3. Plaintiffs are alleging accounting fraud and trading by insiders more frequently in federal actions 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 pleading patterns that have evolved in response to the Act's pleading requirements. In particular, there has been a marked increase in the proportion of federal complaints alleging: (a) misrepresentations or omissions in financial statements; or (b) trading by insiders during the period when the fraud was allegedly alive in the market. Approximately 59% of a sample of post-Reform Act federal complaints allege a misrepresentation or omission in financial statements. Allegations of misstated financials account for 67.4% of Rule 10b-5 complaints involving publicly-traded companies. In sharp contrast, similar allegations are found in only 34% of pre-Reform Act federal cases. Allegations of trading by insiders now appear in about 57% of post-Reform Act federal cases, whereas these allegations are found in only 21% of pre-Reform Act cases.14
The increase in the frequency of these kinds of allegations is consistent with the theory that plaintiffs are increasingly relying on such allegations to satisfy the Act's strong inference pleading requirement.15 To provide additional support for this hypothesis, I have examined a sample of complaints against publicly-traded issuers sued solely in state court where the strong inference standard does not apply.16 Such an analysis is important because if the shift to state court is a substitution effect that is tied to the higher cost of federal litigation in the wake of the Reform Act (here measured in terms of the decreased likelihood of obtaining a settlement or judgment in excess of expected costs), then the cases filed in state court should be those that are expected to be less likely to survive a motion to dismiss or for summary judgment. The significant increase in federal complaints of allegations of material accounting irregularities and insider trading suggest that plaintiffs' attorneys believe these kinds of allegations may be sufficient to satisfy new heightened pleading standards. As a result, if there is a substitution effect, it is reasonable to expect that allegations of accounting irregularities or insider trading should be less frequent in actions filed solely in state court.
Table 5 demonstrates that allegations of misrepresentations or omissions in financial statements appear in only 45.45% of state cases versus 67.4% of federal cases.17 The difference in the frequency of these allegations supports the inference that state court is being used to avoid the federal pleading standard.
4. Companies tend to be sued in federal court after larger stock price declines.
A significant stock price decline over a short period of time may be a necessary but not a sufficient condition leading to class action securities fraud litigation. Prior to the Reform Act, the average stock price decline preceding the filing of a Rule 10b-5 claim was about 19%.18 In a sample of ninety-one post-Reform Act federal cases, the average decline jumped to 28.7%.19
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 support for this hypothesis comes from examining the average stock price declines associated with the sample of post-Reform Act state filings. If factual differences in the complaints and the higher pleading burden in federal court are driving plaintiffs' attorneys' forum choices, then it is reasonable to expect that the mean stock price decline in state court cases will be smaller than in federal cases. Such a result makes sense because a larger stock price decline creates the appearance of more dramatic wrongdoing, making it more likely that the case will survive under the tougher federal pleading standard.
The sample of post-Reform Act state cases shows just such a difference. The average price decline for a sample of issuers sued solely in state court is 19.3%. That figure is about 10% smaller than for companies sued in federal court, and is virtually identical to the pre-Reform Act sample.20 The differences in the mean stock price data suggest that plaintiffs are filing in federal court cases that have larger stock price drops, and which therefore appear to involve more dramatic wrongdoing. It seems reasonable to infer that these decisions are being driven, at least in part, by the new heightened federal pleading standard. The data suggest that cases with smaller stock price drops (i.e., those with less dramatic facts) appear to be filed more frequently in state court proceedings where the strong inference standard does not apply.
5. Technology companies continue to be disproportionately frequent targets of litigation.
High technology companies were among the most vocal proponents of securities litigation reform,21 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 actions. The Reform Act has done little to change the percentage of high technology defendants sued in securities fraud class actions in 1996. High technology companies represent 34% of all issuers sued in federal court in that time period,22 a statistic that is not materially different from the pre-Reform Act experience.23
