This report analyzes securities class action activity in the first quarter of 1998 in order to quantify the impact of passage of the Private Securities Litigation Reform Act (the "Reform Act" or the "Act"). Among the report's most significant findings are:

• The volume of securities class action activity in federal court has grown substantially since the earliest days of the Reform Act. A total of 66 issuers were sued in Q1 1998, as compared to 32 in Q1 1997 and 18 in Q1 1996. If the Q1 1998 rate is maintained for the remainder of the year, then the total volume of litigation would actually be 49.2% higher than the average volume of litigation in the five years preceding passage of the Act.

• Since passage of the Reform Act, at least 366 issuers have been sued in federal securities class actions. Very few of these cases have been settled or otherwise finally resolved. Those cases that remain, therefore, have an enormous potential settlement value. Although that value is difficult to quantify precisely, pre-Reform Act settlement data suggests a range of from $1.8 to $3.1 billion.

• Analyzing securities litigation by exchange presents a mixed picture. More NASDAQ issuers were sued in securities class actions than NYSE issuers. In Q1 1998, there were 1.02 lawsuits per 100 issuers that trade on the NASDAQ National Market, as compared to 0.46 suits per 100 issuers that trade on the NYSE. The NYSE lawsuits, however, seem to have a potentially larger market effect. The NYSE issuers sued in the quarter had a total market capitalization of $43.4 billion as compared to only $17.1 billion for the NASDAQ issuers.

• High technology issuers continue to be the primary target for securities class actions. 57.58% of the issuers sued in Q1 1998 were high technology companies, as compared to 42.86% of the publicly traded issuers sued in federal court in 1996.

• Two types of allegations continue to dominate federal class actions: (i) allegations of accounting fraud; and (ii) allegations that insiders traded in the company's securities while a fraud was allegedly alive in the market. All told, 88% of the cases contain at least one of these allegations.

• Approximately 19% of the cases concern allegations of fraud in connection with an initial or follow-on public offering.

• Over 48% of the litigation is concentrated in two states: California (27.27%) and New York (21.21%). The Northern District of California, which includes Silicon Valley, continues to have the highest volume of litigation, with just over 18% of all litigation filed in the quarter.

• Lower court decisions interpreting one of the centerpieces of the Reform Act, the higher pleading standard, remain inconsistent. Courts continue to disagree about whether demonstrating "motive an opportunity" is sufficient to satisfy the Act's strong inference pleading standard. Even those courts that agree on the standard reach quite different results when applying it. It is unclear when these inconsistencies will be resolved.

• Courts seem to be strictly interpreting the federal safe harbor to provide significant protection against federal class actions based on allegedly false forward-looking statements. These cases provide substantial guidance for companies looking to structure their safe harbor disclosures.

• Since passage of the Reform Act, a substantial portion of class action litigation has shifted from federal to state court in an apparent attempt to evade the Act's provisions. In response to this shift, the Senate has overwhelmingly passed a bill the would preempt certain types of class actions involving nationally traded securities. Both the Securities and Exchange Commission and the White House have endorsed the Senate bill. The House of Representatives is currently debating similar bills.

I. Introduction

This report analyzes securities class action activity during the first quarter of 1998. Section II discusses overall litigation rates. Section III provides an estimate of the settlement value of the current inventory federal class action lawsuits. Section IV discusses litigation activity by exchange. Section V analyzes litigation by industry segment. Section VI discusses the prevalence of certain kinds of allegations in post-Reform Act complaints. Section VII briefly addresses the incidence of claims involving IPO or secondary offerings. Section VIII discusses the geographic incidence of 1998 litigation. Section IX analyzes significant Reform Act decisions handed down in Q1 1998. Section X discusses significant legislative developments.

II. Litigation Rates

There has been a substantial increase in securities class action activity in federal court in the first quarter of 1998. As Table 1 demonstrates, 66 issuers were sued in Q1 1998, as compared to 32 in Q1 1997 and 18 in Q1 1996.¹ On an annualized basis, this suggests that we can expect to see a total of 264 issuers sued in federal court in 1998. That figure would represent an increase of 50.9% over 1997. Moreover, if litigation were to reach that level, it would represent an 20.0% increase over the highest yearly volume of litigation in the five years preceding the Reform Act (220 issuers sued), and a 49.2% increase over the average volume over those same five years (177 issuers sued per year).

Indeed, as Figure 1 shows more clearly, the quarterly data from the first nine quarters of litigation under the Reform Act suggest a steady upward trend in filings since passage of the Reform Act. This trend may indicate that the Reform Act, rather than reducing the incidence of securities class actions, may have actually had the perverse effect of increasing the number of issuers sued. Such an equilibrium is possible if the Reform Act simultaneously made securities litigation riskier (because it increased the number of actions dismissed in pre-trial proceedings) while also decreasing the relative investment that the plaintiffs' law firm would have to make in each case (because the Act's discovery stay means that dismissals would occur before expensive pre-trial proceedings commence). In such a structure, it may make sense for plaintiffs' law firms to bring more actions, particularly if there is little downside risk (because courts rarely impose Rule 11 sanctions) and if settlement amounts increase in the cases that survive dispositive motions.

Of course, the presence of such an equilibrium is merely speculation at this point. It is unclear whether this upward trend will continue, whether the volume of class action activity will outpace pre-Reform Act levels, or whether other factors have influenced filing rates, such as the recent increased stock price volatility among high technology issuers. Additional research must also be done on overall market trends and conditions, on pre-trial dismissal rates since passage of the Reform Act, on plaintiffs' attorneys' pre-filing costs, and on trends in settlement amounts.

One significant concern that has arisen since the Reform Act is that plaintiffs' attorneys have shifted a significant portion of class action activity to state court in an apparent attempt to evade the Act's procedural restrictions.² It is inordinately difficult to track state court filings and to provide precise figures for the volume of state court litigation. We are, however, aware of state court class actions filed against the following issuers in Q1 1998: Cohr Inc. (NASD: CHR); Cybermedia, Inc. (NASD: CYBR); Electronics for Imaging (NASD: EFII); Macola, Inc.; PNC Bank; Raster Graphics (NASD: RGFX); and Vivus, Inc. (NASD: VVUS).

III. An Estimate of the Settlement Value of Pending Federal Class Actions

From passage of the Reform Act on December 22, 1995 through June 1, 1998, at least 366 issuers have been sued in federal securities class action lawsuits. While some of these cases have either settled or been dismissed, the vast majority are still pending in federal court. It is possible to provide a rough estimate of the total settlement value of this inventory of unresolved cases by examining historical settlement and disposition patterns in pre-Reform Act securities class actions.

One study of securities class actions suggests that for the period from January 1991 through October 1996, 80.4% of case dispositions were by settlement.³ Most of the remaining cases (17.8%) were dismissed, and a few (1.8%) were resolved after a trial on the merits.⁴ Average settlements during the study period ranged from a low of $6.12 million (1994) to a high of $10.62 million (1995).⁵ If these historical averages hold for post-Reform Act litigation, then we can expect that about 294 of the 366 cases filed to date will result in a settlement. This inventory of nearly 300 cases thus has an approximate settlement value of from $1.8 billion to $3.1 billion.

These figures must be used with caution. It is not at all clear that pre-Reform Act disposition patterns will continue in post-Reform Act litigation. Both the percentage of cases resulting in settlement and the average settlement amounts may increase or decrease as a result of the Act. Moreover, these figures should not be equated with the cost of securities class action lawsuits because they do not include either the amount of judgments after trial or attorneys' fees. Nonetheless, these figures do provide a rough first order approximation of the amount that can be expected to be paid in settlements for the cases filed to date.

IV. Litigation By Exchange

NASDAQ issuers continue to be frequent targets of securities class actions. As Table 2 demonstrates, NASDAQ issuers account for 47 of the 66 issuers sued in Q1 1998 (71.21%). This percentage is substantially higher than that reported in a previous study, which found that for the period April 1993 through September 1996, NASDAQ issuers accounted for 58.9% of issuers sued in securities class actions.⁶

Of course, these data must be adjusted for the larger number of issuers that trade on NASDAQ. However, even here, NASDAQ issuers remain more frequent targets of securities class action lawsuits than issuers that trade on NYSE. As shown in Table 2, there were 0.87 actions per 100 issuers on NASDAQ, whereas NYSE had a rate of 0.46 issuers per 100 listed companies. If we only consider the 42 issuer-defendants that currently trade on the NASDAQ National Market, then we get an even higher rate of 1.02 actions per 100 NNM issuers. This latter figure is arguably more relevant because approximately 89% of the NASDAQ issuers sued in Q1 1998 currently trade on the NNM. The prevalence of NNM issuers is consistent with prior studies, which suggest the presence of a "threshold effect" whereby securities class actions are rarely filed against small market capitalization issuers. Consequently, these figures suggest that the largest NASDAQ issuers are more than twice as likely to be sued in securities class actions than NYSE issuers.

