ABA Section of Business Law

ABA Section of Business Law
Business Law Today
May/June 1998

Stong is a member of Willkie Farr & Gallagher in New York City. Patrick J. Carty, an associate at the firm, assisted in the preparation of this article.

Reform was the byword. On Dec. 22, 1995, Congress enacted the Private Securities Litigation Reform Act of 1995, (Pub. L. No. 104-67, 109 Stat. 737 (1995)), over a presidential veto. The idea was to address potential abuses in securities litigation, including, of course, class actions. Now that we have had two years of experience under the Reform Act, how has the landscape changed?
Before the Reform Act, a company that announced unexpected bad news could face dozens of class action lawsuits, often filed within days of the announcement by class plaintiffs with only a modest investment in the company's stock. A company could quickly be plunged into costly and protracted discovery, even before the legal merits of the complaint were tested by a motion to dismiss.
These problems were targeted by Congress, and progress has been made. But new issues have arisen, including the filing of duplicative actions in state and federal court, and Congress is considering whether further reform is necessary.
So what has changed in the last two years of court decisions?

Under the Reform Act, the court must choose a lead plaintiff who will direct the case a few months after it begins. With the court's approval, this "most adequate plaintiff" selects lead counsel for the class. Before the Reform Act, Congress was concerned that in some cases, lawyers and "professional plaintiffs" simply raced to the courthouse with a claim, expecting to take charge of the litigation on a "first come, first served" basis.

But the race is over. The Reform Act establishes a rebuttable presumption that the plaintiff with the largest financial stake in the litigation should be in charge. Congress' goal was to promote the participation of large institutional investors as lead plaintiffs in federal securities class actions.

So far, institutional investors have been reluctant to step forward and assume this role. But when they do, courts have followed the Reform Act's mandate to put them in the driver's seat. For example, in Gluck v. CellStar Corp., 976 F. Supp. 542 (N.D. Tex. 1997), the court appointed a large institutional investor, the State of Wisconsin Investment Board, as lead plaintiff in place of the plaintiff who brought the suit. The court rejected arguments that co-lead plaintiffs should be appointed. The court also rejected arguments that the board's choice for lead counsel, a Philadelphia law firm, should be rejected because it had a defense-oriented practice. The plaintiffs who opposed the board's choice of lead counsel proposed instead that Milberg Weiss Bershad Hynes & Lerach, the nation's most active plaintiff's securities law firm, be appointed in place of the Philadelphia law firm.

Where institutional investors do not step forward, some courts have allowed several smaller investors to combine their forces and serve as a collective lead plaintiff, while other courts have rejected such efforts.

For example, in In re Cephalon Sec. Litig., No. Civ. A. 96-CV-0633, 1996 WL 515203 (E.D. Pa. Aug. 27, 1996), the district court granted the motion of three plaintiffs to serve as lead plaintiffs on grounds that, together, they possessed the largest financial stake in the litigation.

And in D'Hondt v. Digi International Inc., Nos. Civ. 97-5, CV. 97-295, Civ. 97-156, Civ. 97- 538, Civ. 97-351, Civ. 97-440, JRT RLE, 1997 WL 405668 (D. Minn. Apr. 3, 1997), plaintiffs' counsel proposed a group of 21 unrelated individuals as a collective lead plaintiff. No institutional investor stepped forward. Defendants objected that this was just business as usual, because such a large group could not exercise control over the action, as desired by Congress. But the court disagreed, observing that it was possible that a larger group of lead plaintiffs could "more effectively withstand any supposed effort by the class counsel to seize control." Id. at *3. But in In re Donnkenny Inc. Sec. Litig., 171 F.R.D. 156 (S.D.N.Y. 1997), the court rejected a proposed lead plaintiff group of two unrelated institutional investors and four individual class members. The court found that allowing "an aggregation of unrelated plaintiffs to serve as lead plaintiffs defeats the purpose of choosing a lead plaintiff ... [because it] would allow and encourage lawyers to direct the litigation." Id. at 157-58. But the court did endorse the selection of two prominent plaintiffs' firms as co-lead counsel, provided that there was no duplication of services.

Before the Reform Act, courts set different standards for pleading a securities fraud claim. At one end of the spectrum, the Ninth Circuit permitted the scienter element to be pleaded generally. See, for example, In re Glenfed, Inc. Sec. Litig., 42 F.3d 1541, 1545 (9th Cir. 1994). At the other end of the spectrum, the Second Circuit required a plaintiff to allege particularized facts sufficient to raise a "strong inference" of fraudulent intent. The standard could be met by pleading facts that constitute strong circumstantial evidence of conscious behavior or recklessness, or a motive and opportunity on the part of the defendant to commit fraud. See, for example, In re Time Warner Inc. Sec. Litig., 9 F.3d 259, 268 (2d Cir. 1993).

