Securities Litigation Reform: Unfinished Business?

July 14, 1998 98-350E

98-350 E
CRS Report for Congress
Received through the CRS Web
Securities Litigation Reform:
Unfinished Business?
Updated July 14, 1998
Gary Shorter
Economic Analyst
Economics Division
Congressional Research Service ˜ The Library of Congress
ABSTRACT
This report discusses legislation, H.R. 1653, H.R. 1689, and S. 1260, which would extend
the reach of the Private Securities Litigation Reform Act of 1995 (P.L. 104-67) to state
courts. Enacted in 1995, P.L. 104-67 attempts to make it more difficult for frivolous
securities class action suits to access the federal courts. This report will continue to track
the ongoing legislative developments in this area.
Securities Litigation Reform: Unfinished Business?
Summary
In December 1995, overriding a presidential veto, Congress enacted H.R. 1058,
the Private Securities Litigation Reform Act of 1995 (the Reform Act) as P.L. 104-
67. The law was a congressional response to concerns that shareholder suits claiming
violations of the Securities Act of 1933 and the Securities Exchange Act of 1934
(especially section 10(b), the antifraud provision of this law) were increasingly
unjustified and frivolous. Among other things, the Reform Act attempted to curtail
frivolous securities suits before the federal courts by: 1) having the court designate
the lead plaintiff in such cases; 2) providing for a safe harbor from legal action for
predictions about future corporate performance; and 3) providing for proportionate
liability wherein a defendant judged not to have knowingly committed the fraud shall
only be liable for the part of the judgement in accord with his overall responsibility.
About a year after the passage of the Reform Act, concerns began surfacing in
the corporate community (particularly high tech-related firms) that the state courts
were increasingly being used to circumvent that law. In the interest of stymying the
migration of frivolous securities suits into the state courts, H.R. 1653, H.R. 1689,
and S. 1260 extend the reach of the Reform Act to the states. Opposition to the
uniform standards legislation derives from a number of concerns, including: 1) the
perception that the uniform standards legislation represents an assault on our tradition
of state/federal “federalism”; and 2) the view that key elements of the Reform Act
are still undergoing interpretation in the courts and thus it would be imprudent to try
to extend such an “unfinished” statute. After espousing the latter view, in March
1998, the SEC gave its support to S.1260 after the bill’s sponsors agreed to say in
the bill’s legislative history that the Reform Act did not represent an attempt to
impose more difficult plaintiff pleading standards than had existed already.
However, there is some skepticism about the effectiveness of this approach. On
May 13, 1998, S. 1260 passed the Senate following Banking Committee markup on
April 29.
Proponents of uniform standards legislation say that the existence of substantive
differences between state and federal courts (such as the fact that state courts do not
tend to have stay of discovery when a defendant’s motion to dismiss a case is
pending) helps foster the filing of state-based frivolous “strike suits” largely waged
to “extort” negotiated settlements from firms. But, others focus on the primacy of
the rights of the legitimately defrauded investor and support a “wait and see”
approach to the current legislation. There is concern about the extent to which the
courts may subsequently interpret the Reform Act’s key provisions in a manner that
further restricts legitimately defrauded plaintiffs’ opportunities for redress. To the
extent that these evolving court-based interpretations could have significant impact
on the cost/benefit equation for defrauded investors (and given what appear to be
credible doubts about the willingness of the courts to uniformly comply with
clarifying statements in current legislative history about congressional intent on
pleading standards in the Reform Act), the “wait and see” perspective would appear
to have potential legitimacy. However, the costs and benefits of extending the
various features of the Reform Act to the states may vary. Section 102, the provision
on safe harbors for forward-looking statements, would appear to have comparatively
greater potential for providing significant benefits to issuers and their shareholders
while not substantially trading off defrauded investors’ chances for legal and
economic redress.
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
P.L. 104-67’s Safe Harbor Provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Legislation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Is Legislation Necessary? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Updating the Numbers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
The Need for Federal and State Uniformity . . . . . . . . . . . . . . . . . . . . . . . . 7
Wait and See? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Framing the Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Securities Litigation Reform:
Unfinished Business?
Introduction
In December 1995, overriding a presidential veto, Congress enacted H.R. 1058,
the Private Securities Litigation Reform Act of 1995 (the Reform Act) as P.L. 104-
67. The law was a congressional response to concerns that shareholder suits claiming
violations of the Securities Act of 1933 and the Securities Exchange Act of 1934
(especially section 10(b), the antifraud provision of this law) were increasingly
unjustified and frivolous. The Reform Act attempts to curtail securities suits before
the federal courts by, among other things, 1) having the court designate the lead
plaintiff in such cases; 2) prohibiting a person from serving as a plaintiff in more than
5 class action suits over a three-year period; 3) eliminating coverage of securities
fraud by the Racketeer Influenced and Corrupt Organizations Act (RICO); 4)
providing for a safe harbor from legal action for predictions about future corporate
performance; 5) providing for proportionate liability wherein a defendant judged not
to have knowingly committed the fraud shall only be liable for the part of the
judgement that corresponds to his percentage of overall responsibility; and 6)
providing for auditor disclosure of corporate fraud.1
Months after the Reform Act’s enactment, there were growing perceptions that
the law was not having the desired effect of curtailing the overall number of (what
many presume to be significantly frivolous) class-action securities suits due in large
part to the increased use of filings in state courts.
For example, Denise Amatena, a partner in the law firm of Wilson, Soneini,
Goodrich & Rosati (a law firm that defends corporate defendants), observed that, as
of July 1996, California defense lawyers were seeing three times as many securities
class-action suits brought in California courts as in federal courts since P.L. 104-67’s
enactment.2
In addition, a study done in late 1996 by the National Economic Research
Associates (NERA), a consulting firm, found that between April 1 and October 31,
1 This section derives from: U.S. Library of Congress. Private Securities Litigation
Reform: P.L. 104-67. CRS Report 96-238 A, by Michael Seitzinger. Washington, 1996.
9 p. For a discussion of the federal securities laws as they relate to issues of mandated
disclosure and charges of shareholder fraud, see: U.S. Library of Congress. Uniform
Standards in Private Securities Litigation: Limitations on Shareholder Lawsuits. CRS
Report 98-164 A, by Michael Seitzinger. Washington, 1998. 5 p.
2 Sclafane, Susanne. Securities Reform Has Unintended Consequences. National
Underwriter, September 16, 1996. p. 34.
CRS-2
1996, 81 securities class-action suits were filed in federal courts — the same number
filed in the same period in the previous year before P.L. 104-67's enactment.
However, NERA also found that in the first 10 months of 1996, the number of class
action securities suits filed in state courts nearly doubled from the same period in
1995, going from 48 to 79. This was nearly double the average number of state
filings in the previous 5 years.3
Joseph Grundfest (a former SEC Commissioner) and Michael Perino, both of
whom teach law at Stanford University, run an internet site for the law school which
lists class-action-related litigation documents, and which has allowed them to
monitor the ongoing effect of the Reform Act. Based on their research in this area,
they found that from the time of the Reform Act’s enactment in the beginning of
1996 up to June 30, 1997, the aggregate number of class-action securities filings in
both federal and state courts appeared to be “roughly equivalent” to the rate of filings
during the pre-Reform Act period of 1991 to 1995.4
The Stanford professors concluded that in the Reform Act’s debut period there
appeared to be little correlation between the existence of the law and a decline in the
overall number of class-action securities suits. However, hidden beneath these
apparently stable pre- and post-Reform Act, aggregate filing rates was a “significant
shift of activity from federal to state court.” This “substantial increase in state court
litigation” was, they say, chiefly driven by 3 things: 1) a “substitution effect” in
which either: a) plaintiffs’ lawyers file in state courts when the facts of their cases
would appear unable to meet the more stringent new federal pleading requirements
brought in by the Reform Act or b) plaintiff lawyers simply attempt to circumvent the
Reform Act’s substantive or procedural demands; or; 2) plaintiff lawyers make
greater use of parallel state and federal litigation for purposes of avoiding “federal
discovery stays” or 3) plaintiff lawyers use alternative state venues for settling
federal claims.5
Somewhat echoing Grundfest and Perino’s findings, were parts of an April 1997
report on the Reform Act’s first year that was done by the Securities and Exchange
Commission (SEC). It reported that the most significant post-Reform Act
development may have been the apparent increase in the number of securities actions
filed in state court. The SEC report also observed that many of the state cases had
been filed simultaneously with similar case filings in federal courts probably in order
3 Starkman, Dean. Securities Class-Action Suits Seem Immune to New Law. Wall Street
Journal Interactive, November 12, 1996. p. 1.