This higher rate is likely attributable to the larger number of high technology issuers that trade on NASDAQ. As is discussed in more detail in Section IV, below, these issuers are much more frequent targets of securities class actions than issuers in other industries. Indeed, previous studies have suggested that, all other thing being equal, high technology companies are twice as likely to be the targets of securities class actions than issuers in other industries.⁸

Counting the raw number of issuers sued is just one way of measuring the amount of securities class action litigation in a market. Another approach is to compare the relative sizes of the issuers sued. Such an analysis gives a markedly different picture of the distribution of securities class action litigation. Table 3 demonstrates that on average, the market capitalization of NYSE issuers is about 7.6 times as large as the market capitalization of NASDAQ issuers. The aggregate market capitalization of NYSE issuers sued in Q1 1998 is $26 billion greater than for the NASDAQ issuers sued in the quarter.⁹ Because NYSE issuers tend to have substantially larger market capitalizations than NASDAQ issuers, it may be that lawsuits against NYSE companies have a larger market effect, even though those suits are fewer in number.

V. Litigation by Industry

High technology companies continue to be frequent defendants in securities class action lawsuits. Table 4, however, reports a significant increase in filings against these issuers. In Q1 1998, 57.58% of the issuers sued in federal court were high technology companies, as compared to 42.86% of the publicly traded issuers sued in federal court in 1996.¹⁰

Within high technology, certain industry segments were harder hit by securities class actions. As Table 5 demonstrates, issuers classified as "Computers and Data Processing Services," which includes software manufacturers, accounted for almost 45% of the class actions filed against high technology issuers. Hardware manufactures (which are included in the "Computer and Office Equipment" and "Electronic and Other Electric Equipment" categories) account for another 34.21% of the high technology issuers sued.

As shown in Table 4, finance companies account for just over 12% of the issuers sued in Q1 1998. This result is consistent with our study of 1996 actions, when 10.1% of the issuers sued were finance companies. The 1998 actions include several cases involving so-called sub-prime lenders. A number of lawsuits were filed against issuers in this industry segment in 1997.¹¹ These actions typically allege that the issuers disseminated false and misleading financial statements by failing to take sufficient loan loss reserves.

The remaining issuers sued in Q1 1998 come from a variety of industries. Healthcare was the only other industry with multiple lawsuits (4 or 6.6% of the issuers sued in Q1 1998).

VI. Nature of the Frauds Alleged

Two types of allegations continue to dominate federal class actions: (i) allegations of accounting fraud; and (ii) allegations that insiders traded in the company's securities while a fraud was allegedly alive in the market. As we explained in earlier studies, these are apparently the kinds of allegations that plaintiff's attorneys believe are more likely to satisfy the new, higher federal pleading standards.¹²

Table 6 describes the frequency of these allegations in Q1 1998 class actions and compares those frequencies to analyses of pre- Reform Act filings and complaints filed in 1996, the first year under the Act. Allegations of misrepresentations in financial statements appear in 57.1% of the Rule 10b-5 complaints brought in Q1 1998, compared to 61.9% of 1996 cases. This difference is not statistically significant at the 10% confidence level (c² = 0.4701, probability > 0.10). Insider trading allegations appear in 48.98% of the Q1 1998 actions, as compared to 54.9% of the 1996 actions. That difference is again, however, not statistically significant at the 10% confidence level (c² = 0.6937, probability > 0.10).

Of the 49 Rule 10b-5 cases brought in Q1 1998, only 6 (12.24%) contain neither allegation. Although the notices we examined for Q1 1998 litigation do not provide enough data to determine whether these actions are based solely on false forward-looking statements, this frequency is quite similar to the percentage of Rule 10b-5 cases filed in 1996 that were based solely on such an allegation (12.67%).

VII. Incidence of Claims Alleging Fraud in Initial or Follow-On Public Offerings

Of the 64 issuers sued in the Q1 1998 for which sufficient data are available, 12 (18.75%) involved allegations of fraud in connection with an initial or follow-on public offering. This figure is roughly equivalent to the percentage found in 1996, the first year under the Reform Act, when 20.9% of the securities class action complaints analyzed involved allegations of fraud in a public offering.

Seven of the complaints that alleged fraud in connection with an initial or secondary public offering (or 58.3%) involved offerings by NASDAQ issuers.¹³

VIII. Litigation By State and District

California and New York continue to lead the nation in securities class action filings. As demonstrated in Table 7, those states account for nearly half (48.48%) of the class actions filed in Q1 1998. Given the continued prevalence of high technology issuers sued in securities class actions, see Section IV, above, it is not surprising that 18.18% of the actions filed in Q1 1998 were filed in the Northern District of California, the home district of Silicon Valley. Other districts with a significant volume of class actions include the Southern District of New York (11 actions, or 16.67% of Q1 1998 filings); the Southern District of California (5 actions, 7.6% of the total); and the District of Massachusetts (4 actions, 6.1% of the total).

IX. Summaries of Significant Reported Decisions

During the first quarter of 1998, the federal courts handed down a number of significant opinions interpreting the Reform Act's new heightened pleading standard and the safe harbor for forward-looking information.

Some general conclusions can be drawn from these and earlier opinions on Reform Act matters. First, the lower courts continue to interpret the heightened pleading standards inconsistently. In particular, lower courts continue to disagree about whether demonstrating "motive and opportunity" is sufficient to satisfy the Act's strong inference pleading standard. Even those courts that agree on the standard reach quite different results when applying it. It is unclear when these inconsistencies will be resolved. At least three significant appeals are currently awaiting decision in the Sixth and Ninth Circuits;¹⁴ however, the uneven interpretations of the pleading standard may persist even after those cases are decided, and a final determination as to the Act's precise meaning may have to await future Supreme Court review.

Second, courts seem to be strictly interpreting the federal safe harbor to provide significant protection against class actions based on allegedly false forward-looking statements. Of course, there is no equivalent safe harbor under state law, and issuers may still be sued and found liable under state law for forward-looking statements even if those statements are protected under federal law. For a discussion of federal legislative developments that seek to address this concern, see Section IX, below.

The Heightened Pleading Standard

Among the most controversial provisions of the Act was a pleading requirement designed to make it harder for unwarranted allegations of fraud to survive a motion to dismiss.¹⁵ The pleading standard was a significant factor in the President's veto¹⁶ and continues to be at the center of significant debate and commentary.¹⁷ Because it prescribes what is required to be alleged in the complaint, the provision has had the most immediate impact in securities litigation.

The new standard contains two significant prongs that raise the hurdle for filing in federal court. First, when a complaint is pleaded on information and belief (as is often the case in securities class actions) it must state "with particularity all facts on which that belief is formed."¹⁸ At least one court has held that the "all facts" provision requires plaintiffs to disclose the names of confidential informants, employees, competitors, and others who provided information leading to the filing of the case.¹⁹

Second, plaintiffs are required to "state with particularity facts giving rise to a strong inference that defendant acted with the requisite state of mind."²⁰ The "strong inference" language was drawn from Second Circuit authority that pre-dated the Reform Act, but the President's veto was premised in part on language in the legislative history suggesting that Congress meant to erect a pleading barrier even higher than the Second Circuit had articulated.²¹ This language has given rise to significant questions concerning whether the Second Circuit's tests for evaluating the strong inference standard, including the case law permitting plaintiffs to satisfy their burden by pleading either "motive and opportunity" or circumstantial evidence of conscious misbehavior or recklessness by the defendants, survived passage of the Act.²²

There has also been a significant debate concerning whether the new heightened pleading standard changed the substantive elements of a Rule 10b-5 claim. In order to prove a violation of the rule, the plaintiff must demonstrate that the defendant acted with scienter, i.e., a state of mind embracing an intent to deceive, manipulate, or defraud.²³ Although the Supreme Court twice reserved the issue, lower courts have consistently held that the plaintiff may satisfy its burden by demonstrating that the defendant acted recklessly. Before passage of the Act, there was a great deal of inconsistency among the Courts of Appeal in terms of defining the precise definition of reckless conduct. Since passage of the Act, a number of courts have held that the plaintiffs must plead facts giving rise to a strong inference of knowing or intentional misconduct.²⁴ These courts hold that knowing conduct only includes "deliberate recklessness." Other courts, by contrast, have found that the new pleading standard did not alter the substantive scienter standard.²⁵

Eleven opinions in the first quarter of 1998 address these issues. These cases are discussed chronologically.

