Good news: Congress has dealt a serious setback to securities class actions. On October 13, 1998, the House and Senate passed the Securities Litigation Uniform Standards Act of 1998 ("the Uniform Act") by veto-proof margins. The President is expected to sign it.
The Uniform Act aims to stop plaintiffs' lawyers from bypassing the protections of the Private Securities Litigation Reform Act of 1995 ("the 1995 Reform Act") by bringing cases in state, rather than federal, courts. Pillsbury attorneys assisted in drafting parts of the Uniform Act, testified before the House Commerce Subcommittee in support of the Act and assisted in the debate about the Act.
Closing the Loopholes of the 1995 Reform Act
The Uniform Act is the culmination of two years of work that began when it became apparent that further federal legislation was necessary to realize the full promise of the 1995 Reform Act. Congress had passed the 1995 Reform Act after it found "significant evidence of abuse in private securities lawsuits": "the routine filing of lawsuits ...whenever there is a significant change in an issuer's stock price," "the targeting of deep pocket defendants," "the abuse of the discovery process," and "the manipulation by class action lawyers of the clients whom they purportedly represent." H.R. Conf. Rep. No. 104-369, 104th Cong., 1st. Sess. 31 (1995). The 1995 Reform Act attempted to stop these abuses by changing the rules for federal securities fraud class actions. (See sidebar below, "Restoring the 1995 Reform Act's Promise.") When the 1995 Reform Act passed, both proponents and opponents forecast that it would effectively curtail private securities class actions.
Both the opponents and the authors of the 1995 Reform Act underestimated the ingenuity of the plaintiffs' lawyers. Dusting off seldom-used state statutes, the plaintiffs' lawyers moved their litigation machine into the state court system. State court judges who had never encountered a securities fraud class action soon found dozens on their dockets, each demanding hundreds of millions of dollars in damages.
In the state court system, the 1995 Reform Act and its Safe Harbor simply did not apply. All the abuses identified by Congress continued. Under the unreformed state procedural rules, plaintiffs' lawyers continued to file complaints upon the drop of a stock price, accusing companies and numerous defendants of fraud when revenue projections were missed. Just as in pre-Reform Act days, massive discovery demands swiftly followed. Auditors and underwriters continued to be sued as "aiders and abettors" allegedly liable for all the damages demanded. One year after the 1995 Reform Act's passage, the SEC characterized the shift to state court as "the most significant development in securities litigation post-1995 Reform Act."
Restoring the 1995 Reform Act's Promise
The Uniform Standards Act aims to ensure that the 1995 Reform Act governs any major securities fraud litigation brought in any court in the United States. The key innovations of the 1995 Reform Act are:
* The Safe Harbor. Defendants are not liable for "forward looking statements," such as revenue projections, unless the statements were made with "actual knowledge" of their falsity and were unaccompanied by meaningful cautions.
* Procedural safeguards. All discovery in the lawsuit is halted until plaintiffs first show the court the facts that prompted the filing of the case, and convince the court that those facts raise a "strong inference" of fraud.
* Proportionate liability. Deep-pocket defendants such as auditors and underwriters are not jointly liable with other defendants for all damages--only for their fair portion, if any.
* Limits on plaintiffs. Plaintiffs with a history of bringing numerous securities class actions are barred from filing more lawsuits. Furthermore, the right to choose the plaintiff class lawyers is given to the plaintiff with the largest shareholding, not the first to run to the courthouse.
The Uniform Standards Act: Restoring Congress' Original Intent
Of course, Congress' intent in enacting the 1995 Reform Act was to end abusive securities litigation, not to burden the state courts with such cases. The Uniform Act restores that intent through two simple and effective means:
* Preemption of state law: No "covered class action" alleging fraud or manipulation in connection with a "covered security" may be maintained under state law in any state or federal court.
* Removal of state cases: When such a "covered class action" is brought in a state court, each defendant has the right to remove the entire case to federal court, where the 1995 Reform Act applies.
The Uniform Act's definitions of "covered class action" and "covered security" were the subject of some political compromise. Nonetheless, they are broad enough to include the great majority of securities fraud class actions.
"Covered Security." The Uniform Act defines "covered security" in technical terms: any security satisfying the standards set forth in Sections 18(b)(1) and 18(b)(2) of the Securities Act of 1933, excepting debt securities exempt from registration under Section 4(2). In plain language, this includes any security listed on the NYSE, AMEX, or on the National Market System of the NASDAQ, or issued by a registered investment company, unless the security is a debt security that was issued in a private placement.
