Joseph A. Grundfest is the William A. Franke Professor of Law and Business and Crocker Faculty Scholar at Stanford Law School. He joined Stanford's faculty in 1990 after having served for more than four years as a Commissioner of the United States Securities and Exchange Commission. While at the SEC, Professor Grundfest dealt extensively with matters related to the enforcement of the federal securities laws, regulation of novel financial instruments, takeovers, corporate governance, market volatility, and internationalization of U.S. capital markets.

Professor Grundfest's scholarship in the areas of corporate law, securities regulation, and litigation has been published in the Harvard, Yale, and Stanford Law Reviews. Professor Grundfest is listed as one of the 100 most influential attorneys in the United States by the National Law Journal. He is principal investigator for Stanford Law School's Securities Class Action Clearinghouse which has been nominated by the Smithsonian Institution for the 1997 Computerworld-Smithsonian Award as one of the five most important applications of information technology to society by an educational institution in 1997. Professor Grundfest's work on Internet-related matters also includes posting of the first hypertext Supreme Court brief and the first preliminary registration statement for a major issuer, Yahoo! Inc.

Prior to joining the SEC, Professor Grundfest served as counsel and senior economist for legal and regulatory matters at the President's Council of Economic Advisors. An attorney and economist, Professor Grundfest has also practiced law with Wilmer, Cutler & Pickering, and has served as an economist with the Brookings Institution and the Rand Corporation.

Professor Grundfest holds a bachelor's degree in economics from Yale University (1973) and completed the M.Sc. program in mathematical economics and econometrics at the London School of Economics (1972). His law degree is from Stanford (1978), where he also completed all requirements for a doctorate in economics, but for the dissertation (1978).

Professor Grundfest directs the Roberts Program in Law, Business and Corporate Governance at Stanford Law School which presents Director's College as an annual executive education program. He has served on the New York Stock Exchange's Legal Advisory Board, on a rules committee of the United States District Court for the Northern District of California, and has been elected to membership of the American Law Institute. Professor Grundfest received the John Bingham Hurlbut Award for Excellence in Teaching as well as the Associated Students of Stanford University award as the best professor at the Stanford Law, Business, and Medical Schools. Professor Grundfest was selected as a National Fellow by the Hoover Institution, was awarded a John M. Olin Faculty Fellowship, and is an Adjunct Scholar of the American Enterprise Institute. Professor Grundfest is admitted to practice in California and in the District of Columbia.

Current as of 07/23/97

Michael A. Perino is a Lecturer and Co-Director of the Roberts Program in Law, Business, and Corporate Governance at Stanford Law School. Mr. Perino's primary areas of scholarly interest are securities regulation and litigation, civil procedure, class actions, and complex litigation. Prior to coming to Stanford, Mr. Perino received his LL.M. degree from Columbia Law School, where he was valedictorian, a James Kent Scholar, and the recipient of the Walter Gellhorn Prize for outstanding proficiency in legal studies. Mr. Perino was also formerly associated with the New York law firm of Cadwalader, Wickersham & Taft, where he handled primarily securities actions and other complex federal litigation. He is a member of the New York bar.

Mr. Perino has written numerous articles on securities fraud and class action litigation, including: (1) Securities Litigation Reform: The First Year's Experience (A Statistical and Legal Analysis of Securities Fraud Litigation Under the Private Securities Litigation Reform Act), Working Paper No. 140, John M. Olin Program in Law and Economics Working Paper Series, Stanford Law School (Feb. 1997) (with Joseph A. Grundfest); (2) Class Action Chaos? The Theory of the Core and an Analysis of Opt Out Rights in Mass Tort Class Actions, 46 Emory L.J. ___ (forthcoming 1997); (3) The Pentium Papers: A Case Study of Institutional Investor Activism in Litigation, 38 Arizona L. Rev. 559 (1996) (with Joseph A. Grundfest); and (4) A Strong Inference of Fraud? An Early Interpretation of the 1995 Private Securities Litigation Reform Act, 1 Securities Reform Act Litigation Reporter 397 (1996).

Mr. Perino is also one of the principal developers of Stanford Law School's Securities Class Action Clearinghouse which has been nominated by the Smithsonian Institution for the 1997 Computerworld-Smithsonian Award as one of the five most important applications of information technology created by an educational institution in 1997.

Introduction

Mr. Chairman and members of the Subcommittee, we are honored by the invitation to appear before you today and to participate in these hearings. These hearings are, we understand, intended to explore the effects of the Private Securities Litigation Reform Act of 1995 (the "Reform Act" or "Act"),¹ and the potential need for further federal legislation establishing uniform federal standards governing private securities fraud litigation.

The Reform Act is now roughly nineteen months old. Like most toddlers of comparable age, there is much we know about its origins, evolution, and character, but there is also much we do not know. Indeed, at this relatively early stage of the statute's development, uncertainties regarding its future application and interpretation dominate the horizon. It is therefore important to approach the issues pending before the Committee with an appropriate sense of humility and respect for the unknown.

To aid the Subcommittee in its inquiry and to help emphasize the uncertainties in our current state of knowledge, we have organized our testimony in three parts. Part I discusses ten important things that we can measure and describe about the operation of class action litigation in the wake of the Reform Act. Part II describes ten important things we do not currently know about the Reform Act, including matters that will take several more years of litigation to resolve. Part III addresses the question of uniform federal standards and concludes that, notwithstanding uncertainties regarding the future effects of the Reform Act, the time is ripe for Congress to consider and to adopt suitably crafted uniform federal standards governing private securities fraud litigation affecting securities traded on national markets.