1. Epstein v. Itron.²⁶ In Epstein, the United States District Court for the Eastern District of Washington applied the "motive and opportunity" test to find that plaintiffs had met their pleading burden under the Reform Act.

Itron (NASD: ITRI) sells systems that automatically collect data from utility meters. The complaint alleged that during the class period the company made false statements about its success in implementing so-called "fixed networks," a product that was in high demand among the utilities that are Itron's primary customers. Itron allegedly knew since at least 1993 that a key component of its system was not technologically feasible for developing fixed networks. To support this allegation, the complaint pointed to statements contained in a company marketing brochure and Itron's Form 10-K, which described delays in meeting performance milestones under an installation contract.

The complaint's motive theory was straight-forward: Itron's "continued economic success depended on its ability to convince its current and potential customers that it would be able to successfully incorporate its core product into the emerging fixed network environment." Itron thus made the false statements during the class period "in an effort to buy time while it searched for a technological 'fix' for the problems described in the 1993 marketing brochure."

The court addressed three questions: (1) whether the Reform Act changed the Rule 10b-5's scienter standard by eliminating some form of recklessness as a basis for liability; (2) whether the Second Circuit's test for determining whether plaintiff pleaded a strong inference of fraud survived passage of the Act; and (3) whether plaintiffs had pled a strong inference of fraud.

The court held that the Reform Act does not establish a uniform state of mind requirement for Rule 10b-5 securities fraud claims that eliminates recklessness. It found that the plain language of the pleading provision-which merely requires that plaintiffs plead sufficient facts to raise a strong inference of the "required state of mind"-does not suggest that Congress meant to change the substantive elements of a Rule 10b-5 claim. Nor was the court persuaded by the "slender threads" of legislative history that other courts have relied on in finding that Congress strengthened Rule 10b-5's state of mind requirements. Those statements merely highlighted that "some members of Congress may have wished to impose a uniform, heightened state of mind requirement on securities fraud claims, [but] the fact that such a change is absent from the language of the statute is compelling evidence that they were not able to achieve this goal." Consequently, the court held that the same scienter requirements that existed prior to the Reform Act applied: actual knowledge or recklessness.

This conclusion seems correct. When Congress adopted the "strong inference" standard it was creating a higher pleading burden; it was not adopting a state of mind requirement. Pleading standards simply mandate that plaintiffs achieve the required level of specificity in their complaint. A pleading standard does not change the substantive requirements for pleading a Rule 10b-5 claim, just as Federal Rule of Civil Procedure 9(b) does not change the substantive requirements for proving a fraud claim. To be sure, there remains a significant issue about whether recklessness satisfies the Rule 10b-5 scienter requirement and, if so, precisely what level of conduct constitutes recklessness. But those issues existed prior to the Reform Act. Nothing in the Act, with the limited exception of the safe harbor and joint and several liability provisions,²⁷ help us to resolve those questions. The best that can be said about the Act and its legislative history is that Congress recognized the issue but ultimately chose not to address it.

The next significant question to which the court turned was whether the Second Circuit tests for finding a strong inference of fraud survived passage of the Act. The court refused to address whether the "motive and opportunity" test survived passage of the Act because it found that plaintiff's factual allegations were insufficient to satisfy that standard. Plaintiff's claim that the company lied in order to maintain its economic position in the business community was the same kind of "generalized allegation" that Second Circuit cases had rejected:

Under the Second Circuit's standard, a showing of motive requires more than the mere potential that financial gain might result from the making of the allegedly false or misleading statements. Instead, a plaintiff must show defendants gained, or intended to gain, some sort of concrete benefit as a result of the false statements, such as insider trading of stock whose price was artificially inflated by false or misleading statements. ... Turkish v. Kasenetz, 27 F.3d 23, 28 (2d Cir. 1994) (avoiding making payments to creditors a sufficient motive); Cohen v. Koenig, 25 F.3d 1168, 1174 (2d Cir. 1994) (securing loans a sufficient motive). Making false or misleading statements to maintain an artificially inflated stock value or to maintain a generally positive public image of one's company are not sufficient motives for showing a strong inference because such generalized allegations describe the motives of "virtually every company in the United States that takes a downturn in stock price." Acito v. Imcera Group, Inc., 47 F.3d 47, 54 (2d Cir. 1994); see also Shields [v. Citytrust Bancorp.], 25 F.3d [1124, 1130 (2d Cir. 1994)]. Moreover, allowing such a de minimis showing of motive would effectively thwart the role of more vigilant gatekeeper against frivolous suits that Congress entrusted to the courts by means of [the pleading standard].

This interpretation is significant because the SEC has also advocated the "concrete benefit" test as a means of providing greater specificity to the motive and opportunity test.²⁸

The court denied the motion to dismiss, however, because it found that the complaint contained allegations that demonstrated strong circumstantial evidence of scienter. The court pointed to the plaintiff's claim that Itron's 1993 marketing brochure and their 1996 Form 10-K demonstrated defendants' awareness that their products were not technologically feasible for fixed networks. These allegations were sufficient because:

As the Second Circuit has noted, the fact that a particular matter constitutes a significant source of income to a company can establish a strong inference that the company and its relevant officers knew of easily discoverable additional facts that directly affected the source of income. In other words, facts critical to a business's core operations or an important transaction generally are so apparent that their knowledge may be attributed to the company and its key officers. ... If it is true, as Plaintiff alleges, that Itron's core product is technologically incapable of meeting requirements that are central to Itron's continued survival as a business entity, it can be strongly inferred that key officers like [the defendant] had knowledge of this fact.²⁹

Although the court did not address the point, a primary difficulty with this analysis is that it highlights a significant tension that exists between the higher pleading standard and plaintiff's ultimate ability to prove an actual claim of fraud. In order to survive a motion to dismiss, the plaintiff must search out and plead specific facts (such as the contents of the 1993 marketing brochure and the 1996 Form 10-K) that create a strong inference of fraud. But while those facts may create an inference as to defendant's knowledge, they may also create a powerful "truth on the market" defense to the extent that plaintiff's investigation was limited to publicly available information.³⁰ In such cases, plaintiffs may succeed in proving knowledge but may open themselves up to dismissal for failure to prove materiality to the extent that the information was available to market participants and so must have already been impounded in the security's price. Even if plaintiffs relied on some non-public sources, they may have to show on a motion for summary judgment that the information did not leak into market.

2. Chan v. Orthologic Corp.³¹ Given the muddled state of the law under the Act, it is perhaps not surprising that only two weeks after Itron was decided, another district court in the Ninth Circuit reached precisely the opposite conclusion with respect to the new heightened pleading standard. In Chan, the Arizona district court granted defendants' motion to dismiss and followed Silicon Graphics in holding that pleading motive and opportunity were insufficient to satisfy the strong inference standard.

Orthologic (NASD: OLGC) manufactures a device designed to stimulate bone growth that had received FDA approval for only certain kinds of fractures. The complaint alleged that the company illegally marketed and sold this product for unauthorized uses. Defendants allegedly concealed both this marketing scheme and their knowledge of an FDA investigation into the matter in order to inflate the company's stock price and to complete a secondary offering. Certain individual defendants were also alleged to have sold stock at inflated prices at two crucial junctures, immediately after being informed of the FDA investigation and just after receiving a formal "Warning Letter" from the FDA.

Although the court rejected motive and opportunity as a sufficient basis for pleading fraud under the Reform Act, it found that these facts were insufficient to satisfy even that standard. The insider sales were insufficient because it was unclear whether these sales were unusual. Indeed, the court noted that many of the defendants retained more stock than they sold and thereby "suffered greater financial losses than gains." Of course, this inference cannot be pushed too far. A smart insider bent on committing securities fraud might sell only a portion of her holdings in an attempt to avoid detection. Nonetheless, the court found that the plaintiffs had failed to meet their burden of showing that the trades were unusual.

Unlike Itron, the opinion in Chan acknowledges the tension between the higher pleading standard and a potential truth-on-the-market defense. In an attempt to establish defendants' knowledge of off-label use and marketing, the plaintiffs pled that such use was "widespread" and that "an insufficient customer base existed" without it. The court found, however, that customer resistance to a product is often public knowledge. If that were the case, the court noted in dicta, plaintiffs would have a difficult time establishing causation because "the same market that is allegedly negatively affected by [defendant's] customer problems should have had knowledge of such problems."

3. City of Painesville, Ohio v. First Montauk Financial Corp.³² This opinion out of the Northern District of Ohio is notable only because it incorrectly holds that plaintiffs bringing market manipulation claims under Rule 10b-5 have a much lower pleading burden than plaintiffs in misrepresentation or omission cases.

