At this stage, the natural inclination is to compare the volume of 1996 litigation reported in Table 1 with the baseline data reported in Table 2 and conclude that the volume of litigation has decreased from approximately 176 companies per year to either: (a) 109 companies per year (a 38% decline) based on observed annual filings; or (b) 124 companies per year (a 30% decline) based on an annualized litigation rate that ignores the low-level first quarter activity due to potential inventory and learning curve effects. Either interpretation of the data is fundamentally flawed because much of this decline appears to be the result of a substitution effect from federal to state court proceedings.
State Litigation Rates
It has historically been more profitable for plaintiffs to initiate class action securities fraud litigation in federal court rather than in state court. Counsel with substantial experience in litigating securities fraud matters suggest that the volume of class action securities fraud litigation in state court has, until passage of the Reform Act, been de minimis.18 Four recent developments, however, suggest an increased incentive to initiate class action securities fraud litigation in state court either instead of or in addition to federal litigation.
First, the new pleading requirements, rules governing joint and several liability, discovery stays, and other provisions of the Reform Act impose costs on plaintiffs that can potentially be avoided in state court. To the extent that the Act shifts the relative profitability of class action litigation in favor of state court, there should be a substitution into state court from federal court. For the defendant, however, the burdens and costs of defending against a state law claim are likely just as large as those in a federal action, and the size of a settlement or judgment can also be just as great.
Second, the automatic stay of discovery contained in the Reform Act provides an incentive to file a parallel state law action as a means to avoid the federal stay. Recent litigation suggests that this incentive is in fact at work. State actions filed for this reason are not, however, a measure of increased litigation activity, rather they are evidence of a new litigation strategy. Any attempt to measure the effect of the Reform Act on class action securities fraud litigation activity must therefore be careful to distinguish between state cases that represent new claims against companies not otherwise sued in federal court and parallel claims that are brought primarily for strategic advantage. Nonetheless, parallel state actions represent an increase in the costs of litigation to the extent that the Act provides an incentive to file duplicative actions.
Third, the Supreme Court's recent decision in Matsushita v. Epstein19 may strengthen the incentives to file substitute or parallel claims by establishing that state court settlements may discharge federal securities law claims that could otherwise only be brought in federal court. A plaintiff who seeks to avoid the new settlement procedures adopted in the Reform Act, who prefers not to deal with the lead plaintiff designated in the federal action, or who otherwise concludes that a more favorable settlement may be available in the state forum, may attempt to resolve all federal and state claims through state procedures that may not respect the Reform Act's innovations.
Fourth, the prospect of passage of California's Proposition 211, a ballot initiative that sought to establish California state securities laws that were substantially more plaintiff-favorable than current federal law, may have also increased the incentives to commence litigation in California state court.20 With the defeat of Proposition 211 in November of 1996, this incentive to file in California state court is not currently present. The pendency of Proposition 211 may therefore be the cause of a transitory and non-recurring increase in the volume of California state litigation activity.
Because plaintiffs are not required to disseminate notice of the filing of state court securities class actions, it is difficult to obtain accurate information on the number and nature of these state court cases.21 As a result, the data upon which this report is based may significantly undercount the actual number of state court filings, particularly for state court cases outside of California. For this reason, we do not attempt to draw any conclusions from these data concerning seasonal filing rates or trends in state court filings. Nonetheless, the available evidence suggests a significant increase in state litigation activity over the de minimis levels of prior years.22 Table 3 shows that from December 22, 1995, to December 31, 1996, sixty-nine companies were sued in securities fraud class action lawsuits filed in state court.23 Of these, thirty-nine were sued solely in state court with no parallel federal complaint in 1996. Although some of this increase in activity may be due to factors like Proposition 211, it appears that a significant portion of this increase is in some way attributable to the Act.
State Court Litigation
|Number of Companies Sued in State Court|
(adjusted for multiple state court filings)
|Number of Companies Sued in Both Federal|
and State Court
|Number of Companies Sued Solely in|
Table 4 describes actual and estimated class action securities fraud litigation rates in federal and state courts. We have observed a total of 148 companies actually sued in state or federal court in the study period, after eliminating double-counting due to the presence of parallel state and federal proceedings. Annualizing the April through December federal litigation rates yields an expected total of 163 companies sued in federal and state court. These figures represent a decline of 7% to 16% when compared to the average number of filings and dispositions in the period from 1991 through 1995. However, the 1991 though 1995 data demonstrate a significant range, and the 1996 data are not materially different from the data for 1991, 1993, and 1995, when filings were 153, 158, and 162, respectively.
Rate Based on
It is too soon to draw any firm conclusions from these data with respect to the effect the Reform Act has had on the aggregate number of securities class action lawsuits filed per year. The difficulty in drawing such conclusions is compounded by the difficulties associated with obtaining a complete census of state court class action activity. Nonetheless, these data suggest that the Reform Act appears to have had a modest effect at best on aggregate securities litigation activity. The more significant effects associated with the Reform Act appear to be the substitution effect that has shifted the venue for much of this litigation from federal to state court and the newly created incentives to file parallel litigation in state court.
In addition to questions concerning the Act's effect on the level of securities litigation activity, another important question is whether the Act has caused any material decline in the number of "meritless" lawsuits. Direct evidence on this issue may be difficult to obtain, particularly in light of disputes between plaintiff and defendant constituencies as to whether any individual claim has merit. Nonetheless, an investigation of the market characteristics24 of the firms sued before and after the Act reveals interesting patterns that may, over time, shed light on the extent to which plaintiff class action securities fraud litigation is, or is not, "merit-driven."
Data on the capitalization of companies named as defendants in federal class action securities fraud litigation suggest that issuers sued since the Reform Act became effective are, on average, smaller than issuers that were sued prior to the Reform Act. The reduction in the size of the average defendant issuer appears to be attributable entirely to a dramatic decline in litigation against the largest issuers, i.e., those with a market capitalization in excess of $5 billion.
Table 5 presents data comparing the size of issuers sued before and after the effective date of the Reform Act. The mean market capitalization of issuers sued in cases raising Section 10(b) claims but no Section 11 claims prior to the Reform Act was approximately $2,080 million, with a median of $180.0 million. Since the effective date of the Reform Act, the mean capitalization of issuers sued in comparable Section 10(b) cases has dropped to $529.3 million while the median has increased to $193.0 million.
|Section 10(b)/No Section 11|
|Pre-Reform Act Simmons|
|Post-Reform Act Sample||45||$529.3||$193.0||$787.5|
|Section 10(b) and/or Section 11|
|Pre-Reform Act Jones and|
Weingram Sample of Litigation
Following Stock Price Declines
|Post-Reform Act Sample||58||$467.0||$173.0||$725.0|
|Post-Reform Act Sample of|
Litigation Following Stock Price
As is apparent from Table 6, this sharp decline in mean capitalization accompanied by relative stability in median capitalization is almost entirely attributable to the absence in the sample studied of any litigation against issuers with a capitalization in excess of $5 billion.27 Preliminary analysis thus suggests that the Reform Act has cut off the tail of the size distribution of defendant firms by sharply reducing claims against the largest firms.
Because the average IPO has a smaller capitalization than the average firm already traded on the market, we expect that the pre- and post-Reform Act differentials in size of defendant firms would diminish if capitalizations are calculated for pooled Section 10(b) and Section 11 claims. Table 5 indicates just such an effect, but demonstrates that post-Reform Act defendant firms are, on average, still significantly smaller than defendants sued prior to the Reform Act's effective date.
As explained in detail below, this new pattern in defendant selection is consistent with our observation that the preponderance of post-Reform Act litigation involves allegations of accounting irregularities and trading by insiders.29 Larger, more established firms are less likely sources for material accounting irregularities or statistically significant trading by insiders. Larger firms are therefore less likely to be named as defendants. In addition, the stock market has experienced a substantial increase in value since the effective date of the Reform Act, with much of the market's strength centered on the most well-capitalized issuers. Between December 29, 1995, and December 31, 1996, the total returns for the S&P 500 were 22.92%. In contrast, the returns for the Russell 2000 Index were 16.52% over the same period.30 That price pattern is also consistent with a shift toward litigation targeting smaller issuers.
Recent speculation that plaintiffs' class action law firms are avoiding litigation against the largest issuers because of concerns regarding the vigor with which they will defend such litigation is therefore not necessarily correct. Other factors may be sufficient to explain this pattern in the data.
Among the more controversial claims made in the debate leading up to adoption of the Reform Act was that a significant stock price decline was frequently sufficient to trigger a class action securities fraud claim.31 Recent research suggests that this assertion is overstated.32 A more accurate characterization is that a significant stock price decline over a short period of time can be a necessary but not sufficient condition leading to class action securities fraud litigation.
Analysis of data describing litigation instituted since the Reform Act became effective suggests that, whatever the causal mechanism linking stock price declines and the institution of class action securities fraud litigation, the decline triggering post-Reform Act litigation is greater than the decline triggering pre-Reform Act litigation. As illustrated in Table 7, the average one-day stock price decline around the end of the class period in a sample of 161 pre-Act cases alleging violations of Section 10(b) but not of Section 11, was approximately 19%. A sample of forty-six equivalent post-Reform Act lawsuits indicates an average one-day decline around the end of the class period of about 31%.
|Section 10(b)/No Section 11|
|Pre-Reform Act Simmons Sample33||161||-19.32%||-17.54%||14.32%|
|Post-Reform Act Sample||46||-30.68%||-28.18%||19.07%|
|Section 10(b) and/or Section 11|
|Pre-Reform Act Jones and|
Weingram Sample of Litigation Following Stock
Price Declines >= 10%34
|Post-Reform Act Sample of Litigation|
Following Stock Price Declines >= 10%
|Post-Reform Act Sample Without Regard|
to Level of Price Declines
A similar increase in stock price declines is found if Section 11 and Section 10(b) cases are pooled in a single sample. A study of 200 class action lawsuits instituted after 10% price declines finds that the average decline surrounding the end of the class period was 24.8%.35 The equivalent statistic for a sample of fifty-four post-Reform Act cases shows a decline of 33.5%. A sample of fifty-nine post-Reform Act cases, which includes five cases brought after one-day declines of less than 10%, shows a one-day average decline of 30.7%.
This increase in one-day stock price declines observed around the end of the class period is consistent with the theory that plaintiffs must, on average, demonstrate more dramatic wrongdoing in the post-Reform Act environment in order to satisfy the new federal pleading standard. Further statistical analysis is necessary, however, to support this conjecture. In particular, it would be valuable to know whether the average stock price decline associated with state court filings that have no parallel federal claims are systematically smaller than those associated with federal claims.
Beta is a measure of the riskiness of a given firm's stock based on correlation between the movement of its stock price and the movement of a broad-based stock market index. A beta in excess of one indicates greater than average risk in that the stock price tends to move more dramatically than the index as a whole, while a beta of less than one indicates below-average risk in that the stock price tends to move less dramatically than the index as a whole.
Preliminary analysis of a sample of forty-six companies suggests that companies sued after the Reform Act are riskier than the market, with an average beta of 1.39, but perhaps no riskier than the targets of pre-Reform Act litigation, with average betas variously reported as 1.190,36 1.25,37 1.408.38 Thus, while targets of class action securities fraud litigation continue to be riskier, on average, than the market index as a whole, the data do not yet indicate a systematic change in the average beta of target companies.