Much of the information reported in this testimony exists only because of the substantial efforts of a hardworking team at Stanford Law School who have built the first Designated Internet Site for the posting of litigation materials on the World Wide Web. This site, which can be viewed at http://securities.stanford.edu, was nominated by the Smithsonian Institution as one of the five best applications of information technology by an educational institution in 1997. As of July 22, 1997, the site lists 202 companies that have been sued in federal securities class actions governed by the Reform Act, together with the full text of more than 100 complaints, as well as myriad briefs, decisions, opinions, and orders relating to securities fraud class action litigation in federal and state court. The site has recently been described as the on-line "mecca" for information on securities class action lawsuits.²

The innovative efforts of the judges of the United State District Court for the Northern District of California who adopted Local Rule 23-3 also deserve special mention.³ Rule 23-3 is the first rule of court that requires Internet posting of specified class action litigation documents. This Rule imposes exceedingly low costs on litigants, dramatically enhances the transparency of the litigation process, and substantially adds to the public's ability to understand and monitor class action litigation. All of these consequences are consistent with Congress' stated desire to enhance public scrutiny and awareness of securities fraud class action activity.⁴ We hope that this Committee will expand the scope of its inquiry to consider the substantial benefits that information technology can bring to bear on the securities fraud class action litigation process, as well as other areas of the law.

I. Ten Things We Know About the Reform Act

There has been intense interest in the effects of the Reform Act on securities class actions. We are aware of three empirical studies that examine securities fraud class action filings subsequent to the Reform Act, including a study we co-authored.⁵ We continue to update our data as new cases are filed and as litigation progresses, and we caution that all empirical analyses of the Reform Act are subject to revision as we gain additional experience with the Reform Act and its provisions. Accordingly, we emphasize that the data discussed below speak only as to the time periods specified and that analysis of more recent experience could lead to materially different conclusions.

1. The total volume of litigation is little changed in the post-Reform Act period.

As detailed more fully in the separate written testimony of Michael A. Perino,⁶ passage of the Reform Act does not appear to be correlated with an unusual decline in the overall volume of securities litigation relative to the rate of litigation observed from 1991 through 1995. While it is too early in the life history of the Act to draw any reliable conclusions about long-term effects on filing rates, analysis of litigation activity through June 30, 1997, reveals that the overall number of companies sued in securities class actions appears to be roughly equivalent to the number sued prior to the Reform Act. In 1996, 150 issuers were sued.⁷ Absent certain one-time effects that depressed the volume of litigation filed in the first quarter of that year, we have estimated that 163 issuers would have been sued.⁸ Data collected in the first six months of 1997 suggests an annualized total of 194 issuers sued in 1997.⁹

How do these figure compare to the years immediately preceding passage of the Act? On average, in the last five years prior to the Reform Act litigation was being filed at a rate of approximately 176 defendant issuers per year in federal court, although the number of issuers sued varied from a low of 153 to a high of 220.¹⁰ Thus, post-Reform Act litigation rates are well within the range observed prior to the Reform Act.

2. State court class action securities fraud litigation against publicly-traded issuers has become a material factor in the litigation process since passage of the Act. These cases were rare prior to the Act's passage.

The relative stability of the aggregate litigation rate masks a significant shift of activity from federal to state court. In the first eighteen months after the Reform Act, a total of ninety-two issuers were sued in state court proceedings.¹¹ As detailed in Mr. Perino's separate testimony, there has been some decline in state court filings in 1997, but overall approximately ninety-two of 238 post-Reform Act litigations (38.6%) involve at least some state component. There is widespread agreement that these figures represent a substantial increase in state court litigation.¹² Two phenomena seem to explain the bulk of this shift. First, there appears to be a "substitution effect" whereby plaintiffs' counsel file state court complaints when the underlying facts appear not to be sufficient to satisfy new, more stringent federal pleading requirements, or otherwise seek to avoid the substantive or procedural provisions of the Act. Second, plaintiffs appear to be resorting to increased parallel state and federal litigation in an effort to avoid federal discovery stays or to establish alternative state court venues for the settlement of federal claims.¹³

In addition to this increase in state class action activity, Figure 1 suggests that there has been a significant shift in the kinds of defendants appearing in state litigation. Prior to the Reform Act, most state cases (approximately 89%) alleging fraudulent activity in connection with the purchase or sale of securities involved non-publicly-traded securities.¹⁴ By contrast, the vast majority of state court class actions filed since the Reform Act (81.5%) involve securities that trade on national markets.¹⁵ These cases typically involve allegations that the price of the company's securities was inflated due to misrepresentations or omissions affecting transactions on national markets, precisely the kinds of claims that were most often filed in federal court prior to the Act. In 1997, these actions continue to be filed in state court, despite overall declines in state filings. The sudden increase in the appearance of these cases in state court strongly supports the inference that the shift in forum selection was driven by the passage of the Reform Act.

3. Plaintiffs are alleging accounting fraud and trading by insiders more frequently than before the Act's effective date.