In its complaint, the City alleged that it was the victim of a market manipulation scheme involving mortgage-backed securities. The opinion suggests that such claims are subject to lower pleading burdens because "the details encompassing fraudulent conduct are more easily described in claims for fraudulent misrepresentation than in claims for market manipulation...." The court reasoned that "because most securities manipulation claims arise out of longer-term schemes that are largely unknown to the investor, specific characteristics or details of the scheme remain undetected. Accordingly, specific details such as the time, place, and actors involved with the scheme are typically more difficult to discover or plead in manipulation cases."

Whether in fact victims of market manipulations have a more difficult time ferreting out the details of those schemes is open to debate. But, as a matter of strict statutory construction, the court's conclusion seems to be correct: market manipulation claims are treated differently under the Reform Act. Ultimately, however, these differences are irrelevant from a practical perspective.

The first prong of the pleading provision (which requires specificity with respect to pleading misrepresentations or omissions)³³ does not apply to at least some market manipulation claims. The statutory language only tracks sub-division (b) of Rule 10b-5.³⁴ A market manipulation claim could instead allege a violation of sub-division (a) of the rule (making it unlawful to employ a device, scheme, or artifice to defraud) or sub-division (c) (which prohibits engaging in an act, practice, or course of business that would operate as a fraud or deceit). The first prong of the Reform Act pleading standard thus would not apply to these claims. In the end, however, such a reading makes little practical difference because the Act's specificity requirement has been universally held to require the same specificity as Federal Rule of Civil Procedure 9(b). Rule 9(b) applies to all cases of fraud, including market manipulation claims under Rule 10b-5(a) and (c). Thus, market manipulation claims should have the same specificity requirements as misrepresentation or omission cases, albeit under Rule 9(b) rather than the Reform Act.

Market manipulation claims brought under either section 9(e) of the 1934 Act or Rule 10b-5 are subject to the Reform Act's state of mind pleading requirements, which apply "[i]n any private action arising under [the 1934 Act] in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind."³⁵ Because section 9(e) and Rule 10b-5 claims for manipulation require proof that the defendant acted either willfully or with scienter, any complaint must satisfy the strong inference pleading requirement.

Arguably, the only practical difference between misrepresentation claims and market manipulation claims arises when complaints are pled on information and belief. Plaintiffs alleging market manipulation would not have to allege all facts upon which their complaint is based because the Act applies only to misrepresentation or omission claims and because there is no equivalent requirement under Rule 9(b).

4. Warman v. Overland Data Inc.³⁶ The District Court for the Southern District of California denied defendants' motion to dismiss this class action, which alleged fraud in connection with Overland Data's IPO. Overland Data (NASD: OVRL) manufactures a magnetic tape storage system that incorporates tape drives manufactured by Quantum Corporation. The IPO prospectus disclosed that Quantum was the only manufacturer of these drives, that it had experienced drive shortages in the past, and that it could give no assurances that such problems would not reoccur in the future. Shortly after the IPO, the company announced that sales for the third and fourth quarter of fiscal 1997 could be adversely affected because the company might not be able to obtain a sufficient number of drives from Quantum. Overland Data's stock price dropped 42%, and the class action ensued.

First, the court held that the complaint did not have to satisfy the "all facts" pleading requirement because it was based not on information and belief but on investigation of counsel. This holding is significant because it is inconsistent with other interpretations of the "all facts" requirement and because class action complaints typically allege that they are based, at least in part, on counsel's investigation. The court also found that the complaint adequately pled scienter because the material allegations satisfied both the motive and opportunity test and the conscious behavior test, although it held that it need not reach the issue of whether the Reform Act eliminated either of these tests.

Finally, the court refused to dismiss the complaint based on the bespeaks caution doctrine. The court's analysis of the doctrine is quite clearly wrong. First, the court accepted plaintiffs' argument that the statements about supply problems only referred to the present situation and were not forward-looking. This statement is simply incorrect; Overland Data's prospectus specifically stated that it could give no assurance "that such problems will not reoccur or that the Company will not experience similar or more serious disruptions in supply in the future." Second, the court held that this warning was merely a boilerplate disclaimer for which the bespeaks caution doctrine offered no protection. A boilerplate warning, however, is one "which merely warns the reader that the investment has risks".³⁷ That was not the kind of warning included in the Overland Data prospectus. Instead, Overland Data specifically warned of the presence of a significant risk factor: that a major component of its product was produced by one manufacturer, that it had supply problems in the past that it thought were remedied, but that it could make no assurances that these problems might not arise again in the future. This is precisely the risk that came to pass, and the prospectus' disclosures should have been protected by the bespeaks caution doctrine.³⁸

5. Polk v. Fritz.³⁹ In Polk, the District Court for the Northern District of California dismissed with prejudice a class action complaint filed against Fritz Companies, Inc. and certain of its officers and directors. The complaint at issue in Polk was the third one plaintiffs had filed. The previous two had also been dismissed, but with leave to replead.

The action arose out of a May 1995 merger between Fritz and Intertrans. The lawsuit was triggered when in July 1996 Fritz restated its merger-related expenses to take an additional $11 million dollar charge on top of its previously announced charge of $30 million. The complaint alleges that Fritz: (1) overstated its earnings and revenues in violation of GAAP; (2) misstated the success of the Intertrans merger; and (3) made misstatements concerning other acquisitions it had undertaken.

The court addressed each of the categories of misrepresentations or omissions in turn. With respect to the claims of accounting fraud, the court held that the complaint did little more than point to the restatement as evidence of fraud. This was not enough. Instead, plaintiff was required to "draw on contemporaneous statements or conditions"⁴⁰ to "demonstrate how the financial statements were false when made and not just through the benefit of hindsight."⁴¹ Moreover, the restatement, standing alone, could not serve as the basis for a fraud claim because when Fritz originally disclosed the merger expenses it emphasized that the charge was an estimate that was subject to change, and that it was not feasible "to determine the actual amount of the merger charge until the operational and transitional plans are completed."

Plaintiffs next alleged that various statements about the success of the Fritz/Intertrans merger were false and misleading because they failed to disclose difficulties integrating the companies' accounting systems. The court rejected these claims because it found that it was not false or misleading for Fritz to state that it had merged with Intertrans when the accounting system had not yet been fully integrated. Finally, the court held that the alleged misstatements regarding Fritz's other acquisitions were merely conclusory statements that lacked the necessary factual support to satisfy Rule 9(b) and the Reform Act.

6. Novak v. Kasaks.⁴² The United States District Court for the Southern District of New York dismissed with leave to replead this class action against AnnTaylor Stores because plaintiffs failed to satisfy their pleading obligations under the Reform Act.

In Novak, plaintiffs alleged that AnnTaylor (NYSE: ANN) artificially inflated the price of its stock through a so-called "box and hold scheme" in which excess inventory was hidden in warehouses and not written-down in accordance with GAAP. The officer and director defendants named in the complaint were alleged to have either actual or constructive knowledge of this scheme and of the company's serious inventory problems when they made optimistic statements to the public about AnnTaylor's inventory. Defendants were alleged to have engaged in this scheme so Merrill Lynch, a substantial AnnTaylor shareholder, could sell off four million shares in a secondary offering at inflated prices.

In dismissing the complaint, the court held that the Reform Act "strengthened the Second Circuit standard" for pleading scienter. For this reason, it found that "pleading of motive and opportunity no longer suffices to raise a strong inference of scienter." In dicta, it noted that the complaint did not even satisfy the rejected motive and opportunity test. Of particular note in this regard is the conclusion that Merrill Lynch's stock sales were not unusual "for entities engaged in the investment banking industry" because Merrill held its stock for five years and sold off less than one-half of its holdings.

On the issue of whether recklessness survives passage of the Reform Act, the court's holding is consistent with Silicon Graphics in finding that only "conscious recklessness or actual intent satisfy the PSLRA's scienter requirement." Plaintiffs failed to satisfy this standard because the complaint "fails to allege with sufficient specificity that at the time the AnnTaylor defendants made favorable statements to securities analysts, they were aware that much of their inventory was worthless or seriously overvalued, or were reckless as to whether that was the case."⁴³

The court's analysis of the "all facts" pleading requirement is also consistent with Silicon Graphics. The AnnTaylor court found that a paragraph that appears in many post-Reform Act complaints, which lists a string of sources for the allegations, was insufficient. Of particular note is the court's treatment of certain unnamed "consultants" which appear to be the source for internal reports describing weakness in sales and mounting excess inventory. The court held that if these consultants were indeed the source for this information, then they should have been named in the complaint.