Joint
4
Written Testimony of Joseph Grundfest and Michael Perino before the Subcommittee
on Securities of the Senate Committee on Banking, Housing, and Urban Affairs on July 24,
1997. p. 3-4.
Ibid
5
. The Stanford professors also found that prior to the Reform Act, the vast majority of
cases securities class-action cases filed in state courts alleged fraudulent activity in
connection with buying or selling stocks of non-publicly traded companies. But, after the
Reform Act, the vast majority of filings involve stocks traded on national securities markets
and allege fraud due to the presence of artificially inflated initial stock prices caused by
corporate misrepresentations or omissions.
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to circumvent some of the Reform Act’s procedural hurdles such as that of the
discovery stay pending a motion to dismiss a plaintiff’s case.6
P.L. 104-67’s Safe Harbor Provision
There is some evidence that companies which make credible, publicly disclosed
corporate projections may not only be providing investors and stock markets with
more meaningful and relevant information, but they may be also helping to lower
their cost of capital.
7
In the interest of making it easier for companies to voluntarily provide
corporate projections on future performance with a credible basis, the Reform Act
gives companies a safe harbor from legal action in the federal courts for such
forward-looking statements if they are accompanied by “meaningful cautionary”
statements that identifies key variables that could cause actual results to differ
substantially from the predictions. (Examples would be unpredicted changes in the
economy or supplier problems.)8
On April 10, 1997, 181 high-tech companies signed a letter that was sent to
House Commerce Committee Chairman Bliley by the American Electronics
Association (composed of electronic, software, and information technology
companies) noting that safe harbor protections were generally not provided in state
courts. And as a consequence, the letter argued that its signatory companies were not
able to provide the public with as “much voluntary information as possible.” And
due to those concerns, the letter urged that the Reform Act be extended to the state
courts.9
SEC
6
Office of the General Counsel. Report to the President and the Congress on the First
Year of Practice Under the Private Securities Litigation Reform Act of 1995. p. 2.
7 For example, see: Skinner, Douglas. Do the SEC’s Safe Harbor Provisions Encourage
Forward Looking Disclosures? Financial Analysts Journal, July/August 1995.
8 The forward-looking statement is also acceptable if the plaintiff fails to prove that if the
statement was made by a natural person, it was made with actual knowledge by that person
that the statement was false or misleading or, if made by a business, was made by or with
the approval of an executive officer and made or approved by the officer with actual
knowledge that the statement was false or misleading. (U.S. Library of Congress. Private
Securities Litigation Reform P.L. 104-67 by Michael Seitzinger. CRS Report 96-238 A.
March 7, 1996. p. 3.)
9 Ibid, p. 23. A number of Wall Street observers say that it is possible for companies who
are being sued for fraudulently using forward-looking statements to win veritable “safe
harbor” status in cases before the state courts by relying on the common law “bespeaks
caution” doctrine. (For some observers, eligibility for “bespeaks caution” status requires
that a company regularly informs Wall Street analysts about the possible risk factors
involved in investing in the company.) But, even with “bespeak caution” immunity,
companies can still face the costly prospect of discovery. (See: Molthrop, Morgan. Navigate
this “Safe Harbor” with Caution. The Georgeson Report, February 1998. p. 5-7.
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The April 1997 SEC report included a review of the impact of the Reform Act’s
safe harbor provision. Based on discussions with corporate officers and corporate
issuers’ outside counsels, as well as its review of post-Reform Act forward-looking
corporate statements, the report observed that in the period after passage of the
Reform Act, companies seemed to be no more willing to provide significant more
forward-looking disclosures than they were before the enactment of the Reform Act.
Two likely explanations were suggested: 1) the safe harbor provisions were still new
and companies were proceeding cautiously in using them pending a clearer
understanding of how courts were interpreting the law; and 2) the existence of
significant corporate anxiety over the threat of possible liability in state courts for
forward-looking statements that did not pan out because of the law’s general
inapplicability in those venues.10
Many of the supporters of the current securities reform litigation say that the
willingness of various state courts to accept securities claims alleging that specific
forward-looking corporate statements are fraudulent, is having a chilling impact on
their willingness to provide forward-looking commentary in their public releases.
For example, a 1997 survey of several hundred venture-capital-backed, largely high-
tech companies found that 60% of the respondents continue to be reluctant to
provide forward-looking statements for fear of being sued in state courts.
11
Representative Anna Eshoo, a co-sponsor of H.R. 1689, testified that she had
received hundreds of letters from business leaders, saying that they would not
provide forward-looking disclosures until the threat of litigation not covered by the
Reform Act’s safe harbor is eliminated.
12
Legislation
On May 16, 1997, responding to concerns that the Reform Act’s restricted reach
was permitting numerous (and, some, think frequently unwarranted) securities class
action cases to employ the alternative venues of the state courts, Representative
Campbell introduced H.R. 1653, the Securities Litigation Improvement Act of 1997.
The bill (which Stanford University law professor and former SEC
Commissioner Joseph Grundfest helped draft) was referred to the Subcommittee on
Finance and Hazardous Materials of the House Committee on Commerce. It amends
the Securities Act of 1933 and the Securities Exchange Act of 1934 by banning
private civil actions in state courts that allege: 1) that there was misrepresentation or
omission associated with the buying or selling of securities that are sold on national
markets; or 2) that the defendant was manipulative or deceptive in connection with
10SEC Office of the General Counsel, Report to the President. p. 2.
High
11
Growth Companies Muzzled by Threat of Strike Suits. U.S. Newswires, October 20,
1997. p. 2.

12 Testimony of Hon. Anna Eshoo during the Hearing on Securities Litigation Reform held
on October 29, 1997, by the Senate Banking Subcommittee on Securities.
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such a transaction. While banning such civil securities suits from state courts, the
bill also gives federal district courts sole jurisdiction over such suits.
In “Dear Colleague” letters sent out a few weeks before H.R. 1653's
introduction, Representative Campbell stated that the bill’s goal of a federal
preemption of securities action filings was necessitated by the threat of a “state by
state” reversal of the Reform Act’s benefits. These are threats that Representative
Campbell sees principally coming from either the actions of plaintiff lawyer-friendly
state legislatures, or the spread of state proposals that are similar to the defeated
November 1996 California initiative, Prop 211.13
On May 21, 1997, Representatives White and Eshoo introduced H.R. 1689, the
Securities Litigation Uniform Standards Act of 1997. The bill was also referred to
the Subcommittee on Finance and Hazardous Materials of the House Commerce
Committee. It amends the Securities Act of 1933 and the Securities Exchange Act of
1934 by disallowing private class action civil suits of more than 25 persons in state
court or under state law, including a pending state claim to an action under federal
law, which alleges either: 1) an untrue statement or omission in connection with the
purchase or sale of a covered security; or 2) or that the defendant used manipulative
or deceptive tactics in connection with the purchase or sale of any security.14
On October 7, 1997, Senator Phil Gramm, Chairman of the Senate Committee
on Banking, Housing, and Urban Affairs Securities’ Subcommittee, introduced S.
