is engaged in rulemaking and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission shall also consider, in addition to the protection of investors, whether the action will promote effi- ciency, competition, and capital formation. * * * * * * * øSTATE CONTROL OF SECURITIES øSEC. 18. Nothing in this title shall affect the jurisdiction of the securities commission (or any agency or office performing like func- tions) of any State or Territory of the United States, or the District of Columbia, over any security or any person.¿ SEC. 18. EXEMPTION FROM STATE REGULATION OF SECURITIES OF- FERINGS. (a) SCOPE OF EXEMPTION.—Except as otherwise provided in this section, no law, rule, regulation, or order, or other administrative action of any State or Territory of the United States, or the District of Columbia, or any political subdivision thereof— (1) requiring, or with respect to, registration or qualification of securities, or registration or qualification of securities trans- actions, shall directly or indirectly apply to a security that— 57 (A) is a covered security; or (B) will be a covered security upon completion of the transaction; (2) shall directly or indirectly prohibit, limit, or impose condi- tions upon the use of— (A) with respect to a covered security described in sub- section (b)(1) or (c)(1)— (i) any offering document that is prepared by the is- suer; or (ii) any offering document that is not prepared by the issuer if such offering document is required to be and is filed with the Commission or any national securities organization registered under section 15A of the Secu- rities Exchange Act of 1934 (15 U.S.C. 78o-3); (B) with respect to a covered security described in para- graph (2), (3), or (4) of subsection (b), any offering docu- ment; or (C) any proxy statement, report to shareholders, or other disclosure document relating to a covered security or the is- suer thereof that is required to be and is filed with the Commission or any national securities organization reg- istered under section 15A of the Securities Exchange Act of 1934 (15 U.S.C. 78o-3); or (3) shall directly or indirectly prohibit, limit, or impose condi- tions, based on the merits of such offering or issuer, upon the offer or sale of any security described in paragraph (1). (b) COVERED SECURITIES.—For purposes of this section, the fol- lowing are covered securities: (1) EXCLUSIVE FEDERAL REGISTRATION OF NATIONALLY TRAD- ED SECURITIES.—A security is a covered security if such security is— (A) listed, or authorized for listing, on the New York Stock Exchange or the American Stock Exchange, or in- cluded or qualified for inclusion in the National Market System of the National Association of Securities Dealers Automated Quotation System (or any successor to such enti- ties); (B) listed, or authorized for listing, on a national securi- ties exchange (or tier or segment thereof) that has listing standards that the Commission determines by rule (on its own initiative or on the basis of a petition) are substan- tially similar to the listing standards applicable to securi- ties described in subparagraph (A); or (C) is a security of the same issuer that is equal in se- niority or senior to a security described in subparagraph (A) or (B). (2) EXCLUSIVE FEDERAL REGISTRATION OF INVESTMENT COM- PANIES.—A security is a covered security if such security is a se- curity issued by an investment company that is registered under the Investment Company Act of 1940 (15 U.S.C. 80a et seq.). (3) SALES TO QUALIFIED PURCHASERS.—A security is a covered security with respect to the offer or sale of the security to quali- fied purchasers, as defined by the Commission by rule. In pre- scribing such rule, the Commission may define qualified pur- 58 chaser differently with respect to different categories of securi- ties, consistent with the public interest and the protection of in- vestors. (4) EXEMPTION IN CONNECTION WITH CERTAIN EXEMPT OFFER- INGS.—A security is a covered security if— (A) the offer or sale of such security is exempt from reg- istration under this title pursuant to section 4(1) or 4(3), and— (i) the issuer of such security files reports with the Commission pursuant to section 13 or 15(d) of the Se- curities Exchange Act of 1934 (15 U.S.C. 78m, 78o(d)); or (ii) the issuer is exempt from filing such reports; (B) such security is exempt from registration under this title pursuant to section 4(4); (C) the offer or sale of such security is exempt from reg- istration under this title pursuant to section 3(a), other than the offer or sale of a security that is exempt from such registration pursuant to paragraph (4) or (11) of such sec- tion, except that a municipal security that is exempt from such registration pursuant to paragraph (2) of such section is not a covered security with respect to the offer or sale of such security in the State in which such security is issued; or (D) the offer or sale of such security is exempt from reg- istration under this title pursuant to Commission rule or regulation under section 4(2) of this title. (c) CONDITIONALLY COVERED SECURITIES.— (1) FEDERALLY REGISTERED OFFERINGS.—Subject to the limi- tations contained in paragraphs (2) and (3), a security is a cov- ered security if— (A) the issuer of such security has (or will have upon con- clusion of the transaction) total assets exceeding $10,000,000; (B) such security is the subject of a registration statement that is filed with the Commission pursuant to this title; and (C) the issuer files with such registration statement au- dited financial statements for each of the two most recent fiscal years of its operations ending before the filing of the registration statement. (2) LIMITATIONS FOR CERTAIN OFFERINGS.—Notwithstanding paragraph (1), a security is not a covered security if such secu- rity is— (A) a security of an issuer which is a blank check com- pany (as defined in section 7(b) of this title), a partnership, a limited liability company, or a direct participation invest- ment program; (B) a penny stock (as such term is defined in section 3(a)(51) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(51)); or (C) a security issued in an offering relating to a rollup transaction (as such term is defined in paragraphs (4) and (5) of section 14(h) of such Act (15 U.S.C. 78n(h)(4), (5)). 59 (3) LIMITATIONS BASED ON MISCONDUCT.—Notwithstanding paragraph (1), a security is not a covered security— (A) with respect to any State, if the issuer, or a principal officer or principal shareholder thereof— (i) is subject to a statutory disqualification, as de- fined in subparagraph (A), (B), (C), or (D) of section 3(a)(39) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(39)); (ii) has been convicted within 5 years prior to the of- fering of any felony under Federal or State law in con- nection with the offer, purchase, or sale of any security, or any felony under Federal or State law involving fraud or deceit; or (iii) is currently named in and subject to any order, judgment, or decree of any court of competent jurisdic- tion acting pursuant to Federal or State law tempo- rarily or permanently restraining or enjoining such is- suer, officer, or shareholder from engaging in or con- tinuing any conduct or practice in connection with a security; or (B) with respect to a particular State, if the issuer, or a principal officer or principal shareholder thereof— (i) has filed a registration statement which is the subject of a currently effective stop order entered pursu- ant to that State’s securities laws within 5 years prior to the offering; (ii) is currently named in and subject to any admin- istrative enforcement order or judgment of that State’s securities commission (or any agency or office perform- ing like functions) entered within 5 years prior to the offering, or is currently named in and subject to any other administrative enforcement order or judgment of that State entered within 5 years prior to the offering that finds fraud or deceit; or (iii) is currently named in and subject to any admin- istrative enforcement order or judgment of that State which prohibits or denies registration, or revokes the use of any exemption from registration, in connection with the offer, purchase, or sale of securities. (4) EXCEPTIONS TO LIMITATIONS.— (A) EXEMPTIONS.—The limitations in paragraph (3)(A) shall not apply if the Commission has exempted the subject person from the application of such paragraph by rule or order, and the limitations in paragraph (3)(B) shall not apply if the securities commission (or any agency or office performing like functions) of the affected State has exempt- ed the subject person from the application of such para- graph by rule or order. (B) REASONABLE STEPS.—The provisions of paragraph (3) shall not apply if the issuer has taken reasonable steps to ascertain whether any principal officer or principal share- holder is subject to such paragraph, and such steps do not reveal a person who is subject to such paragraph. An issuer shall be considered to have taken reasonable steps if such 60 issuer or its agent has conducted a search of any central- ized data bases that the Commission may designate by rule, and has received an affidavit under oath by each such principal officer or principal shareholder stating that such officer or shareholder is not subject to the provisions of paragraph (3). (C) EFFECT OF LIMITATIONS ON REMEDIES.—Notwith- standing paragraph (3), an issuer shall not be subject to a right of rescission under State securities laws solely as a re- sult of the operation of such paragraph. (5) NO EFFECT UNDER SUBSECTION (B).—No limitation under this subsection shall affect the treatment of a security that qualifies as a covered security under subsection (b). (d) PRESERVATION OF AUTHORITY.— (1) FRAUD AUTHORITY.—Consistent with this section, the secu- rities commission (or any agency or office performing like func- tions) of any State or Territory of the United States, or the Dis- trict of Columbia, shall retain jurisdiction under the laws of such State, Territory, or District to investigate and bring en- forcement actions with respect to fraud or deceit in connection with securities or securities transactions. (2) PRESERVATION OF FILING REQUIREMENTS.— (A) NOTICE FILINGS PERMITTED.—Nothing contained in this section shall prohibit the securities commission (or any agency or office performing like functions) of any State or Territory of the United States, or the District of Columbia, from requiring the filing of any documents filed with the Commission pursuant to this title solely for notice purposes, together with any required fee. (B) PRESERVATION OF FEES.—Until otherwise provided by State law enacted after the date of enactment of the Securi- ties Amendments of 1996, filing or registration fees with re- spect to securities or securities transactions may continue to be collected in amounts determined pursuant to State law as in effect on the day before such date. (C) FEES NOT PERMITTED ON LISTED SECURITIES.—Not- withstanding subparagraphs (A) and (B), no filing or fee may be required with respect to any security that is a cov- ered security pursuant to subsection (b)(1) of this section, or will be such a covered security upon completion of the transaction, or is a security of the same issuer that is equal in seniority or senior to a security that is a covered security pursuant to such subsection. (3) ENFORCEMENT OF REQUIREMENTS.—Nothing in this sec- tion shall prohibit the securities commission (or any agency or office performing like functions) of any State or Territory of the United States, or the District of Columbia, from suspending the offer or sale of securities within such State, Territory, or Dis- trict as a result of the failure to submit any filing or fee re- quired under law and permitted under this section. (e) DEFINITIONS.—For purposes of this section: (1) PRINCIPAL OFFICER.—The term ‘‘principal officer’’ means a director, chief executive officer, or chief financial officer of an is- suer, or any other officer performing like functions. 61 (2) PRINCIPAL SHAREHOLDER.—The term ‘‘principal share- holder’’ means any person who is directly or indirectly the bene- ficial owner of more than 20 percent of any class of equity secu- rity of an issuer. When two or more persons act as a partner- ship, limited partnership, syndicate, or other group for the pur- pose of acquiring, holding, or disposing of securities of an is- suer, such syndicate or group shall be deemed a ‘‘person’’ for purposes of this paragraph. In determining, for purposes of this paragraph, any percentage of a class of any security, such class shall be deemed to consist of the amount of the outstanding se- curities of such class, exclusive of any securities of such class held by or for the account of the issuer or a subsidiary of the issuer. (3) OFFERING DOCUMENT.—The term ‘‘offering document’’ has the meaning given the term ‘‘prospectus’’ by section 2(10), but without regard to the provisions of clauses (a) and (b) of such section, except that, with respect to a security described in sub- section (b)(2) of this section, such term also includes a commu- nication that is not deemed to offer such a security pursuant to a rule of the Commission. (4) PREPARED BY THE ISSUER.—Within 6 months after the date of enactment of the Securities Amendments of 1996, the Commission shall, by rule, define the term ‘‘prepared by the is- suer’’ for purposes of this section. * * * * * * * SEC. 28. GENERAL EXEMPTIVE AUTHORITY. The Commission, by rules and regulations, may conditionally or unconditionally exempt any person, security, or transaction, or any class or classes of persons, securities, or transactions, from any pro- vision or provisions of this title or of any rule or regulation there- under, to the extent that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of inves- tors. * * * * * * * SECURITIES EXCHANGE ACT OF 1934 TITLE I—REGULATION OF SECURITIES EXCHANGES SHORT TITLE SECTION 1. This Act may be cited as the ‘‘Securities Exchange Act of 1934’’. * * * * * * * DEFINITIONS AND APPLICATION OF TITLE SEC. 3. (a) When used in this title, unless the context otherwise requires— (1) * * * * * * * * * * 62 (54) The term ‘‘examining authority’’ means any self-regu- latory organization registered with the Commission under this title (other than registered clearing agencies) with the authority to examine, inspect, and otherwise oversee the activities of a reg- istered broker or dealer. * * * * * * * (f) CONSIDERATION OF PROMOTION OF EFFICIENCY, COMPETITION, AND CAPITAL FORMATION.—Whenever pursuant to this title the Commission is engaged in rulemaking, or in the review of a rule of a self-regulatory organization, and is required to consider or deter- mine whether an action is necessary or appropriate in the public in- terest, the Commission shall also consider, in addition to the protec- tion of investors, whether the action will promote efficiency, competi- tion, and capital formation. * * * * * * * MARGIN REQUIREMENTS SEC. 7. (a) * * * * * * * * * * ø(c) It shall be unlawful for any member of a national securities exchange or any broker or dealer, directly or indirectly, to extend or maintain credit or arrange for the extension or maintenance of credit to or for any customer— ø(1) on any security (other than an exempted security), in contravention of the rules and regulations which the Board of Governors of the Federal Reserve System shall prescribe under subsections (a) and (b) of this section; ø(2) without collateral or on any collateral other than securi- ties, except in accordance with such rules and regulations as the Board of Governors of the Federal Reserve System may prescribe (A) to permit under specified conditions and for a limited period any such member, broker, or dealer to maintain a credit initially extended in conformity with the rules and reg- ulations of the Board of Governors of the Federal Reserve Sys- tem, and (B) to permit the extension or maintenance of credit in cases where the extension or maintenance of credit is not for the purpose of purchasing or carrying securities or of evading or circumventing the provisions of paragraph (1) of this sub- section. ø(d) It shall be unlawful for any person not subject to subsection (c) of this section to extend or maintain credit or to arrange for the extension or maintenance of credit for the purpose of purchasing or carrying any security, in contravention of such rules and regula- tions as the Federal Reserve Board shall prescribe to prevent the excessive use of credit for the purchasing or carrying of or trading in securities in circumvention of the other provisions of this sec- tion. Such rules and regulations may impose upon all loans made for the purpose of purchasing or carrying securities limitations similar to those imposed upon members, brokers, or dealers by sub- section (c) of this section and the rules and regulations thereunder. This subsection and the rules and regulations thereunder shall not apply (A) to a loan made by a person not in the ordinary course 63 of his business, (B) to a loan on an exempted security, (C) to a loan to a dealer to aid in the financing of the distribution of securities to customers not through the medium of a national securities ex- change, (D) to a loan by a bank on a security other than an equity security, or (E) to such other loans as the Federal Reserve Board shall, by such rules and regulations as it may deem necessary or appropriate in the public interest or for the protection of investors, exempt, either unconditionally or upon specified terms and condi- tions or for stated periods, from the operation of this subsection and the rules and regulations thereunder.¿ (c) UNLAWFUL CREDIT EXTENSION TO CUSTOMERS.— (1) PROHIBITION.—It shall be unlawful for any member of a national securities exchange or any broker or dealer, directly or indirectly, to extend or maintain credit or arrange for the exten- sion or maintenance of credit to or for any customer— (A) on any security (other than an exempted security), in contravention of the rules and regulations which the Board of Governors of the Federal Reserve System shall prescribe under subsections (a) and (b) of this section; (B) without collateral or on any collateral other than se- curities, except in accordance with such rules and regula- tions as the Board of Governors of the Federal Reserve Sys- tem may prescribe— (i) to permit under specified conditions and for a limited period any such member, broker, or dealer to maintain a credit initially extended in conformity with the rules and regulations of the Board of Governors of the Federal Reserve System; and (ii) to permit the extension or maintenance of credit in cases where the extension or maintenance of credit is not for the purpose of purchasing or carrying securi- ties or of evading or circumventing the provisions of subparagraph (A) of this paragraph. (2) EXCEPTION.—This subsection and the rules and regula- tions thereunder shall not apply to any credit extended, main- tained, or arranged by a member of a national securities ex- change or a broker or dealer to or for a member of a national securities exchange or a registered broker or dealer— (A) a substantial portion of whose business consists of transactions with persons other than brokers or dealers; or (B) to finance its activities as a market maker or an un- derwriter; except that the Board of Governors of the Federal Reserve Sys- tem may impose such rules and regulations, in whole or in part, on any credit otherwise exempted by this paragraph if it determines that such action is necessary or appropriate in the public interest or for the protection of investors. (d) UNLAWFUL CREDIT EXTENSION IN VIOLATION OF RULES AND REGULATIONS; EXCEPTION TO APPLICATION OF RULES, ETC.