Recent Developments Under the PSLRA
In 1995, Congress enacted the Private Securities Litigation Reform Act (the "PSLRA") to deter what was perceived to be meritless class action litigation brought under the Securities Act of 1933 (the "Securities Act") and the Securities Exchange Act of 1934 (the "Exchange Act"). Among the measures included in the PSLRA which have been examined by the federal courts during the past year are the heightened standard for pleading scienter, the elimination of securities fraud as a predicate act for a RICO claim, the stay of discovery during the pendency of a motion to dismiss and the requirements for selecting lead plaintiffs and counsel. In addition, courts have examined the continued viability of the group pleading doctrine in light of the PSLRA's enhanced pleading requirements.
The PSLRA requires that in pleading a fraud claim under Section 10(b) of the Exchange Act, plaintiffs must "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind."1 Congress, however, did not provide a definition of the "required state of mind," and federal courts have diverged in their interpretations of the standard for pleading scienter. Most cases hold that scienter may still be established by reckless conduct and that the pleading standards under the PSLRA may be satisfied by allegations of the defendant's "motive and opportunity" to commit fraud. Other cases hold that while the PSLRA does not alter existing authority permitting scienter to be established by allegations of recklessness, allegations based solely on the defendant's "motive and opportunity" to commit fraud will not satisfy the PSLRA's heightened pleading standard. Yet another line of cases rejects the recklessness standard and requires a plaintiff to plead and prove that the defendant acted with a deliberate conscious intent to commit fraud.
In November 1998, Congress enacted the Securities Litigation Uniform Standards Act of 1998 (the "Uniform Standards Act"). In the Joint Explanatory Statement of the Committee of Conference Regarding S. 1260, the Conference Committee remarked that "it was the intent of Congress . . . that the Reform Act established a heightened uniform Federal standard on pleading requirements based upon the pleading standard applied by the Second Circuit Court of Appeals" and that Congress "did not . . . intend to alter the standards of liability under the Exchange Act."2 In addition, several members of Congress stated in a letter to the SEC that they believed the PSLRA adopted the Second Circuit's pleading standard.3 Despite this guidance, cases decided since the passage of the Uniform Standards Act continue to diverge with respect to the scienter standard.
Without discussing the conflict directly, the United States Court of Appeals for the Second Circuit, in Press v. Chemical Investment Service Corporation,4 concluded that the PSLRA "heightened the requirement for pleading scienter to the level used by the Second Circuit" prior to the enactment of the PSLRA. Under the traditional Second Circuit approach, scienter can be shown by an "intent to 'deceive manipulate or defraud'" or "knowing misconduct," and a plaintiff can satisfy the pleading requirements by alleging either (a) facts to show that "defendants had both motive and opportunity to commit fraud" or (b) facts that "constitute strong circumstantial evidence of conscious misbehavior or recklessness." This decision abrogates earlier decisions within the Second Circuit, such as Novak v. Kasaks5 and Norwood Venture Corporation v. Converse, Inc.,6 which had held that the PSLRA eliminated the "motive and opportunity" standard.
Since the enactment of the Uniform Standards Act, district courts in the Third and Seventh Circuits have issued opinions that are in accord with Press.7 Notably, in In re Home Health Corporation of America, Inc., Securities Litigation,8 the United States District Court for the Eastern District of Pennsylvania concluded from its review of congressional statements that "it was the intention of Congress, when drafting the PSLRA, and again when passing the . . . Uniform Standards Act, that 'the pleading standard rules developed by the United States Court of Appeals for the Second Circuit would continue to govern' and that 'the recklessness standard and Second Circuit pleading rules continue in force.'" In In re First Merchants Acceptance Corporation Securities Litigation,9 the Northern District of Illinois went so far as to state that it is "generally recognized" that the appropriate standard for alleging scienter under the PSLRA is the Second Circuit standard.