1260, the Securities Litigation Uniform Standards Act of 1997. The bill’s cosponsor
is Senator Christopher Dodd, the subcommittee’s ranking minority member. S. 1260
has received strong support form a coalition of high-tech companies, venture
capitalists, securities firms, and accounting firms, as has H.R. 1689 to which it is
very similar. However, H.R. 1689 would preempt state law with respect to a security
that is not traded on a national exchange if its corporate issuer has an outstanding
security that is traded nationally. But, S. 1260 provides for federal preemption of
class- action suits in which the involved security is itself traded on a national
exchange.
The press release accompanying H.R. 1689 stated that the bill would “ensure
that remedies available to purchasers and sellers of nationally traded securities would
be uniform and not vary depending upon the state in which the purchasers or sellers
1 3 Prop 211, or Proposition 211 was a failed initiative on the November 1996 California
ballot which had significant support from the securities’ plaintiff bar, and provoked
widespread opposition from the business community. Generally, the initiative would have
made it easier to file shareholder suits by, among other things: 1) allowing California courts
to consider a doctrine known as “fraud on the market,” which allows shareholders to sue
companies for securities fraud without having to cite specific examples of fraudulent
information on which they may have relied in buying the stock; and 2) mandating that the
cost of defending company executives and directors charged with securities fraud cannot be
picked up by their company. (The cost could still be picked up by insurance companies,
which tend to pay about half of the monetary damages.)
14This section largely derives from: U.S. Library of Congress. Uniform Standards in
Private Securities Litigation: Limitations on Shareholder Lawsuits. CRS Report 98-164 A,
by Michael Seitzinger. Washington, 1998. p. 4.
CRS-6
reside.”
15 In his introduction of S. 1260, Senator Gramm stated that while Congress
had hoped that the Reform Act would deal with frivolous class-action lawsuits
through the federal courts,” [we are] seeing a migration of these lawsuits to State
courts with a real effort and apparently successful effort to circumvent what we had
done [through the Reform Act]. . .”
16
On April 29, 1998, the Senate Banking Committee voted to report S. 1260 to
the full Senate. A substitute amendment was used as a markup vehicle in lieu of the
pre-markup version of S.1260.
During the markup, the committee included a number of changes to the
legislation that in late March, the committee’s leaders had promised the SEC would
eventually be added to the legislation. The changes included insertion of language
into S. 1260’s legislative history indicating that the congressional intent in the
Reform Act was that the standard of liability in the federal securities laws for
corporate defendants’ should be reckless misconduct per se. (For a full discussion
of this issue, see the section below, Wait and See?) The committees’ leaders had
also promised the SEC that S. 1260 would eventually include language that, unlike
the original version of the bill, no longer blocked certain shareholder lawsuits against
corporate directors for breach of fiduciary duty of disclosure under state courts, such
as that of the key Delaware chancery courts. (For a fuller discussion of this issue, see
footnote 34.) The substitute amendment to S. 1260 that the committee marked up
contained these changes.
The marked up, substitute version of S. 1260 also “tightened up” the definition
of “class action” contained in the original legislation by allowing various legal
actions that are deemed to be beyond the bill’s ambit like suits against rogue brokers
— to proceed in the state courts.
About the same time that S. 1260 was being marked up by the Senate Banking
Committee, the White House gave the bill its support. On May 13, 1998, S. 1260
passed the Senate.
On June 24, the House Commerce Committee passed H.R. 1689.
Is Legislation Necessary?
As Congress considers legislation that would preempt state laws pertaining to
securities class-action cases, the basic question is: what are the various costs and
benefits of the proposed uniform standards legislation?
15See: Zeigler, Luther. Plugging A Leak. Legal Times, June 23, 1997.
T
16
he Securities Litigation Uniform Act of 1997. Congressional Record, October 7, 1997.
p. S10475.
CRS-7
Updating the Numbers
In the summer of 1997, the National Economic Research Associates (NERA)
released an update of its earlier study on the impact of the Reform Act. It found that
in the first 5 months of 1997, 78 securities suits were filed in federal district courts
compared with 47 filings during the same period in 1996. It also found that through
from the beginning of 1997 to April of that year, there were 19 securities class
actions filed in state courts. That figure represented more than half of the 40 filings
done in the same period during 1996.”17
In analyzing these findings, a NERA official observed that it appeared that
plaintiff lawyers were realizing that “there’s no significant advantage to filing in state
court [relative to federal district courts].” The NERA findings of a drop in th
18
e
number of class action state filings between early 1996 and early 1997 were echoed
in a study released by Price Waterhouse in 1998 which found a 40% drop in class
action filings before the state courts between 1996 and 1997.
19
In early 1998, an informal SEC study found that 175 companies had been sued
in securities class-action suits during all of 1997 compared to the 105 suits in 1996
and the 158, 221, and 153 in the pre-Reform years of 1995, 1994, and 1993
respectively. It also found that 20 of the 175 federal suits in 1997 were accompanied
by parallel state filings (some perhaps being done to avoid the Reform Act’s ban on
the plaintiff exercising discovery if the defendant has a pending motion to dismiss
the case). This is in contrast to the 31 parallel state filings that accompanied the 105
securities class filings in federal court in 1996.
20
A representative of the Uniform Standards Committee, a group of accountants,
securities, venture capital, and high-tech firms that support uniform standards
legislation responded that the NERA findings are essentially irrelevant because the
mere threat of one state securities class-action case filing has a chilling effect on the
use of forward-looking statements since many states do not provide immunity to
corporate projections as does the Reform Act does.21
The Need for Federal and State Uniformity
Since the introduction of uniform standards legislation in the first part of 1997,
the focus of the debate on the legislation appears to have increasingly shifted from
a discussion of whether or not there have been numerical gains in the volume of
See:
17
Starkman, Dean. Securities Class Action Suits are Making a Comeback. Wall Street
Journal Interactive Edition, July 9, 1997. p. 1
18 Ibid.
19Cited in: What’s the Rush? National Law Journal, March 30, 1998. p. 2.
20SEC Finds Number of Class Actions Rise in 1997 to Pre-Reform Act Levels. Securities
Regulation & Law Report. February 20, 1997. p. 1.
2 1 Coalition of Business Interests Promotes Securities Litigation Reform Legislation.
Securities Regulation & Law Report, February 6, 1998.
CRS-8
state-based class action filings after the Reform Act — to a discussion of whether or
not there is a need for federal/state uniformity per se in the area of securities class
actions.
For example, in separate testimony during July 24, 1997 hearings before the
Senate Subcommittee on Securities of the Committee on Banking, Housing, and
Urban Affairs Hearings, Stanford University’s Grundfest and California
Corporations Commissioner Keith Bishop disputed the SEC’s assertion that it was
too early in its life to speak of extending the Reform Act to the states. They both
also claimed that the real issue is not whether there has been increased utilization of
the state courts, but that the Reform Act cannot be effective per se until there is
federal and state uniformity in the treatment of securities. Professor Grundfest also
22
questioned the wisdom of individual states being allowed to impose individual
jurisdiction over our essentially national capital markets.
23
And, after about a year of being noncommital in its support of uniform
standard legislation (due in part to the view that the Reform Act was still evolving
in the interpretive eyes of the courts and that extending it to the states was thus
premature), on March 24, SEC Chairman Levitt lent the agency’s support to S. 1260,
observing that “dual standards in state and federal courts are wrong.”
24
In introducing S. 1260, Senator Christopher Dodd said that the legislation
would “maintain uniformity and certainty” in the U.S. securities’ market, thus
enabling our markets to keep their competitive edge over rival securities markets in,
for example London, Frankfurt, and Tokyo. Former SEC Commissioner, Steven
Wallman (now with the Brookings Institute), has argued that the continued existence
of state laws that permit plaintiffs to circumvent the Reform Act’s provisions relating
to the discovery stay or the safe-harbor for forward-looking statements create
fragmented legal terrain that injects additional uncertainty into the corporate
decision-making process.
