Private Securities Litigation Reform Act of 1995

October 2004

The following is an expanded discussion of the Private Securities Litigation Reform Act. An abbreviated discussion of the Reform Act's provisions is contained in the “Risk Management” section of The D&O Book under the “Protections Against Personal Liability” discussion.

During the 1980s and 1990s, a trend of securities litigation abuse began to emerge. The increasing cost and frequency of frivolous securities class action lawsuits was making companies hesitant to publicly discuss their future prospects and was thus restricting the flow of information needed by investors to make informed decisions. In addition, being personally liable for wrongful acts committed by others was making competent persons reluctant to serve on corporate boards of directors.

Some of the more frequent abuses of the securities litigation process involved the following:

·   The bringing of private class action “strike suits” against companies by plaintiffs after the value of their stock dropped precipitously. (A “strike suit” is a shareholder derivative action begun with the hope of winning large attorney fees or private settlements, with no intention of benefiting the corporation on behalf of which the suit theoretically is brought.) These actions often contained unsupported allegations that the plaintiff was persuaded to purchase the stock by misleading statements about future earnings and/or by the omission of vital information;

·   Use by attorneys of plaintiffs who own a nominal number of shares in a wide array of public companies to file frivolous lawsuits and to serve as lead plaintiffs;

·   The imposition of high discovery costs on defendants, even when class action suits contained frivolous and unsupported allegations;

·   The disproportionate share of securities class action settlements or awards frequently awarded as fees to plaintiff's attorneys; and

·   The reluctance of many judges to impose sanctions against lawyers, except in cases of truly outrageous conduct.

In an effort to reduce abusive securities litigation, Congress passed the Private Securities Litigation Reform Act of 1995 (the Reform Act). By passing the Reform Act, Congress sought to promote public and global confidence in our capital markets, to help deter wrongdoing, and to guarantee that corporate officers, auditors, directors, lawyers and others properly perform their jobs. At the same time, Congress wanted to protect investors who were true victims of securities fraud.

Specifically, the Reform Act was designed to limit securities litigation abuse by:

·   Creating an incentive for securities issuers to provide relevant information in forward-looking statements without fear of open-ended liability (i.e., a “safe harbor”);

·   Protecting investors who join class action lawsuits by giving control of litigation to lead plaintiffs with substantial holdings of the issuer's securities;

·   Removing the financial incentives for becoming a lead plaintiff by limiting compensation to a prorata share of the settlement or final judgment, plus necessary expenses;

·   Revising and clarifying pleading requirements to prevent the filing of meritless lawsuits;

·   Preventing the unnecessary imposition of discovery costs on defendants;

·   Protecting outside directors and others who may be sued for non-knowing violations of securities laws from liability for damages actually caused by others; and

·   Encouraging the courts to punish lawyers who bring frivolous lawsuits by creating an opportunity for victims of the lawsuits to recover their attorneys' fees at the conclusion of an action.

Safe Harbor Provision

The most controversial portion of the Reform Act is the creation of a so-called “safe harbor” for certain forward-looking statements. The Act's safe harbor provision protects companies from liability arising out of the issuance of earnings projections and other forward-looking statements, so long as the statements are accompanied by a meaningful disclosure of the important factors that might cause results to vary from those expected. Although the terms “meaningful disclosure” and “important factors” are not defined, the more specific the disclosure, the more likely the company is to satisfy the overall disclosure requirements.

Separate safe harbor standards are created for written and oral forward-looking statements. Safe harbor protection for written forward-looking statements can apply in one of two ways. The first is when forward-looking statements, whether made in a periodic SEC or shareholder report, press release or other company communiqué contain the required disclosure. The forward-looking statement must be identified as such and must be accompanied by the required cautionary language. The second way a company can qualify for safe harbor protection is to show that its statements have been made without actual knowledge of falsity.

Oral forward-looking statements, such as discussions with analysts, investors or the media qualify for safe harbor protection if the communication clearly contains a statement that the information being conveyed is forward-looking. The statement also must make it clear that the corporation's actual results may vary and that the factors that could cause results to vary may be found in specifically identified, publicly available documents (for example, in periodic SEC reports).

If a securities lawsuit is filed, an important component of the safe harbor provision precludes further litigation if a plaintiff fails to prove that the statement—if made by a natural person—was made with the actual knowledge that the statement was false or misleading. If the statement was made by a business entity, the plaintiff must prove that it was made by or with the approval of an executive officer who had actual knowledge that the statement was false or misleading.

