On November 3, 1998, President Clinton signed the Securities Litigation Uniform Standards Act (the "Standards Act") into law. Passage of the Standards Act reflected Congressional concern that litigants were avoiding the heightened pleading and other requirements set forth in the Private Securities Reform Act of 1995 (the "Reform Act") by commencing securities class actions in the state courts.
Rationale for the Standards Act
In enacting the Standards Act, Congress cited statistical evidence showing an increase in the number of state court securities class action filings in the wake of the passage of the Reform Act. More than three years after passage of the Reform Act, however, most commentators now agree that after an initial rise in state court filings in 1996 -- mostly California filings involving high-technology companies -- state court filings returned to pre-Reform Act levels in 1997 and 1998.
Ultimately, despite questions raised concerning the need for further legislation, Congress concluded that additional legislation was necessary to ensure compliance with the Reform Act. The Standards Act responds to the purported abuses under the Reform Act by amending the Securities Act of 1933 and the Securities Exchange Act of 1934 to ensure that almost all securities class actions will be permitted only in the federal courts and will be governed under federal law.
Scope of the Standards Act
The Standards Act bars class actions in either federal or state court based on state law if the lawsuit alleges:
(A) an untrue statement or omission of a material fact in connection with the purchase or sale of a covered security; or
(B) the defendant used or employed any deceptive device or contrivance in connection with the purchase or sale of the covered security.
Significantly, under the Standards Act, plaintiffs in "covered actions" in federal court will no longer be able to bring pendent state law claims such as fraud or breach of fiduciary duty claims where these state law claims concern misrepresentations or omissions in connection with the purchase or sale of a "covered security". 1
What are "Covered Securities"?
Covered securities are defined to encompass securities that satisfy the standards of sections 18(b)(1) and (b)(2) of the Securities Act of 1933, including nationally-traded securities such as those listed on the NYSE, AMEX, or NASDAQ, or similar exchanges selected by the SEC, as well as securities issued by registered investment companies. Covered securities also include securities senior to publicly traded common stock such as senior debt securities.
Definition of "Class Action"
Throughout the Congressional debate over the Standards Act, differences remained between the House and Senate with respect to the scope of actions covered by the statute. Concerned that the standards should not unfairly limit litigants' rights while at the same time being sufficient to prevent further abuse, Congress ultimately adopted a definition of class action which is broader than the standards set forth in Rule 23 of the Federal Rules of Civil Procedure.
In addition to a single lawsuit brought by a representative plaintiff(s) on behalf of a class, the class action definition used in the Standards Act also includes so-called "mass actions" brought on behalf of more than 50 persons and which are later joined or consolidated. Accordingly, cases not traditionally viewed as class actions may fall under this definition, such as a breach of warranty action by the purchasers under a note purchase agreement, where the number of investors can often exceed 50 persons.
Exclusions Under the Standards Act
The Standards Act's definition of a covered security does not apply to securities that are exempt from registration under the SEC rules pursuant to section 4(2) of the Securities Act of 1933. However, careful attention must be paid to the underlying statutory basis for an issuer's exemption from registration. For example, securities issued under Rules 504 or 505 of Regulation D may not be exempt under the Standards Act because they originally derive their statutory exemption from section 3(b) of the Securities Act of 1933 and not section 4(2).
Another prominent exclusion under the Standards Act is the so-called "Delaware carve out". Congress agreed to exclude certain actions which would otherwise be covered by the Standards Act if they related to corporate governance issues under state law. For example, communications made by an issuer or its affiliate to shareholders concerning voting, tender offers, proxies or appraisal rights would be excluded under the Standards Act.
The Standards Act also excludes certain state court actions, including actions involving political subdivisions, state pension plans, shareholder derivative actions, and actions commenced by indenture trustees to enforce contract agreements between an issuer and an indenture trustee. Earlier versions of the Standards Act did not include the exception for actions by indenture trustees. During the legislative debates on the statute, Congress realized this oversight and the statute was corrected. In contrast, a substantially similar action that is not commenced by an indenture trustee, but by more than 50 parties under a note purchase agreement, will be governed by the restrictions of the Standards Act. It is likely that courts will be faced with other examples of Congress' careless drafting as they interpret other provisions of the statute.
Procedural Changes: Removal and Discovery Stays
The Standards Act also alters the removal rules with respect to securities class actions involving covered securities. Defendants will be permitted to remove state court proceedings to the federal courts even in the absence of diversity jurisdiction.
The Standards Act also provides that federal judges may quash discovery in state actions if the discovery interferes with proceedings in the federal courts. This provision is intended to be applied liberally so that parties may not use state court actions to obtain discovery that would otherwise be stayed in an action governed by the Reform Act.
Finally, the adoption of the Standards Act may bring some clarity to the disputed issue whether the Reform Act modified the scienter requirement for liability under the Securities Exchange Act of 1934. In an effort to clarify the confusion caused by the Reform Act's legislative history, the Joint Committee of Managers for the Standards Act has stated that the Reform Act did not alter the standards for liability under the Securities Exchange Act of 1934. Individual Senators and Representatives have cited the Managers' statement as authority that the pre-Reform Act pleading standards developed by the United States Court of Appeals for the Second Circuit remain viable, namely that evidence of a defendants' motive and opportunity or recklessness can be used to demonstrate scienter under the securities laws. It remains an open question, however, how persuasive courts will find such post-written legislative history. Moreover, given the ingenuity previously shown by plaintiffs counsel in the securities class action area, the jury shall remain out for some time on the ultimate effects of the Standards Act.