The Subcommittee has requested the Commission's views concerning S. 1260, the "Securities Litigation Uniform Standards Act of 1997," which would adopt a uniform federal standard for the prosecution of certain securities fraud class actions by limiting or eliminating parallel state causes of action. Although the bill could be seen as an effort to extend national standards to fraud involving nationally traded securities, it also appears to reflect concern about an increase in securities fraud class actions in state courts following the passage of the Private Securities Litigation Reform Act of 1995.
The issue of a uniform federal standard for securities litigation is a delicate one. The federal securities laws presuppose an active, vital system of state securities regulation and state court enforcement. The Commission believes that there are important types of antifraud claims that should continue to be governed by state law. The Commission is pleased to note that S. 1260 would preserve such important state court actions as those involving individual claims against brokers, claims involving localized fraud, claims involving fraud in penny stocks and "micro cap" securities, and actions by state regulators.
The Commission is concerned, however, that the bill would deprive investors of important protections, such as aiding-and-abetting liability and longer statutes of limitations, that are only available under state law. Preemption of state claims involving liability for reckless conduct may also be inappropriate while the status of such claims under federal law is still being considered by the courts. The bill could also have the unintended effect of preempting traditional state corporate governance claims, such as class actions involving proxy and tender offer materials, that need to be decided quickly so that mergers can go forward.
The bill would not solve several problems of the Litigation Reform Act that have led to calls for preemption. The bill would not prevent plaintiffs' lawyers from avoiding the stay of discovery in federal cases, because it would still allow them to bring parallel suits on behalf of an individual in state court, where the discovery stay does not apply. If enacted, the bill could also discourage institutional investors from seeking to be named as lead plaintiffs in securities fraud class actions because it would prevent them from bringing related state claims unless they opted out of the plaintiff class.
As Congress considers solutions to the problems of securities fraud litigation, the
Commission believes that great care should be taken to safeguard the benefits of our dual system
of federal and state law, which has served investors well for over 60 years.
Chairman Gramm, Senator Dodd, and other Members of the Subcommittee:
We appreciate the opportunity to testify on behalf of the Securities and Exchange Commission ("Commission") concerning S. 1260, the "Securities Litigation Uniform Standards Act of 1997." We commend the Subcommittee for its continuing efforts to focus on the question of whether frivolous securities litigation threatens to inhibit capital formation and harm investors. The issue is one of importance. It is also one that we must approach with a surgeon's skill to assure that any proposed solutions, whether legislative, judicial, or regulatory, do not foreclose investors with legitimate grievances from obtaining prompt and full redress.
The Subcommittee has requested the Commission's views concerning S. 1260. The bill would adopt a uniform standard for the prosecution of certain securities fraud class actions by limiting or eliminating certain causes of action for fraud under state law. S. 1260 appears to reflect concerns that frivolous class action securities litigation has migrated to state courts and that such state court litigation may undermine the reforms adopted by Congress in the Private Securities Litigation Reform Act of 1995 ("Reform Act" or "Act"). S. 1260 addresses these concerns by preempting class actions that are based on the statutory or common law of any state and that allege an untrue statement or omission of material fact, or other fraudulent conduct, in connection with the purchase or sale of specified securities trading over national exchanges.
The issue of a uniform standard for national securities litigation is a delicate one. The federal securities laws presuppose an active, vital system of state securities regulation and state court enforcement. In addition, state law has traditionally governed issues of corporate governance. This dual system of regulation has worked to the benefit of investors.
More than twenty years before Congress passed the first federal securities laws, state legislatures passed laws to protect their citizen investors. In 1911, Kansas passed the first law regulating securities transactions. A number of states followed suit and today every state has enacted a securities act. These state statutes have been coined "blue sky" laws because of concerns by the Kansas legislature that eastern industrialists were seeking to peddle a multitude of investments to unwary investors, including interests in the blue sky. When the first federal securities laws were passed in the 1930s, federal law was thought to be a supplement to, rather than a substitute for, the blue sky laws. In fact, the Securities Act of 1933 ("Securities Act") and the Securities Exchange Act of 1934 ("Exchange Act") each contain a savings clause preserving the rights and remedies existing at law or in equity. These provisions preserve state blue sky law and corporate law. In addition, the Supreme Court has repeatedly reaffirmed state supremacy in matters involving internal corporate affairs.
