February 23, 1998, 2:00 p.m.
I appreciate Senator Gramm's invitation to appear today and testify about S. 1260, the Securities
Litigation Uniform Standards Act of 1997. Although I serve on the American Bar Association
Task Force on Securities Litigation Reform, and my firm represents, among other groups, the
American Electronics Association and the Uniform Standards Coalition, I am appearing today
not on behalf of those organizations but in my personal capacity. The American Bar Association
has not taken a position on the Uniform Standards Act.
I am a partner in the Washington, D.C., office of the law firm of Gibson, Dunn, and Crutcher. I
have practiced corporate and securities law with that firm for thirty-four years. I have served as
Chairman of the ABA's Committee on Federal Regulation of Securities and currently am a
member of the Committee on Corporate Laws for the ABA Business Law Section, which writes
and revises the Model Business Corporation Act. I have also served on the Legal Advisory
Committee of the New York Stock Exchange, and as chairman of its Corporate Governance
Subcommittee, and on the Legal Advisory Board for the National Association of Securities
I am honored to be part of this Subcommittee's deliberations and welcome the opportunity to
share my views on S. 1260, as well as to answer your questions.
Nearly two years ago, Congress enacted the Private Securities Litigation Reform Act of 1995 (the
"PSLRA"). The PSLRA was intended to curb frivolous federal class action securities suits while
at the same time protecting investors and market participants. The PSLRA recognized that
effective private remedies under the securities laws are essential to police market integrity, deter
fraud, and protect investors. Yet Congress also was concerned about defacto control of litigation by plaintiffs' lawyers, time-consuming and expensive discovery, and coercive "strike suit"
techniques intended to pressure defendants into settling meritless cases. The PSLRA offered a
series of well-considered reforms designed to weed out the most troubling problems affecting
federal class action securities litigation. The PSLRA incorporated a lead plaintiff provision,
designed to ensure that shareholders, rather than their attorneys, retained control of their lawsuit.
It enacted a safe-harbor provision intended to permit and encourage companies to make forward-looking statements. It incorporated a heightened pleading standard that would prevent lawsuits
that were nothing more than baseless fishing expeditions. And it provided for a stay of discovery
pending a defendant's motion to dismiss.
The PSLRA is still in its infancy, and the federal courts are only beginning to interpret and apply
its substantive provisions. If preliminary indications are any guide, however, at least some of
Congress' objectives are being accomplished. (1)
Yet one crucial goal of the PSLRA has not been achieved. The PSLRA was intended to stem
the tide of frivolous nationwide class action lawsuits. Instead, it has had the undesirable effect of
channeling more of that litigation into the state court system.
This phenomenon has been noted by many observers. One of the most knowledgeable, former SEC Commissioner Wallman, described its negative consequences:
[T]he most significant development stemming from the Act has been the increase in state court litigation, apparently as an attempt to avoid some of the provisions of the Act.... [T]his phenomenon is clearly balkanizing the federal securities laws. In this context, disparate state litigation procedures create differing substantive legal standards which the corporate decision maker, with potentially significant liability at risk, cannot determine until after the fact. (2)
Although it is difficult to gauge the extent of the problem, the most current and comprehensive
study of the Act's effects -- conducted by Stanford Law School professors Joseph Grundfest and
Michael Perino (3)-- found that in the first eighteen months after enactment of the PSLRA, the overall rate of securities class action suits remained relatively constant and even increased somewhat. A very recent review completed by the SEC reached similar conclusions, finding that federal securities fraud suits were filed in 1997 at a rate similar to what prevailed prior to
enactment of the PSLRA. (4) The Grundfest-Perino study notes a tremendous jump, however, in the number of state-court securities class actions. In the years 1992 through 1994, only sixissuers of publicly traded securities were sued for fraud in state-court class actions. In contrast, at least seventy-seven publicly-traded issuers were sued in state court class actions brought between January 1, 1996, and June 30, 1997.
Indeed, the increase in state court filings may be even greater than indicated by these dramatic
statistics. Obtaining an accurate count of state court class actions is extraordinarily difficult,
because there is no central repository of such data and plaintiffs are under no obligation to
provide notice of the filing of such suits. The Grundfest-Perino study, for example, suggests that
its data "may significantly undercount the actual number of state court filings."
The shift in securities class action litigation from federal to state court involves two related
developments. First, an increasing number of plaintiffs are filing solely in state court,
presumably to escape the more stringent federal pleading requirements and other procedural and
substantive provisions of the PSLRA. Second, numerous plaintiffs are filing parallel state and
federal suits, so that they can engage in discovery in state court notwithstanding the stay of
discovery imposed in federal court pending a defendant's motion to dismiss.