— (1) PROHIBITION.—It shall be unlawful for any person not subject to subsection (c) of this section to extend or maintain credit or to arrange for the extension or maintenance of credit for the purpose of purchasing or carrying any security, in con- travention of such rules and regulations as the Board of Gov- 64 ernors of the Federal Reserve System shall prescribe to prevent the excessive use of credit for the purchasing or carrying of or trading in securities in circumvention of the other provisions of this section. Such rules and regulations may impose upon all loans made for the purpose of purchasing or carrying securities limitations similar to those imposed upon members, brokers, or dealers by subsection (c) of this section and the rules and regu- lations thereunder. (2) EXCEPTIONS.—This subsection and the rules and regula- tions thereunder shall not apply to any credit extended, main- tained, or arranged— (A) by a person not in the ordinary course of business; (B) on an exempted security; (C) to or for a member of a national securities exchange or a registered broker or dealer— (i) a substantial portion of whose business consists of transactions with persons other than brokers or deal- ers; or (ii) to finance its activities as a market maker or an underwriter; (D) by a bank on a security other than an equity security; or (E) as the Board of Governors of the Federal Reserve Sys- tem shall, by such rules, regulations, or orders as it may deem necessary or appropriate in the public interest or for the protection of investors, exempt, either unconditionally or upon specified terms and conditions or for stated periods, from the operation of this subsection and the rules and reg- ulations thereunder; except that the Board of Governors of the Federal Reserve Sys- tem may impose such rules and regulations, in whole or in part, on any credit otherwise exempted by subparagraph (C) of this paragraph if it determines that such action is necessary or appropriate in the public interest or for the protection of inves- tors. * * * * * * * RESTRICTIONS ON BORROWING BY MEMBERS, BROKERS, AND DEALERS SEC. 8. It shall be unlawful for any registered broker or dealer, member of a national securities exchange, or broker or dealer who transacts a business in securities through the medium of any mem- ber of a national securities exchange, directly or indirectly— ø(a) To borrow in the ordinary course of business as a broker or dealer on any security (other than an exempted security) registered on a national securities exchange except (1) from or through a member bank of the Federal Reserve Board, (2) from any nonmem- ber bank which shall have filed with the Federal Reserve Board an agreement, which is still in force and which is in the form pre- scribed by the Board, undertaking to comply with all provisions of this Act, the Federal Reserve Act, as amended, and the Banking Act of 1933, which are applicable to member banks and which re- late to the use of credit to finance transactions in securities, and with such rules and regulations as may be prescribed pursuant to 65 such provisions of law or for the purpose of preventing evasions thereof, or (3) in accordance with such rules and regulations as the Federal Reserve Board may prescribe to permit loans between such members and/or brokers and/or dealers, or to permit loans to meet emergency needs. Any such agreement filed with the Board of Gov- ernors of the Federal Reserve Board shall be subject to termination at any time by order of the Board, after appropriate notice and op- portunity for hearing, because of any failure by such bank to com- ply with the provisions thereof or with such provisions of law or rules or regulations; and, for any willful violation of such agree- ment, such bank shall be subject to the penalties provided for viola- tions of rules and regulations prescribed under this title. The provi- sions of sections 21 and 25 of this title shall apply in the case of any such proceeding or order of the Federal Reserve Board in the same manner as such provisions apply in the case of proceedings and orders of the Commission. Subject to such rules and regula- tions as the Board of Governors of the Federal Reserve System adopt in the public interest and for the protection of investors, no person shall be deemed to have borrowed within the ordinary course of business, within the meaning of this subsection, by reason of a bona fide agreement for delayed delivery of a mortgage related security or a small business related security against full payment of the purchase price thereof upon such delivery within one hun- dred and eighty days after the purchase, or within such shorter pe- riod as the Board of Governors of the Federal Reserve System may prescribe by rule or regulation. ø(b)¿ (a) In contravention of such rules and regulations as the Commission shall prescribe for the protection of investors to hy- pothecate or arrange for the hypothecation of any securities carried for the account of any customer under circumstances (1) that will permit the commingling of his securities without his written con- sent with the securities of any other customer, (2) that will permit such securities to be commingled with the securities of any person other than a bona fide customer, or (3) that will permit such securi- ties to be hypothecated, or subjected to any lien or claim of the pledgee, for a sum in excess of the aggregate indebtedness of such customers in respect of such securities. ø(c)¿ (b) To lend or arrange for the lending of any securities car- ried for the account of any customer without the written consent of such customer or in contravention of such rules and regulations as the Commission shall prescribe for the protection of investors. * * * * * * * REGISTRATION AND REGULATION OF BROKERS AND DEALERS SEC. 15. (a) * * * * * * * * * * (h) LIMITATIONS ON STATE LAW.— (1) CAPITAL, MARGIN, BOOKS AND RECORDS, BONDING, AND RE- PORTS.—No law, rule, regulation, or order, or other administra- tive action of any State or political subdivision thereof shall es- tablish capital, custody, margin, financial responsibility, mak- ing and keeping records, bonding, or financial or operational reporting requirements for brokers, dealers, municipal securities 66 dealers, government securities brokers, or government securities dealers that differ from, or are in addition to, the requirements in those areas established under this title. The Commission shall consult periodically the securities commissions (or any agency or office performing like functions) of the States concern- ing the adequacy of such requirements as established under this title. (2) EXEMPTION TO PERMIT SERVICE TO CUSTOMERS.—No law, rule, regulation, or order, or other administrative action of any State or political subdivision thereof shall prohibit an associ- ated person from effecting a transaction described in paragraph (3) for a customer in such State if— (A) such associated person is not ineligible to register with such State for any reason other than such a trans- action; (B) such associated person is registered with a registered securities association and at least one State; and (C) the broker or dealer with which such person is associ- ated is registered with such State. (3) DESCRIBED TRANSACTIONS.—A transaction is described in this paragraph if— (A) such transaction is effected— (i) on behalf of a customer that, for 30 days prior to the day of the transaction, maintains an account with the broker or dealer; and (ii) by an associated person (I) to which the customer was assigned for 14 days prior to the day of the trans- action, and (II) who is registered with a State in which the customer was a resident or was present for at least 30 consecutive days during the one-year period prior to the transaction; except that, if the customer is present in another State for 30 or more consecutive days or has permanently changed his or her residence to another State, such transaction is not described in this subparagraph unless the associated person files with such State an application for registration within 10 business days of the later of the date of the trans- action or the date of the discovery of the presence of the cus- tomer in the State for 30 or more consecutive days or the change in the customer’s residence; (B) the transaction is effected— (i) on behalf of a customer that, for 30 days prior to the day of the transaction, maintains an account with the broker or dealer; and (ii) within the period beginning on the date on which such associated person files with the State in which the transaction is effected an application for registration and ending on the earlier of (I) 60 days after the date the application is filed, or (II) the time at which such State notifies the associated person that it has denied the application for registration or has stayed the pend- ency of the application for cause; or (C) the transaction is one of 10 or fewer transactions in a calendar year (excluding any transactions described in 67 subparagraph (A) or (B)) which the associated person ef- fects in the States in which the associated person is not reg- istered. (4) ALTERNATE ASSOCIATED PERSONS.—For purposes of para- graph (3)(A)(ii), each of up to 3 associated persons who are des- ignated to effect transactions during the absence or unavail- ability of the principal associated person for a customer may be treated as an associated person to which such customer is as- signed for purposes of such paragraph. * * * * * * * ACCOUNTS AND RECORDS, EXAMINATIONS OF EXCHANGES, MEMBERS, AND OTHERS SEC. 17. (a) * * * * * * * * * * (i) COORDINATION OF EXAMINING AUTHORITIES.— (1) ELIMINATION OF DUPLICATION.—The Commission and the examining authorities, through cooperation and coordination of examination and oversight as required by this subsection, shall eliminate any unnecessary and burdensome duplication in the examination process. (2) PLANNING CONFERENCES.— (A) The Commission and the examining authorities shall meet at least annually for a national general planning con- ference to discuss coordination of examination schedules and priorities and other areas of interest relevant to exam- ination coordination and cooperation. (B) Within each geographic region designated by the Commission, the Commission and the relevant examining authorities shall meet at least annually for a regional plan- ning conference to discuss examination schedules and pri- orities and other areas of related interest, and to encourage information-sharing and to avoid unnecessary duplication of examinations. (3) COORDINATION TRACKING SYSTEM FOR BROKER-DEALER EX- AMINATIONS.— (A) The Commission and the examining authorities shall prepare, on a periodic basis in a uniform computerized for- mat, information on registered broker and dealer examina- tions and shall submit such information to the Commis- sion. (B) The Commission shall maintain a computerized database of consolidated examination information to be used for examination planning and scheduling and for monitoring coordination of registered broker and dealer ex- aminations under this section. (4) COORDINATION OF EXAMINATIONS.— (A) The examining authorities shall share among them- selves such information, including reports of examinations, customer complaint information, and other non-public reg- ulatory information, as appropriate to foster a coordinated approach to regulatory oversight of registered brokers and 68 dealers subject to examination by more than one examining authority. (B) To the extent practicable, the examining authorities shall assure that each registered broker and dealer subject to examination by more than one examining authority that requests a coordinated examination shall have all requested aspects of the examination conducted simultaneously and without duplication of the areas covered. The examining authorities shall also prepare an advance schedule of all such coordinated examinations. (5) PROHIBITED NON-COORDINATED EXAMINATIONS.—Any ex- amining authority that does not participate in a coordinated ex- amination pursuant to paragraph (4) of this subsection shall not conduct a routine examination other than a coordinated ex- amination of that broker or dealer within 9 months of the con- clusion of a scheduled coordinated examination. (6) EXAMINATIONS FOR CAUSE.—At any time, any examining authority may conduct an examination for cause of any broker or dealer subject to its jurisdiction. (7) BROKER-DEALER EXAMINATION EVALUATION PANEL.—The Commission shall establish an examination evaluation panel composed of representatives of registered brokers and dealers that are members of more than one self-regulatory organization that conducts routine examinations. Prior to each national gen- eral planning conference required by paragraph (2)(A) of this subsection, the Commission shall convene the examination eval- uation panel to review consolidated and statistical information on the coordination of examinations and information on exami- nations that are not coordinated, including the findings of Commission examiners on the effectiveness of the examining au- thorities in achieving coordinated examinations. The Commis- sion shall present any findings and recommendations of the ex- amination evaluation panel to the next meeting of the national general planning conference, and shall report back to the exam- ination evaluation panel on the actions taken by the examining authorities regarding those findings and recommendations. The examination evaluation panel shall not be subject to the Federal Advisory Committee Act (5 U.S.C. App.). (8) REPORT TO CONGRESS.—Within one year after the date of enactment of this Act, the Commission shall report to the Con- gress on the progress it and the examining authorities have made in reducing duplication and improving coordination in registered broker and dealer examinations, and on the activities of the examination evaluation panel. Such report shall also in- dicate whether the Commission has identified additional redundancies that have failed to be addressed in the coordina- tion of examining authorities, or any recommendations of the examination evaluation panel established under paragraph (7) of this subsection that have not been addressed by the examin- ing authorities or the Commission. * * * * * * * 69 EFFECT ON EXISTING LAW SEC. 28. (a) The rights and remedies provided by this title shall be in addition to any and all other rights and remedies that may exist at law or in equity; but no person permitted to maintain a suit for damages under the provisions of this title shall recover, through satisfaction of judgment in one or more actions, a total amount in excess of his actual damages on account of the act com- plained of. øNothing¿ Except as otherwise specifically provided else- where in this title, nothing in this title shall affect the jurisdiction of the securities commission (or any agency or officer performing like functions) of any State over any security or any person insofar as it does not conflict with the provisions of this title or the rules and regulations thereunder. No State law which prohibits or regu- lates the making or promoting of wagering or gaming contracts, or the operation of ‘‘bucket shops’’ or other similar or related activi- ties, shall invalidate any put, call, straddle, option, privilege, or other security, or apply to any activity which is incidental or relat- ed to the offer, purchase, sale, exercise, settlement, or closeout of any such instrument, if such instrument is traded pursuant to rules and regulations of a self-regulatory organization that are filed with the Commission pursuant to section 19(b) of this Act. * * * * * * * SEC. 36. GENERAL EXEMPTIVE AUTHORITY. Notwithstanding any other provision of this title, the Commission, by rule, regulation, or order, may conditionally or unconditionally exempt any person, security, or transaction, or any class or classes of persons, securities, or transactions, from any provision or provi- sions of this title or of any rule or regulation thereunder, to the ex- tent that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors. The Com- mission shall by rules and regulations determine the procedures under which an exemptive order under this section shall be granted and may, in its sole discretion, decline to entertain any application for an order of exemption under this section. * * * * * * * INVESTMENT COMPANY ACT OF 1940 TITLE I—INVESTMENT COMPANIES * * * * * * * GENERAL DEFINITIONS SEC. 2. (a) When used in this title, unless the context otherwise requires— (1) * * * * * * * * * * (51) ‘‘Qualified purchaser’’ means— (A) any natural person who owns at least $10,000,000 in securities of issuers that are not controlled by such person, except that securities of such a controlled issuer may be 70 counted toward such amount if such issuer is, or but for the exception in paragraph (1) or (7) of section 3(c) would be, an investment company; (B) any trust not formed for the specific purpose of ac- quiring the securities offered, as to which the trustee or other person authorized to make decisions with respect to the trust, and each settlor or other person who has contrib- uted assets to the trust, is a person described in subpara- graph (A) or (C); or (C) any person, acting for its own account or the accounts of other qualified purchasers, who in the aggregate owns and invests on a discretionary basis, not less than $100,000,000 in securities of issuers that are not affiliated persons (as defined in paragraph (3)(C) of this subsection) of such person, except that securities of such an affiliated person issuer may be counted toward such amount if such issuer is, or but for the exception in paragraph (1) or (7) of section 3(c) would be, an investment company. The Commission may adopt such rules and regulations govern- ing the persons and trusts specified in subparagraphs (A), (B), and (C) of this paragraph as it determines are necessary or ap- propriate in the public interest and for the protection of inves- tors. * * * * * * * (c) CONSIDERATION OF PROMOTION OF EFFICIENCY, COMPETITION, AND CAPITAL FORMATION.