This is Part 4 in a 4 part series on Securities Class Actions by Martin Chitwood.
The Private Securities Litigation Reform Act
In 1995, Congress passed the Private Securities Litigation Reform Act of 1995 (the “PSLRA”) to “enact reforms to protect investors and maintain confidence in our capital markets.” H.R. Conf. Rep. No. 1058, 104th Cong., 1st sess., at 27 (1995). Proponents of the PSLRA argued that the legislation was necessary to make it more difficult for investors to file “meritless” class action law suits in federal court against companies they claimed had misled them with overly optimistic forecasts of future profits, claiming that the PSLRA would allow officials of public companies to publish statements about their companies’ prospects without fear of shareholder lawsuits. Opponents of the PSLRA, including numerous consumer protection groups, argued that those who lobbied for the legislation were motivated only by their desire to protect themselves from meritorious lawsuits. In reality, they argued, the legislation could go “far beyond curbing meritless lawsuits to all but legalizing securities fraud.”
- Key Provisions of the PSLRA
The PSLRA goes well beyond reform to stifle an individual’s chances of recouping an investment loss. The Act is fraught with potential obstacles for plaintiffs, including several provisions that represent significant departures from traditional securities law, including a statutory “safe harbor” for certain “forward-looking” statements, which includes a heightened pleading requirement, and a proportionate liability provision. Each of these provisions may potentially damage an investor’s ability to recover his lost investment. In addition to the substantive provisions, the PSLRA also provides two key provisions regarding procedural matters: the appointment of a “lead plaintiff” and the automatic stay of discovery pending resolution of a dispositive motion to dismiss.
- Statutory Safe Harbor and Heightened Pleading Requirement
The PSLRA contains a “safe harbor” provision that allows a company or its principals to release statements predicting the company’s future economic performance and describing the assumptions underlying such statements. Securities Act § 27A; Exchange Act § 21E. The safe harbor provision has two prongs that operate in the disjunctive:
* Under the “actual knowledge” prong, the issuer is protected with respect to the forward-looking statement if the plaintiff fails to prove that the statement was made with actual knowledge that the statement was false or misleading. Securities Act § 27A(c)(1)(B); Exchange Act § 21E(c)(1)(B).
* Under the “bespeaks caution” prong, the person making the forward-looking statement is protected if the statement is identified as a forward-looking statement and is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement. Securities Act § 27A(c)(1)(A); Exchange Act § 21E(c)(1)(A).
The “actual knowledge” prong raises several obstacles to recouping investor losses. The first obstacle is encountered in the pleading stage. The PSLRA includes several heightened pleading standards for private actions, including codification of a state of mind requirement that is based on the Second Circuit’s former standard, which is generally regarded as the most stringent standard that had been applied before the passage of the PSLRA. Exchange Act § 21D(b)(2); see also In re Glenfed, Inc., 42 F.3d 1541, 1547 (9th Cir. 1994) (en banc); Phelps v. Wichita EagleBeacon, 886 F.2d 1262, 1270 n.5 (10th Cir. 1989); Auslender v. Energy Management Corp., 832 F.2d 354, 356 (6th Cir. 1987). Under the terms of the PSLRA, a plaintiff must state with particularity facts giving rise to a “strong inference” that the defendant acted with the required state of mind. Exchange Act § 21D(b)(2).
The PSLRA further elevates the plaintiff’s burden by providing that discovery in the case is stayed when the defendant files a motion to dismiss. Securities Act § 27(b); Exchange Act § 21D(b)(3)(B). The effect of the combination of heightened pleading standards and the stay of discovery is that a plaintiff must plead facts that are uniquely within the defendant’s possession, but is precluded from exploring company records that would demonstrate the defendant’s knowledge of the falsity. The PSLRA requires that, before any discovery can be transacted, a plaintiff must carry the often insurmountable burden of pleading, with exacting specificity, facts sufficient to show “actual knowledge.”
The “bespeaks caution” prong of the safe harbor provision is also problematic. Read literally, it will protect forward-looking statements that were known to be false and misleading when made, so long as they were accompanied by meaningful cautionary statements. The Statement of Managers accompanying the PSLRA confirms this reading by providing that “courts . . . examine only the cautionary statement accompanying the forward-looking statement. Courts should not examine the state of mind of the person making the statement.” Statement of Managers at H13703.