District courts in the Eleventh and Ninth Circuits, however, continue to issue conflicting opinions regarding the appropriate standard for pleading scienter. The Southern District of Florida in In re Physician Corporation of America Securities Litigation10 recently held that while recklessness can establish a strong inference of scienter, allegations of motive and opportunity alone would be insufficient. But in another Southern District of Florida decision issued just one week earlier, Profilet v. Cambridge Financial Corporation,11 the district court had held, without discussion, that the Second Circuit test was indeed the proper standard for showing a "strong inference" of scienter in securities fraud cases.
In Schlagal v. Dennis,12 the Central District of California extrapolated from the legislative history of the Uniform Standards Act that although Congress chose not to codify the motive and opportunity language, it did not specifically disapprove of the motive and opportunity test - as evidenced by Congress' statement that it was not attempting to define the state of mind necessary to plead scienter when it enacted the PSLRA. The court went on to conduct its analysis under the Second Circuit test. This decision is in accord with several earlier post-PSLRA Ninth Circuit district court cases,13 but is in direct conflict with other Ninth Circuit district court cases, most notably In re Silicon Graphics, Inc., Securities Litigation,14 which held that evidence of motive and opportunity without more is usually insufficient to satisfy the pleading standard, and that plaintiffs must show "deliberate recklessness" - not merely circumstantial evidence of reckless behavior. The Silicon Graphics approach was recently followed in In re Boeing Securities Litigation,15 where the court noted that "Congress intended to adopt a pleading standard for scienter that was stricter than that in the Second Circuit."
The PSLRA eliminated securities fraud as a predicate act for a private cause of action under the Racketeer Influenced and Corrupt Organizations Act ("RICO").16 A number of federal court decisions in the past year have examined whether the bar should apply retroactively to eliminate securities-based RICO claims that either were filed or concerned fraudulent acts that occurred prior to the enactment of the PSLRA.
In Mathews v. Kidder, Peabody & Co., Inc.,17 the only circuit court decision on the issue, the Third Circuit held that the PSLRA does not apply retroactively to eliminate securities fraud-based claims which were pending when Congress enacted the PSLRA. Applying the test set forth by the United States Supreme Court for determining the "temporal reach of the new federal statutes," the court determined that the PSLRA did not expressly provide for retroactive application. Moreover, the court noted that there was no evidence of a "clear intent" by Congress to overcome the "strong presumption against applying a statute with retroactive effect to pending cases." Finding that retroactive application would have the "legal effect of depriving plaintiffs of a claim," the Third Circuit affirmed the district court's decision to allow plaintiffs to proceed with their RICO claims. Similarly, in 131 Main Street v. Manko,18 the United States District Court for the Southern District of New York held that the PSLRA did not apply retroactively to bar securities-based RICO claims which were pending when the PSLRA was enacted. Without analysis, the court cited earlier Southern District authority disfavoring retroactive application of the PSLRA, and also noted that the amendment does not apply when, as in the case before it, the defendant has been criminally convicted in connection with the fraud.
Courts also have held that securities-based RICO claims that were not pending at the time of the PSLRA's enactment are barred. The United States District Court for the Northern District of Illinois held in Scott v. Steingold19 that the PSLRA retroactively bars securities-based RICO claims which were filed after the enactment of the PSLRA even though the claims concerned fraudulent conduct that occurred prior to the PSLRA's passage. The Southern District of Florida in Kolfenbach v. Mansour,20 came to a similar conclusion based on a different rationale. The court dismissed the plaintiff's RICO claims not because the PSLRA applied retroactively, but because the PSLRA was found not to have a retroactive effect on a complaint filed after its enactment, even if the underlying conduct occurred before the PSLRA's enactment.