Procedural Changes

Lead plaintiffs in securities fraud actions are now required to file a sworn statement certifying that he/she (1) actually reviewed and authorized the filing of the complaint, (2) did not purchase the securities at the direction of counsel or simply to be eligible to participate in a lawsuit, and (3) is willing to serve as the lead plaintiff on behalf of the entire class. Further, the plaintiff must identify any other lawsuits in which he/she has sought to serve as lead plaintiff in the last three years.

One purpose of the Reform Act is to increase the role of institutional investors as lead plaintiffs in securities actions by establishing new procedures for the appointment of both a lead plaintiff and lead counsel. Under the Act, the courts are required to presume that the member of the purported class with the largest financial stake in the relief sought is the “most adequate plaintiff.” However, the shareholder with the largest financial interest may not always be the best representative of the class. For this reason, the Act allows for the presentation of evidence that the designated lead plaintiff would not fairly and adequately represent the interests of the class. Subject to court approval, the “most adequate plaintiff” is charged with the responsibility of selecting and retaining counsel to represent the class.

The Act also limits the amount of the lead plaintiff's recovery to his or her prorata share of the settlement or final judgment. The share is to be calculated in the same manner as the shares of the other class members. If granted by the court, the lead plaintiff's recovery may also include reasonable costs and expenses associated with service as lead plaintiff, including lost wages and attorney fees.

Pleading Requirements

The Reform Act revises and clarifies pleading requirements. Under the Act, the plaintiff must specifically “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” This requirement applies as respects each statement alleged to have been false or misleading. If an allegation is made based on “information and belief,” the plaintiff must state all facts in its possession on which the belief is formed. The Act also requires the plaintiff to first plead, and then in order to prevail, to prove that the misstatement or omission alleged in the complaint actually caused the plaintiff's loss.

The new pleading requirements can be difficult standards to meet. Prior to discovery, plaintiffs may not be able to specify what portion of a statement was misleading. If the misleading portion of a statement cannot be identified, the action may not be allowed to proceed to the discovery phase. Thus, while providing an obstacle for plaintiffs who file unwarranted allegations, the new pleading requirements also make it harder for investors who have actually been defrauded to sue for their losses.

Discovery and Liability

In the past, discovery in securities actions could begin as soon as the action was filed. As a result, innocent parties often settled frivolous lawsuits rather than face the high cost of discovery and the uncertainty of further litigation. Unless exceptional circumstances exist, the court now must suspend all discovery proceedings until it determines that the case has merit and should go forward. Early discovery will be allowed only if it is necessary to preserve evidence or prevent undue prejudice to a party. If fewer securities suits are allowed to proceed to the discovery phase of litigation, the number of settlements made as a means of avoiding payment of large legal fees should be reduced.

Joint and Several Liability

Under prior securities laws, liability could be imposed on one party for damages actually caused by another party. A single defendant who was found only 1 percent liable could be forced to pay 100 percent of the damages in the case. Because of the potential for joint and several liability, entirely innocent parties often felt compelled to settle meritless suits rather than risk exposing themselves to liability for a grossly disproportionate share of the damages in the case.

The Reform Act remedies this potential injustice by establishing a “fair share” system of proportionate liability. Under the Act, full joint and several liability still applies as respects defendants who engage in knowing violations of the securities laws. However, defendants who are found liable, but who have not engaged in knowing violations are responsible only for their proportionate share of the judgment (as assessed by the court), with two exceptions. The first exception applies to plaintiffs who establish that they are entitled to damages exceeding 10 percent of their net worth, and their net worth is less than $200,000. These plaintiffs can be entitled to recovery from all defendants who are found jointly and severally liable. The second exception applies when the insolvency of a defendant prevents it from paying its allocable share of the damages. In this case, each of the other defendants must make an additional payment, up to a maximum of 50 percent of their liability, to make up the difference.

Attorney's Fees

The Reform Act gives victims of abusive securities litigation the opportunity to recover their attorneys' fees if the plaintiff's lawsuit is found to be frivolous. In addition, the Act limits total fees and expenses that can be awarded by the court to a class plaintiff's counsel to a reasonable percentage of the amount of any damages and prejudgment interest actually paid to the class. The provision gives the courts flexibility in determining what is reasonable on a case-by-case basis.