The Reform Act raised the bar for pleading scienter in federal securities actions. It provides that where state of mind is an element of the claim, the complaint shall "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." Pub. L. No. 104-67, § 101(b), 109 Stat. 737, 747. District courts in the Second and Ninth circuits have been among the first to interpret the Reform Act's heightened pleading standard. Courts are in accord that the Second Circuit standard factored prominently in Congress' drafting efforts. But courts have taken different approaches in applying the Reform Act's pleading standard, especially when reviewing the adequacy of allegations based on motive and opportunity, as well as recklessness.

For example, in Marksman Partners, L.P. v. Chantal Pharmaceutical Corp., 927 F. Supp. 1297 (C.D. Cal. 1996), the first reported decision on the Reform Act's pleading standard, the court found that the Reform Act's standard mirrored the Second Circuit's "motive and opportunity" and "circumstantial evidence" tests, and that allegations of recklessness were sufficient. But the court cautioned that allegations of "generic motive," such as a defendant's desire to increase his capital, would be insufficient. Id. at 1310. Instead, the complaint must allege circumstances giving rise to a strong inference that the defendant knew his statements were false. In another case that has been much watched, In re Silicon Graphics Inc. Sec. Litig., the court has issued two decisions addressing the Reform Act's pleading standard, and the case is now in the Ninth Circuit awaiting appellate review.

In the first Silicon Graphics decision, In re Silicon Graphics Inc. Sec. Litig., No. 96-0393, 1996 WL 664639, at *7 (N.D. Cal. Sept. 25, 1996), the court found that Congress adopted neither the Second Circuit's test nor a recklessness standard, but instead codified a more stringent standard requiring plaintiffs to allege facts that support a strong inference of knowing misrepresentation on the part of defendants. The court found that the complaint failed to meet the new test, and dismissed it with leave to replead. In the second round, the Silicon Graphics court dismissed the amended complaint, and did not grant leave to replead. In re Silicon Graphics Inc. Sec. Litig., 970 F. Supp. 746, 768 (N.D. Cal. 1997). The court held that recklessness could be a basis for liability under Section 10(b) only if it rose to the level of "deliberate recklessness" that was tantamount to "intentional misconduct." The court also found that "[m]otive, opportunity and nondeliberate recklessness may provide some evidence of intentional wrongdoing, but are not alone sufficient to support scienter unless the totality of the evidence creates a strong inference of fraud." Id. at 757.

In In re Baesa Sec. Litig., 969 F. Supp. 238 (S.D.N.Y. 1997), the court found that allegations of motive and opportunity would no longer "automatically" suffice to establish scienter. The court held that "under the Reform Act's formulation, the pleadings must set forth sufficient particulars, of whatever kind, to raise a strong inference of the required scienter." The court noted that, in some cases, facts concerning "motive and opportunity" could give rise to a strong inference of fraudulent intent. Id. at 242. The court also concluded that the Reform Act's pleading standard did not change the elements of a securities fraud claim, so that recklessness, if adequately pleaded, could be sufficient. But the court also noted that recklessness was "a conscious state of mind that is inherently deceptive, that is, a conscious and purposeful disregard of the truth about a known risk," as opposed to a form of negligence. Id. at 241.

Other courts have continued to give weight to the motive and opportunity test. For example, in In re Health Management Inc. Sec. Litig., 970 F. Supp. 192 (E.D.N.Y. 1997), the court found that "motive and opportunity, as this concept has been developed by the Second Circuit and the district courts thereunder, is sufficient to plead a strong inference of scienter under the [Reform Act]." Id. at 201.

The debate over whether the Second Circuit's motive and opportunity test is sufficient to pass the Reform Act's heightened pleading test is more than academic. It may be easier to make allegations of this sort against certain kinds of defendants, such as officers and directors of a firm, or its outside advisers and auditors. Recent surveys show that securities fraud claims based on allegations of accounting irregularities and insider selling rose sharply after the Reform Act. Potential defendants should watch closely to see just how high the bar is raised as Silicon Graphics and other cases work their way through the appellate courts.

The Reform Act provides that discovery is stayed while a motion to dismiss is pending. Congress intended the stay to reduce the litigation burden on companies named in meritless suits. But companies that wanted to stop discovery in its tracks while they tested the merits of a securities fraud complaint by a motion to dismiss have learned that the stay can also stop them from getting the discovery they need in cases that are not at all what Congress had in mind. In Medical Imaging Centers of America Inc. v. Lichtenstein, Civ. No. 96-0039-B, 1996 WL 156926 (S.D. Cal. Jan. 19, 1996), aff'd, 917 F. Supp. 717 (S.D. Cal. 1996), the first case decided under the Reform Act, plaintiff Medical Imaging was the subject of an unwanted proxy solicitation, and brought an action against the insurgents. Defendants promptly moved to dismiss, and argued that the Reform Act's discovery stay was triggered by their motion. Medical Imaging pointed to legislative history showing that the stay provisions were included by Congress to curtail "fishing expedition"discovery, id., at *2, in "frivolous security class actions," not discovery in corporate control litigation, but the court rejected these arguments. The motion to dismiss was heard on an expedited schedule and discovery eventually proceeded, but not before the company lost more than five precious weeks in the proxy battle.

