Senate Banking, Housing and Urban Affairs Committee

Subcommittee on Securities

Hearing on S.1260
"The Securities Litigation Uniform Standards Act of 1997"

February 23, 1998, 2:00 p.m.⁽¹⁾

Mr. Chairman and Members of the Committee:

Thank you for inviting me to testify. I am a member of the New York bar, a visiting professor at Cornell Law School and a tenured associate professor at the University of Illinois. For two years, I was director of the University of Oregon's Law and Entrepreneurship Center. My areas of expertise are securities regulation, corporations and legal ethics.

In January, I mailed to various members of this Committee two letters, the first signed by twenty-eight and the second by twenty-three professors of securities regulation and corporate law from around the country.⁽²⁾ The first letter expressed opposition to pending legislation that would preempt private rights of action for securities fraud in class actions brought under state law.⁽³⁾ The second letter explained in more detail some of the signatories' reasons for opposing preemption. Today, however, I speak only on my own behalf.⁽⁴⁾

Most of my objections to the proposed legislation fit under one of two concepts: federalism and fraud. Put simply, I am in favor of federalism and against fraud.

Let us start with federalism.

I am very concerned about federal preemption of state common law and statutes that have existed in one form or another since before the federal securities laws were enacted.⁽⁵⁾ My point is not that federal preemption of state law is never justified, but that proponents of preemption bear a heavy burden of showing that state law unduly interferes with federal laws designed to protect an important national interest. The proponents of the preemption legislation we are discussing today have shown nothing of the kind.

Proponents of preemption point to statistics compiled at Stanford Law School purporting to show that there has been a surge of state court filings since the 1995 Reform Act.⁽⁶⁾ Although the high technology industries of Silicon Valley have seized upon these statistics to argue that litigation is migrating from federal to state court, two separate reports, one prepared by National Economics Research Associates⁽⁷⁾ and the other by Price Waterhouse⁽⁸⁾ demonstrate that levels of litigation in state courts in 1997 appear to have returned to pre-1995 levels. Federal filings also are close to where they were before the 1995 Reform Act.⁽⁹⁾ The alarm that has been sounded about a surge in state court filings after 1995 and a movement of litigation from federal to state court, has been a false alarm.

Furthermore, although preemption proponents claim that state court litigation is a national problem that must be fixed by Congress, most state suits alleging securities fraud have been filed in a single state: California. Almost all of the state law cited in the prior testimony before this Committee and in the House was California law, and almost all of the defendants mentioned in testimony were California based companies. The law professors who testified in support of preemption were both from Stanford University. The issue Congress must decide is whether California is capable of resolving this controversy in a way that will not jeopardize the national interest in safe and efficient securities markets.

I suggest that California voters, legislators and judges will not allow California based companies to be persecuted by frivolous lawsuits. Because the vast majority of state law securities class actions are filed in the state where the issuer is incorporated or has its primary place of business,⁽¹⁰⁾ California law that allows frivolous class actions would hurt California based companies disproportionately and ultimately drive business and jobs away from California. Furthermore, it is difficult to believe that Silicon Valley issuers do not have at least as much influence one hundred miles away in Sacramento as they do here in Washington.

California law, furthermore, shows no signs of bending over backwards to accommodate frivolous lawsuits. Two California ballot measures were proposed in 1996, the first seeking to change California law in a pro-defendant direction and the second seeking changes that would favor plaintiffs. California voters, however, soundly rejected both measures, the pro-plaintiff measure being rejected by a noticeably wide margin.⁽¹¹⁾ Meanwhile, the California Supreme Court will decide whether a nationwide class of investors may sue in a California court over alleged fraud in the sale of securities by a California based issuer.⁽¹²⁾ California courts are also deciding how to respond to plaintiffs who file suits in state court merely to obtain discovery that is unavailable in parallel actions brought in federal court.⁽¹³⁾ Although these issues remain unresolved in California, developments in other states demonstrate that, to the extent state law governing securities litigation is changing, it is changing in the same direction as the federal law, in a decidedly pro-defendant direction.⁽¹⁴⁾

Last October, a House subcommittee was told by Bruce Vanyo, a partner of Wilson, Sonsini, the law firm that defends many of these suits, that there is an onslaught of litigation in

state courts that threatens to undermine the 1995 Reform Act.⁽¹⁵⁾ However, my visit last week to Wilson, Sonsini's World Wide Web page led me to an article by Boris Feldman, one of the firm's most prominent securities litigators, saying precisely the opposite:

"In my opinion, plaintiffs' state court gambit has been a failure and it over . . . I base this conclusion on three factors. First, plaintiffs' attempts to broaden dramatically state laws that have been on the books for years have not worked. . . . Second, I believe that plaintiffs have come to realize that they will not be permitted to use courts in a particular state (i.e. California) to litigate the claims of shareholders around the country . . . Finally plaintiffs have not had much success milking the state cases for discovery that they can then use to file a federal complaint."⁽¹⁶⁾

Mr. Vanyo told Congress that state court litigation is out of control, while his partner Mr. Feldman stayed home and reassured the firm's clients that everything is under control. Which is it? Twenty three professors of securities regulation suggest in the second of the two letters you received, and I suggest in a law review article that I have written on the subject,⁽¹⁷⁾ that the facts are and will continue to be much closer to what Mr. Feldman has said on Wilson Sonsini's Web page.

