The Reform Act in Review: Twenty Months and Counting

In December, 1995, Congress passed the Private Securities Litigation Reform Act of 1995 ("the Reform Act"). The Reform Act changed the federal securities laws in several significant ways in an attempt to discourage frivolous securities class action lawsuits. Twenty months after its passage, the Reform Act has affected the securities litigation landscape in some expected and some unexpected ways:

• Filing trends have changed and include a sharp increase in the number of state court cases filed, but the final pattern of filings is not yet clear.
• The lead plaintiff provisions of the Reform Act have not caused institutions to take control of these cases as Congress hoped.
• Accounting fraud and insider trading remain key allegations by plaintiffs as a tactical move to survive the heightened pleading standards.
• The size of the one-day stock price decline that triggers these cases has increased.
• Securities class action cases are becoming more expensive to defend and more difficult to settle.

A principle objective of passing the Reform Act was to reduce the number of frivolous securities lawsuits. According to a recent report by the Securities and Exchange Commission ("SEC"), 105 companies were sued in federal securities class actions in 1996, down from an average of 170 over the previous five years. However, calendar 1996 may not be reflective of the current trend. During the first seven and a half months of 1997, over 100 federal securities lawsuits were filed. If this pace continues, 1997 will see a return to the level of securities actions filed in the five years before the Reform Act. It is therefore still too early to tell the overall impact of the Reform Act on the number of filings.

Prior to enactment of the Reform Act, the number of securities cases filed in state court was negligible. During the first twelve months after passage of the Reform Act, 39 companies were sued in state court. Many of these cases were filed to avoid the requirements of the Reform Act. The continued viability of these cases will depend on a number of rulings expected during 1997, particularly from the California Supreme Court in late 1997.

An analysis of the increase in state court filings suggests two separate and distinct trends. First, some plaintiffs are resorting to state court in an attempt to escape the reach of the Reform Act and avoid the higher pleading standards continued in the Reform Act. There appears to be some disparity between the quality of the complaints filed in federal court and those filed in state court. The state court complaints are often less detailed and shorter than the average federal complaint. State court cases also seem to lack the compelling facts necessary to survive a motion to dismiss in federal court. The stronger cases, from the plaintiffs perspective, continue to be filed in federal court where there is a higher potential for large recoveries from nationwide classes. Second, and independently, many plaintiffs are filing parallel state court and federal court claims to circumvent the stay of discovery provision under the Reform Act. Whereas parallel state-federal actions prior to the Reform Act were rare, in post-Reform at least 30 companies, or about 28 percent of the federal cases, had parallel state claims. While some state court judges have begun to grant discovery stays based upon the Reform Act, plaintiffs may still gain discovery through certain state court procedures and effectively launch the fishing expeditions that Congress sought to eliminate.

The Reform Act establishes a presumption that the investor with the largest financial interest at stake will be the lead plaintiff and take control of the litigation. Congress specifically intended this provision to reduce the number of "professional plaintiffs" and to encourage institutional investors, such as mutual funds and pension funds, to become more active as plaintiffs in securities fraud litigation. Despite Congressional intent, however, post-Reform cases suggest that institutional investors' involvement in securities fraud litigation will be the exception rather than the rule. Of the 105 federal securities cases filed in 1996, only eight cases even arguably involve institutional investors which have moved to become lead plaintiff. Of these eight cases, seven involve pension funds or entities which had a prior relationship with a traditional plaintiffs' law firm. Only one was a true "institutional" investor taking control of securities litigation as Congress envisioned. The Reform Act provisions on lead plaintiffs have had the unintended effect of bolstering the position of traditional plaintiffs' law firms. Today, in response to the Reform Act, these firms gather as many small investors as possible and join them as lead plaintiffs in order to assert that together they have the largest financial interest under the Reform Act's lead plaintiff provision and thereby reinforce their dominant position. So far, this strategy seems to be working.