High-technology companies were among the most vocal proponents of securities litigation reform,39 in large part because experience prior to the Reform Act indicated that high-technology companies were involved in a disproportionately large number of securities fraud class action cases. One study of securities fraud class action litigation from 1989 through 1992 concluded that high-technology companies were sued twice as often as firms in other industries.40 A study of 348 settlements of open-market fraud securities class actions found that 30.5% were high-technology companies, 22.4% were in financial services, and 47.1% were in some other industry.41 Thus, an important question is whether the overall rate of litigation against high-technology or other industries has changed in the post-Reform Act period.
To determine the post-Reform Act incidence of litigation activity by industry, we use the Standard Industrial Classification ("SIC") codes that were employed in the Jones and Weingram (1996) study. We rely on the primary SIC codes listed on the issuer/defendant's Form 10-K as it appears in the LEXIS database or on company profiles contained in the LEXIS Company library. Where no SIC information was available on-line for a particular defendant, we rely on SIC information compiled by the Center for Research in Security Prices ("CRSP") at the University of Chicago.
Table 8 indicates that of the 109 issuers sued in federal court from December 22, 1995, through December 31, 1996, approximately 34% are high-technology companies, an estimate within the range found in pre-Reform Act samples. The Reform Act thus seems to have had little effect on the percentage of "high-tech" firms named in securities fraud class action lawsuits.
|Pre-Reform Act Complaints||Complaint|
|Jones and Weingram|
Actions involving finance companies constitute 10.1% of the complaints. In contrast to the rate of litigation against high-technology companies, the rate of litigation against finance companies appears to have dropped significantly. It does not appear, however, that this decrease is attributable to passage of the Reform Act. This result is, instead, consistent with the results of earlier studies which observed a decreasing rate of litigation against commercial banks43 attributable primarily to the end of the savings and loan crisis and the associated reduction in loan loss reserve litigation.44
Another measure of the impact of the Act on securities litigation is whether there have been material changes in the frequency of particular allegations of fraudulent conduct. Our analysis of the nature of the frauds alleged is based on our review of sixty-five, post-Reform Act, federal court complaints that we were able to obtain.45 A comparison of these post-Reform Act complaints and available baseline data from pre-Reform Act cases suggests that there has been a significant change in the frequency of particular allegations, apparently in response to the Reform Act's new heightened pleading standard.46
As illustrated in Table 9, one of the most common forms of fraud alleged in the sixty-five complaints analyzed are misrepresentations or omissions in financial statements which appear in 58.5% of the complaints. Thirty complaints (or 79% of those alleging false and misleading financial statements) allege a violation of Generally Accepted Accounting Principals ("GAAP"). Of the thirty-eight complaints alleging misrepresentations or omissions in financial statements, thirty-six (or 95%) allege improperly recorded sales, revenues, or earnings. Allegations of misstated financials account for 67.4% of the forty-six complaints that are based solely on alleged Section 10(b) violations.
|Type of Allegation||Pre-Reform Act|
|All Post-Reform Act|
|Trading by Insiders|
During Class Period
|False or Misleading|
|False or Misleading|
Statement as Sole
The frequency of these accounting-driven allegations appears to have increased markedly in the post-Reform Act period. A study of 174 pre-Reform Act Section 10(b) cases found that only 33.9% of the sample contained allegations of misstated financials.47 This change in allegations does not mean that there is more accounting fraud in the post-Reform Act period. The significant increase in the number of cases involving misrepresentations and omissions in financial statements, particularly those that allege improperly recorded sales, earnings, or revenues or a GAAP violation, is consistent with the Reform Act's higher pleading standard which requires plaintiffs to plead facts giving rise to a strong inference of scienter. Plaintiffs may believe that courts will be more likely to find that they have satisfied their pleading obligations in cases involving such misrepresentations or omissions.
One unexpected result found in the complaints analyzed, however, is the significant number that also contain allegations involving false or misleading forward-looking statements. The Reform Act created a safe harbor for the release of forward-looking information in certain circumstances. Indeed, one of the chief concerns expressed in the Act's legislative history is that companies that released forward-looking information in the pre-Reform Act period were susceptible to securities fraud class actions if those forecasts proved to be inaccurate, regardless of any proof of the company making an intentionally misleading forecast.48 Nonetheless, as detailed in Table 9, forty-two of the sixty-five post-Reform Act complaints analyzed (or 64.6%) contain allegations of false forward-looking statements. Among the forty-two complaints alleging false forward-looking statements, thirty-two (or 76%) allege that the misleading forward-looking statement concerned earnings, sales, or revenue forecasts.
One possible reason that allegations of false forecasts remain a significant part of the litigation landscape is that many of the forecasts alleged to be false occurred prior to the passage of the Reform Act, making it unlikely that any of the companies complied with the safe harbor requirements. It is also important to recognize that allegations of false forecasts were rarely the sole allegation contained in the complaint. Indeed, only nine complaints (or 13.8%) had false forward-looking information as the sole basis for their allegations of securities fraud. In the sample of forty-six Section 10(b) cases that figure drops to three (or 6.5%). In the remaining cases, allegations of false forward-looking statements, were combined with some other allegation of fraud. Thus, where other allegations may be sufficient to satisfy the new pleading standards, plaintiffs may consider that there is little downside in alleging false forecasts as well.
It may also be significant that the nine complaints alleging false forward-looking statements as the sole basis for liability all arose after June 1, 1996. These complaints were thus all filed after the Central District of California's May 21 decision in Marksman Partners, L.P. v. Chantal Pharmaceutical Co.49 As discussed more fully below,50 that decision is significant because the court's interpretation of the new pleading standard was consistent with pre-Reform Act precedent from the Second Circuit. The court rejected language in the Act's legislative history suggesting that the pleading standard was even more stringent than the Second Circuit's interpretation. Some plaintiffs' attorneys may have taken this ruling to suggest that some forward-looking statement cases might be able to survive even under the new pleading standard.
In addition to an observed increase in the frequency of allegations concerning misrepresentations and omissions in financial statements, passage of the Act also appears to be correlated with an increase in allegations of insider trading. As illustrated in Table 9, 52.3% of the complaints studied in this report contain allegations of trading by insiders during the period the alleged fraud was alive in the market. For the forty-six complaints brought solely under Section 10(b), the percentage rises to 56.5%. The only pre-Reform Act study of which we are aware that analyzes insider trading patterns suggests that insider trading allegations appeared in only 20.7% of a sample of 174 Section 10(b) pre-Reform Act cases.51 This significant increase in alleged insider trading is consistent with the theory that plaintiffs are increasingly relying on trading by insiders to support the "strong inference" pleading requirement of the Reform Act.
There also appears to be a significant correlation between the frequency of alleged trading during the class period and the industry of the issuer.52 Table 10 shows that 73.1% of the complaints involving high-technology companies contain allegations of insider sales, compared to approximately 38.5% for all other issuers. Given that stock option compensation in the high-technology sector is more common than in other sectors of the economy, this finding is not surprising. At the same time, however, this compensation practice also means that the baseline level of "normal" insider sales in the high-technology sector is greater than in other sectors. It would therefore be incorrect to draw any inference from these data that opportunistic behavior by insiders is more common in the high-technology sector than in other sectors.
|Type of Allegation||Number||Percent||Number||Percent||Number||Percent||Number||Percent|
|Trading by Insiders|
During Class Period
|False or Misleading|
Statement as Sole
The observation that trading by insiders occurs even when there is no allegation of fraud raises an important and as yet unresolved question with regard to the interpretation of the "strong inference" pleading standard. If trading by insiders during a period when a fraud is allegedly alive in the market is consistent with patterns observed in situations not involving fraud, how is a court to decide whether such conduct will support a strong inference of a state of mind connoting scienter? The resolution of this complex but exceedingly important issue--especially for the high-technology sector--will likely require further statistical research and the evolution of additional legal doctrine refining the notion of strong inference of fraud in the context of "plain vanilla" sales by corporate insiders.
One possible consequence of the Reform Act would be to shift litigation toward claims that do not come under the new heightened pleading standard.53 In particular, claims brought under Section 10(b) must adequately allege scienter, while Section 11 or Section 12(2) claims alleging fraud in initial or follow-on offerings are not subject to this requirement. The heightened pleading requirement thus imposes a differentially greater burden for pleading Section 10(b) claims than for the pleading of Section 11 or Section 12(2) claims. One predictable consequence of the differential pleading standard would be a shift toward Section 11 and Section 12(2) cases.
Prior to the Reform Act, approximately 21% to 24% of class action securities fraud cases involved claims arising from the sale of securities in initial public offerings or follow-on offerings.54 Of these underwritten offerings, IPOs accounted for approximately 14%55 and follow-on offerings 8% to 10%.
To date, we have not observed any increase in the percentage of litigation raising claims of fraud in the sale of securities governed by Section 11 or Section 12(2). In a sample of sixty-five post-Reform Act complaints, fifteen (or 23%) alleged violations of Section 11 or Section 12(2). Allegations involving IPOs are significantly more frequent, accounting for eleven of these claims. Subsequent versions of this report will analyze all 109 companies sued in federal court in 1996 and state court complaints that may assert Securities Act claims.
It was generally understood that prior to passage of the Reform Act, a single law firm, Milberg Weiss Bershad Hynes & Lerach ("Milberg Weiss"), played a dominant role as plaintiffs' class action counsel. Available data suggest that during the period from April 1988 through September 1996, Milberg Weiss represented clients in approximately 31.4% of 842 class action securities fraud cases pending nationwide.56
Since passage of the Reform Act, Milberg Weiss appears to have become even more dominant in the class action securities fraud litigation process. As illustrated in Table 11, of the total of 109 companies sued in federal court, Milberg Weiss has entered an appearance in at least 51 of these federal cases, for a national federal appearance ratio of 46.8%. If the national sample is expanded to include state claims with parallel federal proceedings, we are able to identify Milberg Weiss appearances in 64 of 109 cases, for a 58.7% appearance ratio.
|Federal Court Proceedings||109||51||46.8%|
|Parallel Federal and State Court Proceedings||109||64||58.7%|
|California Federal Court Proceedings||24||17||70.1%|
|Parallel California Federal and State Court|
These national appearance ratios understate Milberg Weiss' particularly active role in litigation pending in California federal and state courts. In the 24 cases identified as filed in a California federal court, at least 17, or 70.1%, involve appearances by Milberg Weiss. If the California sample is expanded to include California state court claims with parallel federal proceedings, we are able to identify Milberg Weiss appearances in 20 of 24 cases, for a 83.3% percent appearance ratio.
These data must be interpreted with caution, however. In addition to the previous comments regarding the preliminary nature of this research, it is important to emphasize that an appearance ratio should not be confused with a market share for several reasons. First, it is common practice for many law firms to enter appearances on behalf of different plaintiffs in the same case. If the average consolidated class action brings together claims filed by different law firms, then the aggregate appearance ratio for the market as a whole will be greater than 100%. Any individual law firm's appearance ratio, calculated as a percentage of the market's aggregate appearance ratio, will therefore be lower than its appearance ratio calculated on a stand-alone basis. At present, we lack a sufficiently large sample of complete dockets to develop a reliable estimate of any firm's appearance ratio as a fraction of average aggregate appearance ratios.
