The Private Securities Litigation Reform Act of 1995
On December 22, 1995, the U.S. Senate voted to override President Clinton's December 19, 1995 veto of the Private Securities Litigation Reform Act of 1995 (the "bill" or the "Reform Act"). With the House of Representatives having similarly voted on December 20, 1995 to override the veto, the Reform Act, which affects dramatically the ability of companies to defend themselves against class actions brought under the Federal securities laws, became law on December 22, 1995; its provisions do not apply, however, to any private action commenced before that date.
The bill is a complex piece of legislation. This bulletin is intended to outline only some of the most important provisions of the bill and their effect on corporate disclosure issues. All companies should immediately review their practices to take advantage of the new provisions. We can provide further analysis to anyone who is interested.
The following are the main provisions in the Reform Act, which are discussed in more detail below:
- Safe Harbor for Forward-Looking Information
- Limitations on Joint and Several Liability
- Increased Pleading and Proof Requirements
- Limitation on Damages
- Class Action Procedural Reforms
- Enhanced Attorney Sanction Provisions
- RICO Amendment Eliminating Sanctions Claims
- Auditor Duty Regarding Financial Fraud
- Additional SEC Rulemaking Authority
For most companies, the most important provision of the Reform Act is the "safe harbor" for forward-looking statements or projections. As finally crafted, this provision will greatly increase protection for such statements and also will provide a mechanism for getting lawsuits dismissed at a very early stage in a proceeding, before legal costs mount and executive time is squandered in depositions and other discovery. The safe harbor applies to actions brought under both the Securities Exchange Act of 1934 (the "Exchange Act") and the Securities Act of 1933 (the "Securities Act"), although its scope as to types of forward-looking statements covered is limited. For example, forward-looking information contained in GAAP financial statements is not protected by the safe harbor (see below). Nor does the provision apply to any initial public offering
Under the bill, a written or oral statement that predicts the future prospects of a company is immune from civil liability (although not from actions brought by the SEC) if either (1) the statement is identified as a forward-looking statement and also identifies "important" factors that may cause actual results to differ materially from those predicted or (2) the statement was not made with actual knowledge of its falsity.
"Bespeaks Caution" Doctrine
Reflecting Congressional supporters' belief that the U.S. capital markets will benefit from an increased flow of forward-looking information, the Reform Act adopts a strong form of the case law that has become known as the "bespeaks caution" doctrine. Under the formulation in the Reform Act, an issuer (and others covered by the safe harbor) will be immune from civil liability if the forward-looking statement is identified as a forward-looking statement. The legislative history accompanying the bill makes clear that it is unnecessary to state explicitly that "This is a forward-looking statement." Instead, cautionary words such as "we estimate" or "we project" likely will be sufficient.
In order for a company to benefit from the protections offered by the "bespeaks caution" prong of the safe harbor, a forward-looking statement must also be accompanied by one or more qualifiers stating "important factors" why the results predicted in the forward-looking statement may not come true. It will not be necessary to identify all the factors that might cause the statement not to "pan out" or even to identify the factor that causes the final result to differ from the prediction. The point is to identify enough factors so that an investor should realize the risks involved in relying on the forward-looking statement.
What is a Forward-Looking Statement?
The Reform Act contains a thorough definition of "forward-looking statement," including those items that one might expect, i.e., projections of revenue or losses, plans and objectives for future operations, products or services and statements relating to future economic performance that would normally be included in a "Management Discussion & Analysis" section. It also includes any underlying or related assumptions that are stated.
Financial Statements Exclusion
Projections and other forward-looking statements contained in GAAP financial statements are not protected by any provision of the safe harbor. Thus, contingent liability disclosure that is protected by the provisions of the safe harbor when contained in the body of a document (such as a Form 10-K) may not be protected by the safe harbor to the extent that it is also contained in the financial statement footnotes. Existing SEC Rule 175, which is promulgated under the Securities Act, provides a much narrower regulatory safe harbor for certain forward-looking information, including, according to some judicial interpretations, information contained in financial statements. Rule 175 is not affected by the Reform Act.