State and federal securities laws have coexisted for over 60 years. Recently, however, Congress has begun to reexamine the federal-state partnership in this area. Last year, for example, Congress enacted the National Securities Markets Improvement Act of 1996 ("Improvement Act"), which, among other things, divides the responsibility for securities registration, and investment adviser registration and oversight, between the Commission and the states. In doing so, Congress sought to promote efficiency and capital formation in the financial markets. The responsibility for policing fraud, however, stands on somewhat different footing. The Commission has always relied, and continues to rely, on private actions in both federal and state courts to support the agency's efforts to combat fraud. Private actions are an especially important supplement to the Commission's enforcement program today because of the phenomenal growth of the securities industry during a time when the Commission's staff and budget levels have remained relatively constant. The importance of private actions has been reinforced by the recently reported rise in fraud similar to that witnessed during the bull market of the 1980s.
Although the Commission staunchly defends the right of defrauded investors to seek
meaningful relief, we are sensitive to the burdens imposed on corporations by abusive litigation,
which increases the cost of capital formation. As an agency whose primary mission is investor
protection, we respect the concerns raised by both sides of this debate.
S. 1260 is best interpreted in light of Congress' most recent litigation reform effort, the 1995 Reform Act. The Reform Act primarily affected federal class actions which, while often providing the only practical method available to compensate defrauded small investors, are commonly thought to be the type of securities suits most prone to abuse. Class actions often involve expensive and time-consuming discovery, de facto control by plaintiffs' lawyers, and the potential for substantial damage awards. In passing the Act, Congress attempted to curb the potential abuses of class actions by adopting the following principal provisions applicable to federal securities litigation:
In the aftermath of the Reform Act, state court class actions have increased in number and become a more important feature of the securities fraud litigation landscape. Several reasons for this increase have been advanced. Some observers believe that the increase is attributable to efforts to circumvent the Reform Act's provisions, particularly the heightened pleading requirements and discovery stay, which do not apply in state court. Others point to the advantages available in state court such as causes of action for aiding-and-abetting, non-unanimous jury verdicts, and punitive damages.
The attractiveness of state court as a venue for class actions may also have been enhanced by the Supreme Court's decision in Matsushita Elec. Indus. Co. v. Epstein. In that case, the Court held that a state court judgment dismissing a state class action suit pursuant to a settlement agreement could include a provision barring federal securities fraud class actions arising out of the same transaction, even if the state court lacked jurisdiction to adjudicate the federal claims in the first place. Paradoxically, by allowing defendants to obtain a global settlement in state court, Matsushita may have made state court class actions more advantageous for both plaintiffs and defendants and may have contributed to the increase in state court suits.
Regardless of the reasons for the increase in state court filings, the question has been raised as to whether these suits may be reducing the Reform Act's effectiveness in achieving its intended goals. Earlier this year, the Commission submitted a Report to the President and the Congress on the First Year of Practice Under the Private Securities Litigation Reform Act of 1995, prepared by the Commission's Office of the General Counsel ("Staff Report"). The Staff Report noted that there has been only limited experience with the Act's key provisions in the short time since its passage, and, consequently, that it was difficult to draw any overall conclusions about the Reform Act's impact on private securities fraud litigation. As promised in the Staff Report, the Commission's staff has continued to monitor developments under the Act. The Commission continues to believe that it is too soon to understand the ultimate impact of the Act. Our conclusion is supported by recent data which tends to show that the migration of securities class actions from federal to state court may have been a transient phenomenon.
Notwithstanding the Act's limited history, the Staff Report did make some preliminary observations about certain provisions of the Act which appear to be achieving their intended objectives, and other provisions which are not.