Second, not all appearances are equal. Prior to the Reform Act, a lead counsel was often designated in class action securities fraud litigation, and that lead counsel typically asserted disproportionate control over the litigation and collected a disproportionate share of the fees awarded, if any, to plaintiffs' counsel in the litigation. It is generally believed that Milberg Weiss, which is the largest of the nation's law firms specializing in class action securities fraud litigation, is often designated lead counsel and often plays a dominant role in the prosecution of these claims. Accordingly, an appearance by Milberg Weiss in any given lawsuit may, on average, indicate a greater influence by that firm than any other making an appearance in the litigation. Again, however, we lack data necessary to adjust for this observation.
Third, the Reform Act established a procedure whereby a lead plaintiff has the obligation to select class counsel subject to approval by the court.57 To the extent that the addition of this statutorily mandated approval process either increases or decreases the probability of Milberg Weiss being named lead counsel, or changes the dynamics of inter-firm management of plaintiff litigation, appearance ratios observed prior to the Reform Act may have a significance that is different from the appearance ratios observed since the Reform Act's effective date. In particular, to the extent that economies of scale for larger firms, such as Milberg Weiss, make it easier for them to attract coalitions of plaintiffs willing to act as lead plaintiff and to designate Milberg Weiss as counsel, this provision of the Act may increase the firm's significance in the litigation process. On the other hand, to the extent that large institutional investors step forward to influence the counsel selection process away from Milberg Weiss, this provision may diminish Milberg Weiss' future influence. Again, we must await further experience before drawing firm conclusions regarding these effects of the Reform Act.
No doubt, data describing the percentage of total plaintiff class action attorney fee awards captured by each class action counsel would play a useful role in estimating a true "market share" as opposed to an appearance ratio statistic. The data necessary for such calculations are not, however, publicly available. While courts are required to approve the aggregate fee award paid to counsel in class action litigation, the court is typically not called upon to approve the division of that fee among the many law firms potentially representing plaintiffs, and the public record typically contains no information regarding these allocations.
Notwithstanding these important cautionary statements, Milberg Weiss' increased dominance as measured by the appearance ratios observed to date is consistent with economic theory regarding firm behavior in a market subject to externalities. Specifically, if Milberg Weiss is the largest and best capitalized of the plaintiffs' class action firms, which it appears to be, then it will be best situated to bear the additional cost of delay and uncertainty associated with litigation in the post-Reform Act era. Further, to the extent that in the earliest years following adoption of the Reform Act any one decision reached by any court interpreting a provision of the Reform Act may have a disproportionately large effect on the resolution of other cases, the Milberg Weiss firm has an incentive to internalize this externality by assuring that early cases do not establish precedents adverse to the interests of the firm. No other firm will have an equally strong incentive to invest for this reason. Put another way, in the early years following adoption of the Reform Act, there will be relatively less well established doctrine on which smaller firms, less capable of financing or undertaking riskier litigation, will be able to "free-ride." Thus, just as the Reform Act may create economic incentives for Milberg Weiss to expand its appearance ratio, it may also establish an incentive for smaller firms to shrink their appearance ratios.
If the preceding analysis is correct, and if historical patterns are not disturbed by lead plaintiffs' decision to exercise a new degree of control over the counsel designation process, then we would not be surprised to find a material period of increased dominance by Milberg Weiss in the market for class action securities fraud litigation.
Table 12 presents data describing the incidence of litigation by judicial circuit from December 22, 1995 through December 31, 1996. As that table demonstrates, the geographic distribution of post-Reform Act litigation by circuit is similar to the distribution of litigation prior to the Reform Act.58 This result is not surprising given the relative stability of high-technology firms among the companies sued. As in the pre-Reform Act period, the Ninth Circuit (which includes California) is the most active forum for securities class actions; however the percentage of cases in that circuit has dropped from 36% to 27.6%. The Second Circuit (which includes New York) remains the next most active circuit, although there has been a modest increase in cases from 15% to 18.1%. Among circuits with significant numbers of filings, modest increases have also been observed in the Fifth (which includes Texas) and Eleventh (which includes Florida) Circuits.
Table 13 lists the top five districts for securities class action filings and describes the number of securities class action filings per thousand civil case filings in those districts. The districts in which the most companies have been sued are the Northern District of California (Silicon Valley's home district) and the Southern District of New York (which includes Manhattan). Each district had fifteen filings or about 13% of the total. In total, California district courts account for about 21% of securities class action litigation in the post-Reform Act period. New York district courts have the second highest incidence of securities class action litigation during the study period with 17.9% of the post-Reform Act litigation activity.
|Southern New York||15||1.460|
Securities class actions are, however, a significantly larger portion of the docket in Northern California, which has nearly twice as many securities class action filings per thousand civil cases (2.872) as the Southern District of New York (1.460).61 While these figures suggest that securities class actions account for only a small percentage of total civil filings, they do not capture the magnitude of the burdens these cases place on the judiciary. The average class action demands considerably more judicial time than either the average civil case or the average non-class action securities fraud case.62
It has frequently been observed that the large majority of federal class action securities litigation filed prior to the Reform Act was resolved by settlement. One study has reported that 87.6% of the securities class actions filed from April 1988 through September 1996 ended in a settlement,63 with the large majority of the remainder being resolved by dispositive motions or voluntary dismissal. Very few class action securities fraud cases go to trial. Another study has found that the median time between filing and settlement was 21.7 months.64 Any trends in the number of cases settling, the length of time between filing and settlement, and the average settlement amounts will provide important data as to the effects of the Reform Act.
The first year of practice under the Reform Act, however, is too short a period within which to expect substantial settlement activity, particularly given the novelty of many of the Reform Act's provisions. We are aware of only five settlements in 199665 of cases brought under the Reform Act, and we expect that it may take several years of experience before we are able to draw broad conclusions as to the effect of the Reform Act on settlement behavior. Nonetheless, early experience supports the tentative inference that plaintiffs are quickly dismissing certain claims with little or no recovery. Such conduct is consistent with a plaintiff filing a lawsuit only to discover quickly that the claim lacks merit or is otherwise not profitable to pursue. It therefore remains an open question as to whether the Reform Act has successfully deterred the filing of claims that can quickly be determined to be weak.
The settling cases are as follows:
1. Caramonta v. Dingus.66 On May 30, 1996, Touchstone Software, a developer and publisher of utility software, announced a settlement of three shareholder class action and derivative suits brought against it and several of its officers and directors. The agreement calls for the establishment of a settlement fund consisting of $500,000 to be paid by Touchstone and issuance of 200,000 new shares of the company's common stock. The agreement also calls for plaintiff review of certain policies.67
2. Levy v. United HealthCare Corporation.68 On December 18, 1996, United HealthCare announced that all claims against it in the Levy action had been voluntarily dismissed with prejudice. Pursuant to a Stipulation and Order, the parties agreed to dismiss all claims prior to class certification. No payment was made to the named plaintiff or his counsel.
3. Alexander v. Health Management.69 Health Management, Inc., announced a settlement of all pending shareholder class actions filed against it. The settlement, subject to final court approval, calls for a $2 million cash payment and the issuance of 2.2 million shares of common stock and 2.2 million warrants to purchase common stock.70
4. Trieff v. Cirrus Logic Inc.71 Cirrus Logic agreed to pay $31.3 million to settle shareholder lawsuits filed against the company in 1993, 1995, and 1996. The post-Reform Act complaint was filed in California state court and alleged claims arising out of Cirrus Logic's announcement that it would restate quarterly results. On August 22, 1996, the Alameda Superior Court dismissed four of plaintiffs' claims for relief. Plaintiffs then filed a second class action complaint against the company in September 1996 alleging the company misstated demand for certain of its products. The company will pay $2.3 million of the settlement.
5. Fradin v. HighwayMaster Communications, Inc.72 Plaintiffs agreed to dismiss voluntarily their class action lawsuit without costs to either side. The complaint alleged that HighwayMaster omitted to disclose in its IPO prospectus certain product defects in mobile communications equipment the company manufactured.
As of the date of this paper, we are aware of twenty-six decisions interpreting provisions of the Reform Act. Because these decisions arise in cases that have all been filed within the last year, they involve exclusively the earliest judicial determinations in class action securities litigation under the Reform Act. These twenty-six decisions involve the: (a) interpretation of the "strong inference of fraud" pleading standard; (b) scope of a discovery stay on a pending motion to dismiss; (c) conflicts between federal and state court; (d) adequacy of notice and the appointment of a lead plaintiff; (e) survival of the recklessness standard for scienter; (f) safe harbor for forward-looking information; and (g) retroactive application of the Reform Act. Two additional decisions, although not decided under the Reform Act, may provide important precedents for its interpretation. This section discusses the decisions chronologically within each of these categories.
To the extent that it is possible to generalize from this early experience, three developments appear to be worth mention. First, of the seven courts interpreting the strong inference pleading requirement, six have concluded that the statute incorporates the Second Circuit's pleading requirement and not some higher standard implied in the legislative history. This is the conclusion preferred by plaintiffs. Second, only one motion to dismiss has been granted without leave to replead the major portion of the case. The sole exception involved a Section 11 claim that was not subject to the new strong inference standard. The new heightened pleading standard therefore does not yet appear to be functioning as a useful device for quickly dismissing claims drafted with an eye toward satisfying the statute's new requirements.
Third, complex issues regarding the interplay of federal and state jurisdiction are rapidly emerging. The application of the discovery stay to state litigation while a federal claim is pending and the interpretation of the federal safe harbor in a state proceeding when there is no state law safe harbor are but two examples of the many issues now arising in class action securities fraud litigation. This tension between the federal and state courts will likely grow over time and may well draw attention from Capitol Hill.
One of the primary reforms Congress put in place to curtail the filing of "meritless" lawsuits was a new heightened pleading standard. Section 21D(b)(2) of the Reform Act requires, among other things, that plaintiffs in securities fraud actions "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." The "strong inference" language was taken from Second Circuit case law interpreting the requirements of Federal Rules of Civil Procedure 8 and 9(b) in the context of securities fraud cases.73 President Clinton cited this provision in his veto of the Reform Act because, in his view, language in the legislative history indicated that Congress was adopting a standard that was more stringent than that of the Second Circuit. Since the veto and subsequent override, commentators and courts have disagreed over what facts will satisfy Section 21D(b)(2) and whether the Second Circuit tests for finding a strong inference of fraud survived passage of the Act. Through January 1997, at least seven courts addressed the new pleading standard, with six finding that the Second Circuit tests survived passage of the Reform Act. In addition, it is significant to note that no motion to dismiss in a case subject to the new pleading standard has been granted without permitting plaintiffs the opportunity to replead at least some of their claims.
1. Marksman Partners, L.P. v. Chantal Pharmaceutical Corp.74 Chantal is the first decision to interpret the Reform Act's more stringent pleading requirements. The Central District of California denied a motion to dismiss and found that plaintiffs had satisfied their pleading obligations. In so holding, the district court determined that Congress did not adopt a more stringent pleading standard than had existed in the Second Circuit. The court also found that two tests the Second Circuit employed to determine whether the plaintiff satisfied its pleading obligations--the "motive and opportunity" test and the "strong circumstantial evidence" test--survived passage of the Reform Act.75 The court held that allegations that the Chairman and CEO sold 20% of her stock during the class period for proceeds of $6.3 million were sufficient to allege a strong inference of fraud, particularly where she had not sold any stock during the previous three years.