Along with the shift to state court, one of the most significant effects associated with passage of the Reform Act are the changes in the style of litigation that has evolved in response to the Reform Act's requirements

In particular, there has been a significant increase in the number of federal complaints alleging trading by insiders during the period when the fraud was allegedly alive in the market and a significant increase in the number of cases alleging misrepresentations or omissions in financial statements as the basis for liability. Approximately 59% of a sample of post-Reform Act federal complaints allege a misrepresentation or omission in financial statements.¹⁶ Allegations of misstated financials account for 67.4% of Section 10(b) complaints involving publicly-traded companies.¹⁷ In sharp contrast, similar allegations are found in only 34% of pre-Reform Act cases.¹⁸ Allegations of trading by insiders now appear in about 57% of post-Reform Act cases, whereas these allegations are found in only 21% of pre-Reform Act cases. Alleged trading by insiders is particularly important in cases against high technology companies, appearing in 73% of those cases, but that statistic must be interpreted with caution because of the prevalence of option-based compensation in the high technology sector.

The rise in these kinds of allegations is consistent with the theory that plaintiffs are increasingly attempting to rely on such allegations to satisfy the Reform Act's strong inference pleading requirement.¹⁹ The relatively small number of cases that allege false forward-looking information as the sole basis for liability (only 6.5% of cases involving publicly-traded companies) also suggests that the new pleading standards are affecting which actions plaintiffs are choosing to file in federal court because these actions are much less likely to satisfy the heightened pleading standard.²⁰

4. Companies tend to be sued after larger stock price declines.

A significant stock price decline over a short period of time may be a necessary but insufficient condition leading to class action securities fraud litigation. Prior to the Reform Act, the average stock price decline preceding the filing of a Section 10(b) claim was about 19%.²¹ During 1996, the average decline in these cases jumped to 31%.²²

This increase in one-day stock price declines observed around the end of the class period is consistent with the theory that plaintiffs must, on average, demonstrate more dramatic wrongdoing in the post-Reform Act environment in order to satisfy the new federal pleading standard. Further statistical analysis is necessary to support this conjecture. For example, it would be valuable to know whether the average stock price decline associated with 1997 federal litigation and post-Reform Act state filings that have no parallel federal claims are systematically smaller than those associated with 1996 federal claims.

5. Technology companies continue to be disproportionately frequent targets of litigation.

High technology companies were among the most vocal proponents of securities litigation reform,²³ in large part because experience prior to the Reform Act indicated that high-technology companies were involved in a disproportionately large number of securities fraud class action cases. The Reform Act has done little to change the percentage of defendants sued in securities fraud class actions in 1996 that are high technology issuers. High technology companies represent 34% of all issuers sued in federal court in that time period.²⁴ That statistic is not materially different from the pre-Reform Act experience.²⁵

6. In 1996, larger companies were being sued less frequently than before passage of the Reform Act.

The average company sued in a federal securities fraud class action in 1996 had a market capitalization of $529.3 million.²⁶ Prior to the Reform Act, the average market capitalization was $2,080 million.²⁷ This decline appears to be attributable almost exclusively to a reduction in litigation naming issuers with market capitalization in excess of $5.0 billion. Prior to the Reform Act, these large corporations represented about 8.4% of federal court activity, but very few of these companies appear to have been sued in 1996.²⁸

This new pattern in defendant selection is consistent with our observation that the preponderance of post-Reform Act litigation involves allegations of accounting irregularities and trading by insiders.²⁹ Larger, more established firms are less likely sources for material accounting irregularities or statistically significant trading by insiders. Larger firms are therefore less likely to be named as defendants. In addition, in 1996 the stock market experienced a substantial increase in value, with much of the market's strength centered on the most well-capitalized issuers. That price pattern is also consistent with a shift toward litigation targeting smaller issuers.³⁰

7. Since passage of the Reform Act the "race to the courthouse" has slowed.

The empirical evidence collected to date suggests that the "race to the courthouse," which was one of Congress' primary concerns in passing the Reform Act, had slowed somewhat.³¹ Even though some issuers are still sued within days of significant stock price drops, these typically involve more dramatic instances of alleged fraud.³² Overall, however, the average time between the end of the class period and the filing of the first complaint has risen from forty-nine days to seventy-nine days.³³ This change appears to be driven largely by two provisions of the Reform Act. First, the creation of the lead plaintiff provision has reduced plaintiffs' attorneys' incentives to be the first to file a class action complaint against an issuer. Second, the Act's heightened pleading requirement may require plaintiffs to engage in more extensive investigation and more careful drafting prior to filing a complaint.

8. Institutional investors are only rarely stepping forward to become lead plaintiffs. They are often vigorously attacked by traditional plaintiffs' counsel when they do so.

Congress created the lead plaintiff provision and early class notification process to curb the race to the courthouse, to lessen the use of so-called "professional plaintiffs," and to lessen the influence of plaintiffs' attorneys on the prosecution of class actions. These provisions were designed to encourage greater institutional investor participation in class action litigation by giving the lead plaintiff the power to control the course of the action, including the selection of lead counsel.³⁴

So far, institutions have not expressed a great willingness to serve as lead plaintiffs. Only a handful of major institutions have stepped forward in post-Reform Act class actions.³⁵ In those cases, the institutions have faced significant opposition from the traditional plaintiffs' bar, who typically allege that the institution is unsuitable to serve as lead plaintiff because their sophistication makes them atypical of the class as a whole or because they are susceptible to unique defenses.³⁶ The traditional plaintiffs' bar has also vigorously attacked institutional investors' choices of counsel when those institutions have not selected members of the traditional plaintiffs' bar.³⁷ Despite this opposition, courts have generally been willing to appoint institutions that volunteer to be lead plaintiff and have approved the institutions' choice of counsel.³⁸