Additionally, the cautionary language that accompanies the forward-looking statement need only identify some important factors that could cause the company’s actual performance to differ materially. See id. “Failure to include the particular factor that ultimately causes the forward-looking statement not to come true will not mean that the statement is not protected by the safe harbor.” Id. (emphasis added). Consequently, a company can release false or incomplete information and still fall within the PSLRA’s safe harbor provision, avoiding any liability.
- Proportionate Liability
In addition to the statutory safe harbor and heightened pleading requirements, the PSLRA also limits the application of joint and several liability to defendants who knowingly commit a violation of the securities laws. Exchange Act § 21D(g). All other defendants are proportionately liable based upon their percentage of responsibility for the damages. See Exchange Act § 21D(g)(3)(C).
Knowledge, for purposes of proportionate liability, exists when the defendant (1) makes an untrue statement of a material fact with knowledge of its falsity, (2) omits to state a fact necessary to make a material statement true, with actual knowledge that without the omitted fact, the representation is false and people are likely to rely on that false representation, or (3) in cases not involving false representations, engages in conduct with actual knowledge of the facts and circumstances that make such conduct a violation of the securities laws. Exchange Act § 21D(g)(10)(A). As discussed above, proof of actual knowledge, particularly at the pleading stage, presents tremendous problems for plaintiffs.
The PSLRA’s departure from joint and several liability demonstrates the extreme nature of this legislation. Joint and several liability is a well-established rule of law grounded in equitable principles that operate to protect investors. See McDermott, Inc. v. Clyde, 114 S. Ct. 1461 (1994). Under the PSLRA, defrauded investors may not be made whole if a defendant is insolvent.
- The Lead Plaintiff Provision
One of the purported purposes of the PSLRA was to discourage the “first come, first served” rule regarding who would be appointed lead plaintiff in a securities class action and to encourage the selection of institutional investors, which usually have the largest financial stakes, as lead plaintiffs. The PSLRA requires courts to choose the “most adequate plaintiff” as the lead plaintiff and to presume that the most adequate plaintiff is the investor with the largest financial stake in the relief sought. Securities Act §27(a)(3)(B)(iii); Exchange Act §21D(a)(3)(B)(iii); Conf. Rep. at 29.
In order to give potential lead plaintiffs with large financial interests the opportunity to serve as lead plaintiff in the action, the Act requires that a plaintiff filing a securities class action must, within 20 days of filing the complaint, provide notice to all potential class members in a “widely circulated national business-oriented publication or wire service.” Securities Act §27(a)(3)(A)(i); Exchange Act §21D(a)(3)(A)(i). The notice must identify the claims alleged in the action and the class period, and it must inform potential class members of their right to move to serve as lead plaintiff within 60 days of the date of the filing the complaint. Id. As a practical matter, such notices also typically include the name, address, and phone number of the attorneys representing the class and direct any potential class members to contact such person for more information.
- Automatic Stay of Discovery
The PSLRA further elevates the plaintiff’s burden by providing that discovery in the case is automatically stayed when the defendant files a dispositive motion to dismiss. Securities Act § 27(b); Exchange Act § 21D(b)(3)(B). The effect of the combination of heightened pleading standards and the stay of discovery is that a plaintiff must plead facts that are often uniquely within the defendant’s possession, but is precluded from exploring documents such as company records that would demonstrate the defendant’s knowledge of the falsity of any statements.
The PSLRA also limits a plaintiff’s ability to seek relief from the court. The PSLRA undermines the trial court’s discretion to guide discovery by limiting discovery during the pendency of a motion to dismiss to exceptional circumstances where particularized discovery is necessary to preserve evidence or prevent undue prejudice to a party. Securities Act § 27(b)(1); Exchange Act § 21D(b)(3)(B).
- The Effects of the PSLRA on Securities Litigation
It will take years to assess the impact of the PSLRA as courts struggle to interpret its provisions. Securities cases filed since the passage of the PSLRA are moving very slowly through the courts as judges consider the effects of its provisions in a cautious and deliberate manner. See Securities and Exchange Commission, 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, April, 16, 1997 (hereinafter “SEC Report”), Section VIII. At least some courts, however, have interpreted the language in the act exactly as its opponents feared, creating almost insurmountable obstacles for defrauded investors trying to recover their losses.