The Eastern District of Pennsylvania in Gubitosi v. Zegeye21 took yet another approach, permitting a securities-based RICO claim to proceed on the grounds that it would be inappropriate to apply the PSLRA bar where the statute of limitations had run on the plaintiffs' prospective securities fraud claim. According to the court, when the PSLRA was enacted, plaintiffs' securities fraud claim was time-barred, and the only claim they could pursue was under RICO, with its longer statute of limitations. The court reasoned that retroactive application of the PSLRA would be inappropriate because it would "have the effect of impairing the plaintiffs' ability to recover for actions which may have violated federal law."
Plaintiffs have also attempted to avoid the PSLRA's bar against securities-based RICO claims by withdrawing securities fraud claims or arguing the RICO and securities claims in the alternative. In Renner v. Chase Manhattan Bank,22 a plaintiff tried to sustain his RICO claims by withdrawing his securities fraud allegations and eliminating reference to the securities laws. The court held, however, that "defensive maneuvers" such as this could not salvage the claim - whether a claim is actionable as securities fraud depends not on the "label affixed to it," but on the substantive law of securities fraud. In another case, Hemispherx Biopharma, Inc. v. Asensio,23 plaintiff argued that the PSLRA barred its RICO claim only if plaintiff actually possessed an actionable securities law claim. The court rejected Hemispherx' argument, finding that the plain language of the PSLRA did not suggest that an exception should be made to the bar against securities fraud actions under RICO for plaintiffs who could not otherwise bring an action under the Exchange Act. The court explained that the legislative history of the PSLRA made clear that its purpose was to eliminate, in general terms rather than as to particular plaintiffs, securities fraud as a predicate act of racketeering in a civil RICO action.
Stay of Discovery
Concerned with abuse of the discovery process by plaintiffs resulting in "costs so burdensome that it is often economical for the victimized party to settle,"24 Congress included a provision in the PSLRA staying all discovery and other proceedings during the pendency of any motion to dismiss, unless upon motion of a party, the court finds that particularized discovery is necessary to preserve evidence or prevent undue prejudice to a party.25 Several decisions have been rendered in recent months interpreting various aspects of this provision.
In In re Rational Software Securities Litigation,26 the Northern District of California concluded that the stay should remain in effect even though no motion to dismiss was actually pending, as the consolidated complaint had previously been dismissed and plaintiffs had not yet filed their amended complaint. "The plain intent of Congress," the court explained, "was to preclude intrusive and burdensome discovery in securities fraud actions until the plaintiffs have stated a viable claim."27 The court also supplied a framework by which a plaintiff can establish the existence of "undue prejudice": (1) allegations of facts that, while not sufficient under the PSLRA, "nonetheless give rise to a strong and credible suspicion that a defendant may be liable for securities fraud" and (2) the demonstration of a probability that the defendant is likely to avoid liability if there is no discovery. Upon making the threshold showing, the plaintiff must then demonstrate that the requested discovery is "sufficiently limited and particularized that discovery will not defeat the express intent of the [PSLRA] by placing an undue legal and economic burden on defendant." While ultimately rejecting certain of plaintiffs' discovery requests as "grossly overbroad," the court did allow the plaintiff to serve ten interrogatories upon defendants and to serve narrowly tailored subpoenas on certain third parties.
Another issue under the discovery stay provisions of the PSLRA concerns the obligations of third parties. Early this year, in In re Fluor Corporation Securities Litigation,28 the Central District of California declined to issue subpoenas commanding non-parties to a securities fraud action to preserve evidence after a motion to dismiss had been filed. Plaintiffs had argued that third-party subpoenas were consistent with the intent underlying the PSLRA's discovery stay "to preserve the status quo." The court disagreed, holding that "preserving the status quo does not encompass efforts by plaintiffs to reach out, during the stay of discovery, to third parties, not already on notice of the litigation, to inform them of the proceedings and place specific requirements on them." Rather, the PSLRA "only imposes responsibilities on parties to the lawsuit, with actual notice of the allegations contained in the complaint" to preserve evidence pending a motion to dismiss.
