Chairman Gramm, Senator Dodd and Members of the Subcommittee:
I appreciate the opportunity to present testimony on behalf of the Securities and Exchange Commission ("Commission") concerning the impact of the Private Securities Litigation Reform Act of 1995 ("Reform Act" or "Act").
Congress enacted the Reform Act just over a year-and-a-half ago. Our experience under the Act is based on activity during an even briefer period of time, because there was a period of about three months after the Act was passed before plaintiffs began filing new actions in earnest. Based on this early and limited data, the Commission staff, under the direction of General Counsel Richard H. Walker, prepared a Report to the President and the Congress on the First Year of Practice Under the Private Securities Litigation Reform Act of 1995 ("Staff Report"), which we submitted this April. We are submitting copies of the Staff Report to the Subcommittee in connection with our testimony and respectfully request that it be included in the record. There have also been a number of private studies analyzing the impact of the Reform Act. The relatively scant statistics to date have received considerable attention as many observers attempt to predict whether the Reform Act will succeed in achieving its stated goal of curbing frivolous securities class action litigation.
Despite limited experience under the Reform Act, there already have been a number of proposals introduced -- at both the state and federal levels -- that would shift the balance that Congress struck when it enacted the Act. Most prominent of these was Proposition 211, a ballot initiative put to California voters last November that would have created broad private rights of action based on claims of fraud, many in conflict with provisions of the Reform Act. The measure was widely opposed by, among others, President Clinton, members of Congress, and myself, and, following an expensive and contentious public debate, it was defeated by a 3 to 1 margin.
Concerns have been raised that measures similar to Proposition 211 may be introduced in other states. In fact, the trend has been to enact reforms that limit, not expand, private rights of action. Three states -- Arizona, Montana, and Ohio -- have adopted the reforms found in the Act, and similar legislation has been introduced in California.
Even before Proposition 211 was defeated, counter-proposals began to surface that would nullify the measure if it were adopted and ensure that similar measures would not be introduced in other states. The counter-proposals to Proposition 211 urged, for the most part, some form of federal preemption of private state securities fraud suits. Two such proposals are now pending in the House of Representatives.
At the President's request, the Commission has been monitoring closely developments under the Reform Act and the Act's impact on the effectiveness of the securities laws and on investor protection. Among other activities, we have closely followed all federal litigation under the Act, intervening as amicus curiae where important issues have been raised; we have monitored litigation in state courts that may affect the Reform Act's effectiveness; we have reviewed and are continuing to evaluate legislative proposals that would enact further reforms; and we have reached out continuously and widely to those who are affected by the Reform Act -- issuers and their advisers, individual and institutional investors, plaintiffs' and defendants' counsel, as well as others. These efforts continue. With just a year-and-a-half's experience under our belts, there is much that we have learned about the Reform Act, but much more that must await developments in the courts -- both state and federal -- and in state legislatures.
We applaud this Subcommittee for conducting this hearing to assess the early
effectiveness of the Reform Act. Two of the key questions raised at today's hearing are
whether the Act is achieving its aims and, if not, whether further reform is required. A little
over two years ago, I testified before this Subcommittee regarding litigation reform legislative
proposals. I stress today, as I did then, the importance the Commission places on private
antifraud actions. The Commission has long maintained that private actions provide valuable
and necessary additional deterrence against securities fraud, thereby supplementing the
Commission's own enforcement activities. Moreover, private suits are the primary method for
compensating defrauded investors. Investors are not well served, however, by frivolous
lawsuits, which raise the cost of capital and in no way deter fraud. The Reform Act was
passed in an effort to discourage such lawsuits. We support that goal.
The Reform Act revised both the substantive standards and procedural rules governing private actions under the federal securities laws. The Act primarily affected class actions, the type of securities suits most prone to abuse due to the potential for expensive and time-consuming discovery, enormous damages and the plaintiffs' lawyers' de facto control over litigation decisions. Among the Act's principal provisions are:
Shortly after the Reform Act became law, President Clinton wrote to me requesting
that the Commission advise him and the Congress about the impact of the Act on the
effectiveness of the securities laws and on investor protection, and on the extent and nature of
any litigation under the Act. On April 15th of this year, I submitted the Staff Report to the
President and Congress. The Staff Report's key findings shape my testimony today.
