February 23, 1998, 2:00 p.m.
Chairman Gramm, Senator Dodd, and Members of the Subcommittee:
I appreciate the opportunity to present testimony on behalf of the Consumer Federation of
America concerning S. 1260, the "Securities Litigation Uniform Standards Act of 1997." CFA is
a non-profit association of more than 250 pro-consumer groups that was founded in 1968 to
advance the consumer interest through advocacy and education. As such, we have a longstanding interest and involvement in investor protection issues.
Consumer groups have a uniquely balanced view of securities litigation issues, representing, as
we do, both defrauded investors and the shareholders who pay the price when a corporation is the
target of abusive litigation. As such, while we have a strong interest in protecting the rights of
defrauded investors to recover their losses, we have no interest in preserving a system that
promotes frivolous litigation, if such is the case. Since these issues were first raised in Congress,
our goal has been to seek a solution to the problem of frivolous litigation that does not
unnecessarily limit defrauded investors' right to redress. We opposed the Private Securities
Litigation Reform Act (and supported alternative legislation), because the PSLRA failed that test
of balance. That is also a major reason why we must oppose S. 1260, the "Securities Litigation
Uniform Standards Act of 1997."
A more detailed explanation of our opposition to S. 1260 follows.
I. The legislation is premature.
S.1260 proposes to impose federal standards for class actions involving securities traded on a
national exchange without knowing what those federal standards are, how well they will solve
the problems Congress set out to address when it passed the PSLRA, and to what degree they
will affect the ability of meritorious cases to go forward and the ability of fraud victims to
recover their losses.
As you know, legislation is not complete when it is enacted by Congress. Only when it has been
interpreted in the courts can we know whether a law will actually operate as intended. Because
that judicial interpretation of the PSLRA has just begun, we will not know the full effects of the
act for several years. (1) At a minimum, then, Congress should preserve access to state courts until we can be certain that the federal law is not limiting the recoveries of
legitimately defrauded investors.
A. PSLRA's safe harbor is a radical experiment.
Caution is particularly warranted in this instance, because the PSLRA has at its heart a radical
experiment of highly questionable benefit to investors -- the safe harbor for forwardlooking
statements. In order to provide investors with more information, and thus improve the efficiency
with which the market allocates capital, the PSLRA protects forward-looking statements from
liability, even when they are knowingly false or made with a reckless disregard for the truth. It is
difficult to understand, however, how investors or the market will benefit from increased
information if they cannot rely on that information as accurate.
It is not that long ago that forward-looking statements were actually prohibited on the grounds
that they were inherently misleading and subject to manipulation. Reading the testimony
presented to the subcommittee on October 29 by the American Electronics Association, the
Software Publishers Association, and the National Association of Manufacturers, it is easy to see
why. All three witnesses described a host of circumstances that make it extremely difficult, even
impossible, to provide forward-looking information with a high degree of accuracy. As Robert
C. Hinckley said in his testimony, "The sheer unpredictability of the market for these new
products, and of the associated revenues, make the business of forecasting extremely difficult for
most technology companies." (2) Or, as Charles A. Laverty said, "When a company is growing rapidly, it is impossible to predict with a high degree of accuracy what will occur -- and what the impact will be on earnings -- for even a ninety-day period." (3) Thus, even when companies are operating with the best of intentions, the forward-looking information they provide may be of
highly questionable value.
The business of providing forward-looking statements is further complicated by the fact that companies, particularly high tech and other growth companies, operate in an extremely competitive marketplace, where one of the chief commodities they compete for is investment capital. As Hinckley explained in his October testimony, the primary motivation for companies to provide forward-looking information is to "broaden and diversify the public ownership in their companies, and stimulate additional investor interest in their stocks." Given these circumstances, and the fact that forecasting is at best an inexact science, it would not be surprising to find companies issuing forward-looking statements that create a somewhat rosier picture than the
facts may warrant, particularly if those statements are protected from liability. Add in federal
and state regulators that don't begin to have the resources to police all such cases, and the
potential decrease in market integrity is enormous.
Interestingly, the first major study of companies' use of the new safe harbor found that firms are
providing forward looking information more frequently and in more detail since PSLRA's
passage. (4) The study also found, however, that companies' projections are somewhat less accurate than they were before PSLRA's passage. (5) As judicial decisions are handed down defining appropriate use of the safe harbor and companies gain experience with the Act, they are likely to make even greater use of the safe harbor. Then, and only then, will we begin to get a better idea of whether the information offered has significant value and whether this radical experiment offers benefits that outweigh its costs. Without that information, it would be irresponsible for Congress to further extend the safe harbor's provisions by preempting state laws.
B. Not enough evidence exists about the reasons lawsuits are being brought in state court
on which to base an appropriate response.