6. In 1996, larger companies were being sued less frequently than before passage of the Reform Act.
The average company sued in federal securities fraud class actions in 1996 had a market capitalization of $529.3 million. Prior to the Reform Act, the average market capitalization was $2,080 million. This decline appears to be attributable almost exclusively to a reduction in litigation naming issuers with market capitalizations in excess of $5.0 billion. Prior to the Act, these corporations represented about 8.4% of federal court activity, but very few appear to have been sued in 1996.24
This new pattern in defendant selection is consistent with the observation that the preponderance of post-Reform Act federal litigation involves allegations of accounting irregularities and trading by insiders.25 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 growth was centered on the most well-capitalized issuers. That price pattern is also consistent with a shift toward litigation targeting smaller issuers.26
7. Since passage of the Reform Act the "race to the courthouse" has slowed.
Available data suggest that the "race to the courthouse," which was one of Congress' primary concerns in passing the Reform Act, has slowed somewhat.27 Although some issuers are still sued within days of significant stock price drops, these typically involve more dramatic instances of alleged fraud.28 Overall, 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.29 This change appears to be driven largely by two Reform Act provisions. First, 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 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.30 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.31 In those cases, the institutions have faced significant opposition from the traditional plaintiffs' bar, who typically allege that institutions are unsuitable to serve as lead plaintiffs because their sophistication makes them atypical of the class as a whole or because they are susceptible to unique defenses.32 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.33 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.34
9. Cases are taking longer to litigate and involve more pretrial motions practice.
Before passage of the Reform Act the median time between filing and settlement in securities class actions was almost two years.35 It is too early to determine whether the Act will affect this statistic; however, early evidence suggests that pre-trial proceedings are taking longer. The increasing length of pre-trial procedures is a necessary consequence of the Act's procedural reforms. 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, which has also slowed 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 before passage of the Act a single law firm, Milberg Weiss Bershad Hynes & Lerach ("Milberg Weiss"), played a dominant role as plaintiffs' class action counsel. Milberg Weiss' appeared in approximately 31% of securities class actions prior to the Reform Act.36
Since passage of the Act, Milberg Weiss appears to have become an even more dominant presence. Milberg Weiss' appearance ratio in 1996 stood at about 59% nationwide and 83% in California.37 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 Act's novel provisions.
II. Ten Things We Don't Know About the Reform Act
While there is much that we know about the Act, our knowledge is typically limited to the early phases of the litigation. Even there, however, significant splits exist among federal district courts that have interpreted key provisions of the Act. The practical implications of these splits are difficult to predict and will probably take years of appellate litigation to resolve. Accordingly, it is safe to conclude that the uncertainties regarding the future interpretation of the Reform Act dominate our current knowledge of the Act's effects.
1. How will the courts interpret the Reform 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 Act provides that:
It is unclear how courts will interpret the "all facts" pleading requirement. The most extensive discussion of the provision to date was in In re Silicon Graphics, Inc. Securities Litig., 970 F. Supp. 746 (N.D. Cal. 1997), where the court granted a motion to dismiss plaintiffs' 73-page amended complaint. In interpreting the "all facts" pleading requirement, the court observed that the provision was the subject of specific debate in Congress. The court quoted Rep. Dingell who expressed concern that this provision would require disclosure in the complaint of names of confidential informants, employees, competitors, and others who provided information leading to the filing of the case. Id. at 763. The court found that because Congress enacted this provision despite these concerns, plaintiffs were obligated to plead precisely the sort of information Rep. Dingell described to satisfy the Act. Id. at 763-64. Plaintiffs had not met their burden and the complaint was dismissed.38
The only other case of which I am aware that has interpreted this provision is Zeid v. Kimberley, a class action involving Firefox Communications, Inc.39 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."40 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, it is reasonable to 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. Silicon Graphics and Zeid are currently on appeal to the Ninth Circuit. The interpretation of the "all facts" pleading requirement is thus a major uncertainty regarding the evolution of the 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?
The Act requires plaintiffs to "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind."41 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,42 while other courts have found that the Reform Act standard goes beyond the Second Circuit standard.43 No appellate court has directly addressed this issue. Accordingly, it is 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. Resolution of this uncertainty may 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 safe harbor elicit more forward-looking information?