In preparing the Staff Report, the Commission's Office of the General Counsel reviewed the complaints from federal securities class action lawsuits filed in 1996, analyzed the court decisions under the Act, and discussed the effects of the Reform Act with a variety of interested parties. In addition, the staff reviewed a sample of complaints filed in securities class actions brought in state courts during 1996.
The Report made the following observations:
The Staff Report identified 105 companies sued in federal securities class actions during the first year following passage of the Reform Act. By contrast, Securities Class Action Alert, a newsletter which tracks these actions, has reported that approximately 153 companies were sued during 1993, 221 during 1994, and 158 during 1995. Accordingly, there was a 34% drop-off from the number of companies sued in federal court in 1995, a 52% drop-off from the number of suits in 1994, and a 31% drop-off from the number of suits in 1993. So far in 1997, the numbers appear to have rebounded to their pre-Reform Act levels. The staff has identified 88 federal securities class actions filed so far this year. If this pace were to continue, this would project to 157 federal securities fraud class actions for 1997.
As the Staff Report noted, however, meaningful conclusions cannot be drawn about the effectiveness of the Reform Act purely from the raw number of filings. Numbers alone do not reveal whether the cases are meritorious or meritless. For various reasons, primarily the novelty of the Act, 1996 may have been an aberrational year for class action filings. Better indicators of the effectiveness of the Act in weeding out frivolous actions -- and affording room for meritorious ones -- would be the nature of the allegations found in the complaints, decisions on motions to dismiss, and terms of settlements reached. To date, however, few motions to dismiss have been decided, and only a handful of settlements have been reached.
The Staff Report analyzed each complaint filed under the Reform Act in 1996 to determine the types of claims being asserted. The staff's review revealed that only 12% were based solely on forecasts that did not prove accurate. The legislative history of the Reform Act indicates that such suits were a central concern of Congress.
Most complaints contained fraud allegations that either went beyond a mere failed forecast, or that did not include such forecasts at all. Many were premised on allegations of either insider trading (48%) or accounting irregularities (43%). A smaller percentage contained allegations of restatements of previously reported financial results (18%), government investigations (15%), or outright Ponzi schemes (2%).
The staff has identified 28 rulings on motions to dismiss federal actions under the Reform Act to date. The results are as follows: six actions have been dismissed with leave to replead; six have been dismissed without leave to replead; three have been dismissed in part; and 13 have been denied. Thus, more than 50% of the motions to dismiss have been granted at least in part.
These motions have focussed mainly on the Act's strict pleading standards that require that the complaint "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." The courts are divided over the proper interpretation of this language, based primarily on their differing views of the legislative history. Eight courts have adopted the traditional Second Circuit standard for pleading scienter, one of the essential elements of all securities fraud suits. This standard allows plaintiffs to plead facts giving rise to a strong inference that the defendants acted either knowingly or recklessly, or that the defendants had a motive and opportunity to commit the fraud.
At least five other courts, however, have adopted a more stringent standard. Four of these hold that only conscious misrepresentations or omissions, or in one case "deliberate recklessness," satisfy the Reform Act's pleading standard. The fifth case essentially eliminates the motive and opportunity prong as a basis for pleading fraud. While these decisions address the pleading requirements of the Reform Act, they may also affect the substantive liability requirements of the securities laws themselves. The law is well established in each of the ten federal appellate courts that have considered the issue, that proof of recklessness satisfies the scienter requirement and can establish liability under the antifraud provisions of Section 10(b) of the Exchange Act. The Commission has consistently supported a recklessness standard of liability because such a standard is needed to protect investors and the securities markets from fraudulent conduct and to protect the integrity of the disclosure process. We are closely monitoring the decisions under the Reform Act which hold that allegations of recklessness do not satisfy the Act's pleading requirements, and we intervened in the Silicon Graphics case to urge the court to follow well established case law upholding recklessness as a basis for liability.