S.1260 is based on the assumption that all, or virtually all, class action lawsuits being brought in
state court since passage of the PSLRA are abusive strike suits seeking to avoid the "reasonable"
protections contained in the federal law. It is just as easy, however, to make the argument that
those lawsuits are meritorious cases being brought in state court because the federal law imposes
unreasonable burdens on plaintiffs. Based on the evidence currently available, it is impossible to
know which view comes closer to the truth. However, that is important information to have if
Congress is to craft an appropriate solution to this perceived problem. If, for example, the
problem is an overly restrictive federal law, then Congress should focus on fixing the federal law,
not on further extending its flawed provisions.
For example, the SEC noted in its report that, since passage of PSLRA, there "seems to be a real
decline in the number of lawsuits against secondary defendants." (6) The study cites as one possible cause the "inability to get discovery which might reveal misconduct by secondary defendants." As the study goes on to explain, secondary defendants are less likely to be named in initial complaints because of the act's heightened pleading standards. Because "complaints are
customarily met with a motion to dismiss, discovery can be stayed for a year or more after the
complaint is filed." Combine this with the restrictive federal statute of limitations, which requires
that lawsuits be brought within a year of discovery of the wrongdoing, and lawsuits against
secondary defendants can become all but impossible to pursue.
This barrier does not discriminate between meritorious and frivolous lawsuits. It does make it
that much more difficult for defrauded investors to fully recover their losses. If plaintiffs'
attorneys are filing parallel lawsuits in state court to get access to discovery that allows them to
press a legitimate claim against secondary defendants -- a claim that would be impossible to
pursue in federal court -- then the proper solution is to fix the federal law, by extending the
statute of limitations, for example.
With regard to the safe harbor, if, as some corporate officials told the SEC, companies are failing
to use the safe harbor because they object to providing a complete list of cautionary statements
on the grounds that it is "cumbersome" or might "water down" the company's disclosures, then
preempting state law will do nothing to resolve the problem. (7) Similarly, if the lack of judicial guidance and experience with the law is the major problem, then time will likely solve it without the need for additional legislation. Until we know whether there really is a persistent "problem" with under-utilization of the safe harbor provision, and until we know the cause of that
"problem," Congress should not rush to adopt a solution that may be neither effective nor
C. There is no crisis that demands action before the full effects of the federal law are
A year ago, when members of Congress first publicly began to discuss the need to preempt state
laws for class action lawsuits involving exchange-traded securities, the call for immediate action
was based on the threat posed by Proposition 21 1 in California. But Proposition 21 1 was
overwhelmingly defeated at the polls, and there is no prospect of its revival in California or
elsewhere in the foreseeable future. (8)
The next justification preemption advocates put forward for precipitate action was the "dramatic"
increase in the number of class actions brought in state court since passage of PSLRA. But that
threat, too, proved ephemeral. Several studies now have clearly shown that the number of state
court filings in 1997 is back to pre-PSLRA levels. Just last month, for example, the accounting
firm Price Waterhouse released a study showing that the number of cases filed in state court had
dropped more than 30 percent, from 66 in 1996 to 44 in 1997. (9) National Economic Research Associates analyzed state court filings in the first five months of 1997 and concluded that the 19 filings from January 1997 through April 1997 projected to a total of 57 filings for the year, approximately the same as the 1991 to 1995 average. (10) New figures released just this month by the SEC indicate that the number of parallel lawsuits -- those filed in both federal and state courts -- is also down dramatically to 20 in 1997 from 31 in 1996. (11)
With no evidence that state court actions are on the rise, some have argued that
immediate action is needed because, left unaddressed, the problem will inevitably get worse. (12)
In fact, however, a number of developments in the courts and at the state level make such a result
far from inevitable. For example, a decision is expected soon on whether national class actions
will be allowed under California law. If the court disallows such actions, then much of the
"problem" this legislation is designed to address will be resolved without the need for additional
federal preemption of states' rights. Similarly, a legislative commission has been established in
California to study its laws and make changes, if necessary. This, too, could resolve many issues
this legislation is designed to address, but in a far less intrusive manner.
Finally, there is no evidence that an economic crisis exists that would justify a hasty
congressional response. Again, the testimony from AEA and SPA is instructive on this point.
Speaking for AEA, Hinckley noted that the technology sector, which is supposedly the leading
target for abusive litigation, has been "one of the fastest growing industry segments in the U.S.
economy over the past decade," the same period when it was supposedly being crippled by
abusive litigation. "In 1996, the technology sector in California represented the number one
industry segment for the creation of new jobs in the entire country," Hinckley said. Similarly, the
SPA's Cooperman made it clear that these high tech companies are not struggling to attract
capital. For example, it has not been "uncommon to see a software company achieve a billion ,
dollar market capitalization with sales of just a few hundred million dollars," he said. This is
hardly the picture of a struggling industry in need of an emergency rescue from Congress.