—Whenever pursuant to this title the Commission is engaged in rulemaking and is required to consider or determine whether an action is consistent with the public inter- est, the Commission shall also consider, in addition to the protec- tion of investors, whether the action will promote efficiency, competi- tion, and capital formation. DEFINITION OF INVESTMENT COMPANY SEC. 3. (a) When used in this title, ‘‘investment company’’ means any issuer which— (1) * * * * * * * * * * As used in this section, ‘‘investment securities’’ includes all securi- ties except (A) Government securities, (B) securities issued by em- ployees’ securities companies, and (C) securities issued by majority- owned subsidiaries of the owner (i) which are not investment com- panies, and (ii) which are not relying on the exception from the defi- nition of investment company in subsection (c)(1) or (c)(7) of this section. * * * * * * * (c) Notwithstanding subsection (a), none of the following persons is an investment company within the meaning of this title: (1) Any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than one hundred persons and which is not making and does not pres- ently propose to make a public offering of its securities. Such issuer nonetheless is deemed to be an investment company for 71 purposes of the limitations set forth in section 12(d)(1)(A)(i) and (B)(i) governing the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end company to any such issuer. For purposes of this paragraph: (A) Beneficial ownership by a company shall be deemed to be beneficial ownership by one person, except that, if the company owns 10 per centum or more of the outstand- ing voting securities of the issuer, and is or, but for the ex- ception in this paragraph or paragraph (7), would be an in- vestment company, the beneficial ownership shall be deemed to be that of the holders of such company’s out- standing securities (other than short-term paper) øunless, as of the date of the most recent acquisition by such com- pany of securities of that issuer, the value of all securities owned by such company of all issuers which are or would, but for the exception set forth in this subparagraph, be ex- cluded from the definition of investment company solely by this paragraph, does not exceed 10 per centum of the value of the company’s total assets. Such issuer nonetheless is deemed to be an investment company for purposes of sec- tion 12(d)(1).¿. * * * * * * * (2) Any person primarily engaged in the business of under- writing and distributing securities issued by other persons, selling securities to customers, øand acting as broker,¿ acting as broker, and acting as market intermediary, or any one or more of such activities, whose gross income normally is derived principally from such business and related activities. For the purposes of this paragraph, the term ‘‘market intermediary’’ means any person that regularly holds itself out as being will- ing contemporaneously to engage in, and is regularly engaged in the business of entering into, transactions on both sides of the market for a financial contract or one or more such finan- cial contracts. For purposes of the preceding sentence, the term ‘‘financial contract’’ means any arrangement that (A) takes the form of an individually negotiated contract, agreement, or op- tion to buy, sell, lend, swap, or repurchase, or other similar in- dividually negotiated transaction commonly entered into by participants in the financial markets; (B) is in respect of securi- ties, commodities, currencies, interest or other rates, other meas- ures of value, or any other financial or economic interest simi- lar in purpose or function to any of the foregoing; and (C) is entered into in response to a request from a counterparty for a quotation or is otherwise entered into and structured to accom- modate the objectives of the counterparty to such arrangement. * * * * * * * ø(7) Reserved.¿ (7)(A) Any issuer (i) whose outstanding securities are owned exclusively by persons who, at the time of acquisition of such se- curities, are qualified purchasers, and (ii) who is not making and does not presently propose to make a public offering of such securities. Securities that are owned by persons who received 72 the securities from a qualified purchaser as a gift or bequest, or where the transfer was caused by legal separation, divorce, death, or other involuntary event, shall be deemed to be owned by a qualified purchaser, subject to such rules, regulations, and orders as the Commission may prescribe as necessary or appro- priate in the public interest or for the protection of investors. (B) Notwithstanding subparagraph (A), an issuer is within the exception provided by this paragraph if— (i) in addition to qualified purchasers, its outstanding se- curities are beneficially owned by not more than 100 per- sons who are not qualified purchasers if (I) such persons acquired such securities on or before December 31, 1995, and (II) at the time such securities were acquired by such persons, the issuer was excepted by paragraph (1) of this subsection; and (ii) prior to availing itself of the exception provided by this paragraph— (I) such issuer has disclosed to such persons that fu- ture investors will be limited to qualified purchasers, and that ownership in such issuer is no longer limited to not more than 100 persons, and (II) concurrently with or after such disclosure, such issuer has provided such persons with a reasonable op- portunity to redeem any part or all of their interests in the issuer for their proportionate share of the issuer’s current net assets, or the cash equivalent thereof. (C) An issuer that is excepted under this paragraph shall nonetheless be deemed to be an investment company for pur- poses of the limitations set forth in section 12(d)(1)(A)(i) and (B)(i) governing the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end company to any such issuer. (D) For purposes of determining compliance with this para- graph and paragraph (1) of this subsection, an issuer that is otherwise excepted under this paragraph and an issuer that is otherwise excepted under paragraph (1) shall not be treated by the Commission as being a single issuer for purposes of deter- mining whether the outstanding securities of the issuer excepted under paragraph (1) are beneficially owned by not more than 100 persons or whether the outstanding securities of the issuer excepted under this paragraph are owned by persons that are not qualified purchasers. Nothing in this provision shall be deemed to establish that a person is a bona fide qualified pur- chaser for purposes of this paragraph or a bona fide beneficial owner for purposes of paragraph (1) of this subsection. * * * * * * * FUNCTIONS AND ACTIVITIES OF INVESTMENT COMPANIES SEC. 12. (a) * * * * * * * * * * 73 (d)(1)(A) * * * * * * * * * * (E) The provisions of this paragraph (1) shall not apply to a secu- rity (or securities) purchased or acquired by an investment com- pany if— (i) the depositor of, or principal underwriter for, such invest- ment company is a broker or dealer registered under the Secu- rities Exchange Act of 1934, or a person controlled by such a broker or dealer; (ii) such security is the only investment security held by such investment company (or such securities are the only invest- ment securities held by such investment company, if such in- vestment company is a registered unit investment trust that issues two or more classes or series of securities, each of which provides for the accumulation of shares of a different invest- ment company); and (iii) øin the event such investment company is not a reg- istered investment company,¿ the purchase or acquisition is made pursuant to an arrangement with the issuer of, or prin- cipal underwriter for the issuer of, the security whereby such investment company is obligated— (aa) either to seek instructions from its security holders with regard to the voting of all proxies with respect to such security and to vote such proxies only in accordance with such instructions, or to vote the shares held by it in the same proportion as the vote of all other holders of such security, and (bb) in the event such investment company is not a reg- istered investment company to refrain from substituting such security unless the Commission shall have approved such substitution in the manner provided in section 26 of this Act. * * * * * * * (G) The provisions of this paragraph (1) shall not apply to securi- ties of a registered open-end company (the ‘‘acquired company’’) pur- chased or otherwise acquired by a registered open-end company (the ‘‘acquiring company’’) if— (i) the acquired company and the acquiring company are part of the same group of investment companies; (ii) the securities of the acquired company, securities of other registered open-end companies that are part of the same group of investment companies, Government securities, and short-term paper are the only investments held by the acquiring company; (iii)(I) the acquiring company does not pay and is not as- sessed any charges or fees for distribution-related activities with respect to securities of the acquired company unless the acquir- ing company does not charge a sales load or other fees or charges for distribution-related activities; or (II) any sales loads and other distribution-related fees charged with respect to securities of the acquiring company, when aggregated with any sales load and distribution-related fees paid by the acquiring company with respect to securities of the acquired company, are not excessive under rules adopted 74 pursuant to either section 22(b) or section 22(c) of this title by a securities association registered under section 15A of the Se- curities Exchange Act of 1934 or the Commission; (iv) the acquired company shall have a fundamental policy that prohibits it from acquiring any securities of registered open-end companies in reliance on this subparagraph or sub- paragraph (F) of this subsection; and (v) such acquisition is not in contravention of such rules and regulations as the Commission may from time to time prescribe with respect to acquisitions in accordance with this subpara- graph as necessary and appropriate for the protection of inves- tors. For purposes of this subparagraph, a ‘‘group of investment compa- nies’’ shall mean any two or more registered investment companies that hold themselves out to investors as related companies for pur- poses of investment and investor services. ø(G)¿ (H) For the purposes of this paragraph (1), the value of an investment company’s total assets shall be computed as of the time of a purchase or acquisition or as closely thereto as is reasonably possible. ø(H)¿ (I) In any action brought to enforce the provisions of this paragraph (1), the Commission may join as a party the issuer of any security purchased or otherwise acquired in violation of this paragraph (1), and the court may issue any order with respect to such issuer as may be necessary or appropriate for the enforcement of the provisions of this paragraph (1). (J) The Commission, by rules and regulations upon its own mo- tion or by order upon application, may conditionally or uncondition- ally exempt any person, security, or transaction, or any class or classes of persons, securities, or transactions from any provisions of this subsection, if and to the extent such exemption is consistent with the public interest and the protection of investors. * * * * * * * REGISTRATION OF SECURITIES UNDER SECURITIES ACT OF 1933 SEC. 24. (a) * * * * * * * * * * ø(e)(1) A registration statement under the Securities Act of 1933 relating to a security issued by a face-amount certificate company or a redeemable security issued by an open-end management com- pany or unit investment trust may be amended after its effective date so as to increase the securities specified therein as proposed to be offered. At the time of filing such amendment there shall be paid to the Commission a fee, calculated in the manner specified in section 6(b) of said Act, with respect to the additional securities therein proposed to be offered. ø(2) The filing of such an amendment to a registration statement under the Securities Act of 1933 shall not be deemed to have taken place unless it is accompanied by a United States postal money order or a certified bank check or cash for the amount of the fee required under paragraph (1) of this subsection.¿ ø(3)¿ (e) For the purposes of section 11 of the Securities Act of 1933, as amended, the effective date of the latest amendment filed 75 øpursuant to this subsection or otherwise¿ shall be deemed the ef- fective date of the registration statement with respect to securities sold after such amendment shall have become effective. For the purposes of section 13 of the Securities Act of 1933, as amended, no such security shall be deemed to have been bona fide offered to the public prior to the effective date of the latest amendment filed pursuant to this subsection. Except to the extent the Commission otherwise provides by rules or regulations as appropriate in the public interest or for the protection of investors, no prospectus re- lating to a security issued by a face-amount certificate company or a redeemable security issued by an open-end management company or unit investment trust which varies for the purposes of sub- section (a)(3) of section 10 of the Securities Act of 1933 from the latest prospectus filed as a part of the registration statement shall be deemed to meet the requirements of said section 10 unless filed as part of an amendment to the registration statement under said Act and such amendment has become effective. ø(f) In the case of securities issued by a face-amount certificate company or redeemable securities issued by an open-end manage- ment company or unit investment trust, which are sold in an amount in excess of the number of securities included in an effec- tive registration statement of any such company, such company may, in accordance with such rules and regulations as the Commis- sion shall adopt as it deems necessary or appropriate in the public interest or for the protection of investors, elect to have the registra- tion of such securities deemed effective as of the time of their sale, upon payment to the Commission, within six months after any such sale, of a registration fee of three times the amount of the fee which would have otherwise been applicable to such securities. Upon any such election and payment, the registration statement of such company shall be considered to have been in effect with re- spect to such shares. The Commission may also adopt rules and regulations as it deems necessary or appropriate in the public in- terest or for the protection of investors to permit the registration of an indefinite number of the securities issued by a face-amount certificate company or redeemable securities issued by an open-end management company or unit investment trust.¿ (f) REGISTRATION OF INDEFINITE AMOUNT OF SECURITIES.— (1) INDEFINITE REGISTRATION OF SECURITIES.—Upon the ef- fectiveness of its registration statement under the Securities Act of 1933, a face-amount certificate company, open-end manage- ment company, or unit investment trust shall be deemed to have registered an indefinite amount of securities. (2) PAYMENT OF REGISTRATION FEES.—Within 90 days after the end of the company’s fiscal year, the company shall pay a registration fee to the Commission, calculated in the manner specified in section 6(b) of the Securities Act of 1933, based on the aggregate sales price for which its securities (including, for this purpose, all securities issued pursuant to a dividend rein- vestment plan) were sold pursuant to a registration of an in- definite amount of securities under this subsection during the company’s previous fiscal year reduced by— (A) the aggregate redemption or repurchase price of the securities of the company during that year, and 76 (B) the aggregate redemption or repurchase price of the securities of the company during any prior fiscal year end- ing not more than 1 year before the date of enactment of the Investment Company Act Amendments of 1996 that were not used previously by the company to reduce fees pay- able under this section. (3) INTEREST DUE ON LATE PAYMENT.—A company paying the fee or any portion thereof more than 90 days after the end of the company’s fiscal year shall pay to the Commission interest on unpaid amounts, compounded daily, at the underpayment rate established by the Secretary of the Treasury pursuant to section 3717(a) of title 31, United States Code. The payment of interest pursuant to the requirement of this paragraph shall not preclude the Commission from bringing an action to enforce the requirements of paragraph (2) of this subsection. (4) RULEMAKING AUTHORITY.—The Commission may adopt rules and regulations to implement the provisions of this sub- section. (g) In addition to the prospectuses permitted or required in section 10 of the Securities Act of 1933, the Commission shall permit, by rules or regulations deemed necessary or appropriate in the public interest or for the protection of investors, the use of a prospectus for the purposes of section 5(b)(1) of such Act with respect to securities issued by a registered investment company. Such a prospectus, which may include information the substance of which is not in- cluded in the prospectus specified in section 10(a) of the Securities Act of 1933, shall be deemed to be permitted by section 10(b) of such Act. * * * * * * * UNIT INVESTMENT TRUSTS SEC. 26. (a) * * * * * * * * * * (e)(1) Subsection (a) shall not apply to any registered separate ac- count funding variable insurance contracts, or to the sponsoring in- surance company and principal underwriter of such account. (2) It shall be unlawful for any registered separate account fund- ing variable insurance contracts, or for the sponsoring insurance company of such account, to sell any such contract, unless— (A) the fees and charges deducted under the contract in the aggregate are reasonable in relation to the services rendered, the expenses expected to be incurred, and the risks assumed by the insurance company, and the insurance company so rep- resents in the registration statement for the contract; and (B) the insurance company (i) complies with all other applica- ble provisions of this section as if it were a trustee or custodian of the registered separate account; (ii) files with the insurance regulatory authority of a State an annual statement of its fi- nancial condition, which most recent statement indicates that it has a combined capital and surplus, if a stock company, or an unassigned surplus, if a mutual company, of not less than $1,000,000, or such other amount as the Commission may from time to time prescribe by rule as necessary or appropriate in the 77 public interest or for the protection of investors; and (iii) to- gether with its registered separate accounts, is supervised and examined periodically by the insurance authority of such State. (3) The Commission may adopt such rules and regulations under paragraph (2)(A) as it determines are necessary or appropriate in the public interest or for the protection of investors. For the purposes of such paragraph, the fees and charges deducted under the contract shall include all fees and charges imposed for any purpose and in any manner. PERIODIC PAYMENT PLANS SEC. 27. (a) * * * * * * * * * * (i)(1) This section shall not apply to any registered separate ac- count funding variable insurance contracts, or to the sponsoring in- surance company and principal underwriter of such account, except as provided in paragraph (2). (2) It shall be unlawful for any registered separate account fund- ing variable insurance contracts, or for the sponsoring insurance company of such account, to sell any such contract unless (A) such contract is a redeemable security, and (B) the insurance company complies with section 26(e) and any rules or regulations adopted by the Commission thereunder. * * * * * * * PERIODIC AND OTHER REPORTS; REPORTS OF AFFILIATED PERSONS SEC. 30. (a) * * * (b) Every registered investment company shall file with the Com- mission— ø(1) such information and documents (other than financial statements) as the Commission may require, on a semi-annual or quarterly basis, to keep reasonably current the information and documents contained in the