Lead Plaintiff and Counsel
The PSLRA provides that when multiple persons or entities seek to represent a class, the lead plaintiff shall be the member or members of the purported class that the court determines to be "most capable of adequately representing the interests of class members." The PSLRA creates a presumption that the most adequate plaintiff is the person or group of persons who has the largest financial stake in the relief sought by the class and who otherwise satisfies the requirements of Rule 23 of the Federal Rules of Civil Procedure. The presumption may be rebutted only upon proof that the presumptively most adequate plaintiff will not fairly and adequately protect the interest of the class, or is subject to unique defenses that render the plaintiff incapable of adequately representing the class.29
Several courts have addressed the issue of whether co-lead plaintiffs are appropriate where only one plaintiff has been determined to have the largest financial stake in a litigation. In Metro Services Inc. v. Wiggins,30 the district court31 had designated three separate groups of plaintiffs as co-leads in a consolidated securities fraud class action lawsuit, despite the fact that only one of the three co-leads was determined to have the largest financial stake in the lawsuit. The court reasoned that a combination of two institutional investors and a small number of individual investors with a large financial stake in the lawsuit would effectively further the PSLRA's goal of promoting greater client control over the litigation. The court also observed that the co-lead structure would facilitate the pooling of knowledge, experience, and financial resources. The court further expressed concern that because the plaintiff with the largest financial stake was a public retirement association with a primary fiduciary duty to government pensioners, it might not be able to effectively pursue the interests of all members of the class on its own. On appeal to the Second Circuit, the retirement fund plaintiff argued that because it had the largest financial stake in the litigation, it should have been designated as the sole lead plaintiff. Because the district court had reserved discretion to reconsider its lead plaintiff determination, however, the Second Circuit declined to review the lower court's decision at that stage of the proceedings.
In contrast, in In re Cendant Corporation Litigation,32 the District of New Jersey decided not to appoint co-lead plaintiffs, despite numerous challenges to the typicality and adequacy of the plaintiff with the largest financial stake. The diversity of the putative class in any large shareholder action, the court stated, "does not justify the appointment of potentially innumerable co-lead plaintiffs to ensure that each individualized interest is represented." The court explained that the PSLRA demands only that the interests of the class members be "adequately represented" by the lead plaintiff. Absent a showing sufficient to rebut the presumption of adequacy given to the plaintiff with the largest financial stake, what matters is that "the claims of every member of the putative class arise from the same false or allegedly fraudulent representations."
The PSLRA also provides that the lead plaintiff shall, "subject to the approval of the court, select and retain counsel to represent the class."33 As protection for plaintiffs and the class, the PSLRA further stipulates that "[t]otal attorneys' fees and expenses awarded by the court to counsel for the plaintiff class shall not exceed a reasonable percentage of the amount of any damages and prejudgment interest actually paid to the class."34 In both Sherleigh Associates, LLC v. Windmere Durable Holdings, Inc.35 and In re Cendant Corporation Litigation,36 the district courts employed a sealed-bid process, open to any licensed attorney, in order to select lead counsel. Among the reasons the courts cited for employing a sealed-bid process were the desire to obtain talented counsel at the requisite reasonable cost and the desire to avoid the uncertain practice of ex post determination of reasonable fees by judges. Noting that the PSLRA affords an opportunity to lead plaintiffs to select lead counsel, the Cendant court held that if counsel selected by lead plaintiff was not the lowest qualified bidder, that counsel would have the right of first refusal to match the lowest bid. The Sherleigh court, however, declined to give lead plaintiff's counsel the right of first refusal, reasoning that a right of first refusal would "unnecessarily abrogate the court's duty to carefully weigh the interests of the class" when selecting counsel.