Opponents of the uniform standards legislation, relying on a study conducted by National
Economic Research Associates ("NERA"), (5) have suggested that the PSLRA has had little or no effect on the number of securities class action suits brought in state courts. A recent private study released by Price Waterhouse reached a similar conclusion. But this conclusion is wrong: the methodology used by NERA and Price Waterhouse was flawed.
Both NERA and Price Waterhouse calculated the number of state court actions by totaling all
cases reported in the Securities Class Action Alert. Yet that publication reports two very
different kinds of cases. It lists state securities class action suits alleging misrepresentations or
omissions in the purchase and sale of nationally traded securities, which were the focus of the
PSLRA and raise the issues you are considering today. But the publication also reports state
suits alleging breach of fiduciary duties of loyalty, care, or candor, as well as suits involving
securities that are not listed on national exchanges or by national listing services. These latter
types of suits traditionally have been brought in state court, were not affected by the PSLRA, and
would not be affected by the Uniform Standards Act, S. 1260. The single fact is that state-court
class actions involving nationally traded securities were virtually unknown prior to the PSLRA;
they are brought with some frequency now.
The increase in state-court litigation documented in the Grundfest-Perino study is of great
concern because, as former Commissioner Wallman has explained, it threatens to balkanize the
applicable disclosure standards for our securities markets. National corporations, whose shares
are traded on national exchanges, may now be threatened with securities class action litigation in
50 different state courts under 50 different standards. Securities class action litigation is a new
phenomena in the state courts, and state courts are just beginning to struggle with the difficult
and unfamiliar issues involved. Given the lack of precedent, and state courts' lack of expertise
with the issues involved in securities class actions, issuers cannot predict with any certainty what
standard might be applied by a trial judge in Alabama, or Vermont, or Nevada, or California.
The chilling impact of this prospect on corporate executives who must make disclosure decisions
is obvious. In my experience, it is the single most important reason why we have not yet
experienced the intended benefits of the "safe harbor" provisions of the PSLRA, which were
designed to encourage disclosure to the market of more forward-looking information that could
be helpful to investors. The companies I counsel are genuinely concerned about the uncertainty,
and the cost, of being exposed to multiple and different standards at the state level when they
consider whether they should make such information available to the marketplace.
As I have counseled our major securities markets, the NYSE and the NASDAQ stock market, I
have found that foreign issuers considering listing their securities on American markets can
understand the need to conform to the SEC's regulations and our rigorous federal securities laws,
but simply cannot fathom why they should also be subject to the vagaries of possibly differing
liability and proof standards from 50 states.
This chilling effect is directly contrary to the policies of the PSLRA and the National Securities
Markets Improvement Act of 1996 ("NSMIA"). Those statutes recognized the importance of
establishing a single standard to judge the behavior of those companies whose securities are
traded in our major national markets. Congress has already determined, in both the PSLRA, and
in NSMIA, that it makes no sense for nationally traded securities to be subject to balkanized
regulations, to a plethora of inconsistent and unpredictable state standards. The Uniform
Standards Act provides an answer to this problem that is entirely consistent with these major
THE UNIFORM STANDARDS LEGISLATION
The Securities Litigation Uniform Standards Act of 1997, S. 1260, would bring predictability and
certainty to participants in the national stock markets. Before I mention its effects, however, I
think it is important to dispel some myths about the proposed legislation. At least as important
as what the Uniform Standards Act would do is what it would not do. In their
enthusiasm to defeat the Act, some of its most vocal opponents have misrepresented what it in
fact would do.
First, the Uniform Standards Act would not affect state securities class actions with respect to
micro-cap or small-cap stocks. Its provisions simply do not apply in the arena of the NASDAQ
small-cap market or the "bulletin board." It will have no impact at all on the SEC's and state
regulators' efforts to clean up those markets or on any private claims related to those markets. Its
provisions would apply solely to "covered securities," which are those securities listed on the
New York or American Stock Exchanges or NASDAQ's national market.
Second, the Uniform Standards Act expressly preserves the authority of state public authorities --
attorneys general, securities commissions, and other government enforcement agencies -- to bring
suit. Public enforcement has been, and will continue to be, a crucial policing method to ensure
the integrity of state and national securities markets. The Act affects only suits brought by or on
behalf of private investors. It has no effect whatever on public enforcement.