registration statement of such company filed under this title; and¿ (1) such information, documents, and reports (other than fi- nancial statements), as the Commission may require to keep reasonably current the information and documents contained in the registration statement of such company filed under this title; and * * * * * * * (c) In exercising its authority under subsection (b)(1) to require the filing of information, documents, and reports on a basis more frequently than semi-annually, the Commission shall take such steps as it deems necessary or appropriate, consistent with the pub- lic interest and the protection of investors, to avoid unnecessary re- porting by, and minimize the compliance burdens on, registered in- vestment companies and their affiliated persons. Such steps shall include considering and requesting public comment on— (1) feasible alternatives that minimize the reporting burdens on registered investment companies; and (2) the utility of such information, documents, and reports to the Commission in relation to the costs to registered investment 78 companies and their affiliated persons of providing such infor- mation, documents, and reports. ø(c)¿ (d) The Commission shall issue rules and regulations per- mitting the filing with the Commission, and with any national se- curities exchange concerned, of copies of periodic reports, or of ex- tracts therefrom, filed by any registered investment company pur- suant to subsections (a) and (b), in lieu of any reports and docu- ments required of such company under section 13 or 15(d) of the Securities Exchange Act of 1934. ø(d)¿ (e) Every registered investment company shall transmit to its stockholders, at least semi-annually, reports containing such of the following information and financial statements or their equiva- lent, as of a reasonably current date, as the Commission may pre- scribe by rules and regulations for the protection of investors, which reports shall not be misleading in any material respect in the light of the reports required to be filed pursuant to subsections (a) and (b): (1) * * * * * * * * * * (f) The Commission may by rule require that semi-annual reports containing the information set forth in subsection (e) include such other information as the Commission deems necessary or appro- priate in the public interest or for the protection of investors. In ex- ercising its authority under this subsection, the Commission shall take such steps as it deems necessary or appropriate, consistent with the public interest and the protection of investors, to avoid unneces- sary reporting by, and minimize the compliance burdens on, reg- istered investment companies and their affiliated persons. Such steps shall include considering and requesting public comment on— (1) feasible alternatives that minimize the reporting burdens on registered investment companies; and (2) the utility of such information to shareholders in relation to the costs to registered investment companies and their affili- ated persons of providing such information ø(e)¿ (g) Financial statements contained in annual reports re- quired pursuant to subsections (a) and ø(d)¿ (e), if required by the rules and regulations of the Commission, shall be accompanied by a certificate of independent public accountants. The certificate of such independent public accountants shall be based upon an audit not less in scope or procedures followed than that which independ- ent public accountants would ordinarily make for the purpose of presenting comprehensive and dependable financial statements, and shall contain such information as the Commission may pre- scribe, by rules and regulations in the public interest or for the pro- tection of investors, as to the nature and scope of the audit and the findings and opinion of the accountants. Each such report shall state that such independent public accountants have verified secu- rities owned, either by actual examination, or by receipt of a certifi- cate from the custodian, as the Commission may prescribe by rules and regulations. ø(f)¿ (h) Every person who is directly or indirectly the beneficial owner of more than 10 per centum of any class of outstanding secu- rities (other than short-term paper) of which a registered closed- end company is the issuer or who is an officer, director, member 79 of an advisory board, investment adviser, or affiliated person of an investment adviser of such a company shall in respect of his trans- actions in any securities of such company (other than short-term paper) be subject to the same duties and liabilities as those im- posed by section 16 of the Securities Exchange Act of 1934 upon certain beneficial owners, directors, and officers in respect of their transactions in certain equity securities. ACCOUNTS AND RECORDS SEC. 31. ø(a) Every registered investment company, and every underwriter, broker, dealer, or investment adviser which is a ma- jority-owned subsidiary of such a company, shall maintain and pre- serve for such period or periods as the Commission may prescribe by rules and regulations, such accounts, books, and other docu- ments as constitute the record forming the basis for financial state- ments required to be filed pursuant to section 30 of this title, and of the auditor’s certificates relating thereto. Every investment ad- viser not a majority-owned subsidiary of, and every depositor of any registered investment company, and every principal under- writer for any registered investment company other than a closed- end company, shall maintain and preserve for such period or peri- ods as the Commission shall prescribe by rules and regulations, such accounts, books, and other documents as are necessary or ap- propriate to record such person’s transactions with such registered company. ø(b) All accounts, books, and other records, required to be main- tained and preserved by any person pursuant to subsection (a), shall be subject at any time and from time to time to such reason- able periodic, special, and other examinations by the Commission, or any member or representative thereof, as the Commission may prescribe. Any such person shall furnish to the Commission, within such reasonable time as the Commission may prescribe, copies of or extracts from such records which may be prepared without undue effort, expense, or delay, as the Commission may by order require.¿ (a) Every registered investment company, and every under- writer, broker, dealer, or investment adviser that is a majority- owned subsidiary of such a company, shall maintain and preserve such records (as defined in section 3(a)(37) of the Securities Ex- change Act of 1934) for such period or periods as the Commission, by rules and regulations, may prescribe as necessary or appropriate in the public interest or for the protection of investors. Every invest- ment adviser not a majority-owned subsidiary of, and every deposi- tor of any registered investment company, and every principal un- derwriter for any registered investment company other than a closed-end company, shall maintain and preserve for such period or periods as the Commission shall prescribe by rules and regulations, such records as are necessary or appropriate to record such person’s transactions with such registered company. In exercising its author- ity under this subsection, the Commission shall take such steps as it deems necessary or appropriate, consistent with the public interest and for the protection of investors, to avoid unnecessary record- keeping by, and minimize the compliance burden on, persons re- quired to maintain records under this subsection (hereinafter in this 80 section referred to as ‘‘subject persons’’). Such steps shall include considering, and requesting public comment on— (1) feasible alternatives that minimize the recordkeeping bur- dens on subject persons; (2) the necessity of such records in view of the public benefits derived from the independent scrutiny of such records through Commission examination; (3) the costs associated with maintaining the information that would be required to be reflected in such records; and (4) the effects that a proposed recordkeeping requirement would have on internal compliance policies and procedures. (b) All records required to be maintained and preserved in accord- ance with subsection (a) of this section shall be subject at any time and from time to time to such reasonable periodic, special, and other examinations by the Commission, or any member or represent- ative thereof, as the Commission may prescribe. For purposes of such examinations, any subject person shall make available to the Commission or its representatives any copies or extracts from such records as may be prepared without undue effort, expense, or delay as the Commission or its representatives may reasonably request. The Commission shall exercise its authority under this subsection with due regard for the benefits of internal compliance policies and procedures and the effective implementation and operation thereof. (c) Notwithstanding any other provision of law, the Commission shall not be compelled to disclose any internal compliance or audit records, or information contained therein, provided to the Commis- sion under this section. Nothing in this subsection shall authorize the Commission to withhold information from Congress or prevent the Commission from complying with a request for information from any other Federal department or agency requesting the information for purposes within the scope of its jurisdiction, or complying with an order of a court of the United States in an action brought by the United States or the Commission. For purposes of section 552 of title 5, United States Code, this section shall be considered a statute described in subsection (b)(3)(B) of such section 552. (d) For purposes of this section— (1) ‘‘internal compliance policies and procedures’’ means poli- cies and procedures designed by subject persons to promote compliance with the Federal securities laws; and (2) ‘‘internal compliance and audit record’’ means any record prepared by a subject person in accordance with internal com- pliance policies and procedures. ø(c)¿ (e) The Commission may, in the public interest or for the protection of investors, issue rules and regulations providing for a reasonable degree of uniformity in the accounting policies and prin- ciples to be followed by registered investment companies in main- taining their accounting records and in preparing financial state- ments required pursuant to this title. ø(d)¿ (f) The Commission, upon application made by any reg- istered investment company, may by order exempt a specific trans- action or transactions from the provisions of any rule or regulation made pursuant to subsection (c), if the Commission finds that such 81 rule or regulation should not reasonably be applied to such trans- action. * * * * * * * UNLAWFUL REPRESENTATIONS AND NAMES SEC. 35. (a) * * * * * * * * * * ø(d) It shall be unlawful for any registered investment company hereafter to adopt as a part of the name or title of such company, or of any security of which it is the issuer, any word or words which the Commission finds and by order declares to be deceptive or misleading. The Commission is authorized to bring an action in the proper district court of the United States or United States court of any Territory or other place subject to the jurisdiction of the United States alleging that the name or title of any registered investment company, or of any security which it has issued, is ma- terially deceptive or misleading. If the court finds that the Commis- sion’s allegations in this respect, taking into consideration the his- tory of the investment company and the length of time which it may have used any such name or title, are established, the court shall enjoin such investment company from continuing to use any such name or title.¿ (d) It shall be unlawful for any registered investment company to adopt as a part of the name or title of such company, or of any secu- rities of which it is the issuer, any word or words that the Commis- sion finds are materially deceptive or misleading. The Commission is authorized, by rule, regulation, or order, to define such names or titles as are materially deceptive or misleading. * * * * * * * Æ U.S. GOVERNMENT PRINTING OFFICE WASHINGTON : 1 59–010 SENATE" ! 105TH CONGRESS 2d Session REPORT 1998 105–182 Calendar No. 355 THE SECURITIES LITIGATION UNIFORM STANDARDS ACT OF 1998 R E P O R T OF THE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS UNITED STATES SENATE TO ACCOMPANY S. 1260 TOGETHER WITH ADDITIONAL VIEWS MAY 4, 1998.—Ordered to be printed 2 COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS ALFONSE M. D’AMATO, New York, Chairman PHIL GRAMM, Texas RICHARD C. SHELBY, Alabama CONNIE MACK, Florida LAUCH FAIRCLOTH, North Carolina ROBERT F. BENNETT, Utah ROD GRAMS, Minnesota WAYNE ALLARD, Colorado MICHAEL B. ENZI, Wyoming CHUCK HAGEL, Nebraska PAUL S. SARBANES, Maryland CHRISTOPHER J. DODD, Connecticut JOHN F. KERRY, Massachusetts RICHARD H. BRYAN, Nevada BARBARA BOXER, California CAROL MOSELEY-BRAUN, Illinois TIM JOHNSON, South Dakota JACK REED, Rhode Island HOWARD A. MENELL, Staff Director STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel DOUGLAS R. NAPPI, Counsel MITCHELL FEUER, Democratic Counsel SUBCOMMITTEE ON SECURITIES PHIL GRAMM, Texas, Chairman RICHARD C. SHELBY, Alabama WAYNE ALLARD, Colorado ROBERT F. BENNETT, Utah LAUCH FAIRCLOTH, North Carolina CHRISTOPHER J. DODD, Connecticut TIM JOHNSON, South Dakota JOHN F. KERRY, Massachusetts RICHARD H. BRYAN, Nevada WAYNE A. ABERNATHY, Staff Director ANDREW LOWENTHAL, Democratic Professional Staff Member (II) 3 C O N T E N T S Page Introduction .............................................................................................................. 1 History of the Legislation ....................................................................................... 1 Purpose and Scope ................................................................................................... 3 Section-by-Section Analysis of S. 1260: ‘‘The Securities Litigation Uniform Standards Act of 1998’’ ........................................................................................ 8 Section 1. Short title ........................................................................................ 8 Section 2. Findings and purposes .................................................................... 8 Section 3. Limitation on remedies ................................................................... 9 Section 4. Applicability .................................................................................... 9 Regulatory Impact Statement ................................................................................. 9 Cost of Legislation ................................................................................................... 9 Changes in Existing Law ........................................................................................ 10 Additional Views ...................................................................................................... 11 (III) Calendar No. 355 105TH CONGRESS REPORT " !SENATE2d Session 105–182 THE SECURITIES LITIGATION UNIFORM STANDARDS ACT OF 1998 MAY 4, 1998.—Ordered to be printed Mr. D’AMATO, from the Committee on Banking, Housing, and Urban Affairs, submitted the following R E P O R T [To accompany S. 1260] INTRODUCTION The Committee on Banking, Housing and Urban Affairs, to which was referred the bill (S. 1260), to amend the Securities Act of 1933 and the Securities Exchange Act of 1934 to limit the con- duct of securities class actions under State law, having considered the same, reports favorably thereon with an amendment in the na- ture of a substitute, and recommends that the bill as amended do pass. HISTORY OF THE LEGISLATION On July 24, 1997, the Subcommittee on Securities held an over- sight hearing on the operation of the Private Securities Litigation Reform Act (hereinafter referred to as either the ‘‘PSLRA’’ or the ‘‘1995 Act’’) which was passed over presidential veto during the 104th Congress (PL–104–67). At this hearing testimony was re- ceived from: Arthur Levitt, Chairman of the Securities and Ex- change Commission; Keith Paul Bishop, Commissioner, California Department of Corporations; Dr. Joseph A. Grundfest, Professor, Stanford Law School and former Commissioner, Securities and Ex- change Commission; Mr. Michael A. Perino Lecturer, Stanford Law School; Mr. Joseph Polizotto, Managing Director, Office of the Gen- eral Counsel, Lehman Brothers (on behalf of the Securities Indus- try Association); Mr. Kenneth Janke, Sr., President and Chief Ex- ecutive Officer, National Association of Investors Corporation; Mr. Richard Miller, General Counsel, American Institute of Certified 2 Public Accountants; Mr. Leonard Simon, Milberg Weiss Bershad Hynes and Lerach (on behalf of the National Association of Securi- ties and Commercial Law Attorneys); Mr. Brian Dovey, President, National Venture Capital Association and; Mr. Robert C. Hinckley, Vice President, Strategic Plans and Programs, Xilinx (on behalf of the American Electronics Association). As a result of the testimony received at the July 1997 hearing, Senators Gramm, Dodd, Boxer, Faircloth, Hagel and Moseley- Braun, together with seven other Senators who are not members of the Committee introduced on October 7, 1997, S. 1260, the ‘‘Se- curities Litigation Uniform Standards Act of 1997’’ (hereinafter re- ferred to as either ‘‘Uniform Standards’’ or ‘‘S. 1260’’) Subsequently, a total of forty Senators cosponsored the legislation, including twelve from the Committee (Senators Gramm. Dodd, Boxer, Fair- cloth, Hagel, Moseley-Braun, Bennett, Grams, Kerry, Mack, Allard and Enzi). On October 29, 1997 and on February 23, 1998, the Subcommit- tee on Securities held legislative hearings on S. 1260. Witnesses testifying on October 29, 1997 included: U.S. Representative Rick White; U.S. Representative Anna Eshoo; Arthur Levitt, Chairman, the Securities and Exchange Commission (SEC); Isaac C. Hunt, Jr., Commissioner, Securities and Exchange Commission; Robert C. Hinckley, Vice President, Strategic Plans and Programs, Xilinx, who testified on behalf of the American Electronics Association; Harry Smith, Mayor of Greenwood, Mississippi, who testified on behalf of the National League of Cities; Herbert Milstein of Cohen, Milstein, Hausfeld & Toll, who testified on behalf of the National Association of Securities and Commercial Law Attorneys; Professor Michael Perino, Stanford Law School; Thomas E. O’Hara, Chair- man, Board of Trustees, the National Association of Investors Cor- porations and Daniel Cooperman, Senior Vice President, General Counsel, and Corporate Secretary, Oracle Corporation, who testi- fied on behalf of the Software Publishers Association. Witnesses testifying on February 23, 1998 included: Boris Feld- man, Wilson, Sonsini, Goodrich & Rosati; Professor Richard W. Painter, Cornell Law School; Michael H. Morris, Vice President and General Counsel, Sun Microsystems; Mary Rouleau, Legislative Di- rector, Consumer Federation of America; J. Harry Weatherly, Di- rector of Finance, Mecklenburg County, North Carolina, on behalf of the Government Finance Officers Association; and John F. Olson, Gibson, Dunn & Crutcher. On April 29, 1998, the Committee met in Executive Session to consider and adopt an amendment in the nature of a substitute that was offered by Chairman D’Amato and Senators Gramm and Dodd. The Committee also adopted an amendment, by voice vote, providing two findings to the bill. The amendment was offered by Chairman D’Amato and Senators Gramm and Dodd. The amend- ment makes clear the Committee’s intention to enact this legisla- tion in order to prevent state laws from being used to frustrate the operation and goals of the 1995 Reform Act. The legislation was or- dered reported from Committee by a vote of 14–4. Senators Shelby, Sarbanes, Bryan and Johnson voted against this legislation. 