Others like Michael Perino of Stanford University Law School argue that the
most compelling reason for adopting uniform standards legislation has nothing to do
with the issue of the Reform Act’s impact. Support for uniform standards, he
argues, should be driven by the prospect that under the currently fragmented state
and federal system, a company such as IBM can be confronted with unsettling and
costly uncertainties that come with facing a host of similar securities suits
simultaneously coming at it from dozens of disparate state courts.
Opponents of uniform standards marshal a number of arguments to rebut the
claims that uniform state and federal standards would be socially optimal. One
argument invokes the historical notion that the U.S. was built on a tradition of
2 2Congress Urged to “Close Loopholes” Adopt Uniform Standards Legislation. Securities
Regulation & Law Report, July 25, 1997. p. 1.
23Ibid.
SEC
24
Throws Weight Behind Reform Bill; Levitt Praised at Renomination Hearing. Daily
Report for Executives, March 26, 1998. p. A-26. For details on the “conditional” nature
of the SEC’s support, see the next section in this report, Wait and See?
CRS-9
federalism and the states retain their rights to protect investors from securities fraud,
an entitlement that uniform standards would abridge. A more functionally oriented
25
response to the pro-uniform standards perspective is based on concerns that as the
current bull market fosters increases in direct and public and private retirement plan-
based investments in our secondary markets, the amount of investment fraud is
growing apace. Given this current reality, they argue that abridging investors’
access to state-based remedies for fraud through imposing uniform standards is bad
public policy.26
Others such as Representative Edward Markey, the ranking minority member
on the House Commerce Committee Subcommittee on Finance and Hazardous
Materials, have questioned whether uniform standards might be legislative “overkill”
given the fact that the preponderance of both state and federal securities class actions
are filed in a single state, California.
27
Wait and See?
In the wake of the passage of the Reform Act, a number of legal scholars
predicted that, given the ambiguity of its various provisions, the Reform Act’s
ultimately interpreted shape and thus its ultimate impact would not be known for a
while. The essential view was that these ambiguities would take some time to be
“worked out” as the various cases wend themselves through federal district and
perhaps appellate courts.
Provisions in the Reform Act that are frequently identified as being legally
ambiguous and that are predicted to go through a series of judicial testing and
refinement include: 1) the issue of the allowable plaintiff pleading standards, 2) the
discovery stay provision, and 3) the “meaningful cautionary language” section in the
25See: Gramm Predicts Passage of Bill, February 27, 1997. p. 1.
2 6 For example, see the summary of the testimony given by J. Harry Weatherly of the
Government Financial Officers Association in: Gramm Predicts Passage of Bill to
Federalize Securities Class Action Suits. Securities Regulation & Law Report, February 27,
1998. p. 1. There are a few aspects of jurisprudence in the federal courts vis a vis that
which is found in state courts that appears to be more pro-plaintiff. For example, federal
courts have generally been more disposed to recognizing the “fraud on the market” theory
in securities which is predicated on the idea that in pricing securities, securities markets are
efficient in assimilating all public information germane to the financial prospects of firms
whose securities are traded on them. Consequently, one who buys or sells a security is
generally presumed under fraud on the market theory to have relied on the market price as
an indication that all material information has been disclosed. As such, investors are seen
largely relying on the integrity of the efficient markets’ pricing mechanism in their decisions
to buy or sell securities and when corporations either omit or misrepresent material data
about themselves to the SEC, they are seen to be fraudulently misinforming the markets ,
and thus the investors as well. Financial economists are increasingly divided on the
credibility of the concept of market efficiency.
For
27
example, see: Levitt Eschews Broad-Based Preemption of Private Securities Litigation.
Securities Regulation & Law Report, October 24, 1997. p.1.
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provision on providing safe harbors for forward-looking corporate statements
provision.28
In testimony in July of 1997 before the Senate Subcommittee on Securities of
the Committee on Banking, Housing, and Urban Affairs, the SEC’s Levitt said that
it was premature to make any definitive statements about the impact of the Reform
Act since insufficient time had elapsed in the wake of the law’s passage to allow for
both meaningful patterns of experience with the law’s provisions and the courts to
clearly interpret it. The SEC chairman also commented that since the passage of the
Reform Act, no case had made it to the jury stage and appellate courts have had little
opportunity to interpret the Reform Act, and relatively few motions to dismiss had
been decided. Likewise, he also observed that very few settlements had yet to
emerge. 29
The chairman also acknowledged that some parts of the Reform Act were not
having the effect that Congress had intended and he also expressed his willingness
30
to support some narrow, targeted changes to the law. However, he warned that
absent solid evidence that the historically viable system of federal-state regulation
had “broken down”— he could not lend his support to broad-based legislative
measures that would undo the present system.
31
During subsequent testimony in late October 1997 before the House Commerce
Committee’s Subcommittee on Securities and Hazardous Materials Subcommittee,
the SEC Chairman reiterated the view that there was insufficient evidence on the
Reform Act’s impact to allow for a reasonable determination that legislation which
would preempt state laws or that would provide for “uniform standards” is currently
required. He predicted that in a year (October 1999), a clearer picture on the impact
For
28
example, Columbia University Law Professor John Coffee wrote: “ Much commentary
about the Reform Act is, for better or for worse, a fait accompli— that is, legislation whose
meaning is fixed and whose impact, while desirable, is not contingent on future
events...[but] the Reform Act is more like wet clay that has been shaped into an
approximation of a human form by an apprentice craftsmen and has now been turned over
to the master sculptor for the details that spell the difference between art and merely
competent mediocrity. Legislation, like art, requires interpretation, and until that
interpretive process is further along, the Reform Act must be regarded as still in its early
formative period... Congress has simply left too many ambiguous gaps and statutory
hiatuses for the Reform Act’s impact to be reliably assessed at this point.” (Coffee, John.
The Future of the Private Securities Litigation Reform Act: or Why the Fat Lady Has Not
Yet Sung. Business Lawyer, August 1996. p. 975.)
2 9 Congress Urged to “Close Loopholes” Adopt Uniform Standards Legislation. Daily
Report for Executives, July 25, 1997. p. 1.
These
30
included the willingness for institutional investors to take the roles of lead plaintiffs
in securities class actions and the extent to which companies were willing to provide
forward-looking disclosures.
3 1 Beckett, Paul. Levitt Urges Caution as Senate Group Mulls Securities Reform. Wall
Street Journal Interactive, July 24, 1997. p. 1.
CRS-11
of the Reform Act would probably emerge. He commented that he was willing to
32
work with both the House Commerce and the Senate Banking committees “to try to
respond to some of the problems that we see with the present [securities litigation
statutory] formulation.”
33
On October 21, before the House Commerce Subcommittee on Securities and
Hazardous Materials, Chairman Levitt reiterated his earlier view that there still was
not sufficient evidence on the Reform Act’s full impact to allow for a reasonable
determination that legislation to preempt the state laws or that would provide for
“uniform standards” is currently required. During the hearing, Mr. Levitt also le
34
t
it be known that he was willing to work with both the House Commerce and the
Senate Banking committees “to try to respond to some of the problems that we see
with the present [securities litigation statutory ] formulation.”
35
Of particular concern to the SEC Chairman has been the manner in which the
courts have and would be interpreting the Reform Act’s pleading standard (the level
of fraudulent misconduct that must be alleged in order that a suit be found acceptable
by the presiding judge). The Reform Act stated that investors must allege that a
complaint “state with particularity facts giving rise to a strong inference that the
defendant acted with the required state of mind.”
This language has resulted in varying interpretations by different federal courts.
The essential interpretive differences have been over whether plaintiffs can simply
demonstrate that corporate defendants were reckless per se (for example in
misrepresenting information or not disclosing information to investors in a timely
fashion) or that a demonstration of mere recklessness is not sufficient; certain courts
have demanded that the plaintiff also demonstrate that the omission or misconduct
was done consciously or deliberately. Other courts have also examined the

32 Witmer, Rachel. Levitt Eschews “Broad-Based Preemption” of Private Securities Actions
Under State Law. Securities Regulation & Law, October 24, 1997. p. 1-2. By that time,
the 105th Congress should have effectively finished its legislative agenda.