The safe harbor does not apply to statements made in connection with initial public offerings, rollup transactions, tender offers or partnership or limited liability company offerings, among other things. Issuers who are subject to judicial or administrative decrees or orders or who have been convicted of crimes relating to violations of the securities laws are prohibited from relying on the safe harbor for three years after the date of such conviction or the entry of such decree or order.
In addition to the general safe harbor coverage for both written and oral statements, the bill affords special "bespeaks caution" treatment for oral forward-looking statements made by issuers and their officers, directors and employees. As to such statements, the general requirement that a forward-looking statement be accompanied by a listing of "important factors" can be met by a statement identifying the information as forward-looking along with a further statement clearly conveying the message that actual results may differ materially from the results predicted in the forward-looking statement and referencing a "readily available written document" that contains cautionary language meeting the standard discussed above. The document reference may be to an SEC filing or to any publicly disseminated document, including those posted by an issuer on-line, as, for example, an earlier press release. Thus, in an oral presentation to analysts or any other group, a company spokesman should refer to the fact that the presentation contains predictions, should identify those by reference to "estimates" or "projections" or similar terms and should refer to written information that is available to the listeners that contains meaningful cautionary language or identifies important factors that could cause actual results to differ from the oral projections.
Requirement to Show Knowledge of Falsity
Persons covered by the safe harbor are not limited to reliance on the "bespeaks caution" prong; in fact, the bill provides that unless a plaintiff proves that a forward-looking statement was made with actual knowledge of its falsity, then the maker of the statement will be immune from liability based on the statement, even where the maker of the statement has not met the "bespeaks caution" requirements. In a colloquy on the Senate floor, the bill's proponents made it clear that recklessness does not suffice for a finding of actual knowledge under this provision.
A notable feature of this second prong of the safe harbor is its "disimputation" clause, which provides that a company or other entity that publishes a forward-looking statement will not be held liable for such a statement unless it is made or authorized by a high-ranking "executive" officer of the company. For liability, the high-ranking officer must have known that the statement was false or misleading at the time he or she made or approved the statement. Often there will be several different views expressed within a company while a final forward-looking statement is being formulated. A company should not, under the Reform Act, be held liable because some lower-level employee had authored a document inconsistent with a forward-looking statement made by a senior executive for publication.
The Reform Act extends the protection of both prongs of the safe harbor to underwriters, but only where the forward-looking information is based on or "derived from" information provided by an issuer. According to the legislative history accompanying the bill, the "derived from" language is intended to allow underwriters, who sometimes have "an adversarial relationship with issuers in performing due diligence," some latitude in disclosing information that an issuer did not necessarily provide but that the underwriter was able to "derive" from information that was provided by the issuer. The bill covers only underwriters acting as such; the legislative history specifically states that "brokers' sales practices" are not covered by the safe harbor. The Reform Act is simply unclear as to the extent to which the safe harbor protects a broker-dealer's sales representative who, during a telephone call with a customer, orally repeats written forward-looking statements that are otherwise covered by the safe harbor.
Again, it is important to understand that the special treatment of oral forward-looking statements (allowing a reference to written documents containing cautionary statements) applies only to issuers and their officers, directors and employees. Underwriters may make oral forward-looking statements only in reliance on the general safe harbor--thus requiring that cautionary statements be included along with any projections.
Statements by Outside Reviewers
The general safe harbor protection extends to an "outside reviewer retained by [an] issuer" who makes a statement on behalf of the issuer. It covers a report that "assesses" a forward-looking statement made by the issuer. The term "outside reviewer" is not defined in the bill, and its effect is unclear. Although a securities analyst "assesses" information provided by an issuer, the bill requires that an outside reviewer be retained by and speak on behalf of the issuer, which typically is not the case for analysts. It appears, then, that the "outside reviewer" protection may at most cover only those speaking on behalf of the company, such as public relations personnel or perhaps attorneys in some situations. In any case, the special treatment of oral forward-looking statements does not apply to "outside reviewers."