Third, the Uniform Standards Act does not bar all access to state courts. It affects a particular
enforcement tool -- shareholder class actions brought on behalf of more than 25 persons. The
vast majority of state remedies would continue to exist, including suits by individual plaintiffs,
derivative actions, suits with fewer than 25 named plaintiffs, and enforcement proceedings
brought by state officials.
Fourth, and finally, the Uniform Standards Act would not even preempt most state-law actions
involving securities. It would not affect, for example, most claims of breach of fiduciary duty.
The Uniform Standards Act tracks the language of Rule 10b-5, and limits its preemptive effect to
class actions alleging "an untrue statement or omission of a material fact," or the "use
or employ[ment of] any manipulative or deceptive device or contrivance in connection with the
purchase or sale of a covered security." The scope of fiduciary duties under state law is much
broader than this provision, and would be left nearly untouched by its enactment. A suit alleging
breach of the fiduciary duty of loyalty, for example, would not fall under the terms of the Act.
Nor would the Act preempt suits involving allegations of breach of the duty of care, such as
claims that an officer failed to explore alternatives to merger, or to negotiate an adequate tender
offer price, and, as noted above, it would have no impact at all on derivative actions brought by a
plaintiff against fiduciaries on behalf of the corporation itself.
STATE LAW GOVERNING THE
FIDUCIARY DUTY OF DISCLOSURE
For the most part, the Uniform Standards Act is precisely tailored legislation that is directed at
the area most in need of reform: national class actions involving nationally traded securities that
mirror the sorts of claims traditionally brought in federal court under the federal securities laws.
There is one area, however, where the proposed legislation may be over-broad. Everyone agrees
that federal legislation should not prevent states from making rules for the governance of
corporations, or from imposing duties on corporate directors and officers. In this regard, I agree
with one concern that has been raised by the SEC and other commenters: whether S. 1260 would
preempt class action suits alleging a breach of directors' or officers' state-law fiduciary duty to
make full disclosure of material information, and to refrain from making misleading statements,
relating to an action for which the corporation seeks shareholder action or approval (6) The Commission's concern has been echoed by members of the bar, and involves those states -- most prominently, Delaware -- that impose this fiduciary duty under state statutory or common law.
Under Delaware law, for example, corporate directors and officers have a fiduciary duty of full
and adequate disclosure of material information when they are seeking shareholder approval of
corporate action. If, for example, a corporate board of directors is advising its stockholders to
respond in a particular way to a tender offer, it must disclose all material information relating to
the offer and is subject to liability for breach of fiduciary duty if it makes misleading partial
disclosures. (7) Similarly, if shareholders are asked to approve a merger, the directors will be liable for breach of fiduciary duty if the proxy statement fails to disclose all
material information about the merger. (8) Claims that officers or directors have breached this fiduciary duty are often litigated in the context of shareholder class action suits, and there has been, I believe, a legitimate concern that these suits would be preempted by the current language of S. 1260.
Such preemption would have two practical consequences. First, plaintiffs in shareholder suits
may allege breach of a variety of fiduciary duties, including not only the duty of disclosure but
also the duties to refrain from self-dealing and to exercise due care. If claims alleging breach of
the directors' duty of disclosure were preempted, plaintiffs would be faced with an unpalatable
choice. They could bring two actions, one in federal court alleging fraud and one in state court
alleging breach of fiduciary duty. This course may be expensive and wastefully duplicative. Or
plaintiffs could bring all claims in federal court, by combining their federal securities law claim
with pendent state law breach of fiduciary duty claims. This option, however, would require
federal judges to decide Delaware state law issues.
Second, cases involving breach of duty claims sometimes arise in suits involving fights over
control of the corporation, in which one side is seeking to enjoin transfer of corporate control.
State courts (and the Delaware courts in particular) have developed expertise in resolving claims
that officers or directors have breached their fiduciary duties by failing to disclose all material
information or by disclosing misleading information to the corporation's shareholders. The
Delaware courts can resolve these claims -- which are governed by a coherent and substantial
body of case law -- in a matter of days or weeks. I Without this quick resolution, disputes over
mergers or acquisitions could jeopardize completion of major transactions and generate
substantial uncertainty and unnecessary expense. The SEC and others, including me, have
expressed a valid concern that enactment of the current preemption language in the Uniform
Standards Act might "diminish the value of this body of precedent and these specialized courts as
a means of resolving corporate disputes." (9)
As I have noted, the SEC is not alone in being concerned about preemption of state law actions
based on a fiduciary duty to disclose. I am a member of the ABA Task Force on Securities
Litigation Reform, which has devoted considerable attention to this issue. The Task Force
includes a number of distinguished securities practitioners and has consulted with respected
members of the Delaware bar and noted state securities law scholars such as Professor Lawrence
A. Hamermesh of the Widener University School of Law and former Delaware Chancellor
William Allen, now a professor at New York University Law School. Under the
leadership of Task Force Chair Richard M. Phillips, of Kirkpatrick and, Lockhart, and full
consultation with SEC General Counsel Richard Walker and members of his staff, the Task
Force has moved far along the road of formulating a proposed solution to this problem.