Under the safe harbor provisions of the Reform Act,44 a company may not be held liable under the federal securities laws for certain written or oral projections and other forward-looking statements. There are two prongs to the safe harbor. The first applies to statements that are identified as forward-looking and accompanied by "meaningful cautionary statements." I know of no decisions interpreting what constitutes a "meaningful cautionary statement." The second prong provides that no liability shall attach unless the speaker had actual knowledge of the falsity of the forward-looking statement. In Silicon Graphics, the court found that the strong inference pleading standard applies equally to forward-looking statements.45
Substantially more litigation experience is necessary to determine whether the Reform Act will prompt increased disclosure of forward-looking information. Even with the safe harbor provisions of the Reform Act,44 a company may not be held liable under the federal securities laws for certain written or oral projections and other forward-looking statements. There are two prongs to the safe harbor. The first applies to statements that are identified as forward-looking and accompanied by "meaningful cautionary statements." I know of no decisions interpreting what constitutes a "meaningful cautionary statement." The second prong provides that no liability shall attach unless the speaker had actual knowledge of the falsity of the forward-looking statement. In Silicon Graphics, the court found that the strong inference pleading standard applies equally to forward-looking statements.45
Substantially more litigation experience is necessary to determine whether the Reform Act will prompt increased disclosure of forward-looking information. Even with the safe harbor provisions of the Reform Act, companies may avoid disseminating forward-looking information because of uncertainty regarding judicial interpretation of the safe harbor and because of fear regarding state court litigation.46
4. What effect will the Reform Act have on pretrial dismissal rates?
The Reform Act has only been in effect for twenty-two 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 more than 220 securities fraud class actions have been filed in federal court since the effective date of the Reform Act. According to a leading plaintiffs' attorney, through mid-August 1997, twenty-six motions to dismiss have been decided.47 In sixteen cases the court found that the complaint satisfied the heightened pleading standard,48 while in the remaining ten the complaint was dismissed, either with prejudice49 or with leave to replead.50
It will probably 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. One study reported that 87.6% of the securities class actions filed from April 1988 through September 1996 ended in a settlement.51 The median time between filing and settlement is about two years.52 Because the Act has been in effect for less than two years, it is too soon to expect substantial settlement activity to have occurred. I am aware of only a handful of post-Reform Act settlements, thus the results from these settlements are not necessarily indicative of future trends. One study which analyzed five post-Reform Act settlements found that the settlements were, on average, over 40 percent higher than pre-Reform Act settlements.53 However, that result was not statistically significant. It will likely take several more years before we are able to draw more reliable conclusions as to the effect of the Reform Act on settlement behavior or amounts.
6. How will the Reform Act influence the incentive to litigate class action fraud claims?
As noted above, only a very small percentage of securities class action fraud cases go to trial, and the overwhelming majority that are not dismissed at the pleading stage or on a motion for summary judgment settle out of court. Certain Reform Act provisions, including the higher pleading standard, the automatic discovery stay, the safe harbor, the damage limitation provision, and the proportionate liability standard for non-knowing violations, could give defendants more incentive to litigate rather than settle class action claims. It is far too soon, however, to be able to discern any such effect.
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."54 I am not aware of any decisions that interpret these provisions. 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 is possible, however, that the new proportionate liability standards may make certain defendants more willing to face a trial on the merits. 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?
As previously noted, since the Act there has been a significant increase in state court class action filings. Because state actions were rarely filed before the Act, there has been comparatively little interpretation of state liability provisions, and state case law remains undeveloped and inconsistent. Very few post-Reform Act cases have been subject to appellate review. The most significant pending state appellate case 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 available only 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).55 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.
The effects of a decision in Diamond Multimedia are unclear. One possible result of a ruling that the statute requires a strict territorial nexus is that there will be a decrease in the number of California state court class actions because they may no longer be economically viable. While such a result would not be surprising, plaintiffs may respond much differently. Securities litigation could begin to look more like tobacco litigation and other mass tort cases.56 After federal rulings denying certification of a nationwide class due to differences in state laws applicable to different plaintiffs, attorneys in the tobacco litigation followed a disaggregative strategy in which they filed multiple class actions in different states.57 Plaintiffs could follow a similar strategy in securities litigation. As a result, a finding of a strict territorial nexus in Diamond Multimedia may have the perverse result of increasing the costs associated with litigating securities class actions and causing securities class actions to display many of the problems that beset mass tort class actions. Alternatively, plaintiffs may still find state actions useful: (1) for purposes of obtaining discovery that might be barred pursuant to the Reform Act's stay provision; (2) if they can create sub-classes of investors from different states; (3) if the state action still provides significant settlement advantages; or (4) if they have a large enough class of intrastate investors to make a single state class action cost effective.