7. Brinker Capital Holdings, Inc. v. Imagex Services, Inc.⁴⁴ In Brinker Capital, the District Court for the Northern District of New York dismissed an individual Rule 10b-5 action brought against Imagex (OTC-BB: IMXS), a small medical imaging company. According to the complaint, Imagex approached Brinker in 1994 to purchase common stock in Imagex and to promise to hold that stock for at least two years.⁴⁵ Brinker Capital, through a special purpose subsidiary, ultimately made this investment. Two years later, it brought suit, claiming that it was fraudulently induced to take this position through a series of unspecified material misrepresentations and omissions regarding Imagex's financial health and management.

In dismissing the action, the court did not address the debate over the interpretation of the Act's pleading standards. However, it relied on pre-Reform Act Second Circuit precedent to apply a detailed and rigorous six-part pleading standard. Specifically, the court held that:

A plaintiff alleging securities fraud must specify for each defendant: (1) each false statement or omission the defendant is responsible for; (2) the time and place each statement or omission was made; (3) the reason the statement or omission is misleading and the manner in which each statement or omission misled the plaintiff; (4) if an allegation concerning such statement or omission is based upon information and belief, all facts which supports [sic] the allegation; (5) what the defendant obtained as a consequence of the fraud; and [(6)] the facts which give rise to a strong inference of scienter.⁴⁶

Of particular note in this standard is the court's emphasis that all of these facts must be separately alleged with respect to each defendant. This standard is also arguably more rigorous than other courts' interpretations because items (5) and (6) are treated as separate and distinct elements. To be sure, the facts that will satisfy these two separate requirements will likely coalesce in a great number of cases. Nonetheless, requiring the plaintiff to plead what each defendant obtained from the fraud may make it more difficult for plaintiffs to add officer or director defendants who did not trade in the company's securities. See Section V, above.

Based on this standard, the court dismissed the claims against one defendant because the complaint did not specifically attribute any misrepresentation to him.⁴⁷ The claims against the remaining defendants were dismissed because the complaint simply lumped all of the defendants together and lodged allegations against them en masse. The court granted plaintiffs leave to replead.

8. Lirette v. Shiva Corporation.⁴⁸ In this class action filed against Shiva Corporation (NASD: SHVA), the United States District Court for the District of Massachusetts issued a very restrictive interpretation of the "all facts" requirement. The opinion is significant because the complaint in Lirette was similar in structure to many other class actions complaints, i.e., it asserted generally in a single paragraph that all of the allegations in the complaint were based either on "information and belief" or "investigation by plaintiffs' counsel." The court found that this pleading tactic utterly failed to comply with the "all facts" requirement because it did not specify which allegations derived from which sources.

To rectify their pleading, the court ordered plaintiffs to file a supplement to the complaint that specifies "as to each particular allegation (i.e., every sentence or clause separated by a common or a conjunction), whether that allegation is made upon information and belief or is supported by some document or statement on personal knowledge by a potential witness." Unlike other early interpretations of the "all facts" requirement, however, the court did not require plaintiffs to reveal the identities of their sources. Consequently, the action appears to have less of a chilling effect on whistle-blowers who may be aware of securities law violations but leery of coming forward with that information.

9. Mark v. Fleming Companies, Inc.⁴⁹ The Western District of Oklahoma dismissed without prejudice plaintiff's complaint against Fleming Companies (NYSE: FLM) for failure to satisfy the Reform Act's pleading standard.⁵⁰ The complaint alleged that Fleming, a wholesale food distributor and marketer, failed to disclose material litigation filed against the company. That lawsuit resulted in a $207.5 million verdict against the company, which was overturned on appeal. The case ultimately settled for $19.9 million.

The court found that the Second Circuit's "motive and opportunity" and "circumstantial evidence of conscious misbehavior or recklessness" tests did not survive passage of the Reform Act.⁵¹ Instead, it required plaintiffs to "plead with particularity facts giving rise to a strong inference that the defendant(s) acted with fraudulent intent."⁵² The court did not address whether plaintiffs could satisfy that standard by pleading facts demonstrating deliberate or severe recklessness, as Silicon Graphics and other courts have found. The court determined, however, that plaintiff's conclusory allegations of scienter were insufficient under the Act.

10. Hockey v. Medhekar.⁵³ In this class action against Alliance Semiconductor Corporation (NASD: ALSC), the United States District Court for the Northern District of California denied in part and granted in part a motion to dismiss plaintiffs' First Amended Complaint. The court had previously dismissed plaintiffs' original complaint without prejudice.⁵⁴ Both complaints alleged that Alliance, a memory chip manufacturer, and certain of its officers and directors made material misrepresentations: (1) in its financial statements, and (2) about its business, products, and future prospects.

The court found that most of the complaint's allegations did not meet the Act's specificity requirements. For example, the complaint alleged that Alliance: (1) inflated its revenues by booking certain contingent transactions as sales in violation of GAAP; (2) failed to book adequate reserves for product returns; and (3) failed to disclose certain non-cancelable purchase commitments. The court found that the revenue recognition and reserve allegations were inadequate because the complaint failed to: (1) "identify the particular transactions underlying [the] alleged accounting deficiencies," and (2) "plead facts sufficient to support a conclusion that defendant[] prepared the fraudulent financial statements and that the alleged financial fraud was material."⁵⁵ Among other things, the conclusory allegations of the complaint failed to provide any support for the factual claim that Alliance's customers had a right of return, failed to identify which customers returned chips, and failed to allege that these chips were returned pursuant to a non-disclosed right of return.

The court also found that plaintiffs failed to adequately plead the existence of "secret" purchase commitments. It was undisputed that certain purchase commitments were disclosed in Alliance's Form 10-Q, but plaintiffs failed to plead specific facts demonstrating that other commitments were not included in those disclosures. The court, however, did find that the complaint adequately pled that Alliance's Form 10-Q did not comply with FAS 47's requirements for disclosing long-term obligations. Defendants argued that these improper disclosures were immaterial, but the court let the allegations stand because it could not determine materiality as a matter of law.

In addition to accounting fraud, the complaint alleged that defendants artificially inflated Alliance's stock price through a combination of overstated financial results, misstatements regarding the current strength of Alliance's business, and false forecasts of continued growth. The court dismissed these claims to the extent that they were based on inconsistent internal corporate reports because the complaint failed to specify facts demonstrating that such reports actually existed. The court, however, let stand allegations that the company made false statements about its ability to meet production goals for a new chip because it failed to disclose quality control problems at one of its facilities. Plaintiffs did not point to any document that demonstrated that defendants knew the statements were false when made, but an Alliance Prospectus touted its on-line information system, and the court found that these statements amounted to a representation that the company became aware of production problems as soon as they occurred.

With respect to pleading scienter, the court found that the plaintiff's burden varies depending on the type of statement at issue. For forward-looking statements, plaintiffs must plead facts demonstrating that the defendant had actual knowledge that the statement was false or misleading when made. For all other statements, the district court adopted the Second Circuit standard by requiring the plaintiff to plead facts giving rise to a strong inference of recklessness, either by demonstrating that the defendants had a motive and opportunity to commit fraud or by alleging specific facts constituting circumstantial evidence of conscious misbehavior or recklessness. The court refused to adopt the stricter Silicon Graphics standard.

The court found that the specifically pleaded accounting fraud allegations failed to create a strong inference of fraud. Plaintiffs attempted to show motive by demonstrating trading by insiders during the class period. The court, however, found that these allegations were insufficient because most of the sales occurred before the allegedly false and misleading statements were made and because plaintiffs did not show that the trading was "dramatically out of line with prior trading practices." The allegation that defendants failed to follow GAAP was also insufficient, standing by itself, to establish circumstantial evidence of conscious misbehavior because defendants' actions may simply have been negligent. The complaint properly pled scienter with respect to the statements that the company was not experiencing any chip production problems; the specific allegations about Alliance's on-line information system were circumstantial evidence that the defendants were aware of the problems when they made these statements.

11. Zuckerman v. FoxMeyer Health Corp.⁵⁶ The Northern District of Texas refused to dismiss this class action against FoxMeyer Health Corp. ("FHC") (NYSE: FOX), the now-bankrupt parent corporation of FoxMeyer Drug Company ("FoxDrug"), formerly the fourth largest drug distributor in the United States. FHC allegedly made false and misleading statements about FoxDrug's efforts to bring a costly, automated drug distribution center on-line in July 1995. This distribution center, and the software designed to run it, proved unable to handle the high volume of business funneled to it, resulting in significant cost overruns for the company.

The court found that the Reform Act did not alter the level of intent necessary to prove a violation of Rule 10b-5. Although in doing so it chose not to follow Silicon Graphics, the scienter standard it follows is quite similar because it requires plaintiffs to show either actual intent or severe recklessness, a concept which is roughly equivalent to Silicon Graphics' notion of "deliberate recklessness." Thus, while the FoxMeyer court correctly concluded that the Reform Act did not alter the substantive requirements for a Rule 10b-5 claim, it ends up with virtually the same result as Silicon Graphics.