Although we have not yet concluded our work, I believe that the Commission staff and the Task
Force will be able to suggest a qualification for the proposed preemption language that will fully
preserve state-law fiduciary duty claims while ensuring the continued effectiveness of the
The general approach favored by the Task Force would add a carve-out provision to the
preemption section of the Uniform Standards Act. This carve-out provision would specifically
and expressly preserve shareholder class actions brought under state law that allege misleading
statements or omissions by corporate fiduciaries directed at present shareholders of the
corporation who are being asked by the corporation to make voting or investment decisions.
This carve-out approach, initially suggested by former Delaware Chancellor Allen, would fully
protect state and private interests in the integrity of corporate governance while maintaining the
effectiveness of the PSLRA and its federal standards with respect to disclosures addressed to the
national trading markets.
Precision is important here, because a broader carve-out provision could substantially undermine the goals of the Uniform Standards Act, just as the shift of securities class action litigation from federal to state court has largely frustrated the goals of the PSLRA. And narrow tailoring of the carve-out provision matches the approach of the Delaware courts, which have refused to extend the fiduciary duty of disclosure of material information relating to an action requiring shareholder approval into a more general duty to the marketplace at large akin to that imposed by federal securities law decisions. Delaware Vice-Chancellor Steele recently observed that:
That is precisely the point of the Uniform Standards Act. In the PSLRA, Congress articulated,
after much thought and considerable study, a uniform federal standard by which securities class
actions are to be judged. The goals of that Act will not be achieved if there is a migration of
securities class actions to state court.
With the addition of a carve-out provision like the one being developed by the Task Force, I
believe that the Uniform Standards Act offers a workable and fair way to ensure that the PSLRA
is implemented as intended, while protecting legitimate state interests in regulating corporate
When this Subcommittee held hearings on the PSLRA, opponents predicted that it would slam
shut the doors of the federal judiciary and keep legitimate cases out of court. Those dire
predictions have proven unfounded: despite the heightened standards it imposed, the number of
federal securities class actions has remained constant and even increased since the PSLRA's
effective date. Now those same opponents predict disaster if the Uniform Standards Act
becomes law. Yet a careful examination of the Uniform Standards Act, with the carve-out
provision I have described, demonstrates that its effect would be limited: it would end the
migration of class actions involving truly national securities markets to the state courts, while
ensuring that state courts will continue to be an important, and accessible, forum for issues
involving smaller cap companies, and for the full range of fiduciary duty and corporate
governance issues, that are the traditional and appropriate province of state law.
1. Testimony of U.S. Securities and Exchange Commission Concerning S. 1260, the "Securities Litigation Uniform Standards Act of 1997," before the Subcommittee on Securities, Committee on Banking, Housing and Urban Affairs, United States Senate 7-8 (Oct. 29 1997) ("SEC Testimony").
2. Statement of Additional Views of Commissioner Wallman Regarding the Report on the First Year of Practice Under the Private Securities Litigation Reform Act of 1995 (Apr. II, 1997).
3. Joseph A. Grundfest and Michael A. Perino, Securities Litigation Reform: The First Year's Experience ii (Working Papers Series Release 97.1 Feb. 27, 1997), discussed and updated in Michael A. Perino, Fraud and Federalism: Preempting Private State Securities Fraud Causes of Action Stanford L. Rev. (forthcoming 1998) ("Grundfest-Perino Study").
4. See Bureau of National Affairs, Daily Report for Executives (Feb. 20, 1998) at A-17.
5. Denise M. Martin, et al., Recent Trends IV: What Explains Filings and Settlements in Shareholder Class Actions? (National Economic Research Associates Nov. 1996).
6. SEC Testimony 20-21.
7. Zirn v. VLI Corp., 681 A.2d 1050, 1056 (Del. 1996).
8. Arnold v. Society for Savings Bancorp., Inc., 650 A.2d 1270,1277 (Del. 1994).
9. SEC Testimony at 2 1.
10. Malone v. Brincat, No. 15 510, 1997 WL 697940, at 2 (Del. Ch. Oct. 3 0, 1997).
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