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. I am aware of only one case where the company's auditors have prepared a report pursuant to the provisions of Title III. In that case, the Cronos Group's auditor, Arthur Andersen, resigned the engagement and stated in a letter to the company's Board of Directors that it was obligated submit a report to the company because it was unable to perform an audit in accordance with generally accepted auditing standards.58
Concern exists that Title III may support an expansive interpretation that in the future generates substantial additional exposure for auditors and issuers alike.59 It is, however, too soon to tell whether Title III will create such new exposure.
10. Will institutional investors develop strategies for effectively monitoring 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 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. Institutions may find that seeking the lead plaintiff position is not cost-effective or they may simply be reluctant 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.60 These methods, which include objecting to settlements, writing letters to counsel, and opposing fee requests, have been used successfully in a number of cases,61 and may provide a more palatable strategy in a wider variety of cases.
III. Uniform Standards as a Solution to the State Litigation Problem
It is 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."62 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 class action litigation has given rise to calls for a uniform federal standard that would govern securities fraud litigation affecting national markets.
As this Subcommittee is well aware, two bills currently pending in the House of Representatives, H.R. 1653 (introduced by Representative Campbell)63 and H.R. 1689 (introduced by Representatives White and Eshoo), would both achieve that result, although through slightly different means.64 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 similar to that contained in the National Securities Markets Improvements Act of 1996, and applies to securities that are listed or quoted on national exchanges or 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.65
Neither bill is intended to limit the scope of any state's authority to bring lawsuits alleging violations of state law. Nor are they intended to intrude upon the dominant corporate law causes of action that are traditionally the province of the states. 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. 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. As the empirical evidence discussed above noted, strategic evasion can have a variety of objectives. Plaintiffs could, without limitation, pursue state litigation in order to :
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.71 He observes that "[m]any state courts permit plaintiffs to recover on a 9-to-3 jury vote, as opposed to the unanimous verdict[s] 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."72 Others suggest that some states provide substantial procedural advantages for plaintiffs, such as longer statutes of limitations.73
These alternative explanations for the increase in state litigation are implausible for at least three reasons. First, even if true, each of these benefits of 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, data on post-Reform Act state filings do not suggest that these proffered procedural advantages are behind the sudden shift to state court. Take for example the presence of longer limitations periods in state court. In a sample of twenty-two cases filed solely in state court since the Reform Act, the mean and median intervals between the end of the class period and the filing date are eighty-five and forty-two days. These intervals are virtually identical to the observed intervals in federal court filings,74 and well within the federal limitations period. Indeed, all twenty-two cases were brought within the federal period.
Third, the statistically significant differences between state and federal filings support the inference that attempts to evade the federal pleading standard are driving cases to state court. Moreover, 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 Reform Act debate. 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.
My analysis regarding the merits of federal uniformity differs from the approaches urged by both plaintiff and defense camps. Significantly, I take no position on the ultimate wisdom of the reforms introduced by the Act, and I respect the concerns voiced by many of the Act's critics. I 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 Act.
The application of these neutral principles leads me to conclude that:
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. What 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 its intended purpose because of the existence of inconsistent state law.
Limiting the availability of state court litigation may also protect defrauded investors because it may limit the ability of attorneys to take advantage of the Supreme Court's recent decision in Matsushita v. Epstein.79 That decision clarified that state court settlements may resolve Rule 10b-5 claims over which federal courts have exclusive jurisdiction.80 Matsushita creates the potential for what Columbia Law School Professor John C. Coffee, Jr. has dubbed a "reverse auction"81 in which a plaintiffs' attorney who is willing to enter a cheap settlement in exchange for a fee award files a state court action arising out of the same facts and circumstances as a presumably more aggressively litigated federal action. The defendant then has the option of negotiating a cheap global settlement with the "friendly" state court attorney that precludes further litigation of the federal claims.82 If a number of lawyers file separate actions in multiple states, the result could be a round of destructive competition in which each tries to underbid the others. These problems may be exacerbated if attorneys are able to identify courts that are "willing to approve settlements with less than rigorous oversight."83
Issuers participating in national markets and the investors who purchase their securities 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.84
B. The Reform Act May Already Preempt Many Conflicting Provisions of State Law.
New York's highest court recently explained that three doctrines 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). 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'."85
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."86 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.87 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'."88
The Court found implied conflict preemption notwithstanding the "savings clause" of Section 28(a) of the Exchange Act. Indeed, the Court explained that "[s]ubstantially similar savings clauses have been interpreted as only negating implied field preemption, but not conflict preemption...."89
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,"90 and should be preempted by many of the Reform Act's provisions. Accordingly, by the logic established in Guice and based on existing precedents, there is a foundation upon which federal and state courts can conclude that several Reform Act provisions preempt conflicting or incompatible state law standards.