Congress has been provided with no evidence that the safe harbor will benefit investors
by providing them with an increased flow of accurate information, no evidence that lawsuits
being brought in state court are frivolous cases seeking to evade federal protections, and no
evidence of a crisis that warrants precipitate action. Therefore, we urge you to take your time in
addressing these issues. It is too important a matter for Congress to decide on an anecdote and a
hunch. We join the SEC in urging you to wait until the full impact of the federal law is known
before extending its provisions to lawsuits being brought in state court.
II. The legislation is seriously flawed.
Even if one accepts as a given that we should have uniform national standards for
securities fraud class action lawsuits involving exchange-traded securities, it does not necessarily
follow that this legislation offers the best means of reaching that goal. In its current form, S.
1260 is unbalanced, unfair to average investors, overly broad, and unlikely to be effective.
A. The legislation is unbalanced.
S.1260 fails to address the potentially harmful effects of PSLRA on investors, and instead
focuses exclusively on concerns raised by industry. The following are among the most serious
problems for investors which S. 1260 either fails to address or actually makes worse.
1. Problems with pleading standards. Since passage of PSLRA, some courts have issued
decisions denying recklessness as a basis for liability. The SEC has stated that preserving
recklessness as a basis for liability "is essential to investor protection." (13) As the SEC stated in its testimony before your subcommittee:
"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." (14)
S. 1260 should clarify that Congress intends recklessness to be considered a basis for liability under federal securities laws.
2. Problems with statute of limitations. As we noted above, the SEC found in its study that the
combination of the federal law's restrictive statute of limitations with PSLRA's heightened
pleading standards and discovery stay may be preventing plaintiffs from filing suit against secondary defendants. (15) This is just the latest evidence that the federal statute of limitations is unreasonably short. Perpetrators of fraud should not be able to escape liability for
their wrong-doing simply by keeping it hidden for three years. (16)
S.1260 should lengthen the federal statute of limitations.
3. Lack of aiding and abetting liability. Further experience with the PSLRA is likely to
show that recoveries for defrauded investors are down, in large part because of their inability to
recover under federal law from those who are not the primary wrong-doers but whose actions
made it possible for the fraud to go forward. There is no justification for permitting those who
aid and abet fraud to escape responsibility for compensating their victims. This is unfair to the
fraud victims. It is also unhealthy for our financial system, as it encourages accountants,
attorneys, and other professionals to look the other way when they suspect their corporate clients
S. 1260 should fully restore civil liability for aiding and abetting securities fraud.
Instead of addressing investor concerns in these areas, S. 1260 threatens to make them worse, by
denying defrauded investors access to state court where most states recognize recklessness as a
basis for liability, have a longer statute of limitations, and offer some form of aiding and abetting
liability. Without addressing at least these basic investor concerns, S. 1260 cannot possibly be
considered a balanced piece of legislation.
B. The legislation is unfair to average investors.
If S.1260 is adopted, institutional investors and the wealthiest investors will still be able to
choose the most favorable venue for their lawsuits, since they have the resources to bring an
individual suit. Only those of more modest means, who must rely on class actions as the only
cost-efficient means to press their case, will be denied that choice. This discriminates against
average investors. Furthermore, as the SEC noted in its testimony, "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." (17)
C. The legislation is overly broad.
The proponents of uniform standards point almost exclusively to two provisions of the
federal law that are being "evaded" -- the safe harbor and the discovery stay. If Congress must
proceed with preemption legislation in advance of any evidence that such legislation is
warranted, it should limit that preemption to areas in which problems are alleged to have
Instead, S. 1260 contains sweeping preemption, not only of state securities laws, but also of state
unfair and deceptive trade practice statutes and even common law fraud, as long as a security
traded on a national exchange is involved. Furthermore, the SEC notes in its testimony that S.
1260 would make state securities laws inapplicable in most class actions, whether they are
brought in federal or state court, and it would prevent state courts from trying claims based on
federal law violations.
Finally, the definition of class action in the legislation could be interpreted to pull in a number of
cases that have not traditionally been considered class actions and that have not been identified as
a problem. For example, as currently written, S. 1260 might prevent state actions by individual
trustees, guardians, and others with custodial relationships. (18) S. 1260's reference to "groups of lawsuits" also raises questions about whether the legislation's preemption would apply if a number of individuals brought separate lawsuits in the same state court. These problems could be fairly easily resolved by changing the definition of class action in the legislation to refer to the
definition of class action in federal and state rules of civil procedure. The rules of civil
procedure are based on years of experience in determining when it is appropriate for an action to
proceed as a class action. Congress should not muddy the water by identifying a new definition
of class actions solely for the purpose of cases involving exchange-traded securities.