3 1 Pub Law No. 104–67 (Dec. 22, 1995). 2 Testimony of Stephen M.H. Wallman, Commissioner, Securities and Exchange Commission; submitted to the Subcommittee on Securities’ ‘‘Oversight Hearing on the Private Securities Liti- gation reform Act of 1995’’ (the ‘‘Reform Act Hearing’’), July 24, 1997, p. 1. 3 Joint prepared statement of Joseph A. Grundfest and Michael A. Perino, ‘‘Reform Act Hear- ing,’’ July 24, 1997, p. 6. 4 ‘‘* * * the apparent shift to state court may be the most significant development in securi- ties litigation post-Reform Act.’’ Securities and Exchange Commission, Report to the President and the Congress on the First Year of Practice Under the Private Securities Litigation Reform Act of 1995, p. 69 (1997); see also Statement of Senator Phil Gramm, Senate Subcommittee on Continued PURPOSE AND SCOPE OF LEGISLATION The need for this legislation became apparent during a Securities Subcommittee hearing on July 24, 1997. This hearing was held to review the status of the implementation and impact of the ‘‘Private Securities Litigation Reform Act of 1995.’’ 1 During the course of that hearing one disturbing trend became apparent; namely, that there was a noticeable shift in class action litigation from federal to state courts. At this hearing, one witness pointed out the dan- gers of maintaining differing federal and state standards of liability for nationally-traded securities: Disparate, and shifting, state litigation procedures may expose issuers to the potential for significant liability that cannot easily be evaluated in advance, or assessed when a statement is made. At a time when we are increasingly ex- periencing and encouraging national and international se- curities offerings and listings, and expending great effort to rationalize and streamline our securities markets, this fragmentation of investor remedies potentially imposes costs that outweigh the benefits. Rather than permit or foster fragmentation of our national system of securities litigation, we should give due consideration to the benefits flowing to investors from a uniform national approach.2 Former SEC Commissioner Joseph Grundfest summarized this post 1995 Act increase in state securities class actions in testimony co-authored with his fellow Stanford Law School faculty member Michael Perino: The relative stability of the aggregate litigation rate masks a significant shift of activity from federal to state court * * *. There is widespread agreement that these fig- ures represent a substantial increase in state court litiga- tion. Two phenomena seem to explain the bulk of this shift. First, there appears to be a ‘‘substitution effect’’ whereby plaintiff’s counsel file state court complaints when the underlying facts appear not to satisfy new, more strin- gent federal pleading requirements, or otherwise seek to avoid the substantive or procedural provisions of the Act. Second plaintiffs appear to be resorting to increased par- allel state and federal litigation in an effort to avoid fed- eral discovery stays or to establish alternative state court venues for settlement of federal claims.3 While there was some disagreement as to the exact size of the increase in state class-action filings, the overall evidence received by the Committee is compelling.4 As one witness testified ‘‘(t)he 4 Securities Hearing, February 23, 1998, entering into the record materials submitted by Price, Waterhouse, LLP documenting both the rise in state securities class action cases and the chang- ing nature of those cases; see also Michael A. Perino, Fraud and Federalism: Preempting Private State Securities Fraud Causes of Action, Stanford Law Review (forthcoming 1998), manuscript at 31, n. 127; see also Joseph A. Grundfest and Michael A. Perino; Securities Litigation Reform: The First Year’s Experience (Release 97.1), Summary of Major Findings, p. ii–iii; Stanford Law School; February 27, 1997. 5 Written testimony of John F. Olson of Gibson, Dunn & Crutcher, ‘‘Hearing on S. 1260,’’ Feb- ruary 23, 1998, p. 5. 6 Joint prepared statement of Joseph A. Grundfest and Michael A. Perino, ‘‘Reform Act Hear- ing,’’ July 24, 1997, p. 6. 7 See, e.g., Prepared statement of Michael Morris, Vice President and General Counsel, Sun Microsystems, ‘‘Hearing on S. 1260,’’ February 23, 1998. 8 Written statement of Thomas E. O’Hara, Chairman, NAIC, ‘‘Hearing on S. 1260,’’ October 29, 1997. 9 See, e.g., Grundfest and Perino, supra, note 2; Written statement of Robert C. Hinckely, Vice President Strategic Plans and Programs, XILINX, on behalf of The American Electronics Asso- ciation, the Reform Act Hearing, July 27, 1997, p. 17. 10 Written statement of Hon. Harry Smith, Mayor, Greenwood, Mississippi, on behalf of the National League of Cities, ‘‘Hearing on S. 1260,’’ October 29, 1997, p. 8. single fact is that state-court class actions involving nationally traded securities were virtually unknown prior to the [1995 Act]; they are brought with some frequency now.’’ 5 Further, the Committee has found that this state class-action trend has had an impact beyond the number of, and dollar amounts involved in, the class actions filed. This trend has created a ripple-effect that has inhibited small, high-growth companies in their efforts to raise capital, and has damaged the overall efficiency of our capital markets.6 Specifically, the increased risk of state court class actions has had a chilling effect on the use of the ‘‘safe- harbor’’ and other important provisions of the 1995 Act.7 The safe harbor was intended to help get valuable financial forecasts and forward-looking information to investors, so that these investors could make decisions with as much information as possible; as Thomas O’Hara of the National Association of Investors Corpora- tion (‘‘NAIC’’), testified: The key to becoming successful with high-tech invest- ments is a willingness to recognize—and tolerate—the in- herent volatility of the business and access to crucial for- ward-looking information so an investor can make a wise decision.8 A number of witnesses at the July 1997 hearing advocated legis- lation to establish uniform standards for private securities class ac- tion litigation.9 This legislation is an outgrowth of the July 1997 hearings and subsequent investigation and oversight by the Com- mittee. Some critics of establishing a uniform standard of liability have attacked such legislation as being an affront on Federalism and contrary to the recent trend towards reinforcing state rights.10 Pro- ponents of the legislation have argued that we live in an informa- tion age in which we have truly national, if not international, secu- rities markets and that uniform standards are entirely consistent with Congress’s preeminent power over the regulation of interstate and foreign commerce. The Committee, while sensitive to both these considerations, found the interest in promoting efficient na- tional markets to be the more convincing and compelling consider- ation in this context. 5 11 Written statement of Hon. Keith Paul Bishop, Commissioner, California Department of Cor- porations, ‘‘Reform Act Hearing,’’ July 27, 1998, p. 3. We do have national markets for certain securities, and fraudu- lent and abusive securities class action litigation distorts the effi- cient operation of those markets and the optimal allocation of avail- able capital. Commissioner Keith P. Bishop, then-California’s pri- mary state securities regulator, testified before the Subcommittee on Securities in July, 1997, that the preponderance of class action litigation in several states is irrelevant to the true national nature of the problem: It is important to note that companies can not control where their securities are traded after an initial public of- fering * * *. As a result, companies with publicly-traded securities can not choose to avoid jurisdictions which present unreasonable litigation costs. Thus, a single state can impose the risks and costs of its peculiar litigation sys- tem on all national issuers.11 The Committee emphasizes the important role that the local ‘‘cop on the beat,’’ i.e., the state securities regulators, plays in a com- plementary state-federal securities regulatory system. In recogni- tion of this dual system, this legislation uses the approach that the National Securities Markets Improvement Act of 1996 (‘‘NSMIA’’) employed. The purpose of NSMIA was described by SEC Chairman Levitt in testimony regarding that legislation: The current system of dual federal-state regulation is not the system that Congress or the Commission would create today if we were designing a new system * * *. An appropriate balance can be attained in the federal-state arena that better allocates responsibilities, reduces compli- ance costs and facilitates capital formation, while continu- ing to provide for the protection of investors. The bill’s ap- proach to the division of responsibilities in the investment adviser and investment company areas exemplifies such a balance. As introduced, the legislation incorporated the conceptual frame- work of NSMIA (with respect to interplay of federal and state regu- lation), while complementing, and hopefully giving full force to the 1995 Act. The Committee strongly notes that this legislation only covers precisely those securities defined in the NSMIA, principally those securities that are traded on national exchanges. During the course of the two hearings held by the Subcommittee on Securities on this legislation, the Subcommittee received a great deal of con- structive advice about how best to give effect to the 1995 Act. Scienter The Committee heard testimony from the Securities and Ex- change Commission and others regarding the scienter requirement under a possible national standard of litigation for nationally trad- ed securities. The Committee understands that this concern arises out of certain Federal district courts’ interpretation of the Private Securities Litigation Reform Act of 1995 [PL 104–67]. In that re- gard, the Committee emphasizes that the clear intent in 1995 and 6 12 See, e.g., Prepared statement of John F. Olson, ‘‘Hearings on S. 1260,’’ Senate committee on Banking, Housing & Urban Affairs, Subcommittee on Securities, February 23, 1998, pp. 8– 13. our continuing intent in this legislation is that neither the PSLRA nor S. 1260 in any way alters the scienter standard in federal secu- rities fraud suits. It was the intent of Congress, as was expressly stated during the legislative debate on the PSLRA, and particularly during the debate on overriding the President’s veto, that the PSLRA establish a uniform federal standard on pleading require- ments by adopting the pleading standard applied by the Second Circuit Court of Appeals. Indeed the express language of the PSLRA itself carefully provides that plaintiffs must ‘‘state with particularity facts giving rise to a strong inference that the defend- ant acted with the required state of mind’’ (emphasis added). The Committee emphasizes that neither the PSLRA nor S. 1260 makes any attempt to define that state of mind. Certain exceptions The SEC, as well as other commentators,12 also noted the need to exempt from the legislation shareholder-initiated litigation based on breach of fiduciary duty of disclosure, in connection with certain corporate actions, that is found in the law of some states, most no- tably Delaware. The Committee is keenly aware of the importance of state cor- porate law, specifically those states that have laws that establish a fiduciary duty of disclosure. It is not the intent of the Committee in adopting this legislation to interfere with state law regarding the duties and performance of an issuer’s directors or officers in connection with a purchase or sale of securities by the issuer or an affiliate from current shareholders or communicating with existing shareholders with respect to voting their shares, acting in response to a tender or exchange offer, or exercising dissenters’ or appraisal rights. In applying the uniform standards in this manner, the Commit- tee expressly does not intend for suits excepted under this provi- sion to be brought in venues other than in the issuer’s state of in- corporation, in the case of a corporation, or state of organization, in the case of an other entity. Definition of ‘‘Class Action’’ The Subcommittee on Securities heard testimony from the Secu- rities and Exchange Commission and others that the definition of class action originally drafted as part of S. 1260 would inadvert- ently include cases that were beyond the intent of the legislation— such as certain types of individual state private securities actions. In response to these concerns, the Committee made several sig- nificant changes to the definition of class action. Because of the unique nature of the suits that the Committee has made subject to the legislation’s provisions, this definition cannot simply track the exact language of Rule 23 of the Federal Rules of Civil Procedure. In order to ensure that individual state actions would not be in- cluded as part of the bill’s definitions, it was necessary for the Committee to create a standard of demarcation between individual actions appropriately brought in state court and those actions that 7 should be subject to the bill’s provisions. To address this goal, and to establish objective criteria in the application of the definition, the Committee specifically included a threshold number of fifty or more persons or prospective class members as part of the definition of a class action under this legislation. Section 2(f)(1)(A)(i)(II) of the legislation provides a definition that closely tracks the relevant provisions of Rule 23 of the Federal Rules of Civil Procedure in which a suit is brought by representa- tive plaintiffs on behalf of themselves and other unnamed parties. Section 2(f)(1)(A)(i)(I), however, provides that any single lawsuit is treated as a class action if it seeks damages on behalf of more than fifty persons and questions of law or fact common to the prospec- tive class predominate, without regard to questions of individual- ized reliance. The predominance requirement, modeled on Rule 23, is included to assure that claims that are not closely related, but that are included in a single proceeding only for the purposes of convenience are not treated as a class action. The Committee is conscious, however, of the danger that the predominance require- ment could be used as a loophole to bring a single suit that names many plaintiffs. If such a suit is brought under a state law that requires proof of each individual plaintiff’s reliance on a defend- ant’s alleged misstatement or omission, the necessity of proving re- liance on an individual basis might mean that common questions would not predominate and the suit accordingly would not be treat- ed as a class action. Indeed the Supreme Court stated in Basic, Inc. v. Levinson [485 U.S. 224, 242, (1988)] that ‘‘requiring proof of individualized reli- ance from each member of the proposed plaintiff class effectively would * * * prevent plaintiffs from proceeding with a class action, since individual issues would * * * overwhelm the common ones.’’ To avoid this problem, the definition provides that the predomi- nance inquiry must be undertaken without reference to issues of individualized reliance, so that the necessity of proving reliance on an individual basis would not defeat treatment of the suit as a class action. Section 2(f)(1)(A)(ii) is a definition of class action that is intended to prevent evasion of the bill through the use of so-called ‘‘mass ac- tions.’’ These kinds of actions are now brought in product liability, environmental tort and similar cases. In practice, such suits may function very much like traditional class actions and, because they involve many plaintiffs, they may have a very high settlement value. They accordingly may be abused by lawyers who seek to evade the provisions of this Act in order bring coercive strike suits. Subpart (A)(ii) addresses the Committee’s concern by including in the definition of class action any group of lawsuits that are filed or pending in the same court, that in the aggregate seek damages on behalf of more than fifty persons, that involve common ques- tions of law or fact, and which are joined, consolidated, or other- wise proceed as a single action for any purpose. The Committee does not intend for the bill to prevent plaintiffs from bringing bona fide individual actions simply because more than fifty persons com- mence the actions in the same state court against a single defend- ant. 8 However, the provisions of the bill would apply where the court orders that the suits be joined, consolidated, or otherwise proceed as a single action at the state level. The Committee also notes that when such suits proceed as a single action in state court, it is fre- quently at the request of the plaintiffs. The class action definition has been changed from the original text of S. 1260 to ensure that the legislation does not cover in- stances in which a person or entity is duly authorized by law, other than a provision of state or federal law governing class action pro- cedures, to seek damages on behalf of another person or entity. Thus, a trustee in bankruptcy, a guardian, a receiver, and other persons or entities duly authorized by law (other than by a provi- sion of state or federal law governing class action procedures) to seek damages on behalf of another person or entity would not be covered by this provision. Finally, while the Committee believes that it has effectively reached those actions that could be used to circumvent the reforms enacted by Congress in 1995 as part of the Private Securities Liti- gation Reform Act, it remains the Committee’s intent that the bill be interpreted broadly to reach mass actions and all other proce- dural devices that might be used to circumvent the class action def- inition. SECTION-BY-SECTION ANALYSIS Section 1. Short title The short title of the bill is the Securities Litigation Uniform Standards Act of 1998. Section 2. Findings Congress finds that in order to avoid the thwarting of the pur- pose of the Private Securities Litigation Reform Act of 1995, na- tional standards for nationally traded securities must be enacted, while preserving the appropriate enforcement powers of state regu- lators, and the right of individuals to bring suit. Section 3. Limitation on remedies Subsection 3(a) amends Section 16 of the Securities Act of 1933 as follows: Subsection 16(a) is a savings clause. Subsection 16(b) provides that no class action based on State law alleging fraud in connection with the purchase or sale of covered securities may be maintained in State or Federal court. Subsection 16(c) provides that any class action described in Sub- section (b) that is brought in a State court shall be removable to a Federal district court, and may be dismissed pursuant to the pro- visions of subsection (b). Subsection 16(d) of the new section 16 provides for the preserva- tion of certain law suits brought under State law affecting conduct of corporate officers with respect to certain corporate actions, in- cluding tender offers, exchange offers or the exercise of dissenter’s or appraisal rights. 