The "group published information presumption" or "group pleading doctrine," first established by the Ninth Circuit in Wool v. Tandem Computers, Inc.,37 provides that corporate publications such as prospectuses, registration statements, annual reports, press releases and other "group published information" are presumed to have resulted from the collective action of those individuals involved in the day-to-day affairs of the corporation, typically senior executives. Thus, for purposes of pleading securities fraud, a plaintiff need not identify the individual sources of statements and may instead presume that misstatements or omissions in a group-published document were attributable to the entire group. The doctrine permits a plaintiff to satisfy the requirements of Rule 9(b) of the Federal Rules of Civil Procedure by pleading the alleged misrepresentations or omissions with particularity and, where possible, the roles of the individual defendants in the misrepresentations.
The continued vitality of the group pleading doctrine, however, is uncertain in light of the enhanced pleading requirements of the PSLRA. Several district courts have applied and implicitly upheld the group pleading doctrine, without addressing the implications of the PSLRA.38 A number of district courts, however, have concluded that the group pleading doctrine is no longer viable in light of the PSLRA's requirement that untrue statements or omissions be set forth with particularity as to the defendant and that scienter be pled with regard to "each act or omission" sufficient to give "rise to a strong inference that the defendant acted with scienter."39 In Marra v. Tel-Save Holdings, Inc.,40 for example, the Eastern District of Pennsylvania concluded that "the group pleading presumption did not survive the PSLRA's enactment." Quoting the Southern District of California's decision in Allison v. Brooktree,41 the court explained that "to permit a judicial presumption as to particularity simply cannot be reconciled with the statutory mandate that plaintiffs must plead specific facts as to each act or omission by the defendant." The court further observed that because the PSLRA allows a plaintiff to assert upon information and belief that a statement or omission is misleading (provided that the complaint states with particularity all facts on which this belief is formed), the plaintiff need not rely on group pleading. Similarly, the court in Coates v. Heartland Wireless Communications42 held that the PSLRA "codifies a ban on group pleading." As in Marra, the Coates court explained that plaintiffs need not rely on the group pleading doctrine because the PSLRA allows a plaintiff to allege that a statement is misleading on information and belief. The Coates court further explained that it would be "nonsensical to require that a plaintiff specifically allege facts regarding scienter as to each defendant, but to allow him to rely on group pleading in asserting that the defendant made the statement or omission. Any remnant of the group pleading presumption that remained in this circuit before the enactment of the PSLRA," the court concluded, "did not survive it." *
Elizabeth Yoo, an associate at the Firm, participated in the preparation of this article.
- § 15 U.S.C. 78u-4(b)(2).
- H.R. Conf. Rep. No. 105-803, 105th Cong., 2d Sess., Joint Explanatory Statement (Oct. 9, 1998).
- Letter from Senators D'Amato, Dodd and Gramm to Arthur Levitt and members of the SEC, Mar. 24, 1998, reprinted in 5 Sec. Ref. Act Litig. Rep. 158 (1998).
- 166 F.3d 529 (2d Cir. 1999).
- 997 F. Supp. 425 (S.D.N.Y. 1998).
- 959 F. Supp. 205 (S.D.N.Y. 1997).
- See Marra v. Tel-Save, 1999 WL 317103 (E.D. Pa. May 18, 1999); Sunquest Info. Sys., Inc. v. Dean Witter Reynolds, Inc., 1999 WL 167091 (W.D. Pa. Mar. 24, 1999); Oran v. Stafford, 34 F. Supp. 2d 906 (D.N.J. 1999); In re Centecor, Inc. Sec. Litig. III, 1998 U.S. Dist. LEXIS 18909 (E.D. Pa. Dec. 1, 1998); In re Next Level Sys., Inc. Sec. Litig., 1999 U.S. Dist. LEXIS 5653 (N.D. Ill. Mar. 31, 1999); Scott v. Steingold, 1998 WL 704287 (N.D. Ill. Sept. 30, 1998).
- 1999 WL 79057 (E.D. Pa. Jan. 29, 1999).