D. The legislation is unlikely to be effective.
If Congress were to pass S. 1260, it would create a strong incentive for institutional investors to
bring their cases individually in state court when that is the more favorable venue. (19) Thus, companies still will face the threat of state court litigation for forward-looking statements. Furthermore, plaintiffs' attorneys may still be able to avoid the federal discovery stay by bringing a parallel individual case in state court. Investors, meanwhile, will have paid an enormous price for legislation that fails even to solve the "problems" Congress set out to address. Thus, when this new law also proves ineffective, will its proponents return to Congress with a request to
preempt all private rights of action under state laws for exchange-traded securities? How big a
sledgehammer is Congress willing to wield to kill this gnat?
Ultimately, the only real, effective solution is for proponents of "reform" to attempt to win
changes, such as safe harbor protections and a discovery stay, in state laws. This has the benefit
of offering a narrowly crafted solution to a narrowly defined problem. It also preserves
protections, such as longer statutes of limitations and aiding and abetting liability, where they
exist in state law. Finally, while attacking an issue one state at a time can be cumbersome, this is
less of a problem here, since roughly 60 percent of state cases are filed in one state, and that state
has already set up a legislative commission to identify problems with its laws. (20) While we continue to question whether these changes are warranted, based on the available evidence, this approach would be far less harmful to investors than the sweeping, but ultimately ineffective, state preemption proposed in S. 1260.
As we have stated to the committee before, we continue to believe that broad preemption
legislation, such as S. 1260, is unwarranted based on the available evidence, harmful to
defrauded investors, and unlikely to be effective. We strongly oppose its passage. We urge
Congress to wait until there is adequate evidence on which to base a careful and unbiased
assessment of any problems that have resulted from passage of PSLRA, including problems that
limit recoveries by legitimate victims of fraud. Only then can Congress craft balanced legislation
that provides appropriate national standards for securities class action lawsuits without placing
unreasonable limits on the rights of defrauded investors.
1. This view has also been expressed by the Securities and Exchange Commission in its Report
to the President and the Congress on the First Year of Practice Under the Private Securities
Litigation Reform Act of 1995, U.S. Securities and Exchange Commission, Office of the General
Counsel, April 1997 and more recently in its October 29, 1997 testimony before this
subcommittee. See also Testimony of Michael A. Perino, Stanford Law School, Before the
Subcommittee on Finance and Hazardous Materials of the House Commerce Committee,
October 21, 1997.
2. Statement of Robert C. Hinckley, Vice President, Strategic Plans and Programs, Xilinx, on behalf of The American Electronics Association, before the Securities Subcommittee of the Senate Committee on Banking, Housing, and Urban Affairs, October 29, 1997.
3. Statement of Charles A. Laverty, Chairman & CEO, Imagyn Medical Technologies, on behalf
of the National Association of Manufacturers, submitted to the Securities Subcommittee of the
Senate Committee on Banking, Housing, and Urban Affairs, October 29, 1997.
4. The Impact of Securities Litigation Reform on Disclosure of Forward-Log"
Information By High Technology Firms, Marilyn Johnson, University of Michigan Business School, Ron Kasmik and Karen K. Nelson, Graduate School of Business, Stanford University, January 5, 1998, pg. 1-2.
5. Ibid, pg. 2.
6. SEC Report, p. 24.
8. To the degree that states are adopting changes in this area, they are more likely to change their laws to mirror PSLRA. Three states -- Arizona, Montana, and Ohio -- have so far adopted laws based on PSLRA.
9. Price Waterhouse Securities Litigation Study (January 1998).
10. Federal Shareholder Class Action Filings Rise to Pre-Reform Act Levels as State Filings Fall, National Economic Research Associates, Inc. (July 1997).
11. "SEC Sees Rise in Filing of Federal Securities Class Actions," Paul Beckett, Dow Jones News Service (February 18, 1998).
12. Statement of Senator Chris Dodd, Oversight Hearing on the Impact of the Private Securities Litigation Reform Act of 1995, Securities Subcommittee of the Senate Committee on
Banking, Housing, and Urban Affairs (July 24, 1997).
13. SEC testimony, p.13.
15. P. 3, infra.
16. Support for a lengthened federal statute of limitations has also been expressed by the SEC and state securities regulators since the Supreme Court's decision in Lamp v. Pleva.
17. SEC testimony, p. 19.
18. Letter to Senator Wayne Allard from James S. Helfrich of Gersh & Helfrich, LLP., October 28, 1997.
19. SEC testimony, p. 21.
20. SEC testimony, p.12.
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