9 Subsection 16(e) of the new section 16 reemphasizes that State securities commissions retain their jurisdiction to investigate and bring enforcement actions. Subsection 16(f) of the new section 16 provides for definitions under the section, including definitions of ‘‘class action,’’ ‘‘covered security,’’ and ‘‘affiliate of the issuer.’’ ‘‘Class action’’ is defined so as to capture mass actions, but to exclude shareholder derivative actions and actions by a group of less than 50 individuals or enti- ties. ‘‘Covered securities’’ includes securities satisfy the definition of that term given in subsection 18(b)(1) and 18(b)(2) of the Securities Act of 1933. Subsection 3(b) amends Section 28 of the Securities Exchange Act of 1934 so as to effect the changes to that section substantially similar to, and consistent with, the amendments that subsection 3(a) makes to the Securities Act of 1933. Section 4. Applicability The changes in law made by the bill do not affect any court ac- tion commenced before and pending on the date of enactment of the legislation. REGULATORY IMPACT STATEMENT This legislation is designed to address and unforeseen ‘‘loophole’’ in the 1995 Private Securities Litigation Act, that has blocked that law from accomplishing its stated goal of reforming private securi- ties litigation. Because S.1260 seeks to achieve further reforms in the private securities litigation system, the Committee believes that this legislation will have little or no regulatory impact. COST OF LEGISLATION U.S. CONGRESS, CONGRESSIONAL BUDGET OFFICE, Washington, DC, May 1, 1998. Hon. ALFONSE M. D’AMATO, Chairman, Committee on Banking, Housing and Urban Affairs, U.S. Senate, Washington, DC. DEAR MR. CHAIRMAN: The Congressional Budget Office has pre- pared the enclosed cost estimate for S. 1260, the Securities Litiga- tion Uniform Standards Act of 1998. If you wish further details on this estimate, we will be pleased to provide them. The CBO staff contacts are Kathleen Gramp (for federal costs), and Pepper Santalucia (for the state and local im- pact). Sincerely, JUNE E. O’NEILL, Director. Enclosure. CONGRESSIONAL BUDGET OFFICE COST ESTIMATE S. 1260—Securities Litigation Uniform Standards Act of 1998 S. 1260 would amend existing law related to class actions involv- ing certain types of securities fraud. Under this bill, certain class 10 actions could not be based on state law and could only be main- tained in federal courts. CBO estimates that implementing S. 1260 would have no signifi- cant impact on the federal budget. Recent data on the number of securities-related class actions brought under state law suggest that fewer than 100 cases per year might shift to federal courts as a result of this bill. Although class actions often involve complex and time-consuming issues, CBO estimates that the federal court system would not incur significant costs to process that number of new cases. Because S. 1260 would not affect direct spending or re- ceipts, pay-as-you-go procedures would not apply. S. 1260 contains an intergovernmental mandate as defined in the Unfunded Mandates Reform Act of 1995 (UMRA) because it would preempt state securities laws. However, CBO estimates that the impact on state budgets would not be significant. The bill contains no private-sector mandates as defined in UMRA. The CBO staff contacts for this estimate are Kathleen Gramp (for federal costs), who can be reached at 226–2860, and Pepper Santalucia (for the state and local impact), who can be reached at 225–3220. This estimate was approved by Robert A. Sunshine, Deputy Assistant Director for Budget Analysis. CHANGES IN EXISTING LAW In the opinion of the Committee, it is necessary to dispense with the requirements of paragraph or subsection 12 of rule XXVI of the Standing Rules of the Senate in order to expedite the business of the Senate. (11) 1 See January 23, 1998 Letter to Senators and Members of Congress from Professors Ian Ayres, Stephen M. Bainbridge, Douglas M. Branson, William W. Bratton, John C. Coffee, Jr., James D. Cox, Charles M. Elson, Merritt B. Fox, Tamar Frankel, Theresa A. Gabaldon, Nicholas L. Georgakopoulos, James J. Hanks, Jr., Kimberly D. Krawiec, Fred S. McChesney, Lawrence E. Mitchell, Donna M. Nagy, Jennifer O’Hare, Richard W. Painter, William H. Painter, Mar- garet V. Sachs, Joel Seligman, D. Gordon Smith, Marc I. Steinberg, Celia R. Taylor, Robert B. Thompson, Manning G. Warren III, and Cynthia A. Williams. ADDITIONAL VIEWS OF SENATORS SARBANES, BRYAN AND JOHNSON I. INTRODUCTION In reporting the Securities Litigation Uniform Standards Act (‘‘Uniform Standards Bill’), the Senate Banking Committee once again sends to the Senate floor a solution in search of a problem. The Committee majority seeks to stem a supposed epidemic of friv- olous securities fraud suits being filed in State court. The majority operates on the assumption that securities fraud class actions filed in State court are being used to evade the provisions of the Private Securities Litigation Reform Act of 1995 (‘‘Litigation Reform Act’’). This assumption is supported neither by empirical studies of State court litigation nor by the record pace of securities offerings. Undeterred by the evidence, the majority would preempt securities fraud causes of action under State law. The Uniform Standards Bill would establish the provisions of the Litigation Reform Act as a uniform standard for litigation involving securities traded on the national stock exchanges. In so doing, the majority turns a blind eye both to the short- comings of the Litigation Reform Act and to the flaws of the Uni- form Standards Bill. We opposed the Litigation Reform Act because we were concerned that it was not sufficiently protective of inves- tors. Developments since its enactment heighten rather than lessen that concern. We oppose the Uniform Standards Bill both because of its overly broad reach and because its sponsors fail to take this opportunity to correct the flaws of the Litigation Reform Act. Should the Uniform Standards Bill be enacted, investors will find their State court remedies eliminated. We fear that in too many cases, investors will be left without any effective remedies at all. Such a result can only harm innocent investors, undermine public confidence in the securities markets, and ultimately raise the cost of capital for deserving American businesses. For these reasons, a broad coalition of groups representing investors, public officials, workers and pension funds, including AARP, AFSCME, Consumer Federation of America, the Government Finance Officers Associa- tion, the National Association of State Retirement Administrators, the National League of Cities, the New York State Bar Association, the U.S. Conference of Mayors, and the United Mine Workers, op- poses this Bill. Over two dozen law professors have expressed their opposition as well.1 12 2 See CRS Report for Congress, ‘‘Securities Litigation Reform: Unfinished Business?,’’ April 4, 1998, at 2. 3 Id. at 6. 4 Joint Written Testimony of Joseph A. Grundfest and Michael A. Perino before the Sub- committee on Securities, July 24, 1997, at Figure 1. 5 See Basic, Inc. v. Levinson, 485 U.S. 224 (1988), adopting the ‘‘fraud on the market’’ theory for Federal securities fraud actions. II. MYTH OF STATE COURT LOOPHOLE The rationale for this legislation rests on a misconception of the facts. The sponsors of the Bill assert that securities fraud class ac- tions have migrated from Federal court to State court in order to evade the provisions of the Litigation Reform Act. In particular, the Bill’s supporters maintain that class actions are being brought in State court to avoid the Act’s stay of discovery and safe harbor for forward looking statements. In fact, every empirical study of securi- ties fraud class action filings reaches the same conclusion: while State court securities filings may have increased in 1996, they de- creased in 1997. For example, a study done by the National Economic Research Associates (NERA), a consulting firm, found that the number of se- curities class action suits filed in State courts during the first 10 months of 1996 increased to 79 from 48 filed during the same pe- riod in 1995.2 In an update released in the summer of 1997, how- ever, NERA found that the number of securities class actions filed in State courts during the first four months of 1997 declined to 19, down from 40 filed in the same period in 1996.3 In July 1997, Pro- fessor Joseph Grundfest and Michael Perino of Stanford Law School testified that the number of issuers sued only in State class actions declined from 33 in 1996 to an annualized rate of 18 in 1997.4 A ‘‘Price Waterhouse Securities Litigation Study’’ posted by that accounting firm on its Internet site corroborated NERA’s find- ings. Using data compiled by Securities Class Action Alert based on the number of defendants sued, Price Waterhouse reported that the number of State court securities class actions increased from 52 in 1995 to 66 in 1996, but then declined to 44 in 1997. That was lower than the number of such actions in 1991 or 1993. The Study found ‘‘the total number of cases filed in 1997 shows little to no change from the average number of lawsuits filed in the period 1991 through 1995.’’ Data provided to the Committee by Price Waterhouse on February 20, 1998 also demonstrate that State court filings declined in 1997. Measured by the number of cases filed, the number of State securities class actions declined from 71 in 1996 to 39 in 1997. As the SEC testified in October 1997, ‘‘recent data * * * tends to show that the migration of securities class ac- tions from federal to state court may have been a transient phe- nomenon.’’ Not only do the Bill’s supporters fail to address the decline in State court securities actions in 1997, they fail to recognize the geo- graphic concentration of such actions. Many securities class actions are brought under the ‘‘fraud on the market’’ theory. Under this theory, each investor need not prove his or her individual reliance on the fraudulent statement.5 Appellate courts in just four States have recognized the ‘‘fraud on the market’’ theory in securities ac- 13 6 Richard H. Walker, ‘‘The New Securities Class Action: Federal Obstacles, State Detours,’’ 39 Ariz. L. Rev. 641, 678 & n.272 (Summer 1997). 7 Id. at 678. 8 Mirkin v. Wasserman, 858 P.2d 568, 580 (Cal. 1993). 9 Testimony of U.S. Securities and Exchange Commission before the Subcommittee on Securi- ties, October 29, 1997, at 12. 10 ‘‘IPO Market Shows its Muscle for a Second-Straight Year,’’ Wall Street Journal, January 2, 1998. 11 ‘‘An Overview of the Capital Markets and Securities Industry in 1997,’’ Securities Industry Association, January 23, 1998, at 4. 12 Marilyn Johnson, Ron Kasznik and Karen K. Nelson, ‘‘The Impact of Securities Litigation Reform on the Disclosure of Forward-Looking Information by High Technology Firms, January 5, 1998. tions.6 The General Counsel of the SEC has suggested ‘‘eliminating the requirement of reliance makes possible a class action for securi- ties suits.’’ 7 Securities fraud class actions therefore may not be pos- sible in the great majority of States. California is one of the few States that recognizes the ‘‘fraud on the market’’ theory.8 Not sur- prisingly, the great majority of securities fraud class actions filed in State court are filed in California. According to the SEC, roughly 60% of State securities class actions brought since enactment of the 1995 Act were brought in California.9 While we do not believe that any one State should set a ‘‘pro-plaintiff’’ national standard for se- curities fraud, we also do not believe that Congress need second- guess the judgments of California at balancing the interests of its local businesses versus those of its local investors. If California law makes it too easy to sue California businesses, then the California legislature should change the law. The record volume of securities offerings is further evidence that investors feel they are receiving adequate information on which to base investment decisions. The $39 billion raised by initial public offerings in 1997 is a record second only to the nearly $50 billion raised in 1996.10 Total underwriting of corporate equities and bonds in 1997 hit a record $1.3 trillion.11 Market capitalization and trading volume on the national securities exchanges are also at record highs. By every measure, the nation’s securities markets re- main preeminent in the world. Whatever the cost of securities liti- gation, at either the Federal or State level, it does not interfere with the functioning of America’s securities markets. Unable to demonstrate a need for this legislation, supporters of preemption next argue that the mere threat of State litigation is a problem. In particular, they argue that the threat of State litiga- tion is deterring companies from making the kind of ‘‘forward-look- ing statements’’ that would be protected from Federal litigation under the ‘‘safe harbor’’ contained in the 1995 Act. We were con- cerned that the safe harbor went too far and might very well pro- tect fraudulent statements from liability. Regardless of one’s views of the safe harbor, the evidence is that companies are in fact using it. A study of 547 high-tech firms by Professors at the University of Michigan and Stanford Business Schools found ‘‘a significant in- crease in both the frequency of firms issuing forecasts and the number of forecasts issued following enactment of the Reform Act.’’ 12 Proponents of preemption also cite the possibility that State ac- tions may be used to circumvent the stay on discovery pending a motion to dismiss that was enacted by the Litigation Reform Act. We agree that State court filings should not be used by plaintiffs 14 13 See, e.g., Milano v. Auhll, No. SB 213 476 (Cal. Super. Court, Santa Barbara County, Oct. 2, 1996; Sperber v. Bixby, No. 699812 (Cal. Super. Court, San Diego County, Oct. 25, 1996) to ‘‘game the system,’’ to enjoy the best of both the State and Fed- eral securities laws. Discovery is an extensive, expensive propo- sition and should not be used to drive up the settlement value of weak cases. In fact, some State courts have voluntarily imposed stays on discovery in circumstances where the Federal courts would do so.13 There is certainly no need to preempt State law causes of action generally in order to effectuate the discovery stay provisions of the Act. A range of experts has concluded that the need for this legisla- tion has not been demonstrated. SEC Commissioner Norman John- son wrote on March 24, 1998: Consistent with the opinion the Commission and its staff have repeatedly taken, I believe there has been inadequate time to determine the overall effects of the Private Securi- ties Litigation Reform Act of 1995, and that the pro- ponents of further litigation reform have not demonstrated the need for preemption of state remedies or causes of ac- tion at this time. Perhaps the most telling debunking of the myth of an explosion in State court actions was provided by Boris Feldman, a partner in the Silicon Valley defendants’ firm Wilson, Sonsini, Goodrich & Rosati. In a report on ‘‘Securities Litigation—Recent Develop- ments’’ posted on his firm’s Internet site, Mr. Feldman stated: In my opinion, plaintiffs’ state court gambit has been a failure and is over. Others may disagree. I base that con- clusion on three factors. First, plaintiffs’ attempts to broaden dramatically state laws that have been on the books for years have not worked. Courts have consistently rejected plaintiffs’ attempts to apply to shareholder dis- putes statutes that impose lower burdens, or greater pen- alties, than do the securities laws. Second, I believe that plaintiffs have come to realize that they will not be permitted to use courts in a particular state (i.e., California) to litigate the claims of shareholders around the country * * * Finally, plaintiffs have not had much success milking the state cases for discovery that they can then use to file a federal complaint. III. SHORTCOMINGS OF THE LITIGATION REFORM ACT The Uniform Standards Bill would preempt State law securities actions in favor of the provisions of the Litigation Reform Act. As we considered the provisions of the Litigation Reform Act insuffi- ciently protective of investors to be an appropriate Federal securi- ties antifraud standard, we cannot support establishing that Act as the sole, ‘‘uniform’’ standard for nationally traded securities. At this juncture, it is necessary briefly to review the shortcomings of the Litigation Reform Act. 15 14 December 6, 1995 Letter to President Clinton. 15 November 15, 1995 Letter to President Clinton. 16 May 23, 1995 Letter to Senate Banking Committee Members from American Council on Education, California Labor Federation—AFL–CIO, Congress of California Seniors—LA County, Consumer Federation of America, Consumers for Civil Justice, International Brotherhood of Teamsters, Government Finance Officers Association, Gray Panthers, National League of Cities, New York State Council of Senior Citizens, North American Securities Administrators Associa- tion, and U.S. PIRG; May 24, 1995 Letter to Members from Citizen Action, Consumer Federa- tion of America, Consumers Union, Public Citizen, U.S. PIRG, and Violence Policy Center. Safe harbor protects fraudulent statements The Litigation Reform Act created a ‘‘safe harbor’’ for forward looking statements, immunizing them from antifraud liability. For- ward looking statements are broadly defined under the Act to in- clude projections of financial items such as revenues, income and dividends as well as statements of future economic performance. Forward looking statements are thus precisely the sort of informa- tion of most interest to investors deciding whether to purchase or sell securities. Given this broad definition, it is crucial that such statements not be immunized when made with fraudulent intent. To do so is to provide fraud artists with an incentive to tailor their frauds to fit the statutory safe harbor and thereby defraud inves- tors with impunity. Prominent legal scholars have warned that the Litigation Reform Act’s safe harbor did precisely that. A body of expert opinion sug- gests that the language of the safe harbor indeed protects delib- erate falsehoods. Professor John Coffee of Columbia Law School wrote, ‘‘even if a knowingly false statement is made, the defendant escapes liability if meaningful cautionary statements are added to the forward-looking statement.’’ 14 (emphasis added) The Associa- tion of the Bar of the City of New York stated the safe harbor ‘‘could immunize artfully packaged and intentional misstatements and omissions of known facts.’’ 