Based on the limited data available, the Staff Report concluded that it is too early to make a definitive assessment of the Reform Act's effectiveness. Again, the raw number of cases filed cannot tell us whether those cases are meritorious or meritless. While the allegations found in the complaints appear to be substantive on their face, the merits of these cases can only be decided by judges and juries on the basis of the evidence. Finally, the district courts are divided on the proper pleading standard under the Reform Act. Until the appellate courts have an opportunity to resolve this conflict, it is premature to evaluate the effect of this most significant reform provision.
Recently, the Staff Report's conclusion that it is too soon to assess the impact of the Act was reinforced. Two weeks ago, National Economic Research Associates ("NERA") issued a study finding that the 1996 trends in the number of federal and state class action filings were "transient." The study found that the federal numbers during the first five months of 1997 had returned to the level observed in the five years prior to passage of the Reform Act. Our staff has identified 88 new cases filed in federal court during 1997, which would project to 157 filings on an annualized basis. This is in line with the numbers from 1991 through 1995, as reported by NERA. Just as the trend in filings for 1996 proved to be short-lived, there is no guarantee that the 1997 numbers will reflect a lasting trend, and, as previously noted, the number of filings tells us little. In light of the variance that we have seen in the early numbers, and for the other reasons set forth here and in the Staff Report, the Commission believes the Staff Report's conclusion that it is premature to assess the Reform Act's impact still holds true today.
The Staff Report, however, did identify three areas where the Reform Act is not yet achieving its intended goals. First, the lead plaintiff provision has not encouraged institutions to become class representatives. Second, the safe harbor has not induced companies to disclose more forward-looking information. Finally, the discovery stay has been circumvented by the filing of parallel state actions where discovery may be had.
To date, the lead plaintiff provision has fallen short of expectations. This provision creates a presumption that the plaintiff or group of plaintiffs with the largest financial stake in the lawsuit during the class period should be appointed as class representative, with the authority to choose class counsel. Congress adopted this provision in an effort to put shareholders, rather than plaintiffs' attorneys, in charge of class actions. This provision has not yet produced the results that Congress intended. The Staff Report found that in only 8 of the 105 class actions filed during the Act's first year did institutions seek to be named lead plaintiff.
Why is this provision not working? In preparing the Staff Report, the staff met with representatives of both public and private institutional investors, and we continue to solicit their views. Their primary concern is litigation-related expense. Making key personnel available for lengthy testimony and opening the institution's books and records to both plaintiffs' and defendants' lawyers exact a heavy toll. In addition, private institutions are reluctant to reveal their proprietary investment strategies in the course of litigation. Public institutions, on the other hand, generally do not share this concern because most states have laws requiring the disclosure of this information. Institutions also expressed concern that service as class representative could expose them to liability to other class members. For example, other class members could sue the class representative if the terms of the settlement were claimed to be inadequate. We also have been told that institutions often get a better return by proceeding with their own individual suits. Further, institutions have reported that, if they continue to hold shares, the costs to the company of defending the suit may outweigh any damages that the institution is likely to receive. The staff will continue to monitor institutional involvement in securities class actions.
Our Staff Report also found that companies are not taking advantage of the safe harbor to make more forward-looking disclosure. The staff spoke with a variety of issuers who stated that their primary concern is the lack of judicial guidance as to the sufficiency of the required "meaningful cautionary" language. They are also waiting to see how other companies are making use of the safe harbor. Concern about potential liability under state law, where the statements may not be protected by the federal safe harbor, was another frequently cited reason for not including more forward-looking disclosure. Definitive appellate rulings on the Reform Act's safe harbor provision will provide more guidance to issuers and will enable us to better evaluate the safe harbor.