The Reform Act appears to be achieving Congress' purposes in the following areas:
Other provisions of the Reform Act, however, appear to have been less successful in achieving Congress' objectives. The Commission's staff has identified three principal areas of concern regarding the implementation of the Reform Act. First, the staff has received anecdotal reports that the safe harbor is not encouraging companies voluntarily to disclose more forward-looking information. Second, parallel cases have been brought in state court where the discovery stay does not apply, thus permitting plaintiffs to obtain discovery that they could not get in federal court. Third, institutional investors are failing to assume active roles as lead plaintiffs in federal class actions.
The Staff Report indicated that it appears that companies are not using the safe harbor to make more forward-looking disclosure. In preparing the Staff Report, the Commission's Office of the General Counsel spoke with 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.
The Staff Report notes that the discovery stay may be avoided by the filing of a parallel state action. Fifty-five percent of the state court cases in a sample reviewed by the staff (35 out of 55) had allegations that were essentially identical to those brought by the same law firm in federal court. Some observers believe that these cases were filed primarily to get discovery for use in the federal action. Others note, however, that state courts may offer advantages to plaintiffs other than discovery. These include, depending on the state: lower pleading standards, longer statutes of limitation, non-unanimous jury verdicts, joint and several liability, and aiding and abetting liability for secondary actors.
The lead plaintiff 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. The Staff Report found that institutions sought to be named lead plaintiff in only eight of the 105 class actions filed during the Act's first year. It appears that in 1997 institutions have continued to remain on the sidelines as lead plaintiffs. In the 124 federal class actions filed to date, we are aware of only six in which institutions have sought lead plaintiff status.
Why are more institutions not coming forward to be lead plaintiff? In preparing the Staff Report, the staff met with representatives of both public and private institutional investors. The institutions' primary concern is litigation-related expense. Institutions also expressed concern that service as lead plaintiff could expose them to liability to other class members. For example, other class members could sue the lead plaintiff if the terms of the settlement were claimed to be inadequate. Finally, and most relevant to the issue presented here, we have been told that institutions sometimes achieve better results by proceeding with their own individual suits. This observation is supported by the fact that at least six individual securities actions have recently been brought by institutions in federal court.
The Reform Act focused exclusively on securities fraud class actions in federal court. There is no evidence in its legislative history that Congress considered the Act's potential impact on private securities fraud lawsuits filed in state court. One possible reason for this is that there were reportedly very few state court securities class actions brought before 1995. State law claims brought pendent to federal claims in federal courts, however, historically have been commonplace. Since the Reform Act has become law, there has been an increase in the number of state court securities class actions, though the overall number remains small. This increase in state filings has caused widespread attention and has led to the introduction of preemption bills in both the Senate and the House.
In July of this year, Chairman Levitt testified before this Subcommittee, on behalf of the Commission, that broad preemption of state remedies to address specific areas of concern would be premature. The Commission continues to believe that additional experience under the Act will better inform our efforts to identify the Act's shortcomings and to craft appropriate solutions to them. In particular, there are several developments we are following in the state courts that may significantly limit the availability and attractiveness of state courts as a venue for securities class actions. In addition, there are developing interpretations of the Act in the federal courts that may critically weaken the ability of investors to pursue meritorious claims in federal court, thus making state court remedies more important than ever.
Several judicial developments may sharply limit the ability of plaintiffs to bring state court class actions. Most significantly, in Pass v. Diamond Multimedia, the California Supreme Court will be called upon 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 less likely to file in state court if they could not bring a nationwide class action to recover damages on behalf of a nationwide class. We recognize that this decision will only govern class actions filed in California state courts. California, however, has been far and away the leading jurisdiction for the filing of state court class actions, with about 60% of the cases to date.