9. Cases are taking longer to litigate and involve more pretrial motions practice.

Empirical evidence suggests that prior to the Reform Act the median time between filing and settlement in securities class actions was 21.7 months.³⁹ It is too early to determine whether the Reform Act will effect this statistic; however, early evidence suggests that pre-trial proceedings in post-Reform Act cases are taking longer. The increasing length of pre-trial procedures is a necessary consequence of the procedural reforms the Act contains. The early notification procedures, the lead plaintiff provision, and the discovery stay pending resolution of any motion to dismiss have all tended to build significant delays into pre-trial practice. Moreover, some courts appear to be moving quite deliberately in interpreting the Act's novel provisions, especially the new heightened pleading standard. That tendency has also slowed down prosecution of these cases.

10. The Milberg Weiss firm has become more dominant as plaintiffs' class action counsel since passage of the Reform Act.

It was generally understood that prior to passage of the Reform Act a single law firm, Milberg Weiss Bershad Hynes & Lerach ("Milberg Weiss"), played a dominant role as plaintiffs' class action counsel. Milberg Weiss' appearance ratio nationwide stood at approximately 31% prior to the Reform Act.⁴⁰

Since passage of the Reform Act, Milberg Weiss appears to have become even more dominant in the class action securities process. Aggregating parallel federal and state activity, Milberg Weiss' appearance ratio in 1996 stood at about 59% nationwide and 83% in California.⁴¹ Milberg Weiss' increased significance can be explained by the fact that: (1) it is likely the best capitalized plaintiffs' firm and therefore best able to finance the delays associated with slower procedures under the Reform Act; (2) it has the most diversified portfolio of plaintiffs' claims and is therefore better able to absorb the risk associated with litigation under the new regime; and (3) it is best situated to internalize the externalities associated with the need to invest to create new precedent interpreting the Reform Act's novel provisions.

II. Ten Things We Don't Know About the Reform Act

While there is much that we know about the Reform Act, our knowledge is typically constrained to factors related to the early phases of the litigation. Even there, however, we observe significant splits among federal district courts that have been called upon to interpret key Reform Act provisions. The practical implications of these splits at the lower court level are difficult to predict and will probably take several years of litigation to resolve at the appellate level. Accordingly, it is safe to conclude that the uncertainties regarding the future evolution of the Reform Act dominate our current knowledge of the Reform Act's effects.

1. How will the courts interpret the Act's requirement that complaints "state with particularity all facts" on which an allegation of fraud is based?

Section 21(D)(b)(1) of the Reform Act provides that:

the complaint shall specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed. (emphasis supplied)

A major question raised by this provision relates to the vigor with which courts will interpret the statutory language calling for an articulation of all facts upon which a plaintiffs' information or belief underlying a complaint is based. For example, the court in In re Silicon Graphics, Inc. Securities Litig., Fed. Sec. L. Rep. ¶99,468 (CCH), 1997 WL 285057 (N.D. Cal. May 23, 1997), held that plaintiffs' allegations in a 73-page amended complaint were too generic and that in order to provide sufficiently detailed information about alleged negative internal reports the allegations "should include the titles of the reports, when they were prepared, who prepared them, to whom they were directed, their content, and the sources from which plaintiffs obtained this information." Id. at 97,133.

The court also observed that the degree of specificity required by the Reform Act was the subject of specific debate in Congress, and quoted the statement of Rep. Dingell who expressed concern on the record that, under the legislation as drafted, names of confidential informants, employees, competitors, and others who provided information leading to the filing of the case would be required to be disclosed. Id. at 97,130-97,131. The court found that Congress had enacted precisely the language as to which Rep. Dingell had complained, and that plaintiffs must plead the sort of information described by Rep. Dingell to meet the requirements of the Reform Act.⁴² Id. at 97,131. Plaintiffs did not meet this burden and the complaint was dismissed.

The only other case of which we are aware that has interpreted this provision of the Reform Act is Zeid v. Kimberley, a class action involving Firefox Communications, Inc.⁴³ In Zeid, the court held that when a complaint is based on "investigation of counsel" rather than "information and belief" plaintiffs are not required to state with particularity all facts upon which their beliefs are formed. In such circumstances, however, the court held that plaintiffs must meet the other strict pleading requirements of the Reform Act. Specifically, the court held that "Plaintiffs cannot rely on conclusory allegations or tenuous inferences but instead, must allege with particularity: (1) each statement, (2) why each statements is false, and (3) as to each statement, facts giving rise to a strong inference that Defendants acted with scienter."⁴⁴ The court found that plaintiffs' 104-page complaint failed to satisfy this standard and it was dismissed with prejudice.

If other courts follow either the Silicon Graphics or Zeid holdings, we would expect to see an increase in the percentage of defendants that prevail on motions to dismiss and a decline in the volume of federal complaints filed. At present, Silicon Graphics and Zeid are on appeal to the Ninth Circuit and we have no information as to whether these decisions will be upheld or modified or whether they will be followed by other district courts or courts of appeal. The interpretation of the "all facts" pleading requirement is, we believe, a major uncertainty regarding the evolution of the Reform Act.