Other Provisions

Under the Reform Act, independent public accountants are required to adopt certain audit procedures and to inform the SEC of certain illegal acts discovered during an audit of securities issuers. Under the new guidelines, each audit of an issuer's financial statements must include:

·   Procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts;

·   Procedures designed to identify related party transactions that are material to the financial statements or otherwise require disclosure; and

·   An evaluation of whether there is a substantial doubt about the ability of the issuer to continue as a going concern during the ensuing fiscal year.

The audits must be conducted in accordance with generally accepted auditing standards, as may be modified or supplemented from time to by the SEC. Also, the Act contains detailed provisions setting forth the required response to problems discovered during the audit (i.e., investigating and reporting illegal acts), a limitation on the liability of auditors, and provisions for the imposition of civil penalties following SEC cease-and-desist proceedings.

Other provisions of the Reform Act limit damages to losses caused by actual fraud and not by other market conditions, prohibit securities brokers, dealers or persons associated with them from receiving referral fees, forbid use of disgorged funds in SEC actions to pay for attorney's fees or expenses incurred by private parties seeking distribution of those funds, and empowers the SEC to prosecute persons who “aid and abet” those who violate federal securities laws. Also, because fraud in the purchase or sale of securities is no longer considered a racketeering activity under the Reform Act, such activity is no longer subject to the RICO statute.

Results of the Private Securities Litigation Reform Act

There has not yet been sufficient time to fully determine whether the Private Securities Litigation Reform Act Of 1995 has met its objectives to discourage frivolous suits and to encourage companies to be more forthcoming with information helpful to investors. Although there is no central depository of information regarding federal or state class action securities fraud litigation, limited studies conducted as of early 1997 show that a few trends appear to be emerging.

Overall Litigation Rate

The Reform Act's passage does not yet appear to have resulted in a significant reduction in the overall number of securities lawsuits. While the combined number of federal and state filings declined approximately 12 percent in 1996 as compared with the previous five-year period, the number of cases filed in 1996 is similar to the number filed in 1991, 1993 and 1995. The reduction in 1996 also may or may not be the result of the Reform Act because increasing stock market prices in 1996 may have reduced the litigation rate. The number of federal filings against companies with market capitalization in excess of $5 billion, however, has declined dramatically since the Act's passage.

One possible result of the Reform Act is that securities litigation appears to be following larger stock price declines than was the case previously. Prior to the Act's passage, filings typically followed a stock price decline of approximately 20 percent. During 1996, however, the average decline prompting lawsuits jumped to more than 30 percent. The heightened pleading requirements under the Act may be inducing plaintiffs' counsel to pursue cases that are correlated with larger stock price declines, and therefore seem to be more apparent instances of fraud.

Even after the Act's passage, high-technology companies continue to represent approximately one-third of all companies sued in federal court.

Shift of Litigation to the State Courts

Although there has been little reduction in the overall securities litigation rate, there appears to have been a significant shift of litigation from federal to state courts. Prior to passage of the Reform Act, class action securities fraud suits were usually filed in either federal or state courts. Actions were rarely filed in both courts. In 1996, more class action suits were filed in state courts than in federal courts. This increase in state court filings may be the result of a “substitution effect” whereby the plaintiff's counsel files only in the state court if it is felt that the underlying facts in the case might not satisfy the new, more stringent federal pleading requirements. Plaintiffs also may be resorting to increased state litigation in an effort to avoid federal discovery stays or to establish alternative state court venues for the settlement of federal claims.

In addition to the securities actions filed only in state courts, more than 25 percent of all federal court actions now are also filed in state courts. Parallel federal and state court filings were rare prior to the Reform Act. It is believed the parallel litigation is brought to avoid the Act's stay on discovery, as well as for other settlement-related reasons.

Effect of the Safe Harbor Provisions

Since the Reform Act's passage, only a small percentage (less than 15 percent) of securities fraud actions allege false forward-looking statements as the sole basis of liability. However, allegations of false forward-looking statements are included along with other allegations in more than half of all securities fraud actions. Since many of these false forward-looking statement allegations refer to forecasts made prior to the Act's passage, it is not yet clear if the safe harbor provisions are having any positive effect in reducing such allegations.

