Diamond Multimedia and the Uniform Standards Act: Will All Nationwide Securities Class Actions Now Be Filed In Federal Court? |
| On November 3, 1998, the Securities Litigation Uniform Standards Act of 1998 ("Uniform Standards Act") was signed into law by President Clinton. This new federal securities act greatly limits securities class actions that can be brought in state court. On January 4, 1999, however, in a case closely watched by the securities bar and many public companies in California, the California Supreme Court, in In re Diamond Multimedia Systems, Inc., held that California-based publicly traded companies can be sued by out-of-state investors (and so a nationwide class action may be maintained) in California state court for violations of California's securities laws. These seemingly conflicting developments leave questions for the securities bar and California public companies regarding the extent to which companies may continue to face the threat of securities fraud class actions filed in state court. |
The Reform Act
The impact of the Uniform Standards Act and Diamond Multimedia must be viewed in light of the passage of the Private Securities Litigation Reform Act of 1995 (the "Reform Act"). In passing the Reform Act, Congress was "prompted by significant evidence of abuse in private securities lawsuits," including the routine filing of lawsuits against public companies based upon nothing else than a stock price drop, the targeting of "deep pocket" defendants, abuse of the discovery process and manipulation by class action lawyers of their clients. Responding to these abuses, Congress heightened the pleading requirement for scienter (the requisite mental state for 10b-5 claims), created a "safe harbor" for companies issuing forward-looking statements and established an automatic stay of discovery until the plaintiffs drafted a complaint strong enough to withstand a motion to dismiss. Discovery is often expensive and time consuming - and Congress recognized that even the threat of litigation (and the associated discovery) may prompt a company to settle rather than defend a meritless action. Preventing costly discovery until a complaint is deemed viable by the court was seen as one way to ensure that investors could still bring valid claims in federal court, while affording public corporations greater protection against abusive litigation.
The Reform Act, however, was applicable only to securities fraud class actions filed in federal court. Many states, including California, have adopted comparable securities laws aimed to protect the citizens of each state from securities fraud which do not impose the same pleading requirements, "safe harbor" provisions or limits upon discovery. Not surprisingly, after passage of the Reform Act, plaintiffs promptly filed more complaints for securities fraud under state laws in state courts in an attempt to avoid the Reform Act's stringent pleading and discovery protections. In the ten months following the Reform Act, 78 securities class action were filed in state courts, compared to only 48 the year before. From January to June 1998, 31 companies were sued for securities fraud in California state court actions.
Diamond Multimedia was one of those securities class actions filed in state court. Purporting to represent a class of nationwide shareholders, plaintiffs sought redress for alleged market manipulation on behalf of all shareholders who purchased or sold Diamond Multimedia stock. Plaintiffs sought relief under California Corporations Code sections 25400 and 25500, which essentially prohibit a seller of securities from willfully making a false or misleading statement intended to induce the purchase or sale of a security.
The case was viewed as important by the securities bar because of the erosive impact it could have upon the hard-won protections imposed in federal court by the Reform Act. Defendants (and various amici curiae, including the Securities Industry Association, the National Venture Capital Association and the American Electronics Association, represented by Brobeck), were particularly concerned about the frustration of the policies contained in the Reform Act through the use of actions brought under state law, with lower pleading requirements and the availability of burdensome discovery tools, and the corresponding expansion of the state court into regulation of the national securities markets. Defendants sought a judicial determination that California securities laws were intended to protect the welfare of state residents and were not intended to extend extraterritorially (i.e., to residents of other states). As Diamond Multimedia argued, the wording of the California security laws use of the phrase "in this State" limited the scope of the law and argued that expansion of the law's reach would impermissibly interfere with the federal government's ability to regulate the national securities market.
Plaintiffs maintained that a wronged shareholder should have recourse in state court even if they were out-of-state residents, as long as the alleged wrong took place in California. Unfortunately, plaintiffs' arguments prevailed, and the California Supreme Court held that claims for violation of California's securities laws may be asserted by California and non-California shareholders alike, who purchased stock in the defendant corporation, so long as the alleged wrongdoing took place in California. This ruling therefore allows a nationwide class of plaintiffs to bring a complaint in state court alleging violations of California securities laws. In essence, any corporation that issued an allegedly false or misleading statement in California would be subject to a securities class action in California state court, but without the protections of the Reform Act. Justice Baxter, writing for the majority, reasoned that a "California remedy for market manipulation helps ensure that the flow of out-of-state capital, necessary to the growth of California business, will continue." While the California Supreme Court's decision was disappointing, its impact will likely be greatly mitigated by the passage of the federal Uniform Standards Act.
Uniform Standards Act
The Uniform Standards Act was enacted "in order to prevent certain State private securities class action lawsuits alleging fraud from being used to frustrate the objectives of the Private Securities Litigation Reform Act of 1995." Effectively, the Uniform Standards Act is intended to make federal court the exclusive jurisdiction, and federal claims the exclusive claims, for large-scale shareholder securities class actions 1. The Uniform Standards Act provides that no class action may be brought in either state or federal court, based on state statutory or common law, including California's securities laws.