33Ibid.
34Chairman Levitt also stated that the proposed legislation to preempt state laws in the area
of securities actions could have “unintended consequences” by undermining critical state-
based corporate governance provisions Specifically, Mr. Levitt observed that the legislation
could produce the harmful impact of preempting the filing of cases involving disputes
having to do with corporate governance in state courts such as Delaware that “have
developed expertise and a coherent body of case law, which provides guidance to companies
and lends predictability to corporate transactions ... [thus] diminish[ing] the value of this
body of precedent as a tool for structuring corporate transactions and resolving corporate
disputes.” (Litigation-Reform Measures Could Backfire, Levitt Says. Wall Street Journal
Interactive, October 21, 1997. p. 1.) However, on March 24th the SEC Chairman agreed to
lend the agency’s support to S. 1260 after (among other things) the bill’s sponsors agreed
to amend the bill at markup so that state corporate governance claims will not be preempted
from state courts. The version of S. 1260 that was marked up by the Senate Banking
Committee on April 29, 1998, included such a provision.
35Levitt Eschews Broad-Based Preemption of Private Securities Actions Under State Laws.
Securities Regulation & Law Report, October 24, 1997. p. 1..
CRS-12
defendant’s motives and opportunity as salient issues in their determination of
whether allegations of recklessness should be dismissed.36
In the past, Chairman Levitt has often spoken of the agency’s concern that, as
in some of the aforementioned court interpretations, any interpretations of the
Reform Act’s pleading standards that go beyond asking that a plaintiff merely plead
that the defendants recklessly defrauded him or her, may run the risk of not providing
investors with sufficient protection from securities fraud. In conjunction with
37
a
securities case that is being appealed, the SEC recently filed an amicus brief in which
it protested a California district court’s departure from the recklessness standard in
the initial ruling in the case.
38
During a March 24 renomination hearing for his SEC chairmanship before the
Senate Banking Committee, Chairman Levitt (in what some observers described as
a surprising “turnaround”) announced that the SEC’s would support S. 1260. It was
support that appeared to be highly contingent on an agreement between the SEC and
Senators D’Amato (the Chairman of the Banking Committee), Gramm, and Dodd
(the bill’s co-sponsors) that during the bill’s markup they would insert language into
S.1260's legislative history, making it clear that it was their intent in enacting the
Reform Act in the 104 Congress that the Act should
th
adopt the recklessness pleading
standard that was applied some years earlier in the Second Circuit.
39
In the wake of the new developments, Chairman Levitt said that S. 1260 was
not “perfect,” but that it offered investors “basic protections.” Some reports have
indicated that Chairman Levitt would have preferred to have altered the relevant
statutory language to expressly communicate the primacy of the recklessness standard
36 Testimony of Arthur Levitt Before the House Commerce Subcommittee on Finance and
Hazardous Materials, October 21, 1997. p. 16. The critical role that the pleading standards
may play in vetting class action cases has also been noted by well known plaintiffs’
attorney, William Lerach. Mr. Lerach thinks that the pleading standards are the most
significant part of the Reform Act. And he characterizes them as “a gate that allows
hostile judges assisted by clever lawyers with a weapon to block any case, however
meritorious.” (Panelists Dispute Reform Laws Impact on Private Class Securities Fraud
Litigation, August 15, 1997. Securities Regulation & Law Report. p. 1)
37Testimony of Arthur Levitt, October 21, 1997. p. 16.
38Silicon Graphics, Inc. Sec. Lit., 1996 U.S. Dist. LEXIS 16989, 1996 WL 664639 (N.D.
Cal. 1996) (reaffirmed on motion to reconsider at 1997 WL 285057). (See: Testimony of
Professor Richard Painter, Cornell Law School Before the Senate Committee on Banking,
Housing, and Urban Affairs , Subcommittee on Securities on February 23, 1998. p. 7)
3 9 See: the March 24, 1998 letter from Senators D’Amato, Gramm and Dodd to Chairman
Levitt and the March 24, 1998 letter from Chairman Levitt and Commissioners Hunt and
Unger to Senators D’Amato, Gramm and Dodd. Three of the five SEC commissioners voted
to support the bill. One commissioner did not vote, and one commissioner, Norman Johnson,
placed a dissenting vote. In doing so, Commissioner Johnson claimed that.”the proponents
of further litigation reform have not demonstrated the need for preemption of state remedies
or causes of action at this time...[and] much more conclusive evidence than currently exists
should be required before state courthouse doors are closed to small investors through the
preclusion of state class actions for securities fraud.” (March 24, 1998 letter from
Commissioner Norman Johnson to Senators D’Amato, Gramm and Dodd.)
CRS-13
for class action securities suits. But as it curr
40
ently stands, the “agreement” between
the SEC and the 3 aforementioned members of the Senate Banking Committee would
use the legislative history of S.1260 to express the fact that Congress did not intend
to “alter the recklessness standard when it enacted the Reform Act.”41
A number of observers, however, are concerned that there be some significant
differences in the public policy outcomes that would derive from the “legislative
history language” approach agreed to between the SEC and the aforementioned
members of the Senate Banking Committee and an approach based on changing the
relevant language in federal securities law to explicitly say that it is acceptable for
plaintiffs to bring suits alleging that defendants simply acted recklessly. For
example, during the March 24 renomination hearing for Chairman Levitt, Senators
Bryan and Reed indicated that they were both skeptical about the efficacy of placing
language in legislative history as a tool for directing the courts to comply with certain
standards: Senator Reed observed that 11 of 27 federal district courts have failed to
accept the authority of language on “the recklessness standard” in the legislative
history of other laws. And, Senator Bryan asked Chairman Levitt whether simply
changing the relevant statutory language would be a far better approach to making
sure that the courts complied with the “recklessness standard.”42
In the aftermath of the SEC’s support for S. 1260, Richard Painter, a visiting
professor of securities law at Cornell University, observed that if Congress is truly
serious about preserving the recklessness standard, it could do either of 2 things: 1)
Amend Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) by
expressly inserting the recklessness standard as the standard of culpability or; at the
very minimum 2) enact statutory language that says that the Reform Act does not
change the aspects of the Section 10(b) of the Exchange Act that relate to plaintiffs’
pleading standards. Professor Painter cites a number of cases that have been before
the Supreme Court which he says indicates the court’s general historical indifference
to non-statutory attempts by subsequent congresses to redefine laws passed by earlier
congresses.
43
4 0 For example, see: Eaton, Leslie. Bill Further Limits Class-Action Lawsuits. New York
Times, March 26, 1998. p. D-7.
4 1 See: the March 24, 1998 letter from Chairman Levitt and Commissioners Hunt and
Unger to Senators D’Amato, Gramm and Dodd.
42SEC Throws Weight Behind Reform Bill, Daily Report for Executives. p. A-26.
Phone
43
conversations between CRS and Professor Painter. For example, he cites Central
Banks of Denver, N.A, v. Interstate Bank of Denver, N.A. (511 U.S. at 164) as a
fairly recent illustration of the Supreme Court’s unwillingness to look at the intent
of a subsequent Congress in its interpretation of the acts of a previous Congress in
a securities fraud case. He also cites the Supreme Court’s handling of a 1997
insider trading securities case, the United States v. O’Hagan, to also show how the
court ignored Congressional attempts in 1984 and 1988 to define insider trading
under Section 10(b) of the Securities Exchange Act of 1934 through the mechanism
of committee prints. (Painter, Richard, Kimberly Krawiec, and Cynthia Williams. Don’t
Ask, Just Tell: Insider Trading After United States v. O’Hagan. Virginia Law Review,
(continued...)
CRS-14
As indicated earlier in the report, on April 29, 1998, the Senate Banking
Committee marked up a substitute amendment in lieu of the original version of S.