- The Heightened Pleading Requirement: Actual Knowledge?
The most significant problem to potential plaintiffs presented by the PSLRA involves the heightened pleading requirement found in the statutory safe harbor provision. Three federal district courts have already issued rulings so restrictive that they threaten almost all private enforcement of the securities laws. In re Silicon Graphics, Inc. Securities Litig,, C 96-0393, 1997 WL 337580 (N.D. Cal. June 5, 1997); Friedberg v. Discreet Logic, Inc., 959 F. Supp. 42 (D. Mass. 1997); Powers v. Eichen, Case No. Civil 96-1431-B (AJB) (S.D. Cal. Mar. 13, 1997). In one of those decisions — holding that reckless wrongdoers are no longer liable to the victims of their fraud under the PSLRA — the SEC took the extraordinary step of filing a brief in the district court to protest the result, arguing that the judge had misread the legislative history, and thus incorrectly nullified 20 years of widely established securities law. In re Silicon Graphics, Inc. Securities Litig., Fed. Sec. L. Rep. (CCH) 99,325 (N.D. Cal. 1996); 1996 U.S. Dist. Lexis 16989.
Apparently in reliance on a single footnote in the PSLRA’s Statement of Managers, a federal judge in the Northern District of California held that the PSLRA required plaintiffs to “allege specific facts that constitute circumstantial evidence of conscious behavior by defendants.” Id. at 95,962. The court held that the plaintiffs must allege facts that would “create a strong inference of knowing misrepresentation on the part of the defendants” in order to survive a motion to dismiss. Id. at 95,963. In effect, the court found that reckless behavior can never constitute securities fraud under the PSLRA.
Following the court’s order granting the motion to dismiss, the Silicon Graphics plaintiffs filed an amended complaint, which the defendants again moved to dismiss. It was in connection with that motion that the SEC filed its amicus curiae brief urging the court to reconsider its earlier decision, arguing that requiring plaintiffs to allege actual knowledge or conscious behavior effectively eliminated recklessness as a sufficient state of mind for liability under Section 10(b) of the Exchange Act, greatly eroding the deterrent effect of Section 10(b) actions. Brief of the Securities and Exchange Commission, amicus curiae, In re Silicon Graphics Securities Litig., Fed. Sec. L. Rep. 99,325 (N.D. Cal. 1996) (hereinafter “SEC Brief”). The SEC advocated that the “look the other way” defense has no place in securities law, because “practical necessities” require a recklessness standard. Id. Proving a defendant’s actual knowledge of fraudulent misconduct in a securities action can be a “daunting task” for plaintiffs, and if the PSLRA were interpreted to require such proof of actual knowledge, it would “for all intents and purposes disembowel” the private enforcement of the federal securities laws. Id. Despite the SEC’s urging, however, the court dismissed the plaintiffs’ amended complaint, again finding the allegations too generic to withstand the heightened pleading requirements of the PSLRA. In re Silicon Graphics, Fed. Sec. L. Rep. ¶99,468 (CCH), 1997 WL 285057 (N.D. Cal. May 23, 1997)
Despite the Silicon Graphics decision, most other federal district courts have interpreted the PSLRA more reasonably and consistently with long-standing securities fraud principles, finding that an allegation of recklessness is sufficient to state a claim for liability. However, the lasting effect of the PSLRA remains to be seen. No appellate court has yet ruled on the provisions of the PSLRA, and it is impossible to arrive at any supportable generalization regarding its effects.
- The Effect of the PSLRA on Securities Actions in State Courts
Less than two years have elapsed since the passage of the PSLRA. Thus, any conclusions about the effects of the PSLRA on the filing of securities actions in state courts must clearly be viewed as preliminary observations. Nevertheless, based on a premature analysis of the scanty evidence provided by less than two years’ worth of experience under the PSLRA, the securities industry has been making claims that, despite the passage of the PSLRA, the flood of “frivolous” securities lawsuits has not waned; instead, they argue, plaintiffs are cleverly “circumventing” the requirements of the PSLRA by merely filing their complaints in state courts. In reality, the evidence suggests that no such “flood” exists; most sources have been able to identify only a handful of securities class actions pending in state court, fewer than 70 nationwide. SEC Report, Section VII. This number represents an infinitesimally small percentage of the roughly 15 million civil cases filed in state courts each year.