2. Zeid v. Kimberley.76 The court dismissed with leave to replead77 a securities class action brought against Firefox Communications, Inc. and certain of its officers and directors. The complaint alleged that defendants had misrepresented the demand for the company's products and the success of its sales and marketing program in the United States. The complaint also alleged that Firefox improperly recognized certain revenues and failed to keep adequate reserves in violation of GAAP and SEC rules.
The court found that plaintiffs failed to plead with sufficient specificity: (i) when or how allegedly misleading statements were communicated to the market; (ii) that the company adopted certain analysts' statements; and (iii) the reasons why certain statements were misleading. Allegations that Firefox violated GAAP by "parking" inventory with distributors were insufficient because the complaint did not "name a single customer or sale where Firefox 'parked' its inventory or prematurely recognized revenue."78 The court did find that the complaint alleged with particularity facts surrounding the company's failure to maintain adequate reserves. However, these claims were dismissed as well for failure to plead a strong inference that defendants' actions were intentional or reckless. As in Chantal, the court in Zeid found that the Second Circuit's tests for pleading scienter survived passage of the Reform Act.
Finally, the court dismissed with prejudice plaintiffs' claims that certain warnings and disclaimers contained in the company's Form 10-Qs were false and misleading. Plaintiffs argued that these statements were merely boilerplate and that the company's reports should have contained specific disclosures of the adverse factors which were then negatively affecting the company's business. The court rejected this argument as "absurd," and held that the warnings were not actionable as a matter of law because plaintiffs did not allege that the warnings were wrong. Instead, they alleged that the warnings "should have been more specific." This was not a proper claim under Section 10(b) and Rule 10b-5, which do not protect against "statements that are too abstract."79
An amended complaint has been filed and is now pending before the court.
3. Sloane Overseas Fund, Ltd. v. Sapiens International Corp.80 The Reform Act's provisions did not apply to this case because the action was filed prior to the effective date of the Act. In deciding a motion to dismiss, however, the court noted in dicta that the Reform Act "codif[ied the] Second Circuit standard for pleading scienter."81
4. In re Silicon Graphics, Inc. Securities Litigation.82 The court in Silicon Graphics reached a substantially different conclusion with respect to plaintiff's pleading obligations than the courts in Chantal and Zeid. Unlike those cases, the Silicon Graphics court held that the Reform Act did not simply codify the prior Second Circuit standard.83 Instead, the court found that Congress meant to erect a higher pleading barrier that requires "that plaintiff must allege specific facts that constitute circumstantial evidence of conscious behavior by defendants."84
The court found that plaintiff's attempt "to couple allegations of defendants' awareness of negative internal reports with their false and misleading statements and stock sales ... [was] not specific enough to raise a strong inference of fraud."85
The court granted plaintiff leave to replead, and an amended complaint was filed on October 17, 1996. A second motion to dismiss the amended complaint is now pending.
5. STI Classic Funds v. Bollinger Industries, Inc.88 In Bollinger, a magistrate judge ruling on a motion to dismiss held that the motive and opportunity test survived passage of the Reform Act. The magistrate judge then found that the facts pleaded in the amended complaint at issue satisfied this standard with respect to claims against the company and certain of its officers, but not with respect to a subsidiary company.
Defendants Glenn and Bobby Bollinger founded and were the two senior officers of Bollinger. The complaint alleged that the company invoiced fraudulent sales transactions with one or more customers in order to inflate reported sales and earnings. These misstatements of financial performance allegedly stemmed from inadequate financial and accounting controls and violations of GAAP of which the company and its senior management were aware. Bollinger was also allegedly aware prior to an announcement in March 1995 that supervisors at its NBF subsidiary were falsifying production reports. In June 1995, two of the company's outside directors and its auditor resigned, allegedly because of these problems.
With respect to motive, the court noted that allegations of materially inflated financial health "benefited the value of Bollinger's shares and likewise increased the value of the Brothers Bollinger's interest in the company."89 The court rejected defendants' argument that a similar finding of motive would apply to any small, family-dominated business. A strong inference could be drawn from the individual defendants' positions within the company "that they were knowledgeable about the methods and billing practices utilized by Bollinger which led to the over-stated sales and revenues reported in the SEC filings signed by them."90 The court found the allegations against the individual defendants with respect to NBF inadequate to satisfy the Reform Act's pleading standard because they failed to plead sufficiently that the defendants knew that the statements were false when made.
The district court adopted the magistrate judge's findings on November 12, 1996.
6. Fischler v AmSouth Bancorporation.91 Plaintiff brought a class action on behalf of all purchasers of non-deposit investment products from AmSouth, claiming that AmSouth failed to disclose certain surrender charges applicable to these instruments. In a brief opinion, the court determined that the complaint satisfied the requirements of Federal Rule of Civil Procedure 9(b) and the Reform Act. The court noted that Rule 9(b) had three purposes: (i) ensuring that the allegations of fraud are specific enough so that defendants will be able to respond effectively; (ii) eliminating those complaints filed as a pretext for discovery of unknown wrongs; and (iii) protecting defendants from unfounded charges of wrongdoing. The court then applied the Second Circuit tests for pleading a strong inference of fraud without discussing whether those tests survived passage of the Act. The also court noted that the "motive and opportunity" test was a "common method for establishing a strong inference of scienter".92
7. Rehm v. Eagle Finance Corp.93 The court in Eagle Finance found that the Reform Act "does not impose a more rigorous pleading requirement than that enunciated by the Second Circuit."94 The Reform Act, however, also "declines to bind courts to the Second Circuit's interpretation of its standard."95 Nonetheless, the court employed the motive and opportunity and strong circumstantial evidence of fraud tests in refusing to dismiss the action, which alleged that Eagle materially understated its credit losses and overstated its earnings.
Following Second Circuit precedent, the court found that certain generic motives that were likely held by executives generally were not enough to create a strong inference of fraud. Similarly, alleged insider sales did not satisfy the motive and opportunity test. The court first noted that two of three individual defendants did not sell any stock during the class period. The third defendant sold only 6% of his personal holdings. While this was the defendant's first sale, the court did not find this unusual because the stock was originally issued only sixteen months earlier.
The court found that plaintiff's combination of allegations constituted strong circumstantial evidence of conscious misbehavior or recklessness. First, Eagle allegedly overstated its 1995 earnings by 91%. This allegedly serious GAAP violation, when combined with allegations that defendants were responsible for calculating and releasing the financial information, supported the conclusion that defendants acted with scienter. Second, the company reported "massive" year-end increases to credit loss reserves and decreases to earnings. The magnitude of these reporting errors lent weight to the allegations of recklessness, especially where defendants were in a position to detect the errors. Third, the court pointed to the nature of Eagle's loan servicing business and defendants' statements downplaying the significance of the accounting errors to support a finding of scienter. "[T]he crucial significance of accurate credit loss accounting in determining the financial viability of Eagle, combined with defendants' careful statements mitigating the seriousness of the credit loss problem, raises a strong inference that defendants acted with knowledge of their public misstatements or were willfully blind to the truth."96
1. Steckman v. Hart Brewing, Inc.97 Hart Brewing is the only post-Reform Act case to date where a complaint was dismissed without leave to replead. Ironically, the Act's new heightened pleading standard did not apply to the case because it alleged only violations of Sections 11 and 12(2) of the 1933 Act in connection with Hart's initial public offering. Nonetheless, the court noted that the Reform Act "encouraged the use of motions to dismiss in certain securities cases."98 The court also echoed one of the Reform Act's rationales when it noted that courts should dismiss 1933 Act claims to "minimize the chance that a plaintiff with a largely groundless claim will bring a suit and conduct extensive discovery in the hopes of obtaining an increased settlement."99
The Hart complaint alleged that defendants failed to disclose material facts indicating an adverse trend of declining sales. Plaintiff alleged that disclosure of partial fourth quarter 1995 results would have shown that Hart could not sustain its past high growth and that this disclosure would have reduced the IPO stock price.
The court's decision hinged on the interpretation of Item 303 of Regulation S-K, which requires companies going public to disclose trends that are presently known to management and reasonably likely to have a material effect on financial condition or operating results. The court found that Item 303 only required a company to disclose intra-quarter results where those results represent an extreme departure from earnings of prior quarters. The complaint was found to allege no facts indicating either that defendants actually knew that the quarterly results would be an extreme departure or that the results were in fact an extreme departure. The court also noted the company had no duty to disclose trends about future performance or to supply other forward-looking information.
In passing the Reform Act, Congress was concerned that "[t]he cost of discovery often forces innocent parties to settle frivolous securities class actions."100 To combat this problem, the Reform Act provides in new Section 27(b) of the 1933 Act and new Section 21D(b)(3) of the 1934 Act that "all discovery and other proceedings shall be stayed during the pendency of any motion to dismiss, unless the court finds upon the motion of any party that particularized discovery is necessary to preserve evidence or to prevent undue prejudice to that party."
At least three federal courts addressed the scope of this discovery stay in 1996. These decisions suggest that courts will interpret broadly the Reform Act's mandatory stay provision.
1. Medical Imaging Centers of America, Inc. v. Lichtenstein.101 Plaintiff, the subject of a corporate control contest, filed an action alleging violations of Section 13(d) of the Exchange Act. Defendants called a special shareholders meeting and filed a proxy indicating their intent to unseat plaintiff's current board of directors. Defendants also moved to dismiss the complaint and requested expedited discovery to be completed before the shareholders' meeting. Plaintiff moved to stay discovery based on Section 21D(b)(3)(B).
The court held that discovery was properly stayed while the motion to dismiss was resolved. The "undue prejudice" standard was held to require the party seeking discovery to show an improper or unfair detriment. The court characterized this showing as something less than irreparable harm. The court noted that if the party seeking discovery "had shown that the discovery stay would prejudice it because [the opposing party] would be shielded from eventual liability for any material violations of the securities laws, the Court would find that an 'undue prejudice' exception to the statutory stay had been shown."102 The court also rejected an argument that Congress did not mean for the statutory stay to apply to proxy contests. Although no absolute "carve out" exists for such actions, the court noted that it would be proper for the court to consider the nature of the action in determining whether an exception to the stay should be recognized.103
2. Novak v. Kasaks.104 The court stayed discovery in a class action involving AnnTaylor Stores because it found that plaintiffs had not satisfied their burden of showing "exceptional circumstances." In response to plaintiffs' concern that non-parties might not retain relevant documents during a stay, the court ordered the 30 non-parties that had previously been served with subpoenas to preserve all responsive documents.