2. How will the courts interpret the Reform Act's "strong inference" pleadings standard? Will they adopt the Second Circuit standard or move to a stricter standard?

Under the Reform Act, plaintiffs are now required to "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind."⁴⁵ The interpretation of this standard has been the subject of considerable disagreement among district courts. The debate focuses on whether the Reform Act simply adopts the Second Circuit standard, or goes further. Several courts have held that the Reform Act adopted the Second Circuit pleading standard,⁴⁶ while other courts have found that the Reform Act standard goes beyond the Second Circuit standard.⁴⁷ No Court of Appeals has directly addressed this issue. Accordingly, we are uncertain if, in the long run, courts will adopt the Second Circuit standard or move to a stricter standard such as that employed by the Silicon Graphics court.

Again, we expect that the resolution of this uncertainty will materially affect the future evolution of federal securities fraud litigation. The higher the standard courts set, the more difficult it becomes for plaintiffs to withstand motions to dismiss and the lower the volume of anticipated litigation in the federal courts.

3. Will the forward-looking safe harbor successfully elicit more forward-looking information?

Under the safe harbor provisions of the Reform Act,⁴⁸ a company may not be held liable under the federal securities laws for projections and other forward-looking statements, either written or oral, that later prove to be inaccurate if:

(A) the forward-looking statement is identified as a forward-looking statement, and is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement; or (ii) the statement is immaterial; or

(B) the plaintiff fails to prove that the forward-looking statement was made with actual knowledge by that the statement was false or misleading.

There are two prongs to the safe harbor under the Reform Act. The first prong applies to statements that are identified as forward-looking, but are accompanied by "meaningful cautionary statements." We know of no decisions interpreting what constitutes a "meaningful cautionary statement."⁴⁹

The second prong provides that no liability shall attach to any forward-looking statement unless the statement was made with actual knowledge of falsity or that it was misleading. The court in Silicon Graphics found that the standard of pleading scienter to establish liability for a forward-looking statement is the same standard to be applied to establish scienter for a false or misleading statement. Id. at 95,963.

Even with the safe harbor provisions of the Reform Act, companies may be avoiding disseminating forward-looking information because of uncertainty regarding judicial interpretation of the safe harbor and because of fear regarding state court litigation where, plaintiffs will argue, no such safe harbor is available. Substantially more litigation experience may therefore be necessary in order to determine whether the Reform Act will have its intended effect on the disclosure of forward-looking information.

4. What effect will the Reform Act have on pretrial dismissal rates?

The Reform Act has only been in effect for nineteen months. It is often many months after a complaint is filed before a motion to dismiss is decided by the court, and only a small sample of cases have proceeded to the motion to dismiss stage. Our data suggest that although more than 200 securities fraud class actions have been filed in federal court since the effective date of the Reform Act, only sixteen motions to dismiss (8% of the population) in such cases that have been decided by the courts. Of these, six motions to dismiss were granted,⁵⁰ four were granted with leave for plaintiffs to amend the complaint,⁵¹ and two were granted in part.⁵² Four motions to dismiss have been denied with respect to the company defendant.⁵³

We expect that it will require another year or two of litigation experience in order to draw more reliable conclusions about the effect the Reform Act has had on pretrial dismissal rates. Even then, those estimates may be unstable because of the previously described uncertainties regarding the interpretation of key Reform Act provisions.

5. What effect will the Reform Act have on settlement amounts?

Very few securities class action fraud cases go to trial. The large majority of federal class action securities litigation filed prior to the Reform Act was resolved by settlement. One study reported that 87.6% of the securities class actions filed from April 1988 through September 1996 ended in a settlement.⁵⁴ Another study found that the median time between filing and settlement was 21.7 months.⁵⁵

Because the Reform Act has been in effect for only a year and a half, it is too soon to expect substantial settlement activity to have occurred. We are aware of only a handful of settlements of cases brought under the Reform Act, thus the results from these settlements are not necessarily indicative of future trends. One study which analyzed five settlements in post-Reform Act cases found that the settlements were, on average, over 40% higher than pre-Reform Act settlements.⁵⁶ However, the study cautioned that due to the small sample of cases, the results were not statistically significant. We expect that it will take several years of additional experience before we are able to draw more reliable conclusions as to the effect of the Reform Act on settlement behavior or settlement amounts.

6. How will the Reform Act influence the incentive to litigate class action securities fraud claims?

As noted above, only a very small percentage of securities class action fraud cases have gone to trial and the overwhelming majority that were not dismissed at the pleading stage or on a motion for summary judgment have settled out of court. The provisions of the Reform Act, including higher pleading standards, automatic discovery stays, safe harbor provisions, damage limitations, and elimination of joint and several liability for unknowing violations, could give defendants more incentive to litigate class action claims than under pre-Reform Act standards. It is far too soon, however, to be able to discern any such effect in the data.

7. How will the courts interpret the Reform Act's proportionate liability standards?

Under the Reform Act, defendants who did not knowingly commit a violation are "liable solely for the proportion of the judgment that corresponds to the percentage of the responsibility."⁵⁷ There are no decisions of which we are aware that interpret the proportionate liability provisions of the Reform Act. This is not surprising because these provisions usually are not considered by courts until late in the litigation process, after motions to dismiss and motions for summary judgment are decided. It often takes several years for a securities class action to reach this stage.