There are other important provisions in the safe harbor. For example, when a defendant makes a motion to dismiss a lawsuit on the basis that the complaint is based on a forward-looking statement, all discovery, except discovery relating to the applicability of the safe harbor, is stayed pending a decision on the motion. Another important provision makes clear that persons relying on the statutory safe harbor are under no obligation to update projections once definitive information becomes available, which, of course, may not match exactly the information given in a particular forward-looking statement. The troublesome provision that would have permitted the SEC to seek class damages even though an issuer was protected from civil liability by the safe harbor was dropped from the bill.
The bill adopts proportionate liability for all non-knowing securities violations under the Exchange Act. (It adopts the same rule for non-officer directors under Section 11 of the Securities Act.) This provision will be particularly important for underwriters, venture capital firms, outside directors, accounting firms and others pulled into securities cases as so-called "deep pocket" defendants. Plaintiffs will no longer have the hammer of joint and several liability to coerce peripheral defendants into settlements because the risk to those defendants of defending the action is unacceptable. Only those whom the trier of fact finds to have committed "knowing" securities fraud, i.e., had actual knowledge that (1) a statement was false and/or that an omission made a statement misleading, and (2) investors were reasonably likely to rely on the misrepresentation or omission, will suffer joint and several liability.
The Reform Act creates one exception to the new proportionate liability rule: where, within six months of judgment, the court determines that one defendant's share is uncollectible, then all other defendants will become jointly and severally liable for that share if the plaintiff (including any class member) (1) is an individual whose recoverable damages equal more than 10 percent of such plaintiff's net worth and (2) the plaintiff's net worth is less than $200,000. Under this exception, the amount paid by each of the remaining defendants to all other plaintiffs is capped at 150 percent of a defendant's proportionate share.
In a separate provision, the Reform Act provides that if one defendant settles, a court is required to issue an order barring all future claims for contribution or indemnity by non-settling persons against the settling defendant and by that defendant against all non-settling defendants. Any verdict or judgment is then reduced by the amount paid to the plaintiff pursuant to the settlement or by an amount corresponding to the percentage of responsibility of the settling person, whichever is greater.
In all private actions for money damages brought under the Exchange Act (i.e., actions under Rule 10b-5), the complaint must "state with particularity facts giving rise to a strong inference" that a defendant acted with the required state of mind; otherwise, the case will be dismissed. In any securities suit, the court must stay discovery during the pendency of a motion to dismiss, unless the court finds that "particularized discovery" is necessary.
We believe that this is an important development because it effectively amends, for purposes of securities class actions, Rule 9(b) of the Federal Rules of Civil Procedure, which permits state of mind to be averred "generally." While not as strong as we might have liked (the House bill required that a plaintiff plead facts that would "establish" the required state of mind), we believe that this provision will give defense counsel a significant new tool to get actions dismissed early in the course of litigation, before costs and time are wasted in discovery. In most cases, the provision should bar plaintiffs from using early discovery to find company documents to use in filing a new complaint.
Moreover, in actions under the Exchange Act seeking money damages, the court, upon request of a defendant, must submit to the jury written interrogatories on the issue of each defendant's state of mind at the time of the alleged violation.
The legislation adopts an approach that takes into account the "bounce-back" phenomenon that often occurs in the price of an issuer's stock after the price first declines on the announcement of surprising news. If a security recovers some or all of its price after the initial disclosure of unfavorable news, damages will be capped at the difference between the price paid for the security and the mean trading price of the security during the 90-day period after the dissemination of corrective information. If the security is sold or repurchased before the 90-day period expires, damages are capped at the difference between the original price paid or received by the plaintiff and the mean trading price of the security during the period between the dissemination of the corrective information and the date on which the plaintiff sells or repurchases the security.