3. Medhekar v. United States District Court.105 In Medhekar, the district court held that the statutorily required stay did not apply to mandatory disclosure obligations under local civil court rules and the Federal Rules of Civil Procedure.106 The court found that disclosure is distinct from discovery and that if Congress had meant to stay both it would have listed both in the statute.107 The court also found that the statutory phrase "other proceedings" did not clearly encompass disclosure. Instead, it interpreted "other proceedings" to refer to formal procedures involving a hearing or other court activity.108
Defendants sought and obtained a writ of mandamus directing the lower court to stay the initial disclosure requirements pending disposition of defendants' motion to dismiss.109 The Ninth Circuit held that mandatory disclosures constitute "discovery" for purposes of the Act's stay provisions. The Ninth Circuit rejected the lower court's conclusion that disclosure and discovery were distinct; instead, it found that disclosure was merely a subset of discovery. The time and expense associated with disclosure were exactly the type of burden the Act sought to eliminate. The court thus found that: "Congress clearly intended that complaints in these securities actions should stand or fall based on the actual knowledge of the plaintiffs rather than information produced by the defendants after the action has been filed."110
The Ninth Circuit also rejected the lower court's interpretation of the phrase "other proceedings". The legislative history and context of the phrase suggested that the term was intended to include litigation activity relating to discovery. Thus, the term includes disclosures. The court was careful to emphasize, however, that the term does not include "all litigation activity in general."111
One strategic response to the Reform Act is to avoid it altogether. Some plaintiffs have sought to escape from the Act's discovery stay and other procedural restrictions by filing parallel or stand-alone state court actions alleging either claims under the 1933 Act or state common law or Blue Sky claims. This strategy raises interesting and difficult federalism problems. In 1996, at least six state courts appear to have addressed whether the Reform Act's discovery stay should apply in state court proceedings. So far, state courts have split on whether the Reform Act's discovery stay is a substantive policy decision that should be respected in state courts or merely a procedural mechanism with no applicability in state fora. The significant substitution effect into state court and the emerging strategy of filing parallel federal and state court actions suggest that resolution of this issue may significantly affect the practical effectiveness of the stay provision.
1. Milano v. Auhll.112 Plaintiff brought a class action against Circon Corporation and certain of its officers and directors alleging violations of the Securities Act of 1933 and the California Corporations Code in California state court. No parallel federal action was pending. Defendants moved to stay discovery pursuant to the Reform Act and the plaintiffs argued that the Act was inapplicable in state court proceedings. The court found that the Reform Act's stay provisions were applicable in state court actions and determined that discovery on both the federal and state claims should be stayed. This result was necessary in order not to undermine the congressional intent "to provide a broad and effective method of weeding out frivolous and unsupported lawsuits."113
2. Sperber v. Bixby.114 In this class action involving Brooktree Corporation, plaintiffs alleged solely state Blue Sky and common law claims. No parallel federal action was filed. Defendants filed both a motion to dismiss and a motion to stay discovery pending resolution of the dismissal motion. Defendants argued that plaintiffs filed in state court to evade the Reform Act's procedures, including the stay of discovery and the heightened pleading standard. In this situation, defendants argued that the Reform Act, although not controlling, provided persuasive authority that should be considered in ruling on stays in state securities class actions. The court stayed discovery pending resolution of the motion to dismiss.
3. Marinaro v. The Superior Court of Santa Clara County.115 In this case involving Network Computing Devices four federal complaints arising out of the same facts and circumstances were filed after the state court complaint. Defendants sought to stay the state case, arguing that the state claims were brought in a separate action in order to avoid the procedural provisions contained in the Reform Act. The lower court denied the stay without opinion and the intermediate appellate court denied a petition for a writ of mandamus. The California Supreme Court, however, directed the appellate court to reconsider defendants' request for a stay.116 As of the date of this paper, we are unaware of any decision from the appellate court.117
Under the Reform Act, Congress sought to increase litigant oversight of plaintiffs' class action attorneys by reducing the number of "professional plaintiffs" and by encouraging institutional investors to become more active in securities fraud litigation. To achieve this result, the Reform Act requires that plaintiffs filing securities class actions file sworn certifications describing, among other things, their transactions in the security and their prior appearances as named plaintiffs in securities class actions.118 The Act also requires the named plaintiff to publish a notice "in a widely circulated national business-oriented publication or wire service" that informs potential class members of the right to move to be appointed "lead plaintiff."119 The law establishes a rebuttable presumption that the lead plaintiff will be the party who volunteers and who "has the largest financial interest in the relief sought by the class."120 Lead plaintiffs can control the course of the class action, including selection of lead counsel, subject to court approval.121
Through January 1997, at least four opinions addressed these provisions.122 The activity to date suggests three significant trends are emerging. First, most of the activity has not involved the institutions Congress sought to get involved in securities litigation. Instead competing groups of individual plaintiffs have tended to vie for the lead plaintiff position. Indeed, one of the unintended consequences of the Reform Act has been to encourage traditional plaintiffs' law firms to cobble together large numbers of smaller claimants who, in aggregate, have the largest financial interest of any individual or group seeking the lead plaintiff position.
Second, firms' initial reaction to the notification procedures was to publish inconspicuous notices in Investors Business Daily. One court found these notices to be inadequate. But that decision may have little practical impact because before it was issued firms had already begun to employ the Act's notification procedures as a means of advertising their actions in order to attract additional plaintiffs or others with relevant information about the asserted claims. The notices therefore now tend to be widely-disseminated on wire services and contain lengthy descriptions of the factual bases for the complaint.
Finally, the decisions to date suggest that if institutions are interested in becoming lead plaintiffs, they should be able to do so in most cases. Significant questions remain concerning the kind of discovery institutions will be subject to if they assume that position, and it is unclear that many major institutional investors will conclude that the benefits of participation as lead counsel will outweigh the costs.123
1. In re Cephalon Securities Litigation.124 Under the Reform Act's provisions for the appointment of lead plaintiff, "discovery relating to whether a member or members of the purported plaintiff class is the most adequate plaintiff may be conducted by a plaintiff only if the plaintiff first demonstrates a reasonable basis for a finding that the presumptively most adequate plaintiff is incapable of adequately representing the class."125 In Cephalon, the Court permitted discovery to resolve a dispute over whether a plaintiff that was seeking to be named lead plaintiff was in fact an institutional investor.126
2. Greebel v. FTP Software.127 Greebel is the first substantive decision addressing a number of important issues that arise from the Reform Act's lead plaintiff provisions. First, the court addressed the defendant's role in the lead plaintiff determination. The court held that defendants have standing to contest plaintiff's failure to file a certification with the complaint or the failure to provide adequate notice to the class. Defendants lack standing to challenge whether a particular plaintiff satisfies the requirements set forth in Section 21D(a)(3)(B)(iii), in particular, whether the proposed lead plaintiff "otherwise satisfies the requirements of Rule 23 of the Federal Rules of Civil Procedure." Because defendants have traditionally been permitted to challenge a plaintiff's satisfaction of the Rule 23 requirements at the class certification stage, the court held "that its determination to appoint a person or persons as lead plaintiff must be without prejudice to the possibility of revisiting that issue in considering a motion for class certification."128
Second, the court held that only representative plaintiffs that file complaints are required to file the certifications required in Section 21D(a)(2). Finally, the court held that publication of a notice on Business Wire, a computer database service that distributes press releases to news media, on-line services, and subscribers in the investment community, satisfies the Reform Act's notice requirement.
3. Gluck v. Cellstar Corporation.129 The State of Wisconsin Investment Board ("SWIB") sought in this case to be named sole lead plaintiff. Class members who had filed a complaint and were represented by Milberg Weiss opposed that motion. Milberg Weiss argued that SWIB was not an appropriate lead plaintiff because SWIB is a sophisticated institutional investor that had used derivatives and is not typical of the entire class of plaintiffs. Milberg Weiss argued that the court should therefore not appoint SWIB as sole lead plaintiff and should instead appoint a plaintiffs' committee that would serve as lead plaintiffs, with Milberg Weiss and SWIB's counsel appointed as co-lead counsel. The court appointed SWIB as sole lead plaintiff and required SWIB, subject to court approval, to appoint counsel for the class within 30 days of the order.
4. Chan v. Orthologic Corp.130 In Orthologic, the City of Philadelphia pension fund and a group of non-institutional plaintiffs (the "Chan Plaintiffs") competed to be appointed lead plaintiff. It was undisputed that the City of Philadelphia had the largest financial stake in the outcome of the case and was therefore the presumptive lead plaintiff under the terms of the Reform Act.131 The Chan Plaintiffs sought to overcome the presumption by arguing that they represented a narrower class of purchasers that purportedly conflicted with the Philadelphia class. As in Cellstar, the Chan Plaintiffs argued that Philadelphia, as a sophisticated, institutional investor, was not typical of the class as a whole and that it was subject to unique defenses. In particular, Philadelphia's investment strategy was said to be atypical of the class as a whole because Philadelphia was a "speculator" that allegedly purchased Orthologic securities after certain bad news had already been disseminated to the market. As a result, the Chan Plaintiffs sought either to be appointed co-lead plaintiffs with Philadelphia or to be named to their own subclass.
The court held that these factors were insufficient to rebut the Act's presumption that Philadelphia was the most adequate plaintiff. First, the court held that the differing class periods did not create a conflict because the parties had similar injuries arising out of the same course of conduct. The court did, however, reserve the right to create appropriate subclasses if a conflict was subsequently revealed. Second, the court held that Philadelphia's sophistication was irrelevant in this case because all plaintiffs had consistent interests. Finally, the court rejected pre-Reform Act precedent that found institutional investors to be atypical of the class. Instead, it relied on Ninth Circuit precedent finding that differences in sophistication among purchasers have no bearing in fraud-on-the-market cases.132
After appointing Philadelphia as lead plaintiff, the court also approved its choice of Milberg Weiss; Barrack Rodos & Bacine; and Bonnett Fairbourn Friedman & Balint as co-lead counsel. The court noted the firms' "extensive experience in the area of class action securities fraud" in finding that they would provide capable representation to the class as a whole.
5. Ravens v. Iftikar.133 In this class action involving Syquest Technology, Inc., Judge Vaughn Walker examined the Reform Act's requirements for the content of the required notice. The notice at issue in Ravens simply stated the date the action had been filed, where it was filed, the alleged class period, the security at issue, and that the complaint asserted violations of Sections 10(b) and 20(a) of the Exchange Act. The notice did not contain a description of the facts underlying the claims. Judge Walker held that the notice did not satisfy the Reform Act's requirements because it was "inadequate to apprise investors of the claims asserted so that those who may wish to do so have a fair opportunity to intervene and assume control of the litigation."134
Congress employed the lead plaintiff and notice provisions to curb "the disproportionate influence lawyers have exerted over securities class actions."135 The Court found that these provisions were meant to "transfer primary control of private securities litigation from lawyers to investors" and were similar to other constitutionally mandated notices required under Federal Rule of Civil Procedure 23(b)(3). He held that the Reform Act notice must at a minimum contain three elements: (1) a notice of the pendency of the action; (2) a description of the claims asserted therein; and (3) a specification of the purported class period.
The bulk of the court's opinion focused on the second element. The court found that the notice provisions will only permit investors to make an informed decision about whether to seek control of the case if investors "are notified of the nature and character, not just the existence, of the claims asserted."136 The notice must contain information describing the legal and factual basis for the claims and not just a recitation of the statute or statutes under which the claims are brought. The court also held that a notice that omits these elements is not cured by an invitation to call the lead lawyer for more information because such a lawyer has incentives to discourage investor competition. Finally, the court noted that a diligent investor might review the complaint itself to obtain notice of the plaintiff's claims. The court held that the complaints provided inadequate notice because they were "verbose, amorphous and confusing" and therefore did not provide the best practicable notice under the circumstances.