At least one study has reported an increase of filings in state court in 1996 compared to previous years; however, its authors also admitted that “[i]t is too soon to draw any firm conclusions from these data with respect to the effect the PSLRA has had on the aggregate number of securities class action lawsuits filed per year” and “we do not attempt to draw any conclusions from these data concerning . . . trends in state court filings.” Joseph Grundfest and Michael Perino, Securities Litigation Reform: The First Year’s Experience, Stanford Law School, Release 97.1, February 27, 1997, at 10-11 (hereinafter “Stanford study”); see also Joint Written Testimony of Joseph A. Grundfest and Michael A. Perino before the Senate Committee on Banking, Housing and Urban Affairs, Subcommittee on Securities, July 24, 1997.
Moreover, the Stanford study was based on an extremely small sample; an increase of just a few cases could result in a significant increase in the percentage of cases filed. Given the small total number of cases filed in state court, a slight annual increase of 10 or 20 cases will substantially skew the percentages. In addition, the Stanford study focuses on the PSLRA’s effect on the total number of filings without any regard to the actual incidence of fraud. As discussed below, SEC regulators have acknowledged that the incidence of securities-related fraud has increased dramatically in recent years. If the incidence of fraud has increased, then the study’s observation that filings have remained roughly constant, or even decreased, since the passage of the PSLRA may in fact reflect a significant decrease in protections for investors — exactly what the opponents of the PSLRA feared and predicted would be the result of its passage.
Furthermore, although the PSLRA presents obstacles to plaintiffs filing securities class actions in federal court, choosing to file an action for securities fraud in state court instead of federal court presents additional obstacles for plaintiffs: not every state even provides a private right of action for claims based on securities fraud, and it is often difficult to establish jurisdiction over the defendants in the particular state. SEC Report, Section VII. Furthermore, few states provide remedies for private plaintiffs that are as broad as the federal remedies for securities fraud. Id. As a result of these limitations on state remedies, plaintiffs in securities class actions are not filing in state courts in significant numbers.
In sum, what little evidence exists regarding the filing of securities class actions in state courts since the passage of the PSLRA suggests only a moderate increase in state court filings in 1996. Furthermore, although the year is not yet over, the evidence thus far indicates that state court filings have actually decreased in 1997. See Securities Class-Action Lawsuits Make Comeback in Federal Court, Wall Street Journal, July 9, 1997, at B11. Thus, there has not been nearly enough time to fully evaluate the effects of the PSLRA on the number of securities class actions filed in state courts.
Frank Lalli, Your 1000 Letters of Protest May Stop this Congress from Jeopardizing Investors, Money Magazine, November, 1995, at 11(2).
In comments submitted to the Securities Exchange Commission on May 1, 1996, the American Association of Retired Persons, the Consumer Federation of America and the National Council of Individual Investors observed that “[w]hile the Act was touted as a way to eliminate frivolous lawsuits, its practical repercussion is that many investors with meritorious claims will be denied access to the courts.” Letter from Martin Corry, Director, Federal Affairs, American Association of Retired Persons, et al., to Jonathan G. Katz, Secretary, Securities and Exchange Commission (May 1, 1996).
The PSLRA amended the 1933 Act and the 1934 Act. Citations within this article are to the 1933 Act and 1934 Act as amended by the PSLRA.
The SEC’s brief reviewed the legislative history of the PSLRA and concluded that the act did not eliminate recklessness as a scienter standard for private securities actions:
Nowhere did the Conference Committee suggest that it was eliminating recklessness as satisfying the scienter requirement, or, indeed, that it was eliminating evidence of motive and opportunity or circumstantial evidence of fraudulent intent (be it conscious or reckless) as factors that the courts might consider in determining whether the strong inference had been established. Instead, Congress simply elected not to attempt to codify the guidance provided in Second Circuit case law, preferring to leave to the courts the discretion to create their own standards for determining whether a plaintiff has established the required strong inference.
The testimony given before the Senate incorporated much of the findings in the original study, but also included some more recent data; therefore, the discussion of the Grundfest and Perino findings applies to both the study and their testimony.