Financial Services Report Spring 1999

Securities Litigation Uniform Standards Act of 1998

Financial services institutions have moved onto the Internet en masse, and the shift to electronic commerce (or, more properly, "e-finance") will only accelerate in the months ahead. Financial institutions generally accustomed to close government regulation in their traditional activities should expect to encounter equally important regulatory hurdles in their dealings on the Internet. Two examples of areas that run headlong into the world of e-finance are encryption of information and personal-data privacy.

Encryption: Regulation Everywhere

E-finance, perhaps more than any other area of e-commerce, necessitates secure transactions and transmission of information. At the same time, government law-enforcement and national-security interests express grave concern over the potential for encryption to shield illegitimate and potentially dangerous activities. It is no surprise, then, that countries around the globe regulate the use and transmission of cryptographic technology, software and hardware.

The United States closely restricts the export of products with encryption or decryption capabilities, although it leaves use within the U.S. unregulated. Moreover, other countries -- notably, France and Singapore -- not only regulate export, but impose rigid restrictions on import and internal use as well. As a result, a company contemplating secure encrypted international services must consider both the U.S. and foreign regulatory implications of its activities.

The Clinton Administration late last year responded to the financial industry's entreaties for relaxation of encryption restrictions by exempting a narrow class of encryption items from its otherwise onerous licensing requirements. Now, unlimited-strength encryption is permitted for use by defined "financial institutions" in 45 designated countries. "Financial institutions" include, in addition to banks, brokers and dealers in securities, and insurance companies.

Items exported pursuant to this "financial services exception" may be used only for communications or transactions between the financial institution and its customers, not between customer and customer. Importantly, a financial institution wishing to take advantage of this exception still must submit its request with a description of the software or commodity in question to the government for a one-time "technical" review.

But, as noted above, a company is not "home free" once it clears the U.S. regulatory hurdle. The country of intended destination may impose its own controls which must be confronted and surmounted.

Personal-Data Privacy: A Growing Concern Abroad And At Home

Protection of personal data represents an issue to which many U.S. companies are not sensitized, but which will raise novel and difficult issues for consideration in this new electronic age. In this regard, financial institutions enjoy a bit of a head start for, although the U.S. does not regulate collection and use of personal data in most contexts, many types of financial institutions have been subject to government-imposed constraints for some time.

Nevertheless, the landscape is changing for internationally involved financial institutions. Most significantly, the European Union has declared a new Privacy Directive that, if implemented without change, may prevent U.S. companies from collecting and using the personal data of European nationals and others in Europe as they have done in the past. The Directive imposes a host of requirements, limiting the type of information that can be collected, requiring notice of the use and extent of disclosure of the information, and affording a virtually unlimited right of access and correction to the subject of the personal data.

Ominously, the E.U. Directive requires that member nations prohibit the transfer of personal data to entities located in countries that do not accord equivalent levels of protection. The U.S., with its generally laissez-faire attitude towards this issue, is such a country. Currently, senior U.S. and E.U. negotiators are attempting to reach a solution to this difficulty, but already one country -- Sweden -- has prohibited a U.S. (non-financial-services) company from transferring data about Swedish customers to its U.S. database.

Financial institutions should remain alert to developments in the U.S.-E.U. talks and begin considering their possible exposure under the Directive. In addition, financial companies should be sure to make the case with U.S. negotiators and E.U. privacy officials that they are already subject to a different degree of restriction than other U.S. companies and should be treated separately in any final resolution.

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SECURITIES LITIGATION UNIFORM STANDARDS ACT OF 1998
William C. Rand

On November 3, 1998, President Clinton signed into law the Securities Litigation Uniform Standards Act of 1998. This Act amends the Securities Act of 1933 and the Securities Exchange Act of 1934 to prohibit the prosecution of class action securities fraud suits in state courts and provide federal courts with the right to stay discovery in state court actions that interfere with their jurisdiction. The Act is designed to prevent state securities lawsuits alleging fraud from being used to frustrate the objectives of the Private Litigation Reform Act of 1995 (the "Reform Act").

The Uniform Standards Act amends Section 16 of the Securities Act of 1933 and adds a new Section 28(f) to the Securities Exchange Act of 1934, which each provide in identical language: "No covered class action based upon the statutory or common law of any State or subdivision thereof may be maintained in any State or Federal court by any private party alleging -- (1) an untrue statement or omission of a material fact in connection with the purchase or sale of a covered security; or (2) that the defendant used or employed any manipulative or deceptive device or contrivance in connection with the purchase or sale of a covered security."