Developments under the Reform Act in the federal courts may also affect the desirability
of preempting state securities actions. The Commission is most concerned about cases raising
the issue of whether the Reform Act eliminated recklessness as a form of liability for fraud-based
violations of the federal securities laws. Several district courts have so held, and the issue is
currently pending in the Sixth and Ninth Circuit Courts of Appeals. Most courts to address the
issue have agreed with the Commission's position that recklessness continues to be a valid basis
for pleading and proving scienter. The Commission strongly believes that recklessness must be
preserved as the standard for liability because it is essential to investor protection. The
Commission has filed an amicus brief in the Ninth Circuit case urging that view. A uniform
federal standard that did not include recklessness as a basis for liability would jeopardize the
integrity of the securities markets, and would deal a crippling blow to defrauded investors with
meritorious claims. A higher scienter standard would lessen the incentives for corporations to
conduct a full inquiry into potentially troublesome or embarrassing areas, and thus would
threaten the disclosure process that has made our markets a model for nations around the
world. Should the courts of appeals conclude that the Reform Act has somehow eliminated
recklessness as a basis for antifraud liability, the preservation of state remedies that allow
recovery for reckless conduct would be critical.
S. 1260 applies to nationally listed securities and shares of registered investment companies. The bill only applies to securities that qualify as "covered securities" under sections 18(b)(1) and (2) of the Securities Act, which were enacted as part of the Improvement Act. Those sections include securities that:
The coverage provision of S. 1260 is narrower than that of the Improvement Act in several respects. In addition to preempting state regulation of "covered securities," the Improvement Act also preempts state regulation of sales to "qualified purchasers," to be defined by the SEC, and of certain exempt offerings, including certain secondary market transactions, unsolicited brokers' transactions, transactions in exempted securities, and private placement transactions made under SEC rules. S. 1260 does not preempt state law claims in these areas.
We believe that these differences between S. 1260 and the Improvement Act are logical and should be preserved. Because there are no registration requirements for exempt offerings, they generally receive no regulatory scrutiny. Thus, investors in exempt offerings need antifraud protection afforded by the choice between federal and state law.
The bill preempts only class actions. Class actions are defined as suits seeking damages on behalf of at least 25 persons, or involving named parties seeking damages on behalf of unnamed parties, or cases where one or more of the plaintiffs did not personally authorize the suit.
The bill's definition of class action is somewhat broader than that used in federal court (and copied in most state courts) under Federal Rule of Civil Procedure 23. A class action in federal court may only be brought if the court finds that the class is too numerous to join all of its members in the suit, the members' claims involve common questions of fact and law, the class representatives have typical claims and will fairly protect class interests, and the claims ought not to be tried separately for one of several other specified reasons. Because these factors are complicated to apply and may be subject to varying judicial interpretations, it would not be practical for the bill's definition of class action to mirror that codified in Rule 23.
The bill would preempt class actions brought by private parties under state law alleging "an untrue statement or omission of material fact" or the use of "a manipulative or deceptive device or contrivance" in connection with the purchase or sale of securities. Thus, the bill would not preempt typical state claims of a breach of a fiduciary duty by an officer or director of a public company, with the exception of claims alleging a breach of the fiduciary duty of disclosure, which is based on a misrepresentation or omission and could be implicated by the purchase or sale of a security.
The fraud language of the bill tracks the antifraud provisions of the securities laws Section 17(a) of the Securities Act, which prohibits untrue statements and omissions of material fact and devices and schemes to defraud, and Section 10(b) of the Exchange Act, which prohibits the use of "a manipulative or deceptive device or contrivance" in connection with the purchase or sale of securities.
The bill allows any class action brought in state court involving a covered security, "as set forth in [the provision preempting state fraud actions]," to be removed by the defendant to federal court. We believe that this provision is coextensive with the preemption provision; it allows a state fraud class action to be removed to federal court, where discovery would be stayed while a motion to dismiss is pending, so that a federal court could decide whether the state court claims are preempted before any discovery occurred in the state court proceeding.
The Commission believes that there are important types of antifraud claims that should continue to be governed by state law. In this regard, we note that S. 1260 would not preempt the following claims, in which the states have a strong interest.