C. Congress Should Enact Uniform Federal Antifraud Standards.
Notwithstanding the 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.91 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.92 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 costs, and potentially gut large portions of the Reform Act.
Fortunately, Congress can put an end to this burdensome 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. At a minimum, uniform federal standards will give the Reform Act's provisions a legitimate chance to either fail or work. It is only then that a truly informed decision can be made as to the merits of those reforms and as to whether additional reforms are needed.
2 Joseph A. Grundfest and Michael A. Perino, Securities Litigation Reform: The First Year's Experience (John M. Olin Program in Law and Economics, Stanford Law School, Working Paper No. 140, Feb. 1997) [hereinafter Grundfest and Perino]; see also U.S. Securities and Exchange Comm. Office of General Counsel, Report to the President and the Congress on the First Year of Practice Under the Private Securities Litigation Reform Act of 1995 (Apr. 1997) [hereinafter the SEC Report]; Denise M. Martin, et al., Recent Trends IV: What Explains Filings and Settlements in Shareholder Class Actions? (National Economic Research Associates, Nov. 1996) [hereinafter NERA Study].
8 Perino, supra note 4, at Table 1. There appears to have been some decline in state court filings in 1997, but overall approximately ninety-four of 238 post-Reform Act litigations (39.5%) have some state component.
9 SCAA is the most readily accessible source of pre-Reform Act filing data and has been relied on in a number of prior securities class actions studies. See, e.g., Willard T. Carleton, et al., Securities Class Action Lawsuits: A Descriptive Study, 38 Ariz. L. Rev. 491 (1996). Data from 1992-94 was chosen to eliminate anticipation of passage of the Reform Act in late 1995 as a confounding variable that may have increased state court filings.
11 See supra Table 1. These data may understate the total volume of state court activity prior to the Act to the extent that SCAA misses some state court filings. The dramatic increase in state filings may also be in part attributable to greater transparency of state court litigation since the Reform Act. These data are thus unlikely to describe the precise volume of litigation at the state level. Nonetheless, the large difference in the observed volume of pre- and post-Reform Act litigation and extensive anecdotal evidence suggest a substantial change in frequency of state filings since passage of the Act. See William S. Lerach, Private Securities Litigation Reform Act of 1995 -- 20 Months Later in Practicing Law Institute, Securities Litigation 1997 24 (1997); Peter Barlas, Local Court Calendars Getting Full with Securities Lawsuits, San Jose & Silicon Valley Bus. J., June 16-22, 1997, at 6; Pamela Sherrid, The General Custer of Shareholder Lawsuits?, U.S. News & World Rept., Apr. 21, 1997, at 66, 67.
12 Source: SCAA (January 1992 - December 1995); Securities Class Action Clearinghouse (January 1996 - June 1997). Data for 1997 are annualized estimates based on filings in the first six months of 1997.
15 Courts have, however, rejected plaintiffs' argument that trading by insiders will, in many circumstances, create the requisite strong inference of scienter. See, e.g., In re Silicon Graphics Securities Litig., 970 F. Supp. 746 (N.D. Cal. 1997).
16 Perino, supra note 4, at 40-41. For purposes of the study, I consider an issuer to have been sued solely in state court if there were no parallel federal actions pending during the study period (January 1, 1996 to June 30, 1997).