This means that certain state law actions for fraud, negligence or breach of fiduciary duty cannot be pled either directly in state court or indirectly as pendant claims in federal court.

The Act defines a covered class action as:

• any lawsuit in which a plaintiff seeks damages on a representational basis on behalf of himself and others similarly situated or in which plaintiff seeks damages on behalf of more than 50 persons, or
• any group of lawsuits pending in the same court involving common questions of law and fact that are joined, consolidated or otherwise proceed as a single action and that together seek damages for more than 50 persons.

The Act specifically indicates that derivative actions brought by shareholders on behalf of a corporation are not included in the definition of "covered class actions." The definition of a "covered class action" may permit defendants to dismiss individual securities fraud actions in state court by consolidating the actions with concurrent securities class actions.

The Act defines a covered security as a security included under Section 18(b)(1) or (2) of the Securities Act of 1933. Section 18(b)(1) defines a covered security as a nationally traded security, and Section 18(b)(2) defines a covered security as a security issued by a registered investment company. Covered securities do not include debt securities that are "exempt from registration under the Securities Act of 1933 pursuant to rules issued by the Commission under Section 4(2) of such Act." The exclusion of privately placed debt securities is designed to prevent the Act from inadvertently limiting contractual remedies for breach of express representations or covenants under note purchase agreements according to the securities that are issued. It should be noted that the exemption on its face does not include securities issued under Rules 504 or 505 of Regulation D, which rely on the statutory exemption in Section 3(b) of the 1933 Act, not Section 4(2).

The Act does carve out certain state actions that are not preempted by the Act. In response to lobbying by the Delaware Bar, the Act makes an exception for actions brought under the state law of the state in which the issuer is incorporated or organized and which involve the following:

• The purchase or sale of securities by the issuer exclusively from or to holders of equity securities of the issuer.
• Any communication related to the sale of securities that is made by the issuer to holders of equity securities of the issuer that "concerns decisions of those equity holders with respect to voting their securities, acting in response to a tender or exchange offer, or exercising dissenters' or appraisal rights."

This provision basically protects state actions related to tender offers, exchange offers and merger transactions but is limited to equity securities. The Act also makes an exception for actions brought by a state or state pension plan bringing an action on behalf of itself or on behalf of a class of other states or state pension plans. Another exception the Act makes is for actions that seek to enforce a contractual agreement between an issuer and an indenture trustee.

The Act expressly allows a federal court to "stay discovery in any private action in a State court as necessary in aid of its jurisdiction, or to protect or effectuate its judgments." This provision was intended to prevent plaintiffs from circumventing the stay of discovery under the Reform Act by using state court discovery in an action filed in state court. The Act also authorizes a defendant to remove a covered class action to federal district court where it will be dismissed.

The language of the Act is silent on the issue of scienter. The Joint Explanatory Statement of the Conference Committee on the Uniform Standards Act did affirm that it was the intent of Congress "that the Reform Act establish a heightened uniform Federal standard on pleading requirements based upon the pleading standard applied by the Second Circuit Court of Appeals." Nevertheless, courts, since the enactment of the Reform Act, have been unclear regarding the scienter pleading standard and have split as to whether the Reform Act permits pleadings that merely allege a "motive and opportunity to commit fraud." [See, e.g., Baffa v. Donaldson, Lufkin & Jenrette Sec. Corp., 999 F. Supp. 725, 728 (S.D.N.Y. 1998) (after the Reform Act, "evidence of a defendant's 'motive and opportunity to commit fraud' is no longer by itself sufficient to support a strong inference of fraudulent intent"); In re Health Management, Inc. Sec. lit., 970 F. Supp. 192, 201 (E.D.N.Y. 1997) (motive and opportunity are still a viable pleading standard); Zuckerman v. Foxmayer Health Corp., 4 F. Supp. 2d 618, 623 (N.D. Tex. 1998) (same).] Neither the Act nor the legislative history appear to modify the scienter pleading requirements of the federal securities laws.

The Uniform Standards Act will force plaintiffs into federal court and will prevent plaintiffs from filing state class actions for the purpose of circumventing the Reform Act's mandatory stay of discovery pending a motion to dismiss. The Act empowers the federal courts to preempt and stay state court class actions and thereby ensures that securities class actions will be governed by the uniform standards of federal law.

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