In contrast to Silicon Graphics, however, the court found that the Second Circuit's motive and opportunity test does survive passage of the Act, "so long as the totality of the allegations raises a strong inference of fraudulent intent."⁵⁷ Plaintiffs met their burden by alleging substantial insider sales during the class period and immediately before FHC's bankruptcy filing. Although defendants contended that these sales were not unusual, the court held that the impropriety of the trading was a question of fact that it would not address on a motion to dismiss. That result differs significantly from the approach taken by other courts, which routinely examine evidence of defendants' trading patterns to determine whether the insider trading is unusual or suspicious.⁵⁸

The Safe Harbor for Forward Looking Information

To address the chilling effect that non-meritorious lawsuits have "on the robustness and candor of disclosure," regarding an issuer's prospects,⁵⁹ the Reform Act provides for a two-pronged safe harbor for forward-looking statements. Under the first prong, statements are protected if they are identified as forward-looking statements and are "accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement."⁶⁰ The second prong focuses on the speaker's state of mind and requires that the forward-looking statement be made with actual knowledge that it was false or misleading.⁶¹ Two opinions handed down in the first quarter of 1998 address these standards.

1. Harris v. Ivax Corp.⁶² In Harris, the United States District Court for the Southern District of Florida applied the safe harbor to dismiss with prejudice a class action filed against Ivax Corporation (AMEX: IVX) and two of its officers. The decision is significant for three reasons. First, the court broadly interprets the safe harbor to protect statements which, although written in the present tense, clearly have a forward-looking aspect. Second, the decision relies on pre-Reform Act case law discussing the "bespeaks caution" doctrine to interpret the safe harbor. The decision thus sends a strong signal to issuers that they should look to this pre-Act case law in structuring their safe harbor disclosures. Third, the court applies the Reform Act's heightened pleading standard to the actual knowledge prong of the safe harbor.

In November 1996 Ivax announced that it would report a loss of $178.7 million for the third quarter. Ivax attributed the loss to several factors, but the majority of the loss (a $104.3 million pre-tax charge) constituted a write-down of goodwill for its US generic drug business. The complaint alleged that certain of the company's prior press releases were materially misleading because the defendants knew, or should have known, that the goodwill write-downs would be necessary. A good example of one of these allegedly false statements comes from IVAX's August 2, 1996 press release: "We believe, however, that the challenges unique to this period in our history are now behind us." Plaintiffs contended that safe harbor protection was not available for that statement because it was not forward-looking in nature, but rather a statement of present business conditions.

While the court acknowledged that plaintiff's argument was grammatically correct, it refused to deny safe harbor coverage on that basis. Instead, the court looked beyond the technical meaning of the words to the clear meaning behind them: "despite the recent rough period, good times are ahead." These kinds of statements were found to be at the core of what Congress meant to protect when it enacted the safe harbor.

Indeed, the court's precise language is quite instructive on the scope of the safe harbor. The court found that:

Representations regarding the state of a business' position in a changing market or the soundness of its growth strategies are necessarily forward-looking. This is especially true where, as here, the representations are made mid-quarter, before the calculations businesses use to quantitatively evaluate their financial well-being are completed. The IVAX press releases were not formal, periodic SEC filings. Until the numbers were crunched at the end of the quarter, the statements in IVAX's press releases that the hard times were over and that the state of the company was strong were nothing more than projections intended to advise the market of anticipated third quarter financial results. These are exactly the kind of forward-looking statements that the Reform Act's safe harbor was intended to shield.

Of course, merely because the statements were forward-looking does not necessarily mean that they could not form the basis for liability. In order to come within the safe harbor, the company is required to identify the statements as forward looking and accompany them with meaningful cautionary language. In interpreting these provisions, the court relied on the judicially created bespeaks caution doctrine upon which the safe harbor is based. Thus, although there remains a dearth of case law on the safe harbor, the IVAX opinion suggests that companies should look to the comparatively plentiful case law on the bespeaks caution doctrine to help them navigate the safe harbor.

The court found that the detailed warnings contained in IVAX's press releases (which appeared in italics at the end of the documents) went far beyond the boilerplate that would generally be deemed insufficient under the Reform Act. The warnings were not simply "vague and general cautions about the generic drug industry," as plaintiffs contended, but rather identified "precisely those factors which led to IVAX's poorer than expected third quarter performance." The court recognized that IVAX did not identify every factor that had caused results to differ from those the company had projected. But it held that it is unnecessary for issuers to satisfy such an "impossible burden." Safe harbor protection was available so long as the "cautionary statements 'directly address[ed] the substance' of the statements Plaintiffs challenge and 'were tailored precisely to address the uncertainty concerning' the projections contained in the IVAX press releases."⁶³

As an alternative basis for its decision, the IVAX court also interpreted the second, subjective prong of the safe harbor. Under that prong, if an issuer's forward-looking disclosures are found not to have been accompanied by sufficiently meaningful disclosure, the issuer may still obtain safe harbor protection if the plaintiff fails to prove that the defendant knew that the forward-looking statement was false or misleading.

The IVAX court brought the Reform Act's higher pleading burden to bear on this issue. It found that plaintiffs failed to allege with particularity facts giving rise to a strong inference that the defendants representations were made with actual knowledge of their falsity, and characterized the complaint as an "attempt simply to hold up the Defendants' predictions against the backdrop of what actually happened. The Reform Act clearly prohibits such pleading practices." Although it does not devote extensive analysis to the issue, the court's decision is significant because it addresses plaintiff's allegation that IVAX's failure to take a goodwill write down in a timely fashion violated generally accepted accounting principals. As noted previously, allegations of accounting misrepresentations are at the heart of a majority of post-Reform Act class actions. See Section V, above. The court, however, held that such an allegation standing alone is insufficient to create a strong inference of actual knowledge.

2. Wegner v. Lumisys.⁶⁴ The Northern District of California dismissed with leave to amend this class action against Lumisys (NASD: LUMI), a company that manufactures medical film digitizer products.⁶⁵ The opinion is significant for its discussion of the safe harbor's protection for oral forward-looking statements made during analysts' conference calls. In particular, it addresses two important issues: (a) the evidentiary support defendants can bring to their motions to dismiss; and (b) the structure of the safe harbor warnings during the conference call. On both questions, the opinion makes it significantly easier for issuers to obtain the benefits of safe harbor protection.

The complaint alleged that Lumisys undertook an IPO so that insiders at the company could sell off a significant amount of stock at inflated prices before adverse facts about Lumisys' products and business prospects became public. In the period after the IPO, the complaint alleges that Lumisys sought to drive up its stock price by releasing false and misleading information about product demand, future revenues and earnings per share, about the operations of a subsidiary, and about a company in which it had a 20% ownership interest.

The complaint alleged that some of these forward-looking statements were made during an analysts' conference call without delivering any safe harbor warning. When defendants sought to have the court take judicial notice of a transcript of the conference call, the plaintiffs argued that Ninth Circuit precedent prohibited the court from considering transcripts that were not mentioned in the complaint.⁶⁶ Of course, such a rule raises an obvious danger: plaintiffs will be able to avoid dismissals in cases where the safe harbor should apply by artfully pleading their complaints to omit reference to any conference call transcript. Under such a rule, companies could be subjected to unwarranted and expensive discovery, thereby eliminating the benefit of the safe harbor protections.

Although not specifically discussing this concern, the court determined that it could consider the transcripts on a motion to dismiss, at least with respect to whether the company actually made the safe harbor warnings. Indeed, the court reasoned that this result was mandated by the Reform Act, which requires the court to "consider ... any cautionary statement accompanying the forward-looking statement, which [is] not subject to material dispute, cited by the defendant."⁶⁷ Because plaintiffs did not dispute that the Lumisys executives actually uttered the cautionary language reflected in the transcript, the court was required to consider them.