17 The hypothesis that cases with this allegation are equally likely in federal and state court can be rejected at the 0.25% confidence level (x2 = 5.238; probability < 0.0025). Insider trading allegations appear in roughly equivalent proportions of the federal and state cases sampled. This result is probably explained by the fact that the percentage of high technology companies in the state sample is higher than in the federal sample (54% versus 40%). A large percentage of federal complaints against high technology companies (73.1%) contain allegations of insider trading, a result that is likely driven by the greater use of option based compensation in the technology sector and the resulting greater baseline level of "normal" insider sales. Because much of the state court activity has occurred in California, where many high technology companies are based, it is unsurprising to see both a higher percentage of high technology companies in the sample and a concomitantly higher percentage of insider trading allegations. Moreover, the fact that the complaint contains insider trading allegations tells us nothing about the quality of those allegations. There may be systematic differences in the amounts, timing, or other characteristics of the alleged trading at issue in the case that these data do not reveal.
19 Perino, supra note 4, at Table 6. The Grundfest-Perino Study reported a mean stock price drop of 30.7% for a smaller sample of fifty-nine companies sued in post-Reform Act federal proceedings in 1996. Grundfest and Perino, supra note 2, at 14.
21 See generally Private Litigation Under the Federal Securities Laws: Hearings Before the Subcomm. on Securities of the Senate Comm. on Banking, Housing, and Urban Affairs, 103d Cong., 1st Sess. (1993).
23 Christopher L. Jones and Seth E. Weingram, Why 10b-5 Litigation Risk Is Higher for Technology and Financial Services Firms 1 (John M. Olin Program in Law and Economics, Stanford Law School Working Paper No. 112, July 1996).
26 Major exceptions to this trend are Sears Roebuck, Westinghouse, and MCI which were sued in securities class action lawsuits in 1997. See Case Information in Securities Class Action Clearinghouse, available on the Internet at http://securities.stanford.edu (last modified October 6, 1997).
28 See, e.g., Wolf Haldenstein Adler Freeman & Herz LLP Announce Notice of Pendency of Class Action on Behalf of Purchasers of Common Stock of Bre-X Minerals, Ltd., PR Newswire, Mar. 31, 1997; Notice of Pendency of Class Action Against Mercury Finance Company and Others, PR Newswire, Jan. 30, 1997.
30 See Report on the Private Securities Litigation Reform Act of 1995, S. Rep. No. 98, 104th Cong., 1st Sess.10 (1995), reprinted in 1995 U.S.C.C.A.N. 679, 689; see also Elliott J. Weiss & John S. Beckerman, Let the Money Do the Monitoring: How Institutional Investors Can Reduce Agency Costs in Securities Class Actions, 104 Yale L.J. 2053 (1995).
32 See State of Wisconsin Investment Board's Reply in Support of Its Motion for Appointment as Lead Plaintiff, Gluck v. Cellstar Corp., No. 3:96-CV-1353-R (N.D. Tex.) at 9-11 (available on the Internet at http://securities.stanford.edu).
34 See, e.g., Gluck v. Cellstar Corp., No. Civ. A. 3:96-CV-1353-R, 1997 WL 558380 (N.D. Tex. Aug. 19, 1997) (appointing the State of Wisconsin Investment Board as sole lead plaintiff over objection of individual plaintiffs who argued that SWIB was a sophisticated investor that was atypical of the class as a whole); Chan v. Orthologic Corp., No. Civ 96-1514 PHX RCB (D. Ariz., Dec. 19, 1996) (appointing the City of Philadelphia pension fund over similar objections).
36 Vincent E. O'Brien, A Study of Class Action Securities Fraud Cases 1988-1996 at 16 (available on the Internet at http://www.lecg.com/study2.htm#att).
38 In Silicon Graphics, the plaintiffs made an in camera submission to the court which may have contained sources or specific facts that bolstered their allegations about the allegedly negative internal reports. The court declined to review plaintiffs' submission, but allowed plaintiffs leave to supplement their allegations with respect to such reports. Plaintiffs declined the invitation and the case is currently on appeal to the Ninth Circuit.
39 No. 96-20136 SW at 8-9 (N.D. Cal. May 6, 1997) (available on the Internet at http://securities.stanford.edu).
42 For example, in Marksman Partners, L.P. v. Chantal Pharmaceutical Corp., 927 F.Supp. 1297 (C.D. Cal. 1996), the court held that the two tests established by the Second Circuit should be employed. Other cases have reached similar results. See, e.g., Zeid v. Kimberley, 930 F. Supp. 431 (N.D. Cal. 1996); STI Classic Funds v. Bollinger Industries, Inc., No. 3-96-CV-823-R (N.D. Tex. Nov. 12, 1996); Fischler v. AmSouth Bancorporation, 1996 U.S. Dist. LEXIS 17670 (M.D. Fla. Nov. 14, 1996); Rehm v. Eagle Finance Corp., 954 F.Supp. 1246 (N.D. Ill. 1997).