When the Reform Act was adopted, many predicted that plaintiffs would try to avoid its key provisions, including the lead plaintiff, pleading standard, discovery stay as well as other provisions, by bringing their cases in state court. What has happened over the last two years? According to a study performed by National Economic Research Associates, in 1996, the first year of the Reform Act, federal filings of securities actions totaled 123, well below the annual average of 179 filings from 1991 to 1995. At the same time, state court filings of securities actions doubled, rising to 110 from an annual average of 52 from 1991 to 1995. But in 1997, these trends seem to have reversed. Through May 1997, NERA found that both state and federal class action filings had returned to pre-Reform Act levels.

Another consequence of the Reform Act is that plaintiffs are proceeding simultaneously in state and federal court. This way, they can avoid the lead plaintiff, pleading standard, and discovery stay provisions in the state case, and still maintain a federal action. A Stanford Law School study shows that 55 percent of state class actions had parallel federal class actions brought by the same law firm.

Data relied on by the SEC show that some 60 percent of the state filings are in California, and many of these seek relief on behalf of a national plaintiff class. In Pass v. Diamond Multimedia Systems Inc., CV 758927 (Cal. Super. Ct. Santa Clara County), defendants have challenged the application of California's state securities laws to a national class. The issue is now before the California Supreme Court.

At least one California trial court has not waited for the California Supreme Court to speak. In Howard Gunty v. Quantum Corp., parallel state and federal class actions were brought by the same plaintiffs' law firm. The court barred the firm from using in the federal case discovery material obtained in the state case, and directed the firm to erect an ethical wall between the legal teams on the state and federal cases.

After two years, it is clear that Congress did not achieve all of its objectives in the Reform Act. The increase in state court filings, and the growing number of parallel state and federal actions, have spurred the introduction of several legislative proposals to advance another round of securities litigation reform. The Securities Litigation Uniform Standards Act of 1997, introduced by Rep. Richard A. White (R-Wash.) as H.R. 1689, on May 21, 1997, has bipartisan support, with 55 Democrats and 79 Republicans among its 134 co-sponsors. A virtually identical bill was introduced in the Senate by Sen. Philip Gramm (R-Texas) as S. 1260 on Oct. 7, 1997. It too has bipartisan support, with eight Democratic and 10 Republican co-sponsors.

These bills would lodge exclusive jurisdiction over securities fraud class actions in the federal courts, and provide that "[n]o class action based on the statutory or common law of any state or subdivision thereof may be maintained in any state or federal court by any private party" to the extent that it alleges that the defendant made "an untrue statement or omission of a material fact" regarding the sale of a security or "[t]hat the defendant used or employed any manipulative or deceptive device or contrivance in connection with the purchase or sale of a covered security." If a class action is filed in state court, the bills provide that it "shall be removable" to federal court in the district where it is pending. H.R. 1689, S. 1260, 105th Cong. § 2 (1997).

A third bill, the Securities Litigation Improvement Act of 1997, also was introduced in May 1997, as H.R. 1653 by Rep. Thomas J. Campbell (R-Calif.), and has six sponsors, including one Democrat and five Republicans. This bill is not limited to class actions, and would preclude the filing of any private state court action based on fraud in connection with the purchase or sale of a security.

In testimony before the Securities Subcommittee of the Senate's Banking, Housing and Urban Affairs Committee on Oct. 29, 1997, SEC Chairman Arthur Levitt outlined the key issues that Congress faces. Levitt did not formally support or oppose the legislation, and stated that any attempt at fine-tuning the Reform Act would be premature because of its recent passage and the dearth of judicial interpretation. He urged Congress to preserve the balance between state and federal forums to redress securities fraud, and observed that the existing federal securities laws presuppose "an active, vital system of state securities regulation and state court enforcement," and a "dual system of regulation" that has worked well for more than 60 years.

The chairman observed that if plaintiffs could not proceed in state court, then certain claims that are no longer available in federal court, like aiding and abetting claims against accountants, and claims that are time-barred under the federal statute of limitations but might not be barred under the longer statutes of limitations prevailing in two-thirds of the states, would be jeopardized. Also, he cautioned that preempting state class actions could have the "unintended effect" of preempting claims where both state and federal governments have a "strong interest," including shareholder suits challenging a board's discharge of its fiduciary duties in corporate control situations. And even if the bill were passed, he noted that plaintiffs could still avoid the discovery stay by bringing an individual claim in state court.

Experience over the past two years shows that progress has been made toward many of Congress' securities litigation reform objectives. The race to the federal courthouse is over, and institutional investors that want to take an active role in securities fraud litigation have the procedural tools to do so. The bar has been raised for allegations of intentional wrongdoing, although precisely where it now lies remains uncertain. Congress got the stay of discovery it wanted, but companies may have gotten more than they bargained for. And numerous important provisions of the Reform Act, such as its modification of the traditional rules of joint and several liability, have not yet been the subject of court tests.

State courts have emerged as the latest battleground for securities fraud class actions, often in situations where identical litigation is pending in federal courts. This has attracted the attention of plaintiffs' lawyers, defense lawyers and Congress, and more reform legislation may be the result.