"Covered Class Action." Subject to certain exceptions detailed below, a "covered class action" is any securities fraud lawsuit seeking damages on behalf of fifty or more persons where "questions of law or fact common to those persons" predominate. The Uniform Act's "predominance" standard is borrowed from federal class action law and is well understood by the federal courts. The Uniform Act also blocks two foreseeable tactics for evading its definition. If the plaintiff seeks damages on behalf of an unspecified number of persons, their number is presumed to be greater than fifty. And if fifty or more plaintiffs break their joint claims into several different lawsuits, each with less than fifty plaintiffs, all those lawsuits are counted together if the state court consolidates them.
Exceptions and limitations. The Uniform Act's application is subject to certain limitations. In the so-called "Delaware carve-out," the Uniform Act exempts lawsuits involving matters of internal corporate governance, which are traditionally governed by the law of the corporation's state of incorporation. The following may still be litigated in state court:
* Derivative actions brought on behalf of the corporation.
* Challenges to an issuer's purchase or sale offer made exclusively to its equity shareholders.
* Challenges to an issuer's statements regarding certain corporate governance issues:
- proxies and shareholder voting decisions
- tender or exchange offers
- dissenters' or appraisal rights
* Disputes between parties to indenture trust agreements.
In addition to the "Delaware carve-out," the Uniform Act also exempts certain lawsuits brought by state entities. Specifically, state pension plans may still bring securities fraud actions under state law in state court--but may not file such lawsuits as class actions. And state securities commissions remain free to enforce their state securities laws in their state's courts.
Not retroactive. The Uniform Act expressly does not apply to any lawsuit filed before its enactment into law.
Stay of discovery in state actions. Since the Uniform Act exempts certain private lawsuits from its removal and preemption provisions, simultaneous litigation about the same facts in both federal and state court will still occur in some cases. For example, still permitted under the Uniform Act is the common scenario of the parallel filing of a class action in federal court alleging securities fraud and a derivative action in state court alleging the directors' and officers' negligence. Such parallel cases can create significant waste when discovery proceeds simultaneously in both, without coordination. The Uniform Act's authors recognized this, and authorized a federal court to stay all discovery in a parallel private state lawsuit.
Legislative History Regarding the 1995 Reform Act. While not contained in the Uniform Act itself, the accompanying legislative history reflects extensive debate and comments by members of Congress regarding the Congressional intent behind the 1995 Reform Act. Indeed, the SEC supported the Uniform Act's passage in part because key Senators agreed to create legislative history stating that Congress in 1995 did not mean to alter the standard of "scienter" (the intent to defraud) necessary for the violation of Section10(b) of the Securities Exchange Act. The SEC became concerned about this issue after some federal courts interpreted the 1995 Reform Act as requiring the plaintiff to prove more than recklessness. On the conference committee, House members resisted this unusual effort to create legislative history interpreting an existing statute, but the final joint conference report does contain a section accommodating the SEC's concerns to some extent. It remains to be seen what weight, if any, courts will give to such post-enactment legislative opinions when interpreting the 1995 Reform Act.
Other Amendments
Congress included in the Uniform Act a number of provisions unrelated to the securities litigation reform, largely consisting of technical amendments to the federal securities laws. However, one "technical" amendment is actually a significant boon for corporate dealmakers, particularly in California. The Uniform Act restores the Section 3(a)(10) exemption from federal registration for securities issued in a transaction that has been approved in a state fairness hearing, such as those conducted under Section 25142 of the California Corporations Code.
Practical Results of the Uniform Act
The Uniform Act will have a number of ramifications for public companies:
* The practice of filing simultaneous class actions against the same company in both federal and state courts should come to an end. While the Uniform Act's exceptions will still permit a few individuals to sue in state court, new lawsuits on behalf of thousands of shareholders will now be pursued in federal court.
* The scores of pending state securities class actions will not be affected, and will continue to work through the state courts over the next several years. They will remain a historically aberrant and unique class of cases.
* The next few years will see hotly contested litigation over the implementation of the 1995 Reform Act and the Uniform Act. Plaintiffs' counsel have proven imaginative in seeking ways to avoid previous efforts to curtail securities suits. Until the judiciary has definitively interpreted the key provisions of the new federal scheme, companies suffering precipitous stock drops can still expect litigation.
* Directors' and officers' insurance premiums, having decreased in recent years, should decrease further if the federal legislation proves successful over the next few years.
* State pension funds and other large shareholders may come to view state courts as a preferable forum for their own individual claims, and opt out of federal class actions.
Conclusion
With the passage of the Uniform Act, the promise of the 1995 Reform Act may finally be realized. The Uniform Act uses the full power of Congress to force class actions into federal court and subject them to the 1995 Reform Act. Under the 1995 Reform Act, securities plaintiffs must show at the outset that their claims are based on actual evidence of fraud, not on speculation. The federal courts are now free to apply the 1995 Reform Act as it was intended.