As S. 1260 only preempts class actions, it would not preempt individual state law claims against brokers. Many of these claims are handled in arbitration proceedings, which often include claims based on state statutory or common law. These claims may arise from, among other things, churning, misappropriation of customer assets, or misrepresentations or omissions concerning the purchase or sale of a security. When these cases involve egregious wrongdoing, punitive damages, which are not available under federal law, are often appropriate. These individual claims do not present the threat of abuse that underlay Congress' passage of the Reform Act and thus should not be preempted. Preemption of these claims would eliminate important protections that state law provides investors in relationships with their brokers. Preemption of individual actions would also preclude investors defrauded in localized transactions from suing in state court, even though the state interest here likely outweighs the federal interest.
States, through their police powers, should have the authority to craft laws governing fraud occurring wholly within their borders. S.1260 would continue to allow individuals who have been defrauded in face-to-face transactions to sue in state courts and seek remedies that the forum state deems appropriate. We note, however, that S. 1260 may be overbroad in some respects because it preempts some state actions involving fraudulent conduct that occurred entirely within one state. For example, if a confidence artist conducted a large-scale fraud involving a covered security in a single state, state law would only provide relief to those investors who sued individually but would be preempted if investors decided to proceed as a class. Penny Stock and Micro Cap Securities
Concerns have been expressed recently at both the federal and state levels concerning a rise in fraud in connection with the market for "penny stock" and "micro cap" securities. Both Congress and the New York State Attorney General's Office have recently conducted hearings on this matter. In testimony before the Senate Permanent Subcommittee on Investigations, Chairman Levitt, on behalf of the Commission, expressed concern about "abuses in the market for micro cap securities, which provide[] opportunity for small businesses to raise capital, but also provide[] opportunity for fraudsters to prey on innocent investors." Given the special concerns of both the federal government and the states in this area, preemption of class claims involving penny and micro cap stocks is not warranted.
S. 1260 would only preempt class actions brought by "any private party." The Commission strongly believes that S. 1260 properly preserves actions brought by state regulators. We have long maintained that the state regulators are the "local cop on the beat" in protecting against fraud, and their continued role in this regard is vital to investor protection.
S. 1260 would preempt most of the securities class actions brought in state courts since passage of the Reform Act. The bill would also preempt all claims based on state statutory and common law even if brought in federal court pendent to a federal claim and pursuant to the terms of the Reform Act. The practical effect of passage will be that state securities laws will be inapplicable in most class actions, whether brought in federal or state court. The governing law will be federal law. Because a number of states allow claims that cannot be brought under federal law, and because it is not always cost-effective for plaintiffs to proceed individually, the bill will preclude relief as a practical matter for some small investors who may have been defrauded.
As a result, certain investor protection laws available at the state level, which the Commission favors, would no longer be available. Forty-nine states as well as the District of Columbia allow for some form of aiding-and-abetting liability. Under a 1994 Supreme Court decision, there is no aiding-and-abetting liability in private actions for most federal securities fraud claims. In addition, as a result of a 1991 Supreme Court decision, private actions under the federal securities laws are subject to a short statute of limitations. Specifically, private actions under Section 10(b) of the Exchange Act must be brought within one year after discovery of the alleged violation, and no more than three years after the violation occurred. By contrast, 33 states allow for longer limitations periods. A state class action brought after the federal statute of limitations had run could not be used to evade the Reform Act's discovery stay provision, because no parallel federal suit could be brought.
S. 1260 could have the unintended effect of preempting certain claims arising from transactions in which both the state and federal governments have a strong interest. In particular, S. 1260 could preempt state class actions for damages based on material misstatements or omissions in proxy and tender offer materials in connection with an extraordinary corporate transaction. Such preemption would eliminate important areas of state corporate law that have long coexisted with indeed, predate by almost a century the federal securities laws.
Under current law, mergers or other extraordinary transactions may give rise to claims under both state corporate law and federal securities law. Shareholders who bring class actions challenging such transactions often allege a breach of fiduciary duty by target-company management and directors under state corporate law. State corporate law imposes duties of care and loyalty on a corporation's directors, as well as a duty of disclosure when the directors are seeking shareholder approval of certain transactions.