Whether reckless conduct satisfies the scienter requirement of Section 10(b) and Rule 10b-5 has been an open question at the Supreme Court level since the Court's 1976 decision in Ernst & Ernst v. Hochfelder,137 although every Court of Appeals that has addressed the issue has concluded that recklessness constitutes scienter. The Reform Act makes limited reference to recklessness and seemingly avoids any implication that it was codifying or eliminating that standard of liability. Nonetheless, two courts have reached opposite conclusions as to the Act's effect on the sufficiency of allegations of recklessness as establishing scienter under Section 10(b).
1. Marksman Partners, L.P. v. Chantal Pharmaceutical Corp.138 The Chantal court held that recklessness continues to satisfy the scienter requirement of Section 10(b). The court gave three reasons for its conclusion. First, it argued that strengthening the pleading standard for scienter does not necessarily result in a change to the nature of the scienter required. Second, although the Reform Act created an actual knowledge requirement for forward-looking statements and joint and several liability, that requirement does not extend to other kinds of Section 10(b) violations.
Third, the court found the Act's legislative history did not support a finding that recklessness had been eliminated as a basis for scienter. The court noted that an earlier House bill had contained a definition of recklessness but that definition had been dropped in the final version of the bill. The court recognized "some ambivalence on the part of Congress regarding recklessness liability in securities fraud cases."139 Nonetheless, in the absence of any express provision eliminating liability for recklessness in the Act itself, the court was unwilling to conclude that it was no longer adequate to establish scienter.
2. In re Silicon Graphics Securities Litigation.140 The court rejected plaintiff's argument that liability for recklessness still exists under the Reform Act. It held that "in order to state a private securities claim, plaintiff must now allege false or misleading statements, describe how the statements are false or misleading, and create a strong inference of knowing misrepresentation on the part of the defendants. This standard applies whether the statements in question are forward-looking or not."141
The court dismissed plaintiffs' initial complaint for failure to satisfy this standard and an amended complaint has been filed. On the currently pending motion to dismiss the amended complaint, the SEC has filed an amicus brief urging the district court to reverse its ruling on the recklessness standard.
The Reform Act sought to encourage the disclosure of forward-looking information by creating a limited safe harbor for these statements if they are identified as such and accompanied by "meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement."142 The safe harbor is subject to significant limitations and does not apply to IPOs and other specified transactions. To date, the only decision interpreting the safe harbor suggests limitations on its usefulness at the motion to dismiss stage. Another decision, however, suggests the continuing importance of the bespeaks caution doctrine in situations where the safe harbor does not apply.
1. In re Silicon Graphics, Inc. Securities Litigation.143 The Silicon Graphics decision contains the first judicial interpretation of the Reform Act's safe harbor provision. The court rejected as a basis for a motion to dismiss defendants' argument that they had in fact provided warnings in analyst conference calls. This argument was based solely on the declaration of the company's Chief Financial Officer. Such evidence was not properly considered on a motion to dismiss because it was neither part of the public record nor referenced in the complaint.
2. Steckman v. Hart Brewing, Inc.144 As noted previously, Hart is the only post-Reform Act case dismissed without leave to replead. The Reform Act's safe harbor did not apply because the case involved alleged misrepresentations and omissions in connection with an IPO. Nonetheless, the decision is significant because it emphasizes the continuing viability of the bespeaks caution doctrine in cases where the safe harbor may be inapplicable.
The complaint in Hart alleged that the IPO prospectus omitted "trends and uncertainties" regarding the company's ability to continue its prior record of increased sales and earnings. The court, however, dismissed the complaint in part because "these alleged omissions were actually addressed in the Prospectus' 'Risk Factors' discussion."145 The court went on to list seven warnings "directly addressing Plaintiff's allegations of omissions."146 The court emphasized that the complaint must be read as a whole and in the context of the type of investment being offered for sale. "Because Plaintiff's allegations that he was not fully informed of the risk and nature of his investment is unsubstantiated by the plain language of the Prospectus, he fails to allege sufficient facts to support any claim under the Securities Act of 1933."147
Section 108 of the Reform Act states that the provisions of the Act "shall not affect or apply to any private action arising under title 1 of the [1934 Act] or title 1 of the [1933 Act], commenced and pending on the date of enactment of this Act." This statutory language has given rise to two questions as to the retroactive effect of the Act. First, does the Act's elimination of securities fraud as a predicate act under the Racketeer Influenced and Corrupt Organizations Act ("RICO") apply retroactively? Second, the Reform Act clarified an issue left open in the Supreme Court's decision in Central Bank of Denver v. First Interstate Bank of Denver by providing that the SEC could still bring actions for aiding and abetting violations of Section 10(b). Did that provision apply retroactively? Four decisions analyzed these questions and held that the RICO may not be retroactively applied but that the aiding and abetting provision could be retroactively applied in certain limited circumstances.
1. District 65 v. Prudential Securities.148 The Reform Act provides that "no person may rely upon any conduct that would have been actionable as fraud in the purchase or sale of securities to establish a violation of [RICO]."149 The court ruled that this provision of the Reform Act did not apply retroactively so as to bar plaintiffs' RICO claim, which had been filed prior to the effective date of the Reform Act.150
2. In re Prudential Sec. Inc. Ltd. Partner. Litig.151 The court held that the Reform Act did not apply retroactively so as to deprive the court of jurisdiction over a RICO claim that had been filed prior to the effective date of the Reform Act.152
3. Baker v. Pfeifer.153 Consistent with District 65 and Prudential, the court held that the Reform Act did not apply retroactively so as to bar plaintiffs' RICO claim, which had been filed prior to the effective date of the Reform Act.154
4. Securities and Exchange Commission v. Fehn.155 In 1994, the Supreme Court held in Central Bank of Denver v. First Interstate Bank of Denver that a private party may not maintain an action for aiding and abetting a violation of Section 10(b).156 The Court refused to address whether the SEC could still maintain an aiding and abetting action. The Reform Act, however, permits the SEC to file actions for injunctive relief and to seek monetary penalties against a "person that knowingly provides substantial assistance to another person in violation of [the Securities Exchange Act of 1934 and regulations promulgated thereunder.]"157 The court held that the Reform Act barred extension of the Central Bank decision to SEC injunctive actions given the peculiar timing of events in the case. The activities at issue occurred before the Central Bank decision but the Reform Act was passed while Fehn's appeal was pending. In these circumstances, retroactive application of the Reform Act did not impair rights that existed when the defendant acted, increase liability for past conduct, or attach new legal consequences to the events underlying the SEC's injunction.
At least two decisions rendered in 1996 could provide significant persuasive authority for interpreting provisions of the Reform Act, although they do not themselves interpret the Act. One decision concerns whether and under what circumstances allegations of insider trading during the class period are sufficient to satisfy plaintiff's obligation to plead scienter. This issue is important because of the significant number of cases alleging insider trading since the effective date of the Reform Act. The other decision concerns the appropriate role for institutions in shareholder litigation, which may be relevant to interpretation of the lead plaintiff provision.
1. Provenz v. Miller.158 The district court granted summary judgment in favor of defendants in this pre-Reform Act class action brought on behalf of purchasers of stock of MIPS Computer Systems, Inc. The Ninth Circuit reversed the district court's determination that there was insufficient evidence to support a finding of scienter. Expert testimony that MIPS violated GAAP and its own internal policies for revenue recognition tended to support a finding of scienter and made summary judgment inappropriate.
Some of the individual defendants' stock sales during the class period were also found to support a finding of scienter. The Chairman and CEO sold 20% of his stock for $1.3 million and the President sold 90,000 shares, six times more than in the 12 months preceding the class period. These sales were also found to have been at "sensitive times," i.e., shortly after an analysts conference call when allegedly false and misleading statements were made. Two other defendants who provided unrebutted evidence of innocent explanations for their stock sales were entitled to summary judgment on the issue of scienter.
This decision may be important for courts interpreting the Reform Act's requirement that a plaintiff plead facts giving rise to a strong inference of fraud. As noted previously, a significant percentage of post-Reform Act cases allege insider sales as support for a finding of scienter. The Provenz decision suggests that such allegations may be sufficient to meet the new higher pleading standard. At the same time, Provenz emphasizes that the mere fact of trading during the class period is not enough. A careful analysis of timing, amounts, and circumstances of the alleged trading is necessary to determine whether trading supports a finding of scienter.
2. Weiser v. Grace.159 This shareholder derivative action involves claims that W.R. Grace & Co. paid excessive "perks" to its former Chairman and paid $20 million in improper severance payments to its former President who resigned after charges of sexual harassment were lodged against him. This decision may provide an important precedent for interpretation of the Reform Act's lead plaintiff provisions.
The court permitted the California Public Employees' Retirement System ("CalPERS") to intervene and to designate co-lead counsel after CalPERS learned that the lead counsel had failed to review key documents relevant to the derivative claims, and after it determined that a proposed settlement was inadequate. In particular, CalPERS objected to a settlement that would have merely required Grace to change its written policy for addressing claims of sexual harassment. The settlement provided no monetary payment from defendants who allegedly received improper payments. Although the court did not address the adequacy of the proposed settlement, it held that intervention was appropriate because "one very large shareholder believes that the present plaintiffs and present co-lead counsel are not adequately representing the interests of the Grace shareholders and has given persuasive reasons why that is so."160 Moreover, the court held that "CalPERS, as a large institutional shareholder of Grace should be allowed a voice in the ongoing discovery and settlement discussions, and not simply given the opportunity to object at the end."161
The W.R. Grace decision emphasizes the important role that institutional investors can play in shareholder litigation. It demonstrates that institutional investor participation need not be limited to the role of lead plaintiff, and that courts need not focus exclusively on the lead plaintiff provision as the sole mechanism through which institutions can or should contribute to the prosecution of securities class actions.
The evidence presented in this report suggests that the level of class action securities fraud litigation has declined by about a third in federal courts, but that there has been an almost equal increase in the level of state court activity, largely as a result of a "substitution effect" whereby plaintiffs resort to state court to avoid the new, more stringent requirements of federal cases. There has also been an increase in parallel litigation between state and federal courts in an apparent effort to avoid the federal discovery stay or other provisions of the Act. This increase in state activity has the potential not only to undermine the intent of the Act, but to increase the overall cost of litigation to the extent that the Act encourages the filing of parallel claims.
The first year of experience with the Act also reveals that federal claims are now rarely filed against the largest firms, that larger stock price declines are associated with the decision to institute litigation now than prior to the Act's passage, and that a shift toward allegations of accounting irregularities and trading by insiders as the primary basis for litigation may be associated with both the decline in litigation against large firms and the continued high incidence of actions against high-technology firms.
The largest plaintiffs' law firm, Milberg Weiss Bershad Hynes & Lerach, has increased its significance in the litigation process most likely because of its capital base, ability to diversify increased litigation risk, and incentive to invest in the creation of favorable new precedent. The dominant emerging judicial interpretation of the Act suggests that the "strong inference" pleading requirement establishes no higher standard than that articulated by the Second Circuit, an interpretation favored by plaintiffs. Moreover, given that the courts have generally been reluctant to dismiss complaints without leave to replead, the Act does not yet appear to be a useful device for quickly eliminating complaints that do not meet the pleading requirement.