15 (emphasis added) To date, no Federal circuit court has had an opportunity to ad- dress the Litigation Reform Act’s safe harbor. The danger that the statutory language immunizes deliberate fraud remains strong. Proportionate liability penalizes innocent investors The Litigation Reform Act eliminated the rule of ‘‘joint and sev- eral’’ liability that has been applied in fraud cases for hundreds of years and that had been applied in Federal securities fraud cases. The Act substituted a system of ‘‘proportionate liability,’’ which transferred responsibility for bearing the results of a fraud from participants in the fraud to innocent victims of the fraud. This change was opposed and continues to be opposed by a host of con- sumer groups, labor unions, and government officials.16 Under joint and several liability, each person who participates in a fraud is liable for the entire amount of the victim’s damages. Mark Griffin, Securities Commissioner for the State of Utah, testi- fied before the Securities Subcommittee on March 22, 1995 on be- half of the 50 State securities commissioners. He explained why the law held all parties who participate in a securities fraud jointly and severally liable: ‘‘Under current law, each defendant who conspires to commit a violation of the securities law is jointly and sev- erally liable for all the damages resulting from the viola- 16 tion. The underlying rationale of this concept is that a fraud will fail if one of the participants reveals its exist- ence and, as a result, all wrongdoers are held equally cul- pable if the fraud achieves its aims.’’ (emphasis in original) In practice, defendants bear the burden of proving their relative fault. Through a contribution action, a defendant in a securities fraud action can seek reimbursement from another party that he believes to be more at fault. The Litigation Reform Act transferred this burden to investors. The Act limited joint and several liability under the Federal securi- ties laws to persons who commit ‘‘knowing securities fraud.’’ All other violators generally are liable only for their proportionate share of the fraud victim’s losses. ‘‘Knowing securities fraud’’ is de- fined in the Act specifically to exclude reckless conduct. The Litiga- tion Reform Act thus reduced the liability for reckless violators from joint and several liability to proportionate liability. When investors’ damages can be paid by a violator who is jointly and severally liable, this change will not affect the recovery avail- able to investors. In many cases, though, the architect of the fraud is bankrupt, has fled, or otherwise cannot pay the investors’ dam- ages. In those cases, this change will harm investors: innocent vic- tims of fraud will be denied full recovery of their damages. In a February 23, 1995 letter to House Commerce Committee Chairman Thomas J. Bliley, Jr., Chairman Levitt wrote, ‘‘[t]he Commission has consistently opposed proportionate liability.’’ Testifying before the Securities Subcommittee on April 6, 1995, Chairman Levitt said ‘‘Proportionate liability would inevitably have the great- est effect on investors in the most serious cases (e.g., where an issuer becomes bankrupt after a fraud is ex- posed).’’ The Litigation Reform Act thus transferred responsibility for bearing the results of a fraud from participants in the fraud to in- nocent victims of the fraud. It provided that those who commit fraud are no longer responsible for the results of their conduct. In- stead, innocent investors must bear the losses if a portion of their damages are uncollectible. In so doing, the Litigation Reform Act seriously undermined the effectiveness of the Federal securities laws as a remedy for defrauded investors. No extension of statute of limitations We were concerned about the provisions of the Litigation Reform Act described above, which harm investors bringing meritorious fraud suits. We were also disappointed that the Act did not contain provisions necessary to aid investors bringing meritorious suits. The first omission was the Act’s failure to extend the statute of limitations for private rights of action under Section 10(b) of the Securities Exchange Act of 1934, the principal antifraud provision of the Federal securities laws. In Lampf v. Gilbertson, 501 U.S. 350 (1991), the Supreme Court significantly shortened the period of time in which investors may bring such securities fraud actions. By a five to four vote, the Court held that the applicable statute of limitations is one year after the 17 17 Testimony of the U.S. Securities and Exchange Commission before the Subcommittee on Se- curities, October 29, 1997, at 20. 18 Senate Banking Committee Hearing, March 25, 1998, Transcript at 30. 19 See, e.g., IIT v. Cornfeld, 619 f.2d 909, 992 (2nd Cir. 1980). plaintiff knew of the violation and in no event more than three years after the violation occurred. This is shorter than the statute of limitations for private securities actions under the law of 33 of the 50 States.17 Testifying before the Banking Committee in 1991, SEC Chair- man Richard Breeden stated ‘‘the timeframes set forth in the [Su- preme] Court’s decision is unrealistically short and will do undue damage to the ability of private litigants to sue.’’ Chairman Breeden pointed out that in many cases, ‘‘events only come to light years after the original dis- tribution of securities and the Lampf cases could well mean that by the time investors discover they have a case, they are already barred from the courthouse.’’ The FDIC and the State securities regulators joined the SEC in 1991 in favor of overturning the Lampf decision. Chairman Levitt testified before the Securities Subcommittee in April 1995, ‘‘[e]xtending the statute of limitations is warranted because many securities frauds are inherently complex, and the law should not reward the perpetrator of a fraud who successfully conceals its ex- istence for more than three years.’’ Chairman Levitt reaffirmed his support for a longer statute of limitations before the Committee as recently as March 25, 1998.18 This shorter period does not allow individual investors adequate time to discover and pursue violations of securities laws. Ignoring these recommendations, the Litigation Reform Act left intact the shorter statute of limitations adopted by Lampf. No restoration of aiding and abetting A final major shortcoming of the Litigation Reform Act was its failure to restore liability in private actions under the Federal secu- rities laws for aiders and abettors of securities fraud. Prior to 1994, courts in every circuit in the country had recognized the ability of investors to sue aiders and abettors of securities frauds. The courts derived aiding and abetting liability from traditional principles of common law and criminal law. To be held liable, most courts re- quired that an investor show that a securities fraud was commit- ted, that the aider and abettor gave substantial assistance to the fraud, and that the aider and abettor had the intent to deceive or behaved recklessly.19 In Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), again by a five to four vote, the Supreme Court eliminated the right of investors to sue aiders and abettors of secu- rities fraud. Testifying at a May 12, 1994 Securities Subcommittee hearing, Chairman Levitt stressed the importance of restoring aid- ing and abetting liability for private investors: ‘‘persons who knowingly or recklessly assist the per- petration of a fraud may be insulated from liability to pri- vate parties if they act behind the scenes and do not them- selves make statements, directly or indirectly, that are re- 18 20 Senate Banking Committee Hearing, March 25, 1998, Transcript at 30. 21 See Testimony of the U.S. Securities and Exchange Commission before the Senate Securi- ties Subcommittee, October 29, 1997, at 13. 22 See, e.g., ‘‘In re Silicon Graphics, Inc. Securities Litigation,’’ C 96-0393, 1997 WL 337580 (N.D. Cal. June 5, 1997). 23 Hoffman v. Comshare, Inc., No. 97–2098 (6th Cir.); Zeid v. Kimberly, No. 97–16070 (9th Cir.). lied upon by investors. Because this is conduct that should be deterred, Congress should enact legislation to restore aiding and abetting liability in private actions.’’ The North American Securities Administrators Association and the Association of the Bar of the City of New York also endorsed res- toration of aiding and abetting liability in private actions. Chair- man Levitt recently testified that he continues to support restora- tion of aiding and abetting liability.20 The Litigation Reform Act ignored the recommendation of the SEC, the State securities regulators and the bar association that aiding and abetting liability be restored for private litigants. The deterrent effect of the Federal securities laws thus remains weak- ened. Pleading standard may have eliminated liability for reckless con- duct In addition to the concerns we identified at the time the Litiga- tion Reform Act was passed, another concern has developed since its enactment: a number of Federal District Courts have inter- preted the pleading standards enacted by the Act as eliminating li- ability for reckless conduct under the Federal securities antifraud provision. No Circuit Court has yet ruled on the issue and the ma- jority of District Courts have ruled that the Act did not eliminate recklessness as a state of mind sufficient to satisfy the require- ments for fraud. If, however, the view of the minority of District Courts should prevail, the effectiveness of the Federal securities laws as a deterrent to and remedy for fraud will be compromised. The Litigation Reform Act enacted a strict pleading standards for Federal securities fraud suits. Following a standard applied by the U.S. Court of Appeals for the Second Circuit, the Act requires a complaint to ‘‘state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.’’ Federal District Courts have disagreed on how to interpret this provision, based primarily on different readings of the Act’s legislative history. According to the SEC, 14 District Courts have interpreted this provision to allow plaintiffs to plead facts giving rise to a strong inference that the defendants acted either know- ingly or recklessly, or that the defendants had a motive and oppor- tunity to commit the fraud.21 However, a minority of District Courts have held that the Act eliminated recklessness as conduct sufficient to constitute fraud.22 This issue is currently pending in the Courts of Appeal for the Sixth and Ninth Circuits.23 The Securities and Exchange Commis- sion has filed an amicus brief in the Ninth Circuit case, urging the view that the Litigation Reform Act did not eliminate recklessness as the standard for antifraud liability. The Commission warned the Securities Subcommittee that elimination of liability for reckless conduct ‘‘would jeopardize the integrity of the securities markets, 19 24 Testimony of the U.S. Securities and Exchange Commission before the Senate Securities Subcommittee, October 29, 1997, at 13. and would deal a crippling blow to defrauded investors with meri- torious claims.’’ 24 The Litigation Reform Act has thus unintention- ally placed the effectiveness of the Federal securities laws at risk. IV. FLAWS OF THE UNIFORM STANDARDS BILL We oppose the Uniform Standards Bill firstly because of the shortcomings of the Litigation Reform Act described above. The Uniform Standards Bill would preempt securities fraud class ac- tions brought under State law. Investors seeking to file class action lawsuits would be forced to file under the Federal securities laws. They would have to endure the objectionable provisions we have cited: the safe harbor and proportionate liability provisions enacted by the Litigation Reform Act and the shorter statute of limitations and the elimination of aiding and abetting liability left intact by the Litigation Reform Act. Because these provisions prevent inves- tors from bringing meritorious securities fraud class actions, we cannot support the preemption of all State law provisions without which investors might have no remedies at all. But the Uniform Standards Bill contains shortcomings of its own, apart from those already present in the Federal securities laws. These include a definition of ‘‘class action’’ that is overly broad; an unfair application of the statute of limitations; and a failure to cod- ify liability for reckless conduct. Definition of class action is too broad Although narrowed by the Substitute Amendment adopted by the Committee, the Bill’s definition of ‘‘class action’’ is still too broad. It may include State court actions brought by separate individual investors, or by groups of public investors such as school districts or local governments. They risk being dragged into Federal court against their will, potentially depriving them of more favorable State statutes of limitations, pleading standards, joint and several liability, and so on. The term ‘‘class action’’ is commonly understood to refer to cases brought by one plaintiff on behalf of all other unnamed plaintiffs similarly situated. Under Rule 23 of the Federal Rules of Civil Pro- cedure, common questions of law and fact must predominate before a judge can certify a case as a class action. This is the type of case about which the proponents of the legislation complain: a case brought by an attorney with just one actual investor as lead plain- tiff, in order to force a company to pay a large settlement. The Bill, however, contains a definition of ‘‘class action’’ broad enough to pick up individual investors against their will. The Bill would amend Section 16 of the Securities Act of 1933 and 28 of the Securities Exchange Act of 1934 to define class action. New Sec- tions 16(f)(1)(A)(ii) and 28(f)(5)(A)(ii) include as a class action any group of lawsuits in which damages are sought on behalf of more than 50 persons, if those lawsuits are pending in the same court, involve common questions of law or fact, and have been consoli- dated as a single action for any purpose. Even if the lawsuits are brought by separate lawyers, without coordination, and common 20 25 Testimony of Harry Smith, Mayor, City of Greenwood, Mississippi, on behalf of the National League of Cities before the Senate Securities Subcommittee, October 29, 1997, at 3. questions do not predominate, they may qualify as a class action and thus be preempted. So, if an individual investor chooses to bring his own lawsuit in State court, to bear the expenses of litiga- tion himself in order to avoid the provisions of the Litigation Re- form Act, he can be forced into Federal court and made to abide by the Federal rules if 50 other investors each make the same deci- sion. Indeed, the Bill provides an incentive for defendants to collude with parties to ensure that the preemption threshold is reached. Such a result does not merely end abuses associated with class action lawsuits, it deprives individual investors of their rem- edies. The definition of ‘‘class action’’ in the Bill would preempt other types of lawsuits as well. New Sections 16(f)(1)(A)(i)(I) and 28(f)(5)(A)(i)(I) include as a class action any lawsuit in which dam- ages are sought on behalf of more than 50 persons and common questions of law or fact predominate. The Bill specifies that the predomination inquiry be made ‘‘without reference to issues of indi- vidualized reliance on an alleged misstatement or omission * * *’’ This ensures that investors receive the worst of both worlds. While the investors could not bring a class action under State law be- cause each investor must prove his or her reliance, they nonethe- less constitute a ‘‘class action’’ under the Bill and their suit is pre- empted. Suits brought by local government investors, such as cities or school districts, are likely to be preempted under this provision. For example, Mayor Harry Smith of Greenwood, Mississippi testi- fied last October, ‘‘[i]n August, we learned that at least 22 cities and 12 counties might have been misled with regard to a series of investments.’’ 25 Should 16 more cities and counties be found to have been victimized, these Mississippi local governments could not bring a suit under Mississippi law. There is no reason for such a suit to be shut out of State court. Such suits are not the vague, open-ended class actions about which the supporters of the Bill complain. Whatever the merits of preempting those cases, individ- ual investors who forego filing such class actions should retain the right to bring a case in either Federal or State court. Application of statute of limitations is unfair The overly broad definition of ‘‘class action’’ leads directly to an- other of the bill’s flaws. The Federal statute of limitations, which the SEC considers unduly short, will now apply in an unfair man- ner to State cases as well. Cases that were timely filed under State statutes of limitations may now be removed to Federal court and dismissed under the shorter Federal statute of limitations. As described above, actions brought by individual investors in State court could constitute a ‘‘group’’ and be removable to Federal court. Similarly, an action brought by more than 50 identified in- vestors, such as school districts or municipalities, could fall within the definition. The bill provides that in such instances the suits may be removed to Federal court. Once there, no action based upon State statutory or common law may be maintained. The investors 21 26 Letter from Chairman Levitt and Commissioners Hunt and Unger to Senators D’Amato, Gramm and Dodd, March 24, 1998. 27 Senate Banking Committee Hearing, March 25, 1998, Transcript at 34. must be able to maintain a suit under Federal law, including the Federal statute of limitations. Since most States have a statute of limitations longer than the Federal time period, it is likely that most investors will have to satisfy a shorter statute of limitations. In other words, investors who filed timely lawsuits under State law may find their lawsuits dismissed for failure to meet a shorter time requirement that they could not have known would be applied to them. Such a result goes far beyond discouraging frivolous suits. It can deprive defrauded investors of any opportunity to seek a rem- edy. Failure to codify liability for recklessness A final shortcoming of this Bill is its failure to codify liability under the Federal antifraud provisions for reckless conduct. Liabil- ity for reckless conduct is crucial to ensure that professionals such as accountants and underwriters perform the responsibilities as- signed to them by the Federal securities laws. The SEC has stated, ‘‘a uniform standard for securities fraud class actions that did not permit investors to recover losses attributable to reckless mis- conduct would jeapordize the integrity of the securities markets.’’ 26 (emphasis added) As described above, a minority of Federal district courts have in- terpreted the Litigation Reform Act and its legislative history as eliminating such liability. We recognize and support the statements made in the Committee Report that Congress did not and does not intend to eliminate such liability. We hope these statements are sufficient to preserve recklessness as the substantive standard for liability under the Federal antifraud provisions. While such legislative history is helpful, however, is not a sub- stitute for legislative language. Federal courts do not uniformly consider legislative history when deciding questions of statutory in- terpretation. Even those courts that do may not consider legislative history prepared in a succeeding Congress when interpreting a statute enacted in a preceding Congress. Chairman Levitt testified that he would prefer legislative language that explicitly codified li- ability for reckless conduct.27 Nonetheless, the Uniform Standards Bill fails to include such language. The Bill therefore would pre- empt State class actions in favor of a uniform Federal standard po- tentially containing a disastrous flaw, namely no imposition of li- ability for reckless conduct. V. CONCLUSION Requiring true class actions regarding securities traded on na- tional exchanges to conform to an appropriate uniform standard is not without some intellectual appeal. But this bill fails on both counts. First, it would reach beyond true class actions to rob inves- tors of their opportunity to bring individual actions in State court. Second, it would impose the current Federal standard as the uni- form standard without rectifying its shortcomings. The SEC testified before the Securities Subcommittee on October 29, 1997 that ‘‘the bill would deprive investors of important protec- 22 28 Testimony of U.S. Securities and Exchange Commission before the Senate Securities Sub- committee, October 29, 1997, at 20. 