The actual effectiveness of the Act's safe harbor provisions may have to be determined by future litigation. While intended to shield a securities issuer if a forward-looking statement contains meaningful cautionary statements, the Act does not define the term “meaningful” nor explain how a company may identify such statements. It is also unclear which factors affecting future earnings must be included or may be omitted in order for the statement to qualify for safe harbor protection. The Act's provisions also do not impose any duty to update forward-looking statements.

Allegations of Accounting Fraud and Insider Trading

The number of securities lawsuits alleging accounting fraud as a basis for liability has more than doubled since passage of the Reform Act and the number of actions alleging insider trading has almost tripled. The dramatic increase in insider trading allegations may be due to the fact that high-tech companies are the ones most likely to be sued and there is a high incidence of option-based compensation in that sector. The shift to more allegations of accounting fraud may simply be an attempt by plaintiffs attorneys to bypass or avoid the Reform Act's safe harbor provisions.

Effect of the New Pleading Requirements

The Reform Act's revised pleading requirements have already become the subject of litigation. Under the Act, plaintiffs in securities actions must be able to show a strong inference that the defendant acted with the required state of mind to deceive, manipulate, or defraud the public. By including such a requirement, Congress hoped to make it harder for plaintiffs to sue without having actual proof that intentional fraud was committed. A mere allegation of fraud would no longer be sufficient to justify continued litigation.

Prior to the Reform Act, the courts tended to apply the Second Circuit court's pleading standard as respects scienter. Scienter is knowledge by a misrepresenting party that material facts have been falsely represented or omitted with an intent to deceive. When applied to an action for civil damages under the Securities Exchange Reform Act of 1934, scienter refers to a mental state embracing intent to deceive, manipulate, or defraud. After the Act's passage, it was uncertain whether the courts would continue to apply the pre-Reform Act pleading standard, or raise the standard to an even higher level of proof as intended by Congress. So far, most courts considering the question have continued to apply the Second Circuit's interpretation of the pleading standard, which favors plaintiffs.

Although the Act has not yet achieved Congress' intended goal of heightening pleading requirements, this goal may eventually be achieved as more litigation over application of the new pleading requirements occurs. (See Medhekar v. United States District Court for the Northern District of California, 99 F.3d 325, 438-29 [9th Cir. 1996]. See also Medical Imaging Centers of America, Inc., 917 F. Supp 717, 722 [S.D. Cal. 1996].)

Effect of Stay of Discovery Changes

If a securities action is filed, provisions of the Reform Act require the court to postpone the discovery phase of litigation until such time as it determines whether the case has sufficient merit to proceed. Congress hoped this stay of discovery provision would discourage plaintiffs from filing frivolous actions for the sole purpose of pressuring defendants into an agreed settlement rather than face the high cost of discovery proceedings and an uncertain outcome.

Although there has already been some litigation over the new discovery provisions, the courts have so far tended to follow the provisions of the Reform Act and postpone discovery. If this tendency continues, Congress' goal of lowering discovery costs and reducing coercive settlements may yet be attained.

Conclusion

While the effects of some provisions of the Private Securities Litigation Reform Act of 1995 may not be seen for some time, other effects of the Act are already emerging. There does not yet appear to be any significant reduction in the overall number of securities lawsuits filed. While federal court filings have somewhat declined, the number of filings in state courts has increased. As was the case prior to the Act's passage, high-tech companies continue to be the target for a disproportionate share of securities class action suits.

The Act's safe harbor provisions, while intended to shield a securities issuer who's forward-looking statements contain the required meaningful cautionary language, do not define the term “meaningful” nor explain how a company may identify such statements. It is also unclear which factors affecting future earnings must be included or may be omitted in order for forward looking statements to qualify for safe harbor protection. Because of these ambiguities, it may take some time to determine if the safe harbor provisions will achieve their intended goal.

The increased number of parallel federal and state securities actions is disturbing from the standpoint of securities issuers, because these issuers now have a greater likelihood of having to defend lawsuits in both federal and state courts. Whether this problem is temporary or whether the Act's provisions will eventually discourage the abusive filing of meritless lawsuits remains to be seen.

If the Reform Act's provisions are interpreted by the courts as Congress intended, more federal suits should be dismissed at the pleading stage, thereby eliminating the need for companies to bear expensive discovery costs. However, the increase in parallel federal and state filings continues, it may dramatically increase the cost of defending and settling securities fraud lawsuits.