In addition to questions related to the general efficacy of the Act and the desirability of some of
its outcomes, including the changing incidence of litigation by firm size and type, complex issues
regarding the interplay of federal and state jurisdiction are rapidly emerging. The substitution of
state for federal venues, as well as the tendency to pursue parallel litigation to avoid application of
the discovery stay are examples of the way jurisdictional issues can circumvent the intent of the Act.
The tension between federal and state courts will likely grow over time and may require Congressional
Cornerstone Research provided funding to support the preparation of this report, but exercised no control or influence over its substance or over any of the conclusions or analyses reported herein. The views expressed are solely those of Professors Grundfest and Perino who accept total responsibility for the contents of this report.
1 Pub. L. No. 104-67, 109 Stat. 737 (1995) (to be codified at 15 U.S.C. §§ 77a et seq.).
2 For an overview of the legislative process leading up to the enactment of the Reform Act, see John W. Avery, Securities Litigation Reform: The Long and Winding Road to the Private Securities Litigation Reform Act of 1995, 51 Bus. Law. 335 (1996).
3 This includes what we believe to be a complete census of all decisions rendered in federal court, as well as the state court decisions of which we are aware that are relevant to the interpretation or operation of the Reform Act's provisions.
4 In a recent Federal Judicial Center study, the median time from filing to ultimate disposition for a sample of 103 federal class action securities fraud cases was 21.7 months. Thomas E. Willging, Federal Judicial Center, Empirical Study of Class Actions in Four Federal District Courts 117 (1996).
6 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. 280 (1993) [hereinafter Private Litigation Under the Federal Securities Laws] (Statement of Senator Dodd).
7 Information on issuers sued in securities class actions was obtained from a number of sources. The Reform Act simplified our data collection efforts in this regard because it requires that plaintiffs filing class action complaints in federal court publish a notice in either a widely-circulated, national, business-oriented publication or a wire service advising putative class members of the pendency of the action, the claims asserted, and the purported class period. 15 U.S.C. §§ 77z-1(a)(3)(A), 78u-4(a)(3)(A). We have searched for these notices, which to date have tended to appear in Business Wire or as legal notices in Investors Business Daily. We have supplemented review of these sources with computer searches of the Westlaw news database, Nexis, the LEXIS SEC filings database, and Securities Class Action Alert.
8 116 S. Ct. 873 (1996).
9 There are several cases for which at least one piece of this information was unavailable. These cases were omitted from the study. Our estimates of litigation activity are therefore conservative.
10 Richard B. Schmitt, Laws Intended to Limit Suits Clog Up Courts, Wall St. J., Jan. 24, 1996, at B1.
11 The 1997 data compiled to date support these hypotheses. In January 1997, at least fourteen companies were sued in federal securities fraud class actions. By comparison, only five companies were sued in January 1996, and the number of companies sued in January 1997 is only two less than were sued in the entire first quarter of 1996.
12 During the Congressional debates over securities litigation reform, Senator Dodd, at the time the Chair of the Senate Subcommittee on Securities of the Committee on Banking, Housing, and Urban Affairs, commented that the
Private Litigation Under the Federal Securities Laws, supra note 6, at 280; see also WILLGING, supra note 4, at 199 (concluding that "in the recent past there were no reliable national data on the number of class action filings and terminations in the federal courts.").
academic and other experts who had done studies on top of studies on securities litigation ... disagreed as to the facts.
Consequently, after a long hearing...we found no agreement on whether there is in fact a problem, the extent of the problem, or the solution to the problem. In my experience with this subcommittee, I've never encountered an issue where there is such disagreement over the basic facts. We often argue about policy, we argue about ideology, we often argue about politics, but it is rare that we spend so much time arguing about basic facts.
13 Private Litigation Under the Federal Securities Laws, supra note 6, at 121 (Prepared Statement of William R. McLucas, Director, Division of Enforcement, United States Securities and Exchange Commission).
14 This is the case in the post-Reform Act securities fraud litigation involving the shares of Vista 2000.
15 Willging, supra note 4, at 198-99. The Federal Judicial Center study documented that the Administrative Office data identified only between one-fifth to one-half of the class action activity in the four districts.
18 It is important to distinguish state securities class actions from state derivative actions that "piggyback" on the filing of a federal court class action. Derivative actions filed in the wake of a class action suit are not uncommon and typically allege that the company's officers and directors violated their fiduciary duties by exposing the company to litigation expenses and potential liability in the securities class actions. See Joseph A. Grundfest and Michael A. Perino, The Pentium Papers: A Case Study of Collective Institutional Investor Activism in Litigation, 38 ARIZ. L. REV. 559, 590-91 n.171 (1996). By contrast, state securities class actions assert either: (i) a claim involving an IPO or follow-on offering under the Securities Act of 1933; or (ii) a state common law or Blue Sky claim alleging fraudulent activity in connection with the purchase or sale of a security.
19 116 S. Ct. 873 (1996).
20 Proposition 211 was defeated in elections held on November 5, 1996. Elizabeth Corcoran, California Voters Reject Proposition 211; Silicon Valley Fought Measure Making Shareholder Fraud Suits Easier, WASH. POST, Nov. 7, 1996, at D3; Greg Lucas, Prop 211 Loses By Wide Margin, S.F. CHRON., Nov. 6, 1996, at A9.
21 See Appendix B for a list of the companies we have identified in state complaints, along with the filing dates, the courts in which the litigation was brought, and whether there is a parallel federal complaint arising out of the same factual allegations.
22 Nation Briefly: Federal Tort Law Seems to Increase State Cases, Orange County Reg., Jul. 23, 1996, at C3; Patrice Duggan Samuels, Investing It: Litigation Law Creates Work for Disclaimer Writers, N.Y. TIMES, Apr. 14, 1996, at § 3, at 3.
23 This figure is adjusted to account for companies that were sued in more than one state.
24 Basic firm characteristics, including measures of market capitalization, stock price declines, and beta were calculated using information obtained from Bloomberg for a number of different sub-samples of the sixty-five companies named in post-Reform Act complaints we were able to obtain. These complaints are listed in Appendix C. Appendix D describes these sub-samples. A number of companies were eliminated from the samples when calculating market capitalization, stock price declines, and beta because of insufficient information. Appendix D also contains a description of the companies eliminated and the reasons for their elimination. Market capitalization was calculated for the day before the stock price decline around the end of the class period (day t-1) using Bloomberg's historical price and Edgar filing functions. Daily stock price return on the day of this stock price decline (day t) was also calculated using the historical price function. For those cases that did not have a stock price decline around the end of the class period, t-1 is defined to be the last day of the class period. Finally, Bloomberg's beta function was used to obtain stock beta over the 125 day period ending on t-1. Beta was calculated by regressing daily stock price returns on S&P 500 index returns.
25 Laura E. Simmons, database compiled for doctoral dissertation, Rule 10b-5 Litigation: An Examination of Merit and Nonmerit-Based Factors Associated with Litigation Outcomes (Aug. 1996) (on file with authors) [hereinafter Simmons Database].
26 Christopher L. Jones & Seth E. Weingram, The Determinants of 10b-5 Litigation Risk (John M. Olin Program in Law and Economics, Stanford Law School, Working Paper No. 118, June 1996) at Table 3 [hereinafter Determinants of 10b-5 Litigation Risk].
27 At least one company sued in federal court in 1996, United Healthcare, has a market capitalization in excess of $5 billion. That action has already been voluntarily dismissed. See infra Section IX. The market capitalization figures discussed herein will be updated to encompass all companies sued in federal court in 1996.
30 Both figures include dividends reinvested monthly.
31 See H.R. Conf. Rep. No. 369, 104th Cong., 1st Sess. 31 (1995), reprinted in 1995 U.S.C.C.A.N. 730.
40 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) [hereinafter Litigation Risk].
41 Willard T. Carleton, et al., Securities Class Action Lawsuits: A Descriptive Study, 38 Ariz. L. Rev. 491, 497-98 (1996). Other studies have found similar or higher percentages of high-technology companies. Jones and Weingram studied a sample of 411 cases and found 27.3% involved high-technology companies and 26% involved financial services companies. Determinants of 10b-5 Litigation Risk, supra note 26, at Table 2. Another study of 319 securities class action settlements found that 31.7% involved high-technology companies while 20.4% involved commercial banking, finance, and insurance. In 81 cases that were dismissed, 43.21% involved high-technology. Overall, 34% of the cases studied involved high-technology companies. Frederick C. Dunbar, et al., Recent Trends III: What Explains Settlements in Shareholder Class Actions? (National Economic Research Associates, June 1995) at Tables 6a & 6b [hereinafter Recent Trends III].
44 For suits alleging misrepresentations regarding loan portfolios and loan loss reserves, see generally Shields v. CityTrust Bancorp, Inc., 25 F.3d 1124 (2d Cir. 1994); Ratner v. Bennett, 1996 U.S. Dist. LEXIS 6259, Fed. Sec. L. Rep. (CCH) ¶ 99,225 (E.D. Penn., May 8, 1996); Grossman v. Texas Commerce Bancshares, Inc., 1995 U.S. Dist. LEXIS 13501, Fed. Sec. L. Rep. (CCH) ¶ 98,964 (S.D.N.Y., Sept. 15, 1995); Lerner v. FNB Rochester Corp., 841 F. Supp. 97 (W.D.N.Y 1993); Goldberg v. Hankin, 835 F. Supp. 815 (E.D. Penn. 1993).
45 We were unable to obtain every complaint filed against every issuer. While complaints filed against a single issuer often contain substantially similar allegations, there may be variations in the allegations made or defendants sued among the separate complaints, and our data may therefore undercount the incidence of certain types of claims. To prevent an over-counting problem, our database consists of only one complaint for each issuer sued. If we were able to obtain more than one complaint, we chose for our sample either: (i) the first complaint we received, or (ii) if multiple complaints were received at one time, the complaint that appeared to contain the most detailed allegations. Appendix C contains a list of the complaints reviewed in our analysis.
46 Because a single complaint can contain multiple allegations of fraud, the total number of "violative acts" constituting fraud exceeds the number of lawsuits filed.
48 H.R. Conf. Rep. No. 369, 104th Cong., 1st Sess. 42-43 (1995), reprinted in 1995 U.S.C.C.A.N. 741-42.
49 927 F. Supp. 1297 (C.D. Cal. 1996).
51 Simmons Database, supra note 25. This study differed from our study because it did not analyze complaints but instead relied on case descriptions from Securities Class Action Alert, Class Action Reports, press articles, and any available court opinions.
Other studies have commented on the connection between insider trading and class action litigation. One commentator observed that there appeared to be some correlation between securities suits and active trading by management prior to a decline in the stock price. O'Brien, supra note 36, at 8. The author, however, did not quantify the connection, and only reported that "for most of the companies sued, management had been actively trading the company's stock prior to the decline in stock price." Id. The author also noted that "no scientific study was done" to confirm whether there was indeed a correlation. At least one other study, however, has found no evidence that trading by insiders increases a firm's litigation risk. CHRISTOPHER L. JONES AND SETH E. WEINGRAM, THE EFFECTS OF INSIDER TRADING, SEASONED EQUITY OFFERINGS, CORPORATE ANNOUNCEMENTS, ACCOUNTING RESTATEMENTS, AND SEC ENFORCEMENT ACTIONS ON 10b-5 LITIGATION RISK (John M. Olin Program in Law and Economics, Stanford Law School, Working Paper No. 139, Dec. 1996).