1260. The new version of S. 1260 contained the agreed-upon language (per
discussions between the committee and the SEC) that the intent of Congress in
passing the Reform Act was not that of changing the previously existing pleading
standards for securities cases before the federal courts.
There is additional skepticism over the efficacy of the SEC-supported
“legislative history” approach to communicating to the courts the proper approach
to dealing with the issue of pleading standards. For example, after the SEC gave its
support to S. 1260, Barbara Roper, director of Investor Protection for the Consumer
Federation of America (a national consumer advocacy group), criticized the SEC’s
chairman for abandoning his “courageous” position on the uniform standards
legislation, saying that the agency had reversed its previous position in exchange for
“cosmetic changes.”44
Additional arguments that have also been marshaled in support of a general
“wait and see” approach on the impact of the Reform Act, have included
observations that: 1) a handful of states (Arizona, Montana, and Ohio) have already
passed legislation akin to the Reform Act, and the possibility exists that others may
as well; and 2) the California Supreme Court has a case pending before it, Pass vs.
Diamond Multimedia, in which the court will have to decide whether California’s
securities laws have applicability to securities transactions occurring outside of the
state. Chairman Levitt of the SEC previously argued (before lending the agency’s
support to S. 1260) that if the California Supreme Court eventually rules in favor of
the corporate issuer/defendant in the case, nationwide class action suits would be
unavailable in California. As a consequence, Chairman Levitt argued that plaintiff
lawyers would generally be uninterested in pursuing the state court option since the
nationwide class action was unavailable.
45
Some of the criticism of the “wait and see” approach has resembled the
arguments employed (and discussed in the previous section, The Need for Federal
and State Uniformity) to support the notion that an unfragmented, uniform state
and federal judicial apparatus for securities class actions is socially optimal,
notwithstanding the Reform Act’s ultimate impact. There has also been criticism
that the “wait and see” approach is essentially a strategic tack to delay the enactment
of uniform standards legislation by those who are concerned that the courts will
continue to interpret various parts of the Reform Act in increasingly restrictive and
undesirable ways (from the plaintiff’s perspective).
43(...continued)
March 1998. p. 200-204.)
Statement
44
of Barbara Roper Director of Investor Protection for the Consumer Federation
of America (March 1998).
Tes
45
timony of Arthur Levitt before the Commerce Committee’s Subcommittee on Finance
and Hazardous Materials, October 21, 1997. p. 23.
CRS-15
Although the SEC’s decision to support S. 1260 appears to signal this very
important player’s abandonment of its “wait and see” position on uniform standards
legislation, we have noted that some observers express significant doubts about the
extent to which the courts will comply with the type of plaintiff’s pleading standard
that the agency has maintained is critical for helping to ensure that investors are
properly protected from fraud.
Framing the Issues
At least one observer has commented that, to a large extent, the combatants on
the two sides of the debate over uniform standards legislation are mirroring the roles
that they played during the earlier debate surrounding the legislation that would
become the Reform Act. And, with some exceptions, the observation appears to be
46
a fairly legitimate one. High-tech companies, venture capital firms, manufacturing
firms, and accounting firms were a significant part of the support for legislation that
became the Reform Act. Now, they are a major part of the constituency for the
uniform standards bills. Interest groups significantly composed of non-corporate
lawyers, state officials, and consumer advocacy groups tended
47
toward opposition
to the Reform Act and its precursors. They also have tended toward opposition to the
uniform standards legislation.
These fairly consistent patterns of support and opposition are not surprising.
The members of these two different groups tend to attach different weights to
different aspects of the securities litigation reform debate. (Or as an economist would
say, they have different utility functions in terms of the securities litigation reform
outcomes that would most satisfy them.) Many of the supporters of the legislation
that became the Reform Act legislation tended to regard any new federal class action
shareholder suit as having a high likelihood that it was frivolous, and essentially
mercenary, and which was probably being spearheaded by a plaintiff’s attorney in
pursuit of the windfall from a negotiated settlement. In addition, many of the
proponents of securities litigation reform have also expressed some concerns over the
tendency for plaintiffs’ attorneys to extract what many perceive to be excessively
high percentages of plaintiffs’ recoveries. (This is a concern that the Reform Act
48
has attempted to at least partially address.)
46For example, the North American Securities Administrators Association (an organization
of state and provincial securities regulators) is taking a neutral stance on uniform standards
legislation as states’ securities regulators in various states appear to be divided in their
opposition and support of the legislation.
4 7 In the case of the American Bar Association, the litigation section basically opposed the
Reform Act while the business section was essentially supportive of it.
4 8For example, see: Macey, Johnathan and Geoffrey Miller. The Plaintiffs’s Role in Class
Action and Derivative Litigation: Economic Analysis and Recommendations for Reform.
University of Chicago Law Review, vol. 58, 1991. p. 8 and Coffee, John. Understanding
Plaintiffs Attorney: The Implications of Economic Theory for the Enforcement of Class and
Derivative Actions. Columbia Law Review, vol. 86, 1986. p. 714-720. Some research
indicates that class action attorney’s fees normally range between 30% and 50% of the total
settlement amount.
CRS-16
Often underpinning this perception appeared to be a general preoccupation with
the potential corporate costs that can be associated with meritless suits. These are
costs that could include: litigation-related dollar costs to the company; lower returns
for shareholders as settlement cost eat into profits, and corporate opportunity costs
from corporate officials who are diverted from normal duties. Many of the firms
49
are high-tech firms whose survival is dependent on their ability to continue fruitful
research and development operations. Litigation-related costs may have a potentially
deleterious impact on the capital that is available for such research and development.
Many of the interests currently backing the uniform standards bill tend to
believe that there is a strong likelihood that any given state-based shareholders suit
will be similarly frivolous and mercenary. As a consequence, many companies
publicly support uniform standards legislation because it promises to reduce the role
that states courts play as perceived conduits for shareholder suits seen to have a high
likelihood of being frivolous. Also, from a cost minimization perspective, companies
should also be as concerned about meritorious suits as they are concerned about the
50
frivolous ones. Thus, firms may actually have the incentives to support policies such
as those contained in the uniform standards bills — policies that carry the promise
of curtailing the flow of class action securities suits of all types.
Many of the detractors of both the Reform Act and its legislative precursors
tend to see any new shareholder class-action lawsuits in the context of its potential
to be a fully warranted legal pursuit on the part of a investor/plaintiff who feels that
he or she had been has been genuinely deceived and financially harmed by a
corporate misrepresentation or omission. It is a perspective that is frequently
underpinned by a central focus on the primacy of the individual’s right to redress
legitimate wrongs, specifically corporate-inflicted damage to shareholders.
In this context, opposition to the Reform Act, and current opposition to uniform
standard’s legislation can be seen to come largely from concerns that additional
restrictions (imposed on the federal courts in the case of the Reform Act and imposed
on state courts in the case of uniform standards’ bills) on plaintiff access to the courts
would and will abridge the opportunities that potentially aggrieved shareholders have
to pursue economic redress.
51
4 9 For example, does the price of the products that are offered to consumers incorporate an
expected corporate cost for coping with legislation without merit?
5 0 This of course assumes that companies acknowledge that certain suits have merit. In
addition, to the extent that (all things being equal) cases with real merit should on average
have a marginally better chance of garnering bigger recoveries than frivolous ones,
companies may have heightened “bottom line-based” concerns over them. Sometimes, this
may manifest itself in a company paying particular attention to the need to “self police”
itself against fraud to minimize the number of defrauded investors.
5 1 Some observers have also argued that, when cases with merit do succeed (whether this
is defined as a certain amount of out of court or trial-based recovery), the society as a whole
may receive additional benefits via the deterrent effect that the case’s success may have on
future corporate wrongdoing. This is a difficult proposition to either prove or disprove.