The court's ruling was limited to determining whether the meaningful cautionary language was spoken during the conference call. It refused to address whether defendants could use the transcripts on the motion to dismiss to show that plaintiffs had inaccurately portrayed Lumisys' statements. The court, however, did highlight one further use for the transcripts: it noted that it might consider them in determining whether to impose sanctions on counsel under Federal Rule of Civil Procedure 11(b). The Reform Act mandates that the court, upon final adjudication of a private securities fraud action, include in the record specific findings that the attorneys have complied with Rule 11 in the complaint, responsive pleadings, and in any dispositive motion.⁶⁸ The court found that: "In light of the language reflected in the transcripts, it is questionable whether plaintiff's counsel possesses evidentiary support for many of the allegations contained in the complaint."⁶⁹

In addition to these evidentiary questions, the court also addressed the requirements for providing meaningful cautionary language during conference calls. The plaintiffs argued that safe harbor protection was unavailable because the defendants failed to "couple each particular forecast made during that call with a statement both identifying the particular forecast as a forward-looking statement and indicating that actual results might differ materially." The court rejected this argument. It found that such an "unwieldy practice" is "contrary to the way in which public companies currently deliver oral forward-looking information, and contrary to the way in which people communicate." Indeed, this common sense conclusion finds support in the Reform Act's legislative history, which notes the expectation that the oral safe harbor warning will be made at the outset of any general discussion of future events and need not be repeated during the course of the discussion.⁷⁰

X. Federal Legislative Developments

As noted previously, there has been a substantial shift in litigation from federal to state court since passage of the Reform Act. See Section II, above. To prevent evasion of the Act's requirements, three bills (H.R. 1653, H.R. 1689, and S. 1260) have been introduced in Congress that would preempt private state securities fraud causes of action brought against issuers whose securities trade on national securities markets.⁷¹ One of the authors has previously analyzed these bills in significant detail, and we refer the reader to that article for a full description and analysis of the originally proposed bills.⁷²

A number of recent events significantly increase the likelihood that a uniform standards bill will become law. On April 28, 1998, the White House endorsed S. 1260. White House approval of the bill came one month after the SEC agreed to support the bill.

On April 29, 1998, the Senate Banking Committee marked up S. 1260 to reflect certain amendments made to win White House and SEC approval of the bill. A copy of the Senate bill appears in Appendix A. The amendments fall into two categories. S. 1260 applies only to class actions, which are defined in the bill, and the first set of amendments narrows that definition. In substance, the amendments seek to alleviate the SEC's concern that the original definition of class action would preempt: (1) groups of individual claims brought in separate cases against the same issuer; and (2) suits by trustees, guardians, or other parties authorized to seek damages on behalf of third parties. Second, S. 1260 was also amended to alleviate concern that it would preempt traditional state corporate law claims that are sometimes brought as class actions.

In its agreement with the committee staff, the SEC abandoned any attempt to amend the text of the legislation to provide a longer statute of limitations for securities fraud actions, to resurrect aiding and abetting liability in private actions under Rule 10b-5, or to clarify that the Reform Act's pleading standard was a codification of the Second Circuit standard that did not eliminate recklessness from the definition of scienter. In exchange, Senators D'Amato, Dodd, and Gramm sent a letter to the Commission stating (1) that they understood the Reform Act to leave undisturbed the pre-Reform Act scienter standard; (2) that they understood the Act to endorse the Second Circuit pleading standard; and (3) that they intend to restate these views in the legislative history and floor debate accompanying the uniform standards legislation.

At the April 29 hearing, an additional amendment was offered and approved to include findings on the necessity of the legislation. These findings were included to assist the Department of Justice should the bill be challenged as unconstitutional under the Tenth Amendment. As amended, the Banking Committee voted 14-4 to report the bill to the full Senate.

On May 13, 1998, the Senate passed S. 1260 by a vote of 79-21. The House is now considering the issue, and held additional hearings on May 19, 1998.

¹ The very low volume of filings in Q1 1996 appears to be an anomaly. It was the first quarter in which the Reform Act was effective, and it appears that filings in that quarter were reduced due to one-time inventory and learning curve effects. See JOSEPH A. GRUNDFEST AND MICHAEL A. PERINO, SECURITIES LITIGATION REFORM: THE FIRST YEAR'S EXPERIENCE 4-5 (John M. Olin Program in Law and Economics, Stanford Law School, Working Paper No. 140, Feb. 1997).

² For a detailed analysis of this shift, see Michael A. Perino, Fraud and Federalism: Preempting Private State Securities Fraud Causes of Action, 50 STAN. L. REV. 273 (1998).

³ DENISE N. MARTIN, ET AL., RECENT TRENDS IV: WHAT EXPLAINS FILINGS AND SETTLEMENTS IN SHAREHOLDER CLASS ACTIONS at Table 5 (National Economic Research Associates Nov. 1996).

⁴ Id.

⁵ Id. at Table 6.

⁶ See VINCENT E. O'BRIEN, A STUDY OF CLASS ACTION SECURITIES FRAUD CASES 7 (Law & Economic Consulting Group).

⁷ The figure for NYSE issuers is as of March 1998 and is taken from the NYSE web site (http://www.nyse.com/). Two figures are listed for NASDAQ: (1) the total number of companies; and (2) the total number of companies in the NASDAQ National Market. These figures are as of February 1998 and are taken from the NASDAQ website (http://www.nasdaq.com/).

⁸ CHRISTOPHER L. JONES & SETH E. WEINGRAM, WHY 10B-5 LITIGATION RISK IS HIGHER FOR TECHNOLOGY AND FINANCIAL SERVICES FIRMS 1 (John M. Olin Program in Law & Economics, Stanford Law School, Working Paper No. 132, July 1996).

⁹ These results are influenced somewhat by one significant outlier among the NYSE companies: Computer Associates, which has a market capitalization of $31 billion. Nonetheless, median market capitalization for the NYSE issuers is still 5 times larger than the median market capitalization for the NASDAQ issuers.

¹⁰ The figure for 1996 has been re-calculated based on a broader definition of "high technology." In our original study, we found that 33.9% of the actions filed in 1996 involved high technology issuers. GRUNDFEST & PERINO, supra note 1, at 16. Under our prior definition, 48.48% of the issuers sued in Q1 1998 would qualify as high technology issuers.

¹¹ These cases include class actions against Mercury Finance (complaint available at http://securities.stanford.edu) and NAL Financial Group Inc. (complaint available at http://securities.stanford.edu).

¹² Michael A. Perino, Fraud and Federalism: Preempting Private State Securities Fraud Causes of Action, 50 STAN. L. REV. 273 (1998); GRUNDFEST & PERINO, supra note 1, at 17.

¹³ During Q1 1998, class actions were filed against Centocor, Inc.; Cor Therapeutics, Inc.; GameTech International, Inc.; Omega Research, Inc.; Precision Response Corp.; Ultrafem, Inc.; and Versatility, Inc.

¹⁴ These cases are Zeid v. Kimberley (see http://securities.stanford.edu) and In re Silicon Graphics Sec. Litig. (see http://securities.stanford.edu) in the Ninth Circuit and Comshare Inc. in the Sixth Circuit (see http://securities.stanford.edu).

¹⁵ 15 U.S.C. § 78u-4(b). See H.R. CONF. REP. 104-369, at 41 (1995) ("Naming a party in a civil suit for fraud is a serious matter. Unwarranted fraud claims can lead to serious injury to reputation for which our legal system effectively offers no redress."). Congress found that Federal Rule of Civil Procedure 9(b), which addresses this concern by requiring plaintiffs to plead fraud with specificity, failed to stem abusive lawsuits, in part because the circuits had differed on its requirements. Id.

¹⁶ Veto Message for Securities Litigation Reform Act 1 (Dec. 19, 1995), reprinted in 141 CONG. REC. S19034 (Dec. 21, 1995) ("I believe that the pleading requirements of the Conference Report with regard to a defendant's state of mind impose an unacceptable procedural hurdle to meritorious claims being heard in Federal courts.").

¹⁷ See, e.g., John C. Coffee, Jr., The Future of the Private Securities Litigation Reform Act: Or, Why the Fat Lady Has Not Yet Sung, 51 BUS. LAW. 975, 977-85 (1996); Elliott J. Weiss, The New Securities Fraud Pleading Requirement: Speed Bump or Road Block?, 38 ARIZ. L. REV. 675 (1996); D.M. Osborne, Getting Back at Lerach, AMER. LAW., Sept. 1997, at 49.

¹⁸ 15 U.S.C. § 78u-4(b)(1).

¹⁹ In re Silicon Graphics, Inc. Secur. Litig., 970 F. Supp. 746 (N.D. Cal. 1997).

²⁰ 15 U.S.C. § 78u-4(b)(2).

²¹ The legislative history of the Reform Act on this point is extensively analyzed in Michael A. Perino, A Strong Inference of Fraud? An Early Interpretation of the 1995 Private Securities Litigation Reform Act, 1 SEC. LITIG. REFORM ACT REP. 397 (1996).

