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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