One hypothesis is that the new proportionate liability standards may make certain defendants more willing to face a trial on the merits. However, without any decisions interpreting the proportionate liability provisions, it is too early to determine what impact they will have on post-Reform Act litigation.

8. Will state courts ultimately prove to be hospitable environments for the litigation of class action securities fraud claims?

Before 1996, securities fraud class action lawsuits were rarely filed in state court. In 1996, there was a significant increase in state court class action filings as a result of the Reform Act. State court class actions continue to be filed in 1997, although the number of issuers sued solely in state court has decreased approximately 30% from 1996 levels.

At the present time, state case law remains undeveloped and inconsistent. Further, very few cases have been subject to appellate review. The most significant pending state appellate case of which we are aware is Diamond Multimedia Systems v. Superior Court of Santa Clara County, 97 Daily Journal D.A.R. 4021 (Mar. 21, 1997). In that case, the California Supreme Court granted defendants' writ of mandate to review a number of questions, including whether a cause of action under section 25400 of the California Corporations Code is only available to California residents. Section 25400(d), upon which plaintiffs rely in most securities class actions filed in California provides that: "It is unlawful for any person, directly or indirectly, in this state" to make false or misleading statements or make omissions for the purpose of inducing the purchase or sale of any security (emphasis added).⁵⁸ Plaintiffs argue that they should be permitted to certify a national class, including plaintiffs who are not residents of California and who have no other nexus to the jurisdiction. Defendants' counsel argue, among other matters, that California law on its face requires that the transaction take place in California, and that no national class can therefore be certified. No hearing date has yet been set in the case.

The California Supreme Court decision in Diamond Multimedia may have significant implications for the future of state court class action litigation because a high percentage of federal and state class action filings are found in California. Thus, although it is still too early to determine whether state courts will ultimately prove to be hospitable environments for the litigation of class action securities fraud claims on a national scale, we expect that the Diamond Multimedia decision will have a major impact on this issue.

9. Will the duty to audit for fraud created in Title III give rise to material new liability for issuers or auditors?

Title III of the Reform Act created a new duty on the part of auditors to adopt certain procedures in connection with their audits and to inform the Securities and Exchange Commission of illegal acts under specified circumstances. We are aware of only one company, the Cronos Group, where the company's auditors have prepared a report pursuant to the provisions of Section 10A(b)(2) of the Securities Exchange Act of 1934 for filing with the SEC. There, the company's auditor, Arthur Andersen, resigned and stated in a letter to the company's Board of Directors that it was obligated submit a report to the company because the circumstances prohibited them from being able to perform an audit in accordance with generally accepted auditing standards.⁵⁹

Concern exists that Title III may support an expansive interpretation that in the future generates substantial additional exposure for auditors and issuers alike.⁶⁰ It is, however, too soon to tell whether Title III will create such new exposure.

10. Will institutional investors develop strategies for effective monitoring of class action fraud claims, whether through the lead plaintiff provision or otherwise?

As noted above, major institutional investors have employed the lead plaintiff device in a relatively small number of cases, and it is unclear whether more institutions will seek that position. It appears that many institutions are evaluating the outcomes of these early cases before determining whether to become involved as lead plaintiffs. But even if these early cases are successful, there are a number of structural barriers that may prevent significant institutional investor participation as lead plaintiffs. Many institutions may be unwilling to undergo the heightened scrutiny of their investment and trading practices that is likely to accompany an attempt to become lead plaintiff. Simply put, institutions may find that seeking the lead plaintiff position is not cost-effective or they may simply be reluctant, as they have traditionally been, to undertake the increased responsibility and scrutiny that comes with the role.

For these reasons, institutions that seek to become active may be more comfortable with initiatives that have both lower costs and lower visibility.⁶¹ These methods, which include objecting to settlements, writing letters to counsel, and opposing fee requests, have already been used successfully in a number of cases⁶² and may provide a more palatable strategy that is useful in a wider variety of cases.

III. Uniform Standards as a Solution to the State Litigation Problem

It worth emphasizing at the outset that a leading plaintiffs' class action attorney describes the Grundfest-Perino Study as "undoubtedly correct in concluding that there has been an increase in the number of securities fraud class action cases filed in state court."⁶³ The fact of an increase in state court securities fraud litigation activity since passage of the Reform Act thus does not appear to be in material dispute. This increase in state securities fraud class action litigation has given rise to calls for a uniform federal standard that would govern securities fraud litigation affecting national markets.⁶⁴

Two bills currently pending in the House of Representatives, H.R. 1653 (introduced by Representative Campbell)⁶⁵ and H.R. 1689 (introduced by Representatives Eshoo and White), would both achieve that result, although through slightly different means. H.R. 1653 would prohibit any state private civil action alleging either a misrepresentation or omission, or that the defendant used or employed a manipulative or deceptive device or contrivance, in connection with the purchase or sale of a "covered security." The definition of a "covered security" is identical to that contained in the National Securities Markets Improvements Act of 1996, and relates essentially to securities that trade on national markets. H.R. 1689 would preempt similar claims, but only with respect to class actions. H.R. 1689 would also preempt class actions against companies that have issued covered securities, even if the security at issue was not itself a covered security. Finally, H.R. 1689 would permit the removal of any class action involving a covered security to federal court.⁶⁶

Neither bill is intended to limit the scope of any state's authority to bring lawsuits alleging violations of state law, and neither bill is intended to intrude upon the dominant corporate law causes of action that are traditionally the province of the states. Our reading of these bills suggests that neither should give rise to these unintended effects, if enacted.