- 1998 WL 781118 (N.D. Ill. Nov. 4, 1998).
- 1999 WL 304629 (S.D. Fla. Feb. 18, 1999).
- 231 B.R. 373 (S.D. Fla. Feb. 11, 1999).
- 1998 U.S. Dist. LEXIS 20306 (C.D. Cal. Dec. 29, 1998).
- See Allison v. Brooktree Corp., 999 F. Supp. 1342, 1350 (S.D. Cal. 1998); Markman Partners., L.P. v. Chantal Pharm. Corp., 927 F. Supp. 1297, 1312 (C.D. Cal. 1996).
- 970 F. Supp. 746 (N.D. Cal. 1997), appeal pending.
- 40 F. Supp. 2d 1160 (W.D. Wash. 1998).
- 18 U.S.C. § 1964(c).
- 161 F.3d 156 (3d Cir. 1998).
- 1998 WL 81175 (S.D.N.Y. Nov. 19, 1998).
- 1998 WL 704287 (N.D. Ill. Sept. 30, 1998).
- 36 F. Supp. 2d 1351 (S.D. Fla. 1999).
- 28 F. Supp. 2d 298 (E.D. Pa. 1998).
- 1999 WL 47239 (S.D.N.Y. Feb. 3, 1999).
- 1999 WL 144109 (E.D. Pa. Mar. 15, 1999).
- Statement of Managers for the Private Securities Litigation Reform Act of 1995, H.R. Conf. Rep. 104-369 (Nov. 28, 1995).
- 15 U.S.C. § 77z-1(b)(1) and 15 U.S.C. § 78u-4(b)(3)(B).
- 28 F. Supp. 2d 562 (N.D. Cal. Dec. 4, 1998).
- In contrast, the Northern District of Texas in Dartley v. Ergobilt, 1998 WL 792500 (N.D. Tex. Nov. 4, 1998), denied defendant's motion to enforce the mandatory stay provisions of the PSLRA because there was no motion to dismiss actually pending before the court -- notwithstanding defendant's representations that the filing of such a motion was imminent.
- Fed. Sec. L. Rep. (CCH) 6 90,420 (C.D. Cal. Jan. 15, 1999).
- 15 U.S.C. § 78u-4(a)(3)(B)(i).
- 158 F.3d 162 (2d Cir. 1998).
- See In re Oxford Health Plans, Inc. Sec. Litig., 182 F.R.D. 42 (S.D.N.Y. 1998).
- 182 F.R.D. 144 (D.N.J. 1998).
- 15 U.S.C. § 77z-1(a)(3)(B)(v).
- 15 U.S.C. § 77z-1(a)(6).
- 1999 WL 137746 (S.D. Fla. Mar. 9, 1999).
- 182 F.R.D. 144 (D.N.J. 1998).
- 818 F.2d 1433 (9th Cir. 1987).
- See In re Aetna Inc. Sec. Litig., 34 F. Supp. 2d 935 (E.D. Pa. 1999); Pegasus Holdings v. Veterinary Centers of America, Inc., 1998 WL 951690 (C.D. Cal. Oct. 6, 1998).
- 15 U.S.C. § 78u-4(b).
- 1999 WL 317103 (E.D. Pa. May 18, 1999).
- 999 F. Supp. 1342 (S.D. Cal. 1998). Although the Ninth Circuit has not yet addressed the issue, it did affirm the group pleading doctrine in an April 1999 decision in Berry v. Valence, 1999 WL 249207 (9th Cir. Apr. 29, 1999), in connection with a complaint filed before the enactment of the PSLRA.
- 26 F. Supp. 2d 910 (N.D. Tex. 1998).
Dennis J. Block and Jonathan M. Hoff are members of Cadwalader, Wickersham & Taft. Associate Elizabeth Yoo, assisted in the preparation of this article.
This article is reprinted with permission from the June 24th issue of the New York Law Journal © 1999 NLP LP Company.