Uniform Standards Act: Covered Class Actions
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Furthermore, any state court securities class action that satisfies the definitional requirements of the Uniform Standards Act is removable to federal court. The Uniform Standards Act is not retroactive and will apply only to actions filed after November 3, 1998.
There are, however, a few exceptions. Derivative actions, cases involving suits against corporate officers arising out of a tender offer or an exchange offer and brought in the state in which the issuer of the security is incorporated, actions seeking to enforce a contractual agreement between an issuer and indenture trustee, or state class actions brought by a state government, local government, or political subdivision or its pension plans on behalf of a class comprised of such entities may still be maintained in state or federal court under state law. Additionally, if an action brought in federal court falls within these exclusions, the action is removable to state court.
Exceptions to the Uniform Standards Act
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Even with these exceptions, the Uniform Standards Act promotes the objectives of the Reform Act by providing that a federal court may stay discovery in the state court action "as necessary in aid of its jurisdiction, or to protect or effectuate its judgments." Therefore, even in actions brought under one of the exceptions to the Uniform Standards Act, a federal court may stay the state court discovery if a parallel federal action has been filed against the defendants in federal court. For example, a state pension fund could file action in state court under state law alleging securities violations. However, if a group of individual shareholders brings a class action against the same defendants in federal court alleging securities fraud, the federal court may issue an injunction preventing discovery in the state action. The benefit to the defendant is clear and consistent with the Reform Act policies - the defendant has a chance to challenge the complaint with a motion to dismiss (or a demurrer in state court) without the distraction of expensive and time-consuming discovery.
The Impact of Dimaond Multimedia and the Uniform Standards Act
While Diamond Multimedia allows nationwide securities class actions in California state courts based on alleged violations of the California securities laws, the Uniform Standards Act prohibits the filing of most securities class actions in state court. Diamond Multimedia will affect the approximately 80 securities fraud class action lawsuits already pending in state courts, allowing those actions to proceed without the protections of the Reform Act.
Will all nationwide securities class actions now be filed in federal court? Almost certainly that answer is yes - but while it would seem that state securities class actions will now be a thing of the past, the plaintiffs' bar may attempt to utilize one exception to the Uniform Standards Act in order to maintain securities class actions in California state court. Because nothing precludes a state court action brought by a state government, local government, or its pension plans, or a class action on behalf of such entities, the plaintiffs' bar could conceivably enlist these entities, and perhaps induce them to bring such actions in state court. It is unclear, however, how many municipalities or pension funds would be willing to participate in a state securities fraud class action. Traditionally, large institutional investors have not actively participated in class actions on either the state or federal level. It is not unheard of, however, for such investors to be named plaintiffs. For example, the City of Philadelphia's pension plan has recently served as a named plaintiff in several securities class actions. The impact of this exception depends in part on the plaintiffs' bar's ability to recruit these institutions. It also depends upon the scope of the holdings this class of investors may have in a particular company, and whether a class action on behalf of those shareholders alone would be economically viable. Thus, the effect of the exceptions contained in the Uniform Standards Act remains to be seen.
Real Legacy of Diamond Multimedia May Be it's Requirement of Purposeful Wrongdoing for Liability Under Sections 25400 and 255500 of the California Corporations Code
Ironically, although in the short term the Diamond Multimedia result may be viewed as a loss by the defense bar, in the longer term, its legacy may well prove a boon to defendants. Specifically, the Supreme Court's Diamond Multimedia opinion made clear that "[c]ivil and criminal liability under Section 25400 attach only if a person omits a material fact for the purpose of inducing the sale or purchase of the stock with knowledge that the omission was false or misleading" (emphasis added).
The express recognition by the Supreme Court that sections 25400 and 25500 address "purposeful" manipulation of the market, and that statements must be knowingly false in order to be actionable in a civil proceeding under sections 25400 and 25500, should end any remaining debate concerning whether negligent misstatements are actionable under those code sections. The plaintiffs' bar historically has argued that negligent misstatements are in fact actionable. The defense bar has taken the opposite view, based upon the express language of the statutes, as well as commentary by the law's authors, which also made clear that these statutes were not designed to target negligent misstatements or omissions. In Diamond Multimedia, the California Supreme Court now has ratified defendants' position, and has made it considerably more difficult for the plaintiffs' bar to bring such claims. First, these state law claims clearly should now be subject to the rigorous pleading standards applied to fraud claims. Second, to establish liability, plaintiffs will have to show purposeful wrongdoing by defendants, a far more formidable hurdle than mere negligence. Finally, in light of the Uniform Standards Act, plaintiffs likely will be unable to bring claims under sections 25400 and 25500 in the form of a class action in any court. In other words, the Diamond Multimedia decision may prove to be a Pyrrhic victory for the plaintiffs' bar.
1. A "class action" is defined in the Uniform Standards Act as: 1) an action brought on behalf of more than fifty persons; 2) an action brought by one or more named parties seeking recovery on behalf of himself or similarly situated persons; or 3) a group of lawsuits filed in the same court and involving common questions of law or fact.
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