29 Id. at 19. tions, such as aiding-and-abetting liability and longer statutes of limitations, that are only available under state law.’’ This concern remains valid. Thirty-three of 50 States provide longer statutes of limitations for securities fraud actions than do the Federal securi- ties.28 Forty-nine of 50 States provide liability for aiders and abet- ters of such fraud.29 In too many instances, these provisions would no longer be available under the Uniform Standards Bill, leaving investors without remedies. For these reasons, State and local government officials, unions, senior citizens, academics, consumer groups and others oppose the Uniform Standards Bill. The New York State Bar Association con- cluded in January 1998, ‘‘the proposed solution far exceeds any ap- propriate level of remedy for the perceived problem.’’ We urge the Senate carefully to consider the Bill’s impact on individual inves- tors before approving it in its current form. PAUL S. SARBANES. RICHARD H. BRYAN. TIM JOHNSON. (23) 1 15 U.S.C. § 77(l). 2 See Testimony of Securities and Exchange Commission, Hearings on Securities Litigation Uniform Standards Act. Subcommittee on Securities, United States Senate Committee on Bank- Continued ADDITIONAL VIEWS OF SENATOR JACK REED S. 1260 SECURITIES LITIGATION UNIFORM STANDARDS ACT INTRODUCTION As a supporter of the Private Securities Litigation Reform Act of 1995 (hereafter ‘‘PSLRA’’ or ‘‘1995 Act’’) , I am pleased to support S.1260, the Securities Litigation Uniform Standards Act of 1998 (hereafter ‘‘1998 Act’’). This legislation will create a uniform stand- ard for securities class action lawsuits against corporations listed on the three largest national exchanges. While class action suits are frequently the only financially feasible means for small inves- tors to recover damages, such lawsuits have also been subject to abuse, draining resources from corporations while inadequately representing the interests of investor plaintiffs. In 1995, I voted for the PSLRA in order to curtail this abusive litigation. At that time it was obvious that some class action suits were being filed after a precipitous drop in the value of a corpora- tion’s stock, without citing specific evidence of fraud. Such lawsuits frequently inflict substantial legal costs upon corporations, harm- ing both the business and its shareholders. Unfortunately, since passage of federal litigation procedures protecting corporations from such suits there has been some attempt by class action plain- tiffs to circumvent these safeguards by filing similar lawsuits in state courts. The 1998 Act will preempt this circumvention, creating a na- tional standard for class action suits involving nationally traded se- curities. I favor this legislation because it recognizes the national nature of our securities markets, provides for more efficient capital formation, and protects investors. NEW RESPONSIBILITIES OF CONGRESS Preemption marks a significant change concerning the obliga- tions of Congress. When federal legislation was enacted to combat securities fraud (the Securities Act of 1933 and the Securities Ex- change Act (SEA) of 1934, which included section 10(b), the anti- fraud provision upon which private actions are now based 1), the federal law augmented existing state statutes. States were still free to provide greater protections to their citizens from fraud. Indeed, in 1995, the Chairman of the Securities and Exchange Commission provided testimony concerning the multifaceted system by which securities were regulated: through both public and private lawsuits in both state and federal courts.2 Many of my colleagues voted for 24 ing, Housing and Urban Affairs, October 29, 1997. (‘‘* * * the benefits of our dual system of federal and state law, which has served investors well for over 60 years.) 3 See Testimony of Professor Richard W. Painter, Hearings on Securities Litigation Uniform Standards Act. Subcommittee on Securities, United States Senate Committee on Banking, Hous- ing and Urban Affairs, February 23, 1998, citing colloquy of Representative Christopher Cox with Professor Daniel Fischel, Hearings Concerning the Common Sense Legal Reform Act. Sub- committee on Telecommunications and Finance, House Committee on Commerce, January 19, 1995, at 110 (Mr. Cox. ‘‘So if you were a plaintiff, who like any plaintiff has a choice of forum, and if you were one of the investors who were defrauded in Orange County, for example, you might file your suit in State court or in Federal Court, depending on how you saw your advan- tage * * * ’’ Mr. Fischel. ‘‘Yes, you would still have the same choice of forums.’). 4 See Time Warner, Inc. v. Ross, 9 F3d 259, 268-69 (2d Cir. 1993). 5 A plaintiff can plead scienter, without direct knowledge of the plaintiff’s state of mind, in two ways: ‘‘The first approach is to allege facts establishing a motive to commit fraud and an opportunity to do so. The second approach is to allege facts constituting circumstantial evidence of either reckless or conscious behavior.’’ Id. 6 See attached list of recent judicial adjudications of this standard, prepared at my request, by the staff of the Securities and Exchange Commission. The analysis indicates that of the thir- ty-two (32) federal district courts which have ruled on the issue, eighteen (18) have correctly upheld the previous Second Circuit Standard, whereas fourteen (14) have not. the 1995 legislation knowing that if federal standards failed to pro- vide adequate investor protections, state suits would provide a nec- essary backup.3 With passage of this legislation, my colleagues and I have now accepted full and sole responsibility for securities traded on the three national exchanges to ensure that standards concerning fraud allow victimized, small investors to recoup lost funds through class action suits. A meaningful right of action against those that defraud guarantees the average investor confidence in our national markets. A uniform national standard concerning fraud provides no benefit to markets if issuers having listed securities can, with im- punity, fail to ensure that consumers receive truthful, complete in- formation on which to base investment decisions. My support for this legislation rests on the presumption that the scienter standard was not altered by either the 1995 Act or this legislation. I strongly endorse the Report which accompanies this legislation, which states clearly that nothing in the 1995 legislation changed the scienter standard 4 or the previous case law, estab- lished by the Second Circuit, concerning the means to successfully plead that state of mind.5 The reason such standards were not changed in 1995 is that they are essential to providing adequate investor protection from fraud. I have been deeply troubled by the ruling of several federal dis- trict courts 6 which, ignoring the clear legislative history of the 1995 Act, have invalidated the proper pleading standard for a 10b– 5 action. With regard to 10(b) class action lawsuits, the PSLRA mandated stiffer pleading requirements concerning the defenddant(s)’s state of mind. See 15 U.S.C. §§ 77z–1, 78u–4. The PSLRA requires plaintiffs to plead specific facts ‘‘giving rise to a strong inference’’ hat the defendants acted with the required state of mind. See 15 U.S.C. § 78u–4(b)(2). In contrast, some circuits al- lowed scienter to be averred generally prior to adoption of the PSLRA. (See In re Glenfed, Inc., 42 F.3d 1541, 1545–47 (9th Cir. 1994). However, the PSLRA’s heightened standard was specifically linked to the most stringent pleading standard at the time, that of the Second Circuit. See The Conference Committee Report (Report), 141 Cong. Rec. H13702 (daily ed. Nov. 28, 1995). 25 7 See Testimony of Securities and Exchange Commission, Hearings on Securities Litigation Uniform Standards Act. Subcommittee on Securities, United States Senate Committee on Bank- ing, Housing and Urban Affairs, October 29, 1997. (‘‘The Commission strongly believe that reck- lessness must be preserved as the standard for liability because it is essential to investor protec- tion.) PRE-1995 STANDARDS In Ernst & Ernst v. Hochfelder, the Court held that to establish liability under Section 10(b) and Rule 10b–5, a plaintiff must ‘‘es- tablish scienter on the part of a defendant.’’ 425 U.S. 185, 193 & n. 12 (1976). While in Hochfelder the Court failed to address whether recklessness satisfied the scienter requirement, subse- quent decisions by virtually all the courts of appeals held that reck- lessness did meet the scienter requirement. Time Warner, supra. Sundstrand v. Sun Chemical Corp., 553 F.2d 1033, 1045 (7th Cir. 1977) (defining reckless conduct as ‘‘a highly unreasonable omis- sion, involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is ei- ther known to the defendant or is so obvious that the actor must have been aware of it.’’) (No Circuit Court has held otherwise.) With regard to the standards necessary to establish scienter in a pleading, the Second Circuit developed the most stringent re- quirement. That court required plaintiffs to allege in the complaint ‘‘facts that give rise to a strong inference of fraudulent intent.’’ Shields v. Citytrust Bancorp. Inc., 25 F.3d 1124, 1128 (2d Cir. 1994). Such a ‘‘strong inference’’ could be established in two ways: by ‘‘alleging facts to show that defendants had both the motive and opportunity to commit fraud, or by alleging facts that constitute strong circumstantial evidence of conscious misbehavior or reck- lessness.’’ Id. See also Beck v. Manufacturers Hanover Trust Com- pany, 820 F.2d 46 at (2d Cir. 1987), and Ross v. A.H. Robins Co., 607 F.2d 545 (2nd Cir. 1979). THE NEED TO PRESERVE THE RECKLESSNESS STANDARD The court’s reason for allowing a plaintiff to establish scienter through a pleading of motive and opportunity or recklessness is clear: ‘‘a plaintiff realistically cannot be expected to plead a defend- ant’s actual state of mind.’’ Cohen v. Koenig, 25 F.3d 1168, 1173 (2d Cir. 1994) (quoting Connecticut Nat’l. Bank v. Fluor Corp., 808 F.2d 957, 962 (2d Cir. 1987) (quoting Goldman v. Belden, 754 F.2d 1059, 1070 (2d Cir. 1985)). Since the 1995 Act allows for a stay of discovery pending a defendant’s motion to dismiss, requiring a plaintiff to establish actual knowledge of fraud or an intent to de- fraud in a complaint raises the bar far higher than most legiti- mately defrauded investors can meet. The SEC has been clear on this point 7 and it has been well recognized by the supporters of both the 1995 and 1998 Acts that neither changed the preexisting scienter standard. Indeed, proponents of the 1995 Act were clear that the bill included recklessness. William H. Kuehnle, Comment, ‘‘On Scienter, Knowledge, and Recklessness Under the Federal Se- curities’’ Laws, 34 House. L. Rev. 121, n. 93, citing 141 Cong. Rec. S17934 (daily ed. Dec. 5, 1995) (statement of Senator D’Amato) (‘‘The legislation creates a uniform standard for complaints that al- lege securities fraud. This standard is already the law in New 26 8 See Amicus Curiae brief of American Institute of Certified Public Accountants in the matter of Zeid v. Kimberely, (9th Cir. 1998)(No. 97–16070). 9 Four years after Hochfelder, in Aaron v. SEC, the Court, held that the SEC must meet the same scienter standards as private litigants, since the 1933 and 1934 Acts contained no distinc- tions in the standards of proof that either private or public litigants must meet. 446 U.S. 680 at 701 (1980). York.’’). Even after passage of the Conference Report of the 1995 Act and the President’s veto and message were complete, pro- ponents of the legislation described the bill as retaining reckless- ness. See, e.g., 141 Cong. Rec. S19150 (daily ed. Dec. 22, 1995) (statement of Senator Domenici) (‘‘[I]t is the Second Circuit’s plead- ing standard.’’); 141 Cong. Rec. S19067 (Dec. 21, 1995) (statement of Sen. Dodd) (‘‘[P]leading standard is faithful to the Second Cir- cuit’s test.’’); and 141 Cong. Rec. H15219 (daily ed. Dec. 20, 1995) (statement of Rep. Lofgren) (‘‘The President says he supports the Second Circuit standard for pleading * * *. That is * * * included in this bill.’’) Thus, the legislative history well establishes that the 1995 Act retained the standards, as established by the Second Circuit Court of Appeals, associated with pleading and establishing scienter in a 10(b) action. Not only are the standards clear, but it is clear that a weakening of such standards threatens the security of investors and the stability of our markets. The views of the Majority, as outlined in this Report, make clear that interpretations which eviscerate a plaintiff’s ability to plead motive and opportunity or recklessness, as defined by the Second Circuit prior to the 1995 Act, are both incorrect and a threat to the security of our markets. Such standards are under attack by both those who both misinterpret the standards of the 1995 Act and those who argue that recklessness fails to satisfy the scienter standard as established in the 1933 and 1934 Acts.8 This later in- terpretation is particulary dangerous in that it could eliminate li- ability for recklessness in both private actions as well as regulatory enforcement actions by the SEC.9 CONCLUSION With assurances of the Chair and sponsors of S. 1260 that proper protections for investors will remain in place, I supported the 1998 Act, thus moving toward an efficient, national, uniform standard for securities class action lawsuits. I trust that higher courts will adhere to current principles of legislative history and case law to rule that the pleading and scienter standards continue to protect investors. Additionally, as expressed in votes during the mark-up of this legislation, I am concerned that the definition of class ac- tion, as currently included in the bill, is too broad. Specifically, by defining a class as those whose claims have been consolidated by a state court judge, the bill infringes upon the rights of individual investors to bring suit; a situation sponsors have sought to avoid. I hope that this issue can be resolved before the bill reaches the Senate floor. Finally, I have appreciated the expert analysis that the Chairman, Commissioners, and staff of the Securities and Ex- change Commission have provided on this issue. I thank them for their assistance. JACK REED. 27 OFFICE OF THE GENERAL COUNSEL, U.S. SECURITIES AND EXCHANGE COMMISSION, Washington, DC, April 20, 1998. TED LONG, Legislative Counsel, Offices of Senator Jack Reed, Hart Senate Office Building, Washington, DC. DEAR MR. LONG: The attached responds to your request for staff technical assistance with respect to S. 1260, the ‘‘Securities Litiga- tion Uniform Standards Act of 1997.’’ This technical assistance is the work of the staff of the Securities and Exchange Commission; the Securities and Exchange Commission itself expresses no views on this assistance. I hope the attached is responsive to your request. Sincerely, RICHARD H. WALKER, General Counsel. Attachment. PLEADING STANDARD SCORECARD I. CASES APPLYING THE SECOND CIRCUIT PLEADING STANDARD 1. City of Painesville v. First Montauk Financial Corp., 1998 WL 59358 (N.D. Ohio Feb. 8, 1998). 2. Epstein v. Itron, Inc., No. CS–97–214 (RHW), 1998 WL 54944 (E.D. Wash. Jan. 22, 1998). 3. In re Wellcare Mgmt. Group, Inc. Sec. Lit., 964 F. Supp. 632 (N.D.N.Y. 1997). 4. In re FAC Realty Sec. Lit., 1997 WL 810511 (E.D.N.C. Nov. 5, 1997). 5. Page v. Derrickson, No. 96–842–CIV–T–17C, 1997 U.S. Dist. LEXIS 3673 (M.D. Fla. Mar. 25, 1997). 6. Weikel v. Tower Semiconductor Ltd., No. 96–3711 (D.N.J. Oct. 2, 1997). 7. Gilford Ptnrs. L.P. v. Sensormatic Elec. Corp., 1997 WL 757495 (N.D. Ill. Nov. 24, 1997). 8. Galaxy Inv. Fund, Ltd. v. Fenchurch Capital Management, Ltd., 1997 U.S. Dist. LEXIS 13207 (N.D. Ill. Aug. 29, 1997). 9. Pilarczyk v. Morrison Knudsen Corp., 965 F. Supp. 311, 320 (N.D.N.Y. 1997). 10. OnBank & Trust Co. v. FDIC, 967 F. Supp. 81, 88 & n.4 (W.D.N.Y. 1997). 11. Fugman v. Aprogenex, Inc., 961 F. Supp. 1190, 1195 (N.D. Ill. 1997). 12. Shahzad v. H.J. Meyers & Co., Inc., No. 95 Civ. 6196 (DAB), 1997 U.S. Dist. LEXIS 1128 (S.D.N.Y. Feb. 6, 1997). 13. Rehm v. Eagle Fin. Corp., 954 F. Supp. 1246, 1252 (N.D. Ill. 1997). 14. In re Health Management Inc., 970 F. Supp. 192, 201 (E.D.N.Y. 1997). 15. Marksman Partners, L.P. v. Chantal Pharmaceutical Corp., 927 F. Supp. 1297, 1309–10, 1309 n.9 (C.D. Cal. 1996). 16. Fischler v. AmSouth Bancorporation, 1996 U.S. Dist. LEXIS 17670 (M.D. Fla. Nov. 14, 1996). 28 17. STI Classic Fund v. Bollinger Industries, Inc., No. CA 3:96– CV–0823–R, 1996 WL 866699 (N.D. Tex. Nov. 12, 1996). 18. Zeid v. Kimberley, 930 F. Supp. 431 (N.D. Cal. 1996). II. CASES APPLYING A STRICTER PLEADING STANDARD THAN THE SECOND CIRCUIT A. Cases holding that motive and opportunity and recklessness do not meet pleading standard 1. Mark v. Fleming Cos., Inc., No. CIV–96–0506–M (W.D. Okla. Mar. 27, 1998). 2. In re Silicon Graphics Sec. Lit., 970 F. Supp. 746 (N.D. Cal. 1997). 3. In re Comshare, Inc. Sec. Litig., Case No. 96–73711–DT, 1997 U.S. Dist. LEXIS 17262 (E.D. Mich. Sept. 18, 1997). 4. Voit v. Wonderware Corp., No. 96–CV. 7883, 1997 U.S. Dist. LEXIS 13856 (E.D. Pa. Sept. 8, 1997). 5. Powers v. Eichen, NO. 96–1431–B (AJB), 1997 U.S. Dist. LEXIS 11074 (S.D. Cal. Mar. 13, 1997). 6. Norwood Venture Corp. v. Converse Inc., 959 F. Supp. 205, 208 (S.D.N.Y. 1997). 7. Friedberg v. Discreet Logic, Inc., 959 F. Supp. 42, 48–49 (D. Mass. 1997). 8. In re Glenayre Technologies, Inc., 1997 WL 691425 (S.D.N.Y. Nov. 5, 1997). 9. Havenick v. Network Express, Inc., 1997 WL 626539 (E.D. Mich. Sep. 30, 1997). 10. Chan v. Orthologic Corp., et al., No. CIV–96–1514–PHX–RCB (D. Ariz. Feb. 5, 1998) (dicta). B. Cases holding only that motive and opportunity do not meet Re- form Act’s pleading standard 1. Novak v. Kasaks, No. 96 Civ. 3073 (AGS), 1998 WL 107033 (S.D.N.Y. Mar. 10, 1998). 2. Myles v. MidCom Communications, Inc., No. C96–614D (W.D. Wash. Nov. 19, 1996). 3. In re Baesa Securities Litig., 969 F. Supp. 238 (S.D.N.Y. 1997). 4. Press v. Quick & Reilly Group, Inc., No. 96 Civ. 4278 (RPP), 1997 U.S. Dist. LEXIS 11609, at *5 (S.D.N.Y. Aug. 8, 1997). III. EXAMPLES OF CASES WITH LANGUAGE QUESTIONING RECKLESS- NESS AS A BASIS OF LIABILITY (ALL CASES PREVIOUSLY LISTED ABOVE) 1. In re Silicon Graphics Sec. Lit., 970 F. Supp. 746 (N.D. Cal. 1997). 2. Friedberg v. Discreet Logic, Inc., 959 F. Supp. 42, 49 n.2 (D. Mass. 1997). 3. Norwood Venture Corp. v. Converse Inc., 959 F. Supp. 205, 208 (S.D.N.Y. 1997). Æ