CRS-17
Part of the catalyst for the introduction of the uniform standards bills is the
widely held perception that after the passage of the Reform Act’s enactment, the
number of shareholder suits in state courts began to mushroom, a behavior perceived
to be tied to class action securities filings that bypassed the plaintiff impediments that
the Act imposed on federal courts through the use of state filings. However, as 1997
progressed, newer information indicated that state filings were not continuing to
grow at a significant pace. There were, however, indications that the number of
state-based suits filed parallel to similar federal filings had grown to levels that were
much higher than before the Reform Act. The difference between these two types
of filings is discussed below.
But, the real insight here is that there is actually no insight. Even under the best
of conditions, there are simply not enough years of annual post-Reform Act stat
52
e
filing data to allow for the construction of a credible, predictive trend line at this
point time.
More importantly, one should be aware of the fact that increases in the number
of state filings or the percentage of state filings filed parallel to federal filings need
not necessarily translate into increases in the absolute number or the percentage of
frivolous class actions filed in the state courts. They may possibly translate into
increases in the number or percentage of baseless lawsuits, but we do not really
know for sure. As we alluded to earlier, there are some good, strategically optimal
reasons why plaintiffs with credible cases might choose a state venue over or in
addition (in the case of parallel filings) to a federal venue in the post-Reform Act era.
Moreover, it must be remembered that the Reform Act’s essential goal was that of
curtailing the flow of frivolous law suits, not the outright curtailment of legitimate
class-action suits.53
Much of the concern on the part of advocates of uniform standards legislation
over the migration of cases from the federal courts to the state courts, is over the
parallel filings in state courts that do not have stay of discovery provisions like the
one that the Reform Act imposed on the federal courts. Parallel state filings ca
54
n
enable plaintiffs to circumvent the federal stay of discovery rules that allows courts
to freeze pre-trial discovery until a judge can rule on the defendant’s motion to
dismiss the case.
There certainly have been and there probably will continue to be a number of
baseless and opportunistic shareholder “strike suits” that use pre-trial discovery
(sometimes the costliest part of the litigation process) to make burdensome demands
of time and resources on corporate defendants to ultimately force them into a
negotiated settlement (which the firm may perceive to be a less costly alternative to
If
52
the post-Reform Act state filing data begins to resemble the seemingly scattershot annual
state filing data in the years leading up to the Reform Act, trend lines may still have little
real predictive value.
5 3 For example, see: U.S. Library of Congress. Uniform Standards in Private Litigation:
Limitations on Shareholder Lawsuits. CRS Report 98-164 A, by Michael Seitzinger. p. 2.
In
54
its study, the SEC found that parallel state filings constituted a significant number of the
state shareholder filings that it sampled.
CRS-18
going to trial.) And, to the extent that these kinds of “bad” cases use parallel state
55
filings to avoid the stay of discovery in federal courts, there are should be no net
social benefits, but we would expect some net social costs.
But, contrary to what some of the proponents of uniform standards legislation
suggest, it is quite easy to conceive of situations in which the “migration” of certain
securities cases to state courts via parallel filings is essentially a recovery optimizing
strategy for plaintiffs who believe that they have legitimate claims.
56
For example, the federal court’s stay of discovery may result in plaintiffs who
believe that they have been defrauded being unable to pursue potentially critical and
revealing search of the defendant’s documents if the defendant’s motion to dismiss
the case is pending. But, filing a similar case in a state court could allow the plaintiff
to circumvent the federal stay of discovery, enabling him or her to pursue the
potentially pivotal search for evidence.
Also, the stay of discovery can impede the legal progress of plaintiffs who are
trying to address legitimate claims, but who have had their suits dismissed because
of the heightened pleading standards that were imposed by the Reform Act. In the
event of such a dismissal. plaintiffs can try to amend their complaints before the
court. But, this amendment process might require some evidence that is itself
foreclosed by the existence of a stay of discovery.57
Chairman Levitt has indicated that to the extent that parallel state filings are
done to circumvent the Reform Act’s stay of discovery, the intentions behind the Act
are undermined. And, this is probably correct. But, some observers claim that the
essential goal of the Act’s stay of discovery was to make it harder for the wielders of
strike suits to use the leverage of the potentially costly discovery phase to force
defendants into a negotiated pre-trial settlement. In this context, one could argue that
both the wielders of legitimate and the wielders of bogus securities class-action
claims may have strong incentives to make parallel filings in state courts in order to
try to better accomplish their ends. But, what is not known is the extent to which
these kinds of filings are frivolous or credible.58
55Some meritorious cases are also settled out of court.
However,
56
the SEC also has observed that the stay of discovery “imposed by the Act during
the pendency of a motion to dismiss, coupled with the heightened pleading standards that
the Act imposes has made it more difficult for plaintiffs [presumably those with baseless as
well as those with legitimate claims] to bring and prosecute securities class action lawsuits.
. .” (Report to the President and the Congress on the First Year of Practice under the Private
Securities Litigation Reform Act of 1995. SEC Office of the General Counsel, April 1997.
p. 2.
57For example, see: the SEC staff commentary in: Report to the President and the Congress
on the First Year of Practice under the Private Securities Litigation Reform Act of 1995.
SEC Office of the General Counsel, April 1997. p. 2.
In
58
addition, the various partisans in the securities litigation reform debate would no doubt
attach different weights to their importance.
CRS-19
Some supporters of uniform standards legislation speak of the legislation’s
importance in enhancing the global competitiveness of the U.S. capital markets by
providing a relatively more transparent, seamless, and unfragmented, unified court
system. But, a perusal of the financial press and academic studies on the pivotal
impediments facing foreign issuers interested in tapping into the U.S. financial
markets, provides little evidence that this country’s bifurcated state and federal
court structure is regarded as a significant barrier . It is certainly possible that the
59
relative uncertainties inherent in a federal/state court system may pose some
problems for some prospective foreign issuers. But, given the widely acknowledged
allure of the U.S. capital markets, these concerns would currently appear to, at best,
have marginal importance.
Some of the proponents of the uniform standards legislation also describe the
legislation as an antidote to the plausible threat in which firms may simultaneously
confront similar securities suits from as many as 50 states. They also argue that this
kind of situation would generate substantial corporate costs and would significantly
complicate the already formidable process of corporate-decision making, while
producing no visible societal benefits.
Although undeniably possible, the notion that domestic companies can
realistically expect to simultaneously contend with dozens of similar state-based
securities class actions is probably weakened by the reality that the vast majority of
securities class actions at both the state and the federal level are based in a single
state, California. Being simultaneously besieged by a constellation of similar suit
60
s
from dozens of state courts is certainly possible. But, it would appear to be far
removed from the norm. The alarming description basically appears to depict a kind
of “worst case” low-probability scenario that might occur over time, but most likely
in isolated situations.
The California basis of the majority of securities suits has caused other
concerns to be raised about the necessity of uniform standards legislation. For
example, Representative Edward Markey, has asked whether the broad-based bills
make fundamental sense given the strong California basis of much of the nation’s
securities litigation.61
As mentioned earlier in this report, a number of the supporters of uniform
standards legislation agree with the view that it is too early in its judicially
interpreted life to attempt any meaningful analysis of the Reform Act’s probable
impact. But, they also say that this fact is of very little consequence because the
creation of a single securities class-action judicial venue per se is clearly socially
optimal. But, this view may have a number of weaknesses. A central problem is that
the arguments that have been employed to demonstrate that uniform standards would
A
59
central concern is that foreign companies must go from native accounting standards that
tend to yield corporate disclosures that are comparatively less forthcoming and more opaque
than those that are provided by U.S.
6 0 The state is the major location for the nation’s high-tech companies whose
characteristically volatile stock makes them attractive targets of shareholder suits.
61See: Securities Regulation & Law Report, Congress Urged to “Close Loopholes.” p. 1.
CRS-20
be socially optimal, tend to be fashioned exclusively from the perspective of
corporate issuers.
A theoretically sound argument can also be made that the presence of an
unfragmented judicial system could reduce some of the uncertainties of corporate
decision-making, lowering overhead (by reducing some of the costs associated with
decision-making) possibly increasing profits which could redound to corporate
investors as increased stock returns. But, it is conceivable that some of the investors
who are the real victims of corporate fraud (as well as investors who falsely allege
fraud) could be economically disadvantaged from the loss of (federal/state) choice
to pursue the optimal strategy of legal redress.