It would, however, be a relatively straightforward matter to add to either bill a savings provision making it crystal clear that uniform federal class action securities fraud standards do not limit the authority of state agencies to prosecute violations of state securities laws. Such a provision would be wholly consistent with the structure of the Reform Act itself, which is intended to regulate only private litigation and has no effect on the SEC's enforcement authority. It would also be a straightforward matter to add language assuring that uniform securities fraud litigation standards do not intrude on traditional corporate law causes of action.

The objective of each of these bills is, instead, to eliminate the strategic use of state securities fraud litigation as a means to evade key provisions of federal law. Strategic evasion can have a variety of objectives. Plaintiffs could, without limitation, pursue state litigation in order to:

(1) take discovery that would be prohibited by a federal stay;⁶⁷

(2) avoid defenses available pursuant to the federal forward-looking safe harbor;⁶⁸

(3) plead cases where the facts alleged would be insufficient to avoid dismissal in a federal court;⁶⁹

(4) avoid the need for the designation of a lead plaintiff; or ⁷⁰

(5) avoid heightened scrutiny of settlement terms.⁷¹

In defense of the increase in state court litigation, a leading plaintiffs' counsel claims that there are "many good reasons why victims of securities fraud might prefer to attempt to litigate their claims in state court," other than simple evasion of Reform Act provisions.⁷² Counsel observes that "many state courts permit plaintiffs to recover on a 9-to-3 jury vote, as opposed to unanimous verdicts required in the federal system; [that] many state laws permit a recovery upon a showing of negligence, as opposed to recklessness or intentional misconduct, and some states permit recovery without any showing of reliance."⁷³ Counsel also asserts that some states provide substantial procedural advantages for plaintiffs.⁷⁴

These alternative explanations for the increase in state level litigation are implausible for at least two simple reasons. First, even if true, each of these factors supporting state court litigation existed prior to the effective date of the Reform Act. If state court litigation is currently attractive for the stated non-evasive reasons, then state court litigation would have been equally attractive years ago and should have occurred with greater frequency prior to the Act's passage. But it did not. The inescapable conclusion is that the alleged pre-existing benefits of state litigation cannot be the cause of the post-Reform Act increase in state litigation. Second, plaintiffs' own litigation conduct demonstrates an obvious effort to avoid the mandatory discovery stay through state court litigation.⁷⁵ Plaintiffs' actual conduct is therefore inconsistent with the proffered rationalizations for increased state court activity. Accordingly, the most reasonable explanation for the undisputed increase in state court litigation is plaintiffs' desire to evade certain Reform Act provisions.

Because state court litigation is employed as a means to evade key provisions of the Reform Act, it should come as no surprise that the debate over uniform federal securities fraud litigation standards often divides combatants along the same lines observed in the debate over the Reform Act. Pro-plaintiff forces who bemoan passage of the Act oppose uniform standards while pro-defense forces who support the Act's reforms call for uniformity as a necessary adjunct to reform. Viewed from this perspective, the uniformity debate is merely a reprise of the debate over the Reform Act itself.

Our analysis regarding the merits of federal uniformity differs from the approaches urged by both plaintiff and defense camps. Significantly, we take no position on the ultimate wisdom of the reforms introduced by the Act, and we respect the concerns voiced by many of the Act's critics. We believe that the uniformity debate can and should be resolved according to a set of neutral principles that apply whether or not one supports the provisions of the Reform Act, and that the debate over uniformity should not be an occasion to reopen the debate over the merits of the 1995 reforms.

The application of these neutral principles leads us to conclude that:

(1) National markets should, for reasons wholly unrelated to the debate over the merits of the Reform Act, be governed by uniform national standards;

(2) Under the doctrine of implied conflict preemption, many provisions of the federal securities laws - including large portions of the Reform Act - can and should be interpreted as preempting conflicting provisions of state law; and

(3) In order to promote certainty and efficiency in federal and state courts, and in our national securities market, Congress should enact legislation that makes it clear that federal antifraud standards prevail in national markets.

A. National Markets Should be Governed by National Standards.

Our nation is blessed with vast and liquid capital markets that pay no heed to state boundaries. Whether buyers or sellers are located in New York, California, Texas, Connecticut, or Montana matters not a whit to the disclosure rules, price discovery mechanisms, or trading practices that govern transactions in national markets.

If individual states are permitted to assert individual jurisdiction over transactions in national markets, the predictable result is chaos and mayhem. To present just one illustration of the untoward consequences of unconstrained state level litigation, imagine the predicament confronting a large issuer such as IBM in the event of an allegation of fraud in connection with the purchase and sale of its securities.

If state law causes of action are permitted to proceed, IBM could be exposed to litigation in each of the fifty states under fifty different procedural and substantive standards. Many of these regimes would reflect dramatically opposed and irreconcilably different policy judgments regarding the costs and benefits of disclosure and litigation. No reasonable public policy purpose would be served by such a proliferation of litigation.

Even if litigation could be confined to one forum, enormously complicated choice of law questions will arise regarding the application of different states' laws to different members of the class. A court may have to apply as many as fifty different substantive legal standards to members of the class. The resulting confusion and complexity will essentially replicate many of the management problems that pervade mass tort and other kinds of class actions based on state law.⁷⁶ Again, it is difficult to recognize any socially beneficial purpose that would be served.