The Staff Report also notes that the discovery stay may be avoided by the filing of a
parallel state action. Fifty-five percent of the state court cases (35 out of 55) have allegations
that are essentially identical to those brought by the same law firm in federal court. It is
reasonable to assume that these cases were filed primarily to get discovery for use in the
As part of our ongoing efforts to monitor the progress of the Act and its impact on investor protection, the Commission's staff has been studying securities class actions brought in state courts. Concerns have been raised that the Act has led to a migration of cases to state courts where federal reforms likely do not apply. Unlike federal class actions, notice does not have to be given to shareholders when actions are filed in state court. As a result, tracking state court cases is more difficult and the numbers are less reliable than those available for federal filings. Nonetheless, Stanford University's Securities Class Action Clearinghouse has identified approximately 90 securities class actions that have been brought in state courts since passage of the Reform Act, approximately 50 of which have been brought in California.
The staff has obtained and reviewed a total of 55 state securities class action complaints. While this sample may not be representative, the staff's review of those complaints discloses the following:
The NERA study released two weeks ago concludes that the number of state securities fraud class actions filed thus far in 1997 is significantly lower than in 1996. In fact, NERA finds that the number of 1997 state cases, like the number of federal suits, is roughly equivalent to the average number filed in the five years prior to the Reform Act.
Raw numbers aside, we have uncovered other interesting data about state lawsuits. The Staff Report analyzed a small sample of 1996 state court complaints. In the chart below, we compare the allegations in federal complaints with the allegations found in all of the state complaints in our sample, and with the state complaints that have no parallel federal action:
The small sample size (26) does not allow for a definitive assessment of the state complaints. The staff analyzed these complaints merely to categorize the nature of the allegations, and could not attempt to judge the merits of the lawsuits. But the chart is nevertheless instructive. While the allegations in the state court complaints overall are substantially the same as allegations in federal complaints, the stand-alone state complaints contain a somewhat different mix of allegations. For example, the percentage of state failed forecast cases is double the federal percentage, and the percentage of state insider trading cases is approximately half that of the federal complaints. The parallel state court complaints, not surprisingly, contain allegations nearly identical to their federal court counterparts. The stand-alone complaints in the sixteen cases reviewed by the staff, which are not subject to the federal pleading standards, are less likely to contain allegations of fraud other than a failed forecast.
What caused the increase in state court filings in 1996? Some believe that the main reason is the availability of discovery. As noted, many of the state cases were filed parallel to a federal case, presumably for the purpose of seeking discovery that would not otherwise be available in the federal action due to the discovery stay.
Some suggest that the increase in 1996 state court filings may have resulted from efforts to avoid the federal safe harbor for forward-looking statements. Fifty-three percent (29 out of 55) of the state cases the staff charted include claims based on forward-looking statements, as well as other claims; while 11% (6 out of 55) of the cases are primarily based on forward-looking statements.
Another factor which makes state court lawsuits increasingly attractive is the Supreme Court's decision in Matsushita Electric Industry Co. v. Epstein. This decision, handed down a few months after passage of the Reform Act, held that a state court judgment dismissing a state class action pursuant to a settlement agreement could include a provision barring federal securities fraud actions arising out of the same transaction. By allowing defendants to obtain a global settlement in state court, Matsushita made state court class actions more advantageous for plaintiffs. Accordingly, it is possible that there would have been an increase in state court class actions even if the Reform Act had not been enacted.
California has been the most popular forum for these state court filings. At least two factors contribute to California's popularity. The first is the absence of a requirement -- which most states have -- that an individual plaintiff prove that he relied on a misstatement or an omission. Proving individual reliance makes a class action unwieldy because individual questions of fact would predominate over the questions common to the class. In Mirkin v. Wasserman, the California Supreme Court stated that plaintiffs need not plead or prove actual reliance in an action under the state's securities law. California's elimination of the reliance requirement makes possible a state class action for securities fraud.