In order to satisfy the Reform Act's heightened pleading requirements, post-Reform plaintiffs are including specific allegations of accounting fraud and insider trading more often than ever before in their complaints. Roughly 67 percent of the 105 federal class action complaints filed in 1996 contained allegations of accounting irregularities, compared to 34 percent pre-Reform cases. The increase in such allegations does not suggest that accounting irregularities occur more often, but that plaintiffs now feel that they must allege accounting fraud in order to survive a defendant's motion to dismiss. The types of accounting fraud alleged include improper revenue recognition, improper software capitalization, and reserve manipulation.

Similarly, insider selling allegations are on the rise. Of the 105 federal class action complaints filed in 1996, 48 percent of them alleged insider sales. If one considers only post-Reform Section 10(b) claims, the percentage of complaints alleging insider sales jumps to 57 percent. This is up significantly from the pre-Reform era, where only 21 percent of the cases included insider selling allegations. For cases with high-technology companies as defendants, the percentage of complaints containing insider trading allegations has increased particularly dramatically. Of the 26 complaints filed in 1996 involving high-technology companies, 73 percent contain allegations of insider sales. This high percentage can be explained by the fact that a significant portion of officers' and directors' compensation in the technology industry is dependent upon stock options. Quite simply, because these officers and directors sell more stock as part of their regular income, plaintiffs have more sales to point to as "evidence" of securities fraud. Of course, simply because there are more insider sales in the high-technology industry, it does not necessarily indicate that there is a greater amount of fraud.

It appears plaintiffs favor targeting smaller companies due to increased stock volatility and a perception that larger companies are more likely to use their resources to fight rather than settle litigation.

Historically, plaintiffs have waited for a sharp decline in a company's stock price before filing suit in order to show the dramatic effects of the alleged fraud. The size of the one-day stock price decline necessary to get the attention of plaintiffs' counsel has increased since the Reform Act. The average one-day stock decline at the end of the class period in pre-Reform Section 10(b) cases was 19 percent, compared to 31 percent in the post-Reform environment. This increase in the post-Reform stock price decline probably signals greater selectivity on the part of plaintiffs' counsel and probably demonstrates that a higher threshold of price decline is now in place.

While there are no studies to support any concrete conclusions regarding the Reform Act's effect on settlements at this time, some initial observations are possible. First, it appears to be more difficult to settle a case in federal court in the post-Reform era than it was prior to the Reform Act. Because the plaintiffs' law firms are filing fewer cases in federal courts, and because plaintiffs are, on average, investing more resources to draft stronger complaints, plaintiffs' law firms need to bring in more money per case just to cover costs. As a result, plaintiffs are pushing these better-prepared cases farther in the hopes of securing a larger settlement.

There is also greater resolve on the part of defendants to fight securities class actions. Knowing that Congress has weighed in on their side, companies now have less fear of being sued. When they are sued, they appear to be bolstered by the additional tools Congress has provided to fight these cases. As a result, companies seem to be more inclined to litigate instead of settle.

Finally, it appears that settlement in state court cases depends on a variety of factors not present in federal cases. Because nearly every major issue or decision in state court securities cases is potentially precedent setting, plaintiffs are careful to make sure their case is as strong as it can be before an issue is decided. Otherwise, plaintiffs run the risk of receiving an adverse judgment and, more importantly, setting bad precedent for future cases. Consequently, plaintiffs will settle a state court case if it appears to be headed for an unfavorable ruling. If, on the other hand, a case involves particularly favorable facts for plaintiffs, they will be less likely to settle than usual because they want to set good precedent for future cases in state court.

As expected, plaintiffs and defendants continue to adjust to the changes created by the Reform Act. In order to satisfy the heightened pleading requirements of the Reform Act, plaintiffs are spending more money to conduct research and allege complaints with greater specificity. The focus on accounting irregularities and insider sales has a direct effect on the types of companies sued. Smaller companies are now more often the target of complaints under the Reform Act. While the federal courts appear to be supporting the spirit of the Reform Act, many important precedent- setting cases are still pending or are on appeal. In state court, every procedural issue is being tested and, consequently, it is more difficult to predict specific trends. It appears that the Reform Act has created disincentives for both plaintiffs and defendants to settle.