With different liability standards, enormous time and energy will also be devoted to resolving arcane legal questions, such as determining the particular state where the fraud allegedly took place or whether the particular state court may properly assert personal jurisdiction over the defendant. Moreover, if federal and state actions proceed simultaneously, both the courts and the parties face a significant increase in the time and costs associated with resolving the litigation.⁷⁷

Issues raised by forward-looking statements provide an excellent example of the substantive problems that this balkanization of the federal securities laws will inevitably create. Congress created the Reform Act's safe harbor to alleviate the chilling effect that lawsuits have "on the robustness and candor of disclosure," particularly with respect to the release of valuable forward-looking statements regarding an issuer's prospects.⁷⁸ But if one or more states do not have similar safe harbors, then issuers face potential lawsuits and liability for actions that do not violate federal standards. Under these circumstances, issuers will naturally be reluctant to provide the forward-looking information Congress sought to elicit and the federal standard will fail of its intended purpose because of the existence of inconsistent state law.

Issuers participating in national markets - and the investors who purchase securities in national markets - have an interest in avoiding such litigation nightmares. Issuers and investors alike reasonably require that each transaction in the securities market be subject to a single, coherent, set of regulatory principles with which honest market participants can efficiently comply. It serves no rational purpose to expose honest participants in a uniform national market to conflicting and inconsistent procedural or substantive standards. In the field of securities regulation, these uniform standards are most readily articulated at the federal level.⁷⁹

B. The Reform Act May Already Preempt Many Conflicting Provisions of State Law.

New York's highest court recently explained that three doctrines can support a finding of federal preemption over a state securities regime. First, the doctrine of "express preemption" requires specific language articulating a Congressional intent to preempt. Second, "implied field preemption" may be found when "the Federal legislation is so comprehensive in its scope that it is inferable that Congress wished fully to occupy the field of its subject matter...." Guice v. Charles Schwab & Co., Inc., 89 N.Y.2d 31, 674 N.E.2d 282, 285 (N.Y. 1996), cert. denied, 117 S.Ct. 1250 (1997). [A copy of the Guice decision is annexed hereto as Exhibit A.] Third, "implied conflict preemption may be found when it is impossible for one to act in compliance with both the Federal and State laws, or when 'the state law * * * stan[ds] as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress'."⁸⁰

In Guice, the court held that SEC regulations governing payments for order flow preempted state law because "[p]ermitting the courts of each state to impose civil liability on national securities brokerage firms ... would inevitably defeat the congressional purpose of enabling the SEC to develop and police [a] 'coherent regulatory structure' for a national market system."⁸¹ The application of state law antifraud principles in private litigation would, according to the court, lead to a "chaotic regulatory structure" in which brokerage firms would have to tailor communications with clients to meet fifty different state standards as well as a federal standard.⁸² The court observed further that when state law "through the imposition of common law tort liability or otherwise, adversely affects the ability of a Federal administrative agency to regulate comprehensively and with uniformity ... then the state law may be pre-empted even though 'collision between state and federal regulation may not be an inevitable consequence'."⁸³

The Court found implied conflict preemption notwithstanding the "savings clause" of Section 28(a) of the Exchange Act.⁸⁴ Indeed, the Court explained that "[s]ubstantially similar savings clauses have been interpreted as only negating implied field preemption, but not conflict preemption...."⁸⁵

The logic of the Guice decision has substantial implications for the debate over uniformity and the Reform Act. For example, it is clearly impossible to achieve the objectives Congress intended under the mandatory stay if plaintiffs can evade the stay simply by filing individual or class action complaints in state courts. Similarly, it is impossible for the Reform Act to stimulate greater forward-looking disclosure if issuers continue to be subject to state court liability that is more expansive and pays no heed to the Reform Act's forward-looking safe harbor. Much the same can be said for state court litigation that avoids the need to designate a lead plaintiff, has no proportionate liability standard analogous to the Reform Act's, allows complaints to proceed on the basis of weaker allegations that fail to meet the Act's "strong inference" pleading requirement, and does not impose heightened scrutiny of settlement agreements. State litigation thus "stan[ds] as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress,"⁸⁶ and should be preempted by many of the Reform Act's provisions.

Accordingly, by the logic established in Guice and based on existing precedent regarding implied conflict preemption, there is a strong foundation upon which federal and state courts can and should conclude that several Reform Act provisions preempt conflicting or incompatible state law standards.

C. Congress Should Enact Uniform Federal Antifraud Standards.

Notwithstanding the powerful arguments that can be made in support of implied conflict preemption under existing law, it is clear that litigation over this issue can impose substantial costs on plaintiffs and defendants alike.⁸⁷ It is also clear that there exists a possibility that at least one of the fifty states will conclude that the Reform Act does not preempt state standards in some material respect.⁸⁸ Indeed, plaintiffs need to identify only one state willing to act as a safe harbor for an expansive application of state law in order to wreak significant procedural and substantive confusion, impose substantial cost, and potentially gut large portions of the Reform Act.

Fortunately, Congress can put an end to this burdensome and potentially dangerous litigation by enacting legislation that makes it crystal clear that national markets are subject to uniform national standards. The debate over the most appropriate antifraud standards in national markets could then be addressed to Congress, the deliberative body that is best suited to balance competing national interests in this complex area of law.