Appointment of Lead Plaintiff
Many legislators criticized securities class actions as being controlled by "entrepreneurial lawyers" who, in effect, ignored any client relationship with the plaintiff class in an effort to wring fee-based settlements from defendant companies and from peripheral defendants such as law and accounting firms. The Reform Act adopts a procedure that is designed to give investors, particularly those with a greater or more long-term stake in the defendant company, greater control of the conduct of the class action litigation.
The legislation creates a procedure for a court to appoint as lead plaintiff the member or members of the purported plaintiff class that the court determines to be most capable of representing the interests of the class. The bill requires that a plaintiff filing a complaint must publish a notice, within 20 days of the filing of the complaint, advising members of the purported class that any class member has 60 days in which to ask the Court to serve as lead plaintiff. The bill creates a presumption that the class member that has the "largest financial interest in the relief sought by the class" is the most adequate plaintiff to represent the class. Despite the creation of this procedure, the legislative history of the Reform Act states expressly that it is not intended to be exclusive and that defendants may continue, as under current law, to challenge the adequacy of the named plaintiff to represent the class.
Ban on Professional Plaintiffs
A person may be a lead plaintiff, or an officer, director or fiduciary of a lead plaintiff, in no more than five securities class actions during any three-year period, although a court may make an exception for good cause shown.
In any settlement, the parties must disclose (a) a statement concerning the average amount of damages per share recoverable if the plaintiff were to prevail on all counts, if the settling parties agree on the amount, (b) any disagreement between the settling parties as to the amount recoverable and (c) the amount of attorneys' fees and expenses sought.
No funds disgorged as the result of court or administrative action undertaken by the SEC may be distributed as payment for attorneys' fees or expenses incurred by private parties seeking distribution of the disgorged funds, unless otherwise ordered by the court.
A court is required, on final adjudication of an action, to include in the record specific findings regarding compliance by all parties and attorneys with Rule 11 of the Federal Rules of Civil Procedure, which relates to attorney conduct and frivolous actions. A finding that a party or attorney violated Rule 11 creates a presumption in favor of an award to the opposing party of reasonable attorneys' fees and other expenses incurred as a direct result of the violation. Rebuttal is allowed only by proof (i) that such an award would impose an unreasonable burden on the party or attorney to be sanctioned and would be unjust, and that the failure to award sanctions would not impose a greater burden on the party in whose favor sanctions are to be awarded, or (ii) that the violation of Rule 11 was de minimis.
In any RICO case, "no person may rely upon conduct that would have been actionable as fraud in the purchase or sale of securities to establish a [RICO] violation." An exception is made for individuals criminally convicted of violating the securities laws.
Public company auditors who perform audits required under the Exchange Act must adopt certain procedures for identifying illegal acts and related party transactions, and must undertake evaluations of companies in order to ascertain whether there is "substantial doubt" as to an issuer's ability to continue as a going concern. The auditor must make a report of these findings to the senior management of the company and ensure that the audit committee of the company is adequately informed as to any illegal acts detected by the auditor. If the auditor determines that the management has not adequately responded to the report of illegal acts, the auditor under certain circumstances must make a report to the board of directors of the company, which must in turn be reported to the SEC by the board of directors or by the auditor if the board of directors does not comply with the requirement. Alternatively, an auditor may resign from the engagement with the company, but must then submit the report to the SEC. Auditors who do not comply with the reporting requirements can be subject to civil penalties.
In an odd twist during the negotiations that led to the final version of the bill, the safe harbor provisions were amended to grant near plenary authority to the SEC to exempt by rule or regulation any person from any provision (not just the requirements of the safe harbor) of either the Securities Act or the Exchange Act. This authority is similar to the authority granted to the SEC under the Investment Company Act of 1940, except that it does not expressly permit the SEC to exempt by order on a case-by-case basis.