43 See, e.g., In re Silicon Graphics, Inc. Securities Litig., 970 F. Supp. 746 (N.D. Cal. 1997) (plaintiff must create a "strong inference of knowing or intentional misconduct."); Friedberg v. Discreet Logic, 959 F.Supp. 42, 48 (D. Mass. 1997) (holding that the pleading standard was intended to be stronger than the existing Second Circuit standard); Norwood Venture Corp. v. Converse, 959 F.Supp. 205, 208 (S.D.N.Y. 1997) (holding that Congress sought to raise the pleading standard beyond the Second Circuit standard).
45 In re Silicon Graphics, Inc. Securities Litig., U.S. Dist. LEXIS 16989, [1996-97 Tr. Binder] Fed Sec. L. Rep. (CCH) ¶ 99,325 (N.D. Cal. Sept. 25, 1996). In Silicon Graphics, defendants argued that their statements fell within this safe harbor because they gave safe harbor warnings on two conference calls with analysts. Silicon Graphics submitted the declaration of its Chief Financial Officer along with the warnings he allegedly read on these calls. The court held that such evidence could only be heard in connection with a summary judgment motion, but not on a motion to dismiss. Id. at 95,962.
The only other application of the safe harbor of which I am aware was in Hockey v. Medhekar, Fed. Sec. L. Rep. (CCH) ¶ 99,465 (N.D. Cal. Apr. 14, 1997). In granting a motion to dismiss in that case, the court held that because the allegedly false and misleading statements all fell within the Reform Act's definition of forward-looking statements, plaintiff had to plead facts giving rise to a strong inference that the defendants had actual knowledge of their falsity.
48 Id.; see e.g., Marksman Partners, L.P. v. Chantal Pharmaceutical Corp., 927 F.Supp. 1297 (C.D. Cal. 1996); STI Classic Funds v. Bollinger Industries, Inc., No. 3-96-CV-823-R (N.D. Tex. Nov. 12, 1996); Greebel v. FTP Software, No. 96-10544-JLT (D. Mass. 1996); In re Wellcare Management Group, Inc. Securities Litig., 1997 WL 222254 (N.D.N.Y. Apr. 30, 1997).
49 See, e.g., Fazio Living Trust, et al. v. Palmieri, et al., No. C96 1096D (W.D. Wash. Apr. 10, 1997); Fernhoff v. NuMed Home Health Care, Inc., No. 96-200-CIV-T-21C (M.D. Fla. 199_); Finkel v. Putnam Convertible Opportunities & Income Trust, Fed. Sec. L. Rep. (CCH) ¶ 99,427 (S.D.N.Y. Feb. 11, 1997); In re Silicon Graphics, Inc. Securities Litig., 970 F. Supp. 746 (N.D. Cal. 1997); Steckman v. Hart Brewing Co., Fed Sec. L. Rep. ¶ 99,420 (S.D. Cal. Dec. 24, 1996); Zeid v. Kimberley, No. 96-20136 (N.D. Cal. May 6, 1997).
50 See, e.g., In re BAESA Securities Litigation, 96 Civ. 7435 (S.D.N.Y. July 9, 1997); Hockey v. Medhekar, Fed. Sec. L. Rep. ¶ 99,465, 1997 WL 203704 (N.D. Cal. Apr. 15, 1997); Myles v. Midcom Communications, Inc., No. 96-614D (W.D. Wash. Nov. 19, 1996) (available on the Internet at http://securities.stanford.edu); Rehm v . Eagle Finance Corp., 954 F.Supp. 1246 (N.D. Ill. 1997). In a number of cases, motions to dismiss were granted in part. Friedberg v. Discreet Logic, Inc., 959 F.Supp. 42 (D. Mass. 1997); Powers v. Eichen et al., No. Civ. 96-1431-B (S.D. Cal. Mar. 13, 1997).
58 On February 3, 1997, entities affiliated with the Cronos Group filed Form 8-K's with the SEC which reported Arthur Andersen's resignation. These documents are available on the Internet at the SEC's EDGAR database (http://www.sec.gov/cgi bin/srch edgar?cronos).