The nature of the potential economic benefits of providing (where statutorily
permissible) defrauded investors with a choice between or (as in the case of parallel
filings) among state and federal venues in securities class-action filings appear to be
strongly connected to the extent to which the courts interpret key provisions in the
Reform Act more restrictively (for plaintiffs) in the months to come.
Some of the proponents of the “wait and see” approach will probably have less
interest in supporting legislation for uniform standards if court interpretations “down
the road” produce a Reform Act that they perceive to further limit plaintiffs’
opportunity for redress. Indeed, there are some indications that at least some of the
adherents of this “wait and see” approach are already basically opposed to the
uniform standards bills.
From the cost/benefit perspective of legitimately aggrieved investors, the
effects of the Reform Act are not known until more court interpretation is
forthcoming. (And, to the extent that there are credible doubts over the ability of the
aforementioned SEC-supported “S. 1260 legislative history” approach to direct the
courts to comply with pleading standards that are more investor protection oriented,
a reasonable case can be made that the Reform Act’s final import may also not be
known in this key area.) For these individuals, the economic consequences of the
Reform Act, therefore, are not yet known. It then follows that an application of the
Reform Act to state securities litigation — before these interpretations are
forthcoming — has the effect of magnifying this uncertainty, becoming an additional
and potentially credible argument for the wait-and-see approach.
However, the costs and benefits of some features of the Reform Act are less
ambiguous than others. Section 102, the safe harbor for forward-looking statements,
appears to have significant potential for providing benefits to issuers and their
shareholders without significantly reducing defrauded investors’ opportunities for
legal redress.
Section 102 in the Reform Act applies to the Securities Act of 1933 and the
Securities Exchange Act of 1934 and provides that liability will not be imposed upon
a person concerning any-forward-looking statement if either of the following certain
conditions are met: 1) the forward-looking statement identifies important factors
that could cause actual results to differ materially from those in the forward-looking
statement or 2) the plaintiff fails to prove that the forward-looking statement, if
made by a natural person, was made with actual knowledge by that person that the
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statement was a false or misleading or, if made by a business, was approved by the
officer with actual knowledge that the statement was false or misleading.
62
The courts are still working out the specific meaning of “meaningful cautionary
statements” in the safe harbor provision and the SEC staff has been divided over the
preferred interpretation of that language. Still, compared to other key provisions in
the Reform Act, the safe harbor section appears to have the greatest potential for
providing significant benefits to issuers and their shareholders that are not
substantially gained at the expense of defrauded investors’ opportunities for
economic redress.
The idea of a safe harbor for forward-looking corporate statements has received
support from an unusually disparate array of entities and interest groups This would
include groups or entities generally aligned with corporate issuers such as the
American Electronics Association (composed of electronic, software, and
information technology companies) as well as investor-oriented entities like the
National Association of Investors Corporations, (a coalition of more than 700,00
individual investors and 33,000 investment clubs) and the SEC.
63

64
Nonetheless, some observers believe that the provision of legal safe harbors for
forward-looking statements is of little consequence because the predictive financial
data that is being (and presumably would be) issued is “low-quality or dubious, at
best”65 Others claim that safe harbors may have only a tenuous effect on the
willingness of some firms to provide forward-looking data: firms are seen occupying
a continuum between those who willingly disclose and thus may experience higher
(short-term) stock prices and those who are less willing to disclose due to concerns
over the competitive implications of this kind of information sharing.66 Others are
concerned that the safe harbor “allows individuals to disseminate information they
know to be false by surrounding such information with cautionary language....”
67
62See: CRS Report, Private Securities Litigation Reform: P.L. 104-67. p . 6-7.
63For example, see: The testimony of Thomas O’Hara founder of the National Association
of Investors’ Corporations before the Senate Securities Subcommittee of the Committee on
Banking, Housing, and Urban Affairs on October 29. 1997. p. 1.
64For many years prior to the enactment of the Reform Act, the agency pursued the idea of
broadening the exemption from liability for certain forward-looking statements.
For
65
example, see the summarization of the statement by Michael Dye, project manager for
the National Association of Securities and Commercial Attorneys (NASCLA) in: Hersch,
Warren. Investors, Tech Companies Back Bill; Attorneys, Consumer Advocates Opposed
— Congress to Weigh Limit on Securities Suits. Computer Reseller News, August 18,
1997. p. 37.
6 6 For example, see: Seligman, Joel. The SEC’s Soft Information Revolution. Fordham
Law Review, May 1995. p. 1975.
6 7 Spencer, Steven. How Congress Learned Its Lesson: A Plain Meaning Analysis of the
Private Securities Litigation Reform Act of 1995. St. John’s Law Review, Winter 1997.p.
99.
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Concerning the idea that some companies may simply not have the proper
incentives use the safe harbors, it is important to remember that the federal safe
harbors are voluntary and to the extent that companies do not use them, attendant
concerns about their potential social costs (in the form of badly misled or defrauded
investors) simply become moot.
On the view that predictive disclosures tend to be of generally dubious value,
there is empirical evidence which appears to suggest otherwise: among other things,
there is evidence that earnings-related projection disclosures tend to affect stock
prices, suggesting that such managerial disclosures provide investors with credible,
and value-relevant information.68 The evidence also suggests that increased
voluntary predictive disclosures appears to help lower a firm’s capital costs.
69
The argument against safe harbor for forward-looking disclosures that carries
the most weight is that they tend to encourage companies to deliberately lie about
their financial prospects. How strong this incentive would be is unknown. The
incentive to misrepresent would be weakened by market mechanisms (in addition
to the threat of litigation) that discipline (and thus deter) firms inclined to knowingly
make overblown projections. Generally, publicly owned companies who return to
the marketplace for capital can ill afford to squander their credibility in the eyes of
creditors, financial peers, and security analysts. In effect, the market is seen
rewarding firms that meet their projections and punishing firms that do not,70
although, clearly, this incentive does not eliminate the potential for fraudulent
statements.
There is widespread disappointment over the limited use of safe harbor
disclosures in the Reform Act. The continued acceptance of forward-looking
shareholder suits in many state courts may be one of a number of reasons why
companies have been loath to take advantage of the safe harbor provision in the
Reform Act. Again, some empirical evidence exists which indicates that in the pre-
Reform Act era, companies who regularly made forward-looking disclosures tended
not to make them in periods before they made public stock offerings (when the threat
of disclosure-related shareholder litigation is highest). This strongly suggests that
71
the threat of litigation — any litigation — may have a chilling effect on the
willingness to make forward-looking disclosures.
68See: Skinner, Douglas. Does the SEC’s Safe Harbor Provision Encourage Forward-
Looking Disclosures? Financial Analysts Journal, July/August 1995. p. 23.
69Ibid.
See:
70
Phelps, Richard and Gilbert Miller. Private Securities Litigation Reform Act of 1995.
Business Lawyer, August 1995. p 1020. The reader may want to look at the Fortune cover
story for October 27, 1997, which chronicles the growing power over the short-term stock
price behavior of their designated companies that is appears to be held by a number of
brokerage firm securities’ analysts. (Nocera, Joseph. The Analysts: Who Really Moves the
Market? Securities Analysts: Securities Analysts are Wall Street’s New Stars: They Bring
in Banking Deals, Make the Calls that Move Billions in and out of Stocks. Fortune, October
27, 1997. p. 90.)
7 1Skinner, Does the SEC’s Safe Harbor Provision Encourage Forward-Looking
Disclosures? p. 23
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Consequently, an additional legislative option presents itself. In addition to the
choice of extending or refusing to extend the Reform Act to the states, or of waiting-
to-see before making a choice or extension, it is also possible to extend only part of
the Reform Act, such as the forward-looking statement safe harbor.