52 Indeed, our estimates concerning the frequency of insider trading allegations may be somewhat skewed because our sample of cases contains a slightly higher percentage of high-technology companies (40% for the sample of sixty-five and 48% for the sample of forty-six) than the entire population of 109 companies sued in 1996 (34%). Future versions of this report will examine complaints in all filed class actions.
53 See John C. Coffee, Jr., The Future of the Private Securities Litigation Reform Act: Or, Why the Fat Lady Has Not Yet Sung, 51 Bus. Bus. Law. 975, 1002-03 (1996) (noting this possibility).
56 Id. 16.
57 15 U.S.C. § 78u-4(a)(3)(B)(v).
58 The number of filings exceeds the number of issuers because several issuers were sued in more than one circuit or district. Percentage calculations for incidence of litigation by circuit use a denominator of 116 to account for these multiple filings. District court filings use a denominator of 117.
60 Source: Administrative Office of the United States Courts, 1995 Federal Court ManaGEMENT STATISTICS (1996). The figures for total civil filings are for the time period October 1, 1994-September 30, 1995, the latest Administrative Office data available, and so do not correspond to the same time period as the securities class action filing data. We have no reason to believe that overall civil filings have changed substantially in these districts.
61 The observed differences in securities class action filing rates among districts do not seem to be closely correlated with overall civil action filing rates. For example, for the 12 month period from October 1, 1994 through September 30, 1995, overall civil filings in the Northern and Central Districts of California were 5,223 and 10,303, respectively. ADMINISTRATIVE OFFICE OF THE UNITED STATES COURTS, 1995 FEDERAL COURT MANAGEMENT STATISTICS (1996) 127, 129. Nonetheless, during the study period, the Northern District had more than twice as many securities class action filings as the Central District.
62 Willging, supra note 4, at 22-23 (noting that class actions, if separately categorized, would have a higher "case weight" than all civil cases other than death penalty habeas corpus cases and that securities class actions require 3.2 times the judicial time spent on all securities cases).
65 We are aware of two additional settlements in early 1997 involving cases against Network Computing Devices and Nutrition for Life International, Inc.
66 No. SACV-96-81-GLT (Eex) (C.D. Cal., filed Jan. 26, 1996).
67 Touchstone Reaches Agreement in Principle to Settle All Pending Class Action Suits, Business Wire, May 30, 1996, available in LEXIS, News Library, Wires File.
68 No. 96 Civ. 750 (D. Minn., filed Aug. 7, 1996).
69 No. CV-96-0889 (E.D.N.Y., Feb. 28, 1996).
70 Health Management, Inc. Reaches Agreement to Settle Shareholder Litigation, PR Newswire, Sept. 17, 1996, available in LEXIS, News Library, Wires File.
71 No. 188961 9 (Supr. Ct, Alameda County, CA, filed Feb. 21, 1996).
72 (S.D.N.Y., filed Feb. 23, 1996).
73 See, e.g., Shields v. CityTrust Bancorp, Inc., 25 F.3d 1124, 1128 (2d Cir. 1994); In re Time Warner, Inc. Sec. Litig., 9 F.3d 259, 269 (2d Cir. 1993), cert. denied, 114 S. Ct. 1397 (1994).
74 927 F. Supp. 1297 (C.D. Cal., May 21, 1996).
75 For an in depth analysis of the Chantal decision, see Michael A. Perino, A Strong Inference of Fraud? An Early Interpretation of the 1995 Private Securities Litigation Reform Act, 1 Sec. Reform Act Litig. Rept. 397 (1996).
76 930 F. Supp. 431 (N.D. Cal., June 6, 1996).
77 The court rejected defendants' argument that the Reform Act required dismissal with prejudice. Id. at 438.
78 Id. at 437.
80 941 F. Supp. 1369 (S.D.N.Y., Aug. 19, 1996).
81 Id. at 1377.
82 1996 U.S. Dist. LEXIS 16989, Fed. Sec. L. Rep. (CCH) ¶ 99,325 (N.D. Cal., Sept. 25, 1996).
83 1996 U.S. Dist. LEXIS 16989 at *15-16.
84 Id. at *16.
85 Id. at *34-35.
86 Id. at *35.
87 Id. at *36-37.
88 No. 3-96-CV-823-R (N.D. Tex., Nov. 12, 1996).
89 Id. at 2-3.
90 Id. at 4.
91 1996 U.S. Dist. LEXIS 17670 (M.D. Fla., Nov. 14, 1996).
92 Id. at *8.
93 1997 U.S. Dist. LEXIS 767 (N.D. Ill., Jan. 27, 1997).
94 Id. at 16.
96 Id. at *31.
97 No. 96-1077-K (RBB) (S.D. Cal., Dec. 24, 1996).
98 Id. at 9.
100 H.R. Conf. Rep. No. 369, 104th Cong., 1st Sess. 37 (1995), reprinted in 1995 U.S.C.C.A.N. 736.
101 917 F. Supp. 717 (S.D. Cal., Feb. 14, 1996).
102 Id. at 721 n.3.
103 Id. at 721.
104 1996 U.S. Dist. LEXIS 11778, Fed. Sec. L. Rep. (CCH) ¶ 99,307 (S.D.N.Y., Aug. 16, 1996).
105 99 F.3d 325 (9th Cir., Oct. 31, 1996).
106 Hockey v. Medhekar, 932 F. Supp. 249, 252-53 (N.D. Cal., Jul. 11, 1996)
107 Id. at 252.
108 Id. at 253.
109 The authors of this study submitted an amicus curiae brief on behalf of Bank of America and the American Electronics Association urging that the Ninth Circuit accept review of the writ of mandamus and reverse the lower court decision.
110 99 F.3d at 328.
112 No. SB 213 476 (Cal. Super. Court, Santa Barbara County, Oct. 2, 1996).
113 Id. at 7.
114 No. 699812 (Cal. Super. Court, San Diego County, Oct. 25, 1996).
115 1996 Cal. LEXIS 6105 (Oct. 30, 1996).
117 We have been informed that this matter was settled in January 1997 and that, as a result, there will be no decision from the intermediate appellate court. To date, we have no information on this purported settlement.
We have also been informed of three other cases in which these issues have arisen, although we have been unable to obtain opinions in any of these cases. First, in a class action involving Diamond Multimedia, Pass v. Hyung Hwe Huh, No CV758927 (Cal. Super. Court, Santa Clara County), the trial court denied a motion to stay the state action in favor of a parallel federal action. However, a discovery master in the case recommended that the trial court stay discovery pending resolution of class certification issues. Second, in a class action involving Fritz Companies, Levenson v. Fritz, No 979971 (Cal. Super. Court, San Francisco County), a trial judge denied a motion to stay discovery in the state action. Defendants sought a writ of mandate from the Court of Appeal. In the interim, however, a second trial court judge sustained a demurrer to the state complaint without leave to replead. Third, in an action involving Cinergi Pictures, Shores v. Cinergi Pictures Entertainment, Inc., No. BC149861 (Cal. Super. Court, Los Angeles County), the court held that plaintiff could not circumvent the Reform Act's discovery stay by filing 1933 Act claims in state court. The court, however, permitted substantially similar discovery to proceed on a common law negligent misrepresentation claim.
118 15 U.S.C. §§ 77z-1(a)(2)(A), 78u-4(a)(2)(A).
119 15 U.S.C. §§ 77z-1(a)(3)(A)(i), 78u-4(a)(3)(A)(i).
120 15 U.S.C. §§ 77z-1(a)(3)(B)(iii)(I)(bb), 78u-4(a)(3)(B)(iii)(I)(bb).
121 15 U.S.C. §§ 77z-1(a)(3)(B)(v), 78u-4(a)(3)(B)(v).
122 We are also informed that institutions or entities purporting to be institutional investors were active in at least six additional cases. These activities included filing the initial or a subsequent complaint or moving to be named co-lead plaintiff with individual investors. These cases involved the following companies: Bollinger Industries, Fleming Companies, Ivax Corporation, Micro Warehouse, Inc., Pepsi Cola Puerto Rico Bottling Co., and Summit Technology.
124 1996 U.S. Dist. LEXIS 10546 (E.D. Pa., July 18, 1996).
125 15 U.S.C. §§ 77z-1(a)(3)(B)(iv), 78u-4(a)(3)(B)(iv).
126 It is unclear whether significant discovery was undertaken. An subsequent order indicates that the competing factions agreed to be named co-lead plaintiffs with their respective counsel named as co-lead counsel. In re Cephalon Secur. Litig., 1996 U.S. Dist. LEXIS 13492, Fed. Sec. L. Rep. (CCH) ¶ 99,313 (E.D. Pa., Aug. 27, 1996).
127 CA No. 96-10544-JLT (D. Mass., Aug. 15, 1996).
128 Id. at 6-8.
129 No. 396CV14356 (N.D. Tex., Oct. 1, 1996).
130 No Civ 96-1514 PHX RCB (D. Ariz., Dec. 19, 1996).
131 15 U.S.C. §§ 77z-1(a)(3)(B)(iii)(I)(bb), 78u-4(a)(3)(B)(iii)(I)(bb).
132 Chan, slip op. at 11 (citing Blackie v. Barrack, 524 F.2d 891, 905 (9th Cir. 1975), cert. denied, 429 U.S. 816 (1976); Hanon v. Dataproducts Corp., 976 F.2d 497, 506 (9th Cir. 1992).
133 No. C-96-1224-VRW (N.D. Cal., Jan. 7, 1997).
134 Id. at 3.
135 Id. at 2.
136 Id. at 5.
137 425 U.S. 185, 194 n.12.
138 927 F. Supp. 1297 (C.D. Cal. 1996).
139 Id. at 1309 n.9.
140 1996 U.S. Dist. LEXIS 16989, Fed. Sec. L. Rep. (CCH) ¶ 99,325 (N. D. Cal., Sept. 25, 1996).
141 Id. at *21.
142 15 U.S. C. § 77z-2(c)(1)(A)(i).
143 1996 U.S. Dist. LEXIS 16989, Fed. Sec. L. Rep. (CCH) ¶ 99,325 (N.D. Cal., Sept. 25, 1996).
144 No. 96-1077-K (RBB) (S.D. Cal., Dec. 24, 1996).
145 Id. at 7.
146 Id. at 7-8.
147 Id. at 8-9.
148 925 F. Supp. 1551 (N.D. Ga., Apr. 29, 1996).
149 18 U.S.C. § 1964(c).
150 925 F. Supp. At 1566-70.
151 930 F. Supp. 68 (S.D.N.Y., June 10, 1996).
152 Id. at 77-81.
153 940 F. Supp. 1168 (S.D. Ohio, Sept. 20, 1996).
154 Id. at 1175-79.
155 97 F.3d 1276 (9th Cir., Oct. 9, 1996).
156 511 U.S. 164 (1994).
157 15 U.S.C. § 78t(f).
158 95 F.3d 1376 (9th Cir., Sept. 11, 1996).
159 Index No. 106285/95 (N.Y. Supreme, Sept. 3, 1996).
160 Id. at 6.