59 See, e.g., Harvey L. Pitt, More Than "Classical GAAS": Audits and Corporate Illegality Under the Litigation Reform Act (1996), reprinted in Hon. Jed S. Rakoff et al., Corporate Sentencing Guidelines: Compliance and Mitigation, App. R. (1996); Statement on Auditing Standards No. 82 -- Consideration of Fraud in a Financial Statement Audit, J. Of Accountancy, April 1997.
61 See, e.g., In re California Micro Devices Securities Litig., 168 F.R.D. 257 (N.D. Cal. 1996); Weiser v. Grace, Index No. 106285/95 (N.Y. Sup. Ct., Sept. 3, 1996); The Pentium Papers, supra note 60; Dean Starkman, Institutions Are Challenging Legal Fees, Wall St. J., Sept. 30, 1997, at B14.
64 On October 7, 1997, a bill entitled the Securities Litigation Uniform Standards Act of 1997 was introduced in the Senate. 143 Cong. Rec. S10475 (daily ed. Oct. 7, 1997). It is substantially similar to the White-Eshoo bill, except with respect to the definition of a covered security. The White-Eshoo bill ties preemption to an issuer that has covered securities while the Senate bill applies only to the covered securities themselves. In addition, the White-Eshoo bill adopts the definition of covered security contained in section 18(b)(1) of the Securities Act of 1933 while the Senate bill looks to sections 18(b)(1) and (b)(2).
65 Although these differences are highly technical, they could potentially have important real-world consequences. For example, because H.R. 1653 preempts all private actions it would prevent a plaintiff from filing an individual action in state court in order to obtain discovery that might be stayed in a parallel federal action. H.R. 1689 applies to far more securities than H.R. 1653, and would permit issuers with covered securities to obtain preemption of class actions involving other non-covered securities. H.R. 1653 would not allow a defendant to remove a securities action that was actually filed in state court, but the bill can easily be amended to deliver the same result, if necessary or appropriate.
75 See, e.g., Oak Technology v. Superior Court of Santa Clara County, H016141, slip op., at 2 (Cal. 6th App. Aug. 14, 1997) (denying stay of discovery in three separate state court class actions involving Oak Technology, Diamond Multimedia Systems, Inc., and IMP, Inc.); Marinaro v. Superior Court of Santa Clara County, 1996 Cal. LEXIS 6105 (Oct. 30, 1996) (noting that lower court had denied stay of state action in favor of four federal parallel federal actions); Shores v. Cinergi Pictures Entertainment, Inc., No. BC149861 (Cal. Super. Ct., Los Angeles County, Sept. 19, 1996) (staying discovery on 1933 Act claim but permitting discovery to proceed on a common law negligent misrepresentation claim).
77 See Bill Kisliuk, Are Two Securities Cases Better Than One?, Recorder, July 14, 1997, at 1, 2 (noting a defense counsel estimate that the cost of pretrial proceedings has increased by about one-third as a result of dual filings).
80 Grundfest and Perino, supra note 2, at 8. For a discussion of the Matsushita decision, see Marcel Kahan & Linda Silverman, Matsushita and Beyond: The Role of State Courts in Class Actions Involving Exclusive Federal Claims, 1996 Sup. Ct. Rev. 219 (1997).
84 In theory, each issuer could also be subject to a uniform standard if: (1) the individual states were authorized to adopt their own securities antifraud regimes which could preempt federal law; and (2) issuers were permitted to elect into any one state's antifraud regime or into the federal regime. Such a system would come close to replicating our federal approach to corporation law and would generate a predictable debate over a potential "race to the bottom" resulting from issuers gravitating to the jurisdiction with the most relaxed standards as opposed to a potential "race to the top" as a result of beneficial competition among state securities regulatory regimes. While such a system is possible in theory, no pending legislation suggests that uniformity be attained by allowing state law to preempt federal standards. Accordingly, this alternative approach appears to be a matter of academic interest only. See Perino, supra note 4, at 54-55.
92 See supra note 75 for citations to decisions that do not apply the federal stay to state securities fraud class actions see also Bill Kisliuk, Rough Ride for Securities Defenders, Recorder, July 16, 1997, at 1.
23 Oct 1997