²² A number of courts have held that the provision codifies or is substantially similar to the Second Circuit standard. See, e.g., Marksman Partners, L.P. v. Chantal Pharmaceutical Corp., 927 F. Supp. 1297 (C.D. Cal. 1996); Zeid v. Kimberley, 930 F. Supp. 431 (N.D. Cal. 1996); Fugman v. Aprogenex, Inc., 961 F. Supp. 1190, 1195 (N.D. Ill. 1997) (non-class action); Rehm v. Eagle Finance Corp., 954 F. Supp. 1246, 1253-55 (N.D. Ill. 1997); STI Classic Funds v. Bollinger Industries, Inc., No. 3-96-CV-823-R (N.D. Tex., Nov. 12, 1996) (available at http://securities.stanford.edu); In re Oak Technology Sec. Litig., No. 96-20552 SW at 7 (N.D. Cal. Aug. 1, 1997) (available at http://securities.stanford.edu); see also Sloane Overseas Fund, Ltd. v. Sapiens International Corp., 941 F. Supp. 1369 (S.D.N.Y. 1996) (dicta).

Courts finding that the Act created a higher pleading standard include In re BAESA Sec. Litig., 969 F. Supp. 238 (S.D.N.Y. 1997); Silicon Graphics, 970 F. Supp at 757; Norwood Venture Corp. v. Converse Inc., 959 F. Supp. 205, 208-09 (S.D.N.Y. 1997 (non-class action); Powers v. Eichen, Case No. Civil 96-1431-B (AJB) (S.D. Cal., Mar 13, 1997); Friedberg v. Discreet Logic, Inc., 959 F. Supp. 42, 47-50 (D. Mass. 1997); In re Silicon Graphics, Inc. Sec. Litig., Fed. Sec. L. Rep. (CCH) ¶99,325 (N.D. Cal. 1996), 1996 U.S. Dist. LEXIS 16989 ("plaintiff must allege specific facts that constitute circumstantial evidence of conscious behavior by defendants").

²³ Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976).

²⁴ Silicon Graphics, 970 F. Supp. at 757.

²⁵ See, e.g., In re BAESA Sec. Litig., 969 F. Supp. at 241.

²⁶ No. CS-97-214-RHW (E.D. Wash. Jan. 22, 1998) (available at http://securities.stanford.edu).

²⁷ See 15 U.S.C.A. § 78u-4(g)(2)(A) (limiting joint and several liability to knowing violations of the securities laws); 15 U.S.C.A. § 78u-5 (providing that safe harbor protection is available unless plaintiff proves that a forward-looking statement was made with actual knowledge of its falsity).

²⁸ See, e.g., Brief of the Securities and Exchange Commission, Amicus Curiae in In re Silicon Graphics Sec. Litig., No. 97-16240 (9th Cir.) (available at http://securities.stanford.edu).

²⁹ Id. at *33-34 (citation omitted).

³⁰ Weilgos v. Commonwealth Edison Co., 892 F.2d 509 (7th Cir. 1989).

³¹ No. CIV-96-1514-PHX-RCB (D. Ariz. Feb. 5, 1998) (available at http://securities.stanford.edu).

³² No. 1:96-CV-1063 (N.D. Ohio Feb. 8, 1998) (available at http://securities.stanford.edu).

³³ 15 U.S.C. § 78u-4(b)(1).

³⁴ Sub-division (b) makes it unlawful "to make any untrue statement of material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading." 17 C.F.R. § 240.10b-5 (1997).

³⁵ 15 U.S.C. § 78u-4(b)(2).

³⁶ No. 97cv833 JM (JFS) 1998 US Dist. LEXIS 2009 (S.D. Cal. Feb. 20, 1998) (available at http://securities.stanford.edu).

³⁷ In re Donald J. Trump Casino Sec. Litig., 7 F.3d 357, 371 (3d Cir. 1993).

³⁸ Id. at 371-72 (noting that "the cautionary statements must be substantive and tailored to the specific future projections, estimates, or opinions in the prospectus which the plaintiffs challenge").

³⁹ No. C 96-2712 MHP (N.D. Cal. Mar. 5, 1998) (available at http://securities.stanford.edu).

⁴⁰ Id. at 10 (quoting In re Glenfed, 47 F.3d 1541, 1549 (9th Cir. 1994)).

⁴¹ Id. at 11.

⁴² No. 96 Civ. 3073 (AGS), 1998 US Dist. LEXIS 2777 (S.D.N.Y. Mar. 10, 1998) (available at http://securities.stanford.edu).

⁴³ Id. at *17.

⁴⁴ No. 96-CV-1138 (FJS), 1998 US Dist. LEXIS 3853 (N.D.N.Y. Mar. 26, 1998) (available at http://securities.stanford.edu.

⁴⁵ In the securities industry, such investors are known as "strong hands" investors because they undertake to maintain their investment position throughout the ups and downs of the company's formative years.

⁴⁶ 1998 US Dist. LEXIS at *6.

⁴⁷ Id. at *8.

⁴⁸ No. CIV. A. 97-11159-WGY, 1998 WL 138886 (D. Mass. Mar. 26, 1998) (available at http://securities.stanford.edu).

⁴⁹ No. CIV-96-0506-M (W.D. Okla. Mar. 29, 1998) (available at http://securities.stanford.edu).

⁵⁰ The court also dismissed plaintiff's claim under § 11 of the Securities Act of 1933 because he could not trace his purchase of the debt securities at issue to Fleming's initial public offering of those securities.

⁵¹ Mark, slip op. at 17 (quoting Voit v. Wonderware, 977 F. Supp. 363 (E.D. Pa. 1997)).

⁵² Mark, slip op. at 17 (quoting Havenick v. Network Exp., Inc., 981 F. Supp. 480, ___ (E.D. Mich. 1997)).

⁵³ No. C-96-0815 MHP, 1998 US Dist. LEXIS 4297 (N.D. Cal. Mar. 31, 1998) (available at [Insert URL]).

⁵⁴ Hockey v. Medhekar, No. C-96-0815 MHP (N.D. Cal. Apr. 15, 1997) (available at http://securities.stanford.edu).

⁵⁵ 1998 US Dist. LEXIS at *19-20 (quoting In re Oak Technologies Sec. Litig., 1997 US Dist. LEXIS 18503; In re Wells Fargo Sec. Litig., 12 F.3d 922, 926-67 (9th Cir. 1993)).

⁵⁶ No. 3:96-CV-2258-T, 1998 US Dist. LEXIS 4227 (N.D. Tex. Mar. 31, 1998) (available at http://securities.stanford.edu).

⁵⁷ 1998 US Dist. LEXIS at *14.

⁵⁸ See, e.g., In re Silicon Graphics, 970 F. Supp. 767-68.

⁵⁹ See H.R. CONF. REP. 104-369, at 43 (quoting Testimony of Richard C. Breeden, former Chairman, SEC, before the Securities Subcommittee of the Senate Committee on Banking, Housing, and Urban Affairs, Mar. 2, 1995).

⁶⁰ 15 U.S.C. §§ 77z-2(c)(1)(A)(i), 78u-5(c)(1)(A)(i).

⁶¹ 15 U.S.C. §§ 77z-2(c)(1)(B), 78u-5(c)(1)(B).

⁶² 1998 WL 159195 (S.D. Fla. Mar. 30, 1998) (available at http://securities.stanford.edu).

⁶³ Id. at 5 (quoting In re Donald J. Trump Casino Sec. Litig., 7 F.3d 357, 371 (3d Cir. 1993)).

⁶⁴ No. C-97 20609 RMW (N.D. Cal. Mar. 31, 1998) (available at http://securities.stanford.edu).

⁶⁵ These products permit x-ray, ultrasound, and MRI images to be transmitted over computer networks.

⁶⁶ 1998 WL 199082, at *6 (citing Cooper v. Picket, 1998 WL 32678 (9th Cir. 1998) (pre-Reform Act case)).

⁶⁷ 15 U.S.C. § 78u-5(e).

⁶⁸ 15 U.S.C. § 78u-4(c)(1). Under Rule 11(b)(3), an attorney signing a complaint warrants that the allegations of the complaint have evidentiary support or are likely to have such support after a reasonable opportunity for further investigation or discovery.

⁶⁹ 1998 WL 199082, at *19 n.11.

⁷⁰ 1998 WL 199082, at * 7 (quoting Senate Report No. 104-98, Pub. L. No. 104-67, 1995 U.S.C.C.A.N. 679, 696).

⁷¹ See Securities Litigation Improvement Act of 1997, H.R. 1653, 105th Cong. (1997); Securities Litigation Uniform Standards Act of 1997, H.R. 1689, 105th Cong. (1997); Securities Litigation Uniform Standards Act of 1997, S. 1260, 105th Cong. (1997).

⁷² See Michael A. Perino, Fraud and Federalism: Preempting Private State Securities Fraud Causes of Action, 50 STAN. L. REV. 273, 329-337 (1998).