Preemption of state duty of disclosure claims raises significant federalism concerns. Many state courts, particularly those in Delaware, have developed expertise and a coherent body of case law which provides guidance to companies and lends predictability to corporate transactions. In addition, the Delaware courts, in particular, are known for their ability to resolve such disputes expeditiously in days or weeks, rather than months or years. Delay in resolving a dispute over a merger or acquisition could jeopardize completion of a multi-billion-dollar transaction. Broad preemption would diminish the value of this body of precedent and these specialized courts as a means of resolving corporate disputes.
One of the concerns about the Reform Act identified by the Commission is the filing of parallel state and federal actions based on the same conduct to avoid the federal discovery stay. In the Staff Report, the Commission noted that "[o]f the 105 federal actions filed in 1996, we have identified 26 that are tied to a parallel state action." The Staff Report also observed that "plaintiffs may be able to use state discovery procedures to uncover facts necessary to frame allegations sufficient to withstand a motion to dismiss, either in the state court proceeding or in a subsequently filed federal complaint." If discovery is available in state courts that can be used to avoid the stay of discovery in federal court, one of the goals of the Reform Act may be frustrated.
Because S. 1260 would preempt only class actions, law firms representing plaintiffs would still be free to file a lawsuit on behalf of an individual in state court, and a parallel suit on behalf of a class in federal court. This approach would allow plaintiffs to continue to avoid the effect of the federal discovery stay despite preemption of state class actions. Closing this gap in the bill by extending its coverage to all actions may be undesirable because it would require much broader preemption and raise even greater federalism concerns. Absent some form of exclusion, broader preemption would probably preclude state law claims based on face-to-face transactions and investors' claims against their brokers and investment advisers. Fraud claims arising from such relationships arguably invoke the strongest of state interests in protecting their citizens, and the Commission would be reluctant to see such claims left exclusively to federal law. Any provision that would successfully carve out every individual fraud action that ought to remain in state court is likely to be cumbersome and subject to varying judicial interpretations.
The Commission has been concerned by the fact that few institutions have sought to become lead plaintiffs in federal securities class actions. S. 1260 could further reduce the incentives for institutions to seek lead plaintiff status. If institutional investors sought lead plaintiff status after S. 1260 became law, the bill's preemption provisions would bar them from asserting pendent state claims in federal court. If institutions brought individual actions in federal court, however, they would remain free to assert state as well as federal claims.
We understand and appreciate the concerns that have been raised about the apparent increase in state court securities fraud class actions. We realize that many Members have concluded that the time to address these concerns is now, through legislation that would limit or eliminate state causes of action. Some supporters of legislation view preemption as necessary to prevent frustration of the Reform Act's goals; others see preemption as a logical extension of the division between state and federal functions set forth in the Improvement Act.
We all share the overarching goal of ensuring that the Act operates as intended. A substantial move toward national standards, however, would be much more far-reaching than merely correcting the problems with the Reform Act identified to date. Even the broadest calls for national standards seem to have been triggered by the effects of the Reform Act. All commentators concede, however, that we will not fully understand the effects of the Reform Act for at least several years. Care should be taken in proposing solutions to the Reform Act's problems to safeguard the benefits of our dual system of federal and state law that has served investors well for over 60 years.
S. 1260 attempts to adjust the balance between state and federal rights and adopt national standards where the need for uniformity eclipses legitimate state interests. Some members of the current Commission sympathize with the argument that national securities markets should be governed by a national standard, provided that the national standard properly safeguards the right of injured investors to pursue meritorious claims. As we have pointed out, however, additional work and study are necessary to assure that the bill preserves important rights under state corporate law, rights to pursue claims for localized frauds, and that it does not provide a disincentive for institutions to serve as lead plaintiffs in federal class actions. We also hasten to add that our testimony today reflects the views of a three-member Commission. As you know, we will soon be joined by Commissioners Laura Unger and Paul Carey. The Commission's position on litigation reform issues will, of course, require consideration of their views.
The Commission looks forward to working with the Subcommittee as it goes forward in
its consideration of this bill.
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