The other factor is the availability of jurisdiction over high-technology firms, who are
frequently named as defendants in securities suits. Silicon Valley contains the largest
concentration of high-technology firms in the United States. Those firms tend to have a
volatile share price. In addition, those firms often compensate their officers and directors in
company stock and stock options, which means that these individuals will be more likely to
sell shares during a period of volatility. Insider sales and volatility are frequently relied upon
by plaintiffs when pleading fraud. Thus, California state courts provide an attractive
alternative to federal courts for securities class actions.
It remains to be seen whether California state court actions will remain a viable long-term alternative to filing in federal court. The California legislature may take steps which will affect the future of state court class actions. California State Senator John Vasconcellos recently introduced a bill that would incorporate the provisions of the Reform Act into California state law. If enacted, this bill would substantially diminish California's attractiveness as an alternative forum. Already three other states -- Arizona, Montana, and Ohio -- have enacted their own versions of the Reform Act, and other states may well follow suit.
Judicial developments also may affect the ability of plaintiffs to bring state class actions. Most significantly, the California Supreme Court has a case pending before it, Pass v. Diamond Multimedia, which calls upon the court to decide the currently unsettled question of whether the state's securities laws apply to transactions taking place outside of California. If the court rules in favor of the defendant issuer, then nationwide class actions will be unavailable in California. Plaintiffs' lawyers would be unlikely to look to state court if they could not bring a nationwide class action.
In addition to the statutory question to be decided in Diamond Multimedia, there are constitutional limits that can prevent a state court from certifying a nationwide class. The United States Supreme Court has held that the claims asserted by each member of the plaintiff class must have a significant contact with the forum state in order for that state to apply its law. The California Supreme Court, and other state courts, will eventually have to decide whether this test is satisfied in a securities class action.
Finally, state courts voluntarily may import the provisions of the federal Reform Act.
For example, some state courts, guided by the Reform Act, have imposed a stay of discovery
while a motion to dismiss is pending. State courts also may look to and incorporate other
provisions of the Reform Act, such as the safe harbor.
Various proposals have been put forward that would broadly preempt private state antifraud actions. While we are extremely sensitive to the concerns raised by the high-technology community and others that frivolous litigation continues to burden capital formation, we counsel caution in responding to these concerns in order to avoid impairing the rights of investors with meritorious claims. To this end, any proposals that restrict investors' rights to recover for injuries they have suffered should be narrowly tailored to address documented abuses.
The Commission believes that the states should be afforded an opportunity, in the first instance, to address and resolve issues arising under their own securities laws that may affect the Reform Act's effectiveness. If these issues are not resolved appropriately and if frivolous lawsuits migrate to state court and undermine the Reform Act's provisions, additional federal legislation may well be in order. On the present record, however, we believe that broad preemption is not needed to facilitate the goals of the Reform Act.
Broad preemption could have the unintended effect of preempting certain types of cases
arising from transactions in which both the states and the federal government have a strong
interest. For example, the proposals we have seen could preempt state actions based on
material misstatements in proxy and tender offer materials in connection with an extraordinary
transaction which may give rise to claims under both state corporate law and federal securities
law. Shareholders who bring suit challenging such transactions in these cases typically allege
a breach by target-company directors of their fiduciary duties under state corporate law,
including the duty of disclosure. Such actions now may be brought in either or both state and
federal court. If state-law actions were preempted, plaintiffs would be forced to either bring
two suits or bring all their claims in federal court where most judges do not have the
familiarity and expertise in corporate law issues that state courts, such as those in Delaware,
The Reform Act became law only a year-and-a-half ago. There has not been enough
time to gain sufficient practical experience with the Reform Act's key provisions or to develop
an authoritative body of court decisions interpreting the Act. It will take additional time for
the effects of the Reform Act to become clear -- most importantly, whether it deters frivolous
actions while allowing meritorious ones to proceed -- and to judge whether the plaintiffs' bar
is abusing the remedies available in state court. Those state court remedies traditionally have
been an important component of investor protection. Preemption of those remedies based on
limited data or before the states have had a chance to respond to the changes in litigation
practice brought about by the Reform Act would be premature. As always, the Commission
and its staff will be pleased to assist the Subcommittee as it goes forward.
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