Perhaps most important, Wilson, Sonsini is continuing to advise its clients to use the federal safe harbor for forward looking statements, one of the provisions of the 1995 Act purported to be threatened the most by securities fraud litigation in California state courts.⁽¹⁸⁾ A recent study, conducted by three business school professors, two from Stanford University's School of Business and one from the University of Michigan Business School, also confirms that "there was an increase in both the frequency of firms issuing forecasts and the mean number of forecasts issued following enactment of the Reform Act."⁽¹⁹⁾ For issuers that want to use the federal safe harbor, California state court suits thus do not appear to have presented a substantial obstacle.

In summary, California does have the situation under control. The interests of investors and issuers have been balanced under California law, and if California law is found to favor one side over the other, there are mechanisms available in California to correct this. There is simply no need for Congress, which has embraced federalism in a wide array of areas including health care,⁽²⁰⁾ welfare⁽²¹⁾ and unfunded mandates,⁽²²⁾ to preempt state law when it comes to securities fraud.

Now, let us turn to fraud and the role of state causes of action in deterring and compensating the victims of fraud.

In 1933 and 1934, Congress decided that state law alone did not adequately protect investors from abuses in the securities markets, including securities fraud. Congress enacted a national system of securities regulation. Express private rights of action were enacted in several parts of the securities laws, including for misleading statements in registration statements in Section 11 of the 1933 Act ⁽²³⁾ and against sellers of securities using misleading prospectuses in Section 12(2),⁽²⁴⁾ but nowhere did Congress create an express private right of action under the general anti-fraud statute, Section 10(b) of the 1934 Act.⁽²⁵⁾ Congress knew at the time, however, that many state statutes as well as state common law provided private rights of action for

securities fraud, and Congress expressly stated that these state remedies would remain intact.⁽²⁶⁾

Since then, federal courts have implied remedies for securities fraud under Section 10(b) even though the statute did not expressly provide a remedy. However, this implied private right of action is very limited. Under the case law, a federal plaintiff may not sue an aider and abetter of securities fraud (only a primary violator),⁽²⁷⁾ a federal plaintiff may not sue if she was defrauded more than three years ago (longer statutes of limitations under state law do not apply in federal court),⁽²⁸⁾ and a federal plaintiff may not sue a person whose fraudulent statements induced her not to sell an overvalued security in her portfolio.⁽²⁹⁾ Many of these restrictions have been shaped by the Supreme Court's hostility to a cause of action never expressly bestowed by Congress⁽³⁰⁾ as well as by the Court's knowledge that defrauded investors denied access to federal courts still have remedies under state law.⁽³¹⁾ Furthermore, some members of the Congress that passed the 1995 Reform Act, which curtailed substantive and procedural federal rights of action even more,⁽³²⁾ knew and explicitly pointed out that state causes of action for securities fraud were being preserved.⁽³³⁾

Finally, it is entirely possible that federal private rights of action for securities fraud could continue to disappear. Some federal courts are already interpreting the heightened pleading standards in the 1995 Reform Act to preclude suits based on recklessness.⁽³⁴⁾ It has been suggested in an article in the Harvard Law Review by Professor Joseph Grundfest, himself a former SEC Commissioner, that the SEC should take advantage of the fact that Section 10(b) contains no express private right of action, and scale back, or "disimply", through administrative rule the cause of action that federal courts have implied.⁽³⁵⁾ If the preemption legislation we are discussing here today is enacted, this state law limitation on the SEC's ability to disimply causes of action for securities fraud will no longer exist.

In short, plaintiffs' right to sue in federal court for securities fraud is anything but safe and secure, and as the private right of action under federal law grows increasingly limited, state law has an invaluable role in the federal system. This is particularly true if future legislation, administrative action or judicial decisions make federal law even more inhospitable for investors.

Conclusion

It is by no means clear that federal law is a better vehicle for addressing securities fraud than state law. Indeed, some leading scholars of securities law have suggested that the states ought to play more of a role in securities regulation relative to the federal government, not less.⁽³⁶⁾ I suggest that this Committee give federalism a chance before rushing to the conclusion that preemption is required.

At a minimum, before taking such a drastic step, Congress should make sure that it is relying on unambiguous and uncontroverted information showing (1) whether a significant number of suits have migrated from federal to state courts since the 1995 Act (the answer appears to be that they have not); (2) whether state court suits have less merit than suits filed in federal court; (3) whether state courts will allow plaintiffs to use parallel state court litigation to circumvent the new limitations on discovery in federal court; (4) whether most states will continue the current trend toward conforming state law to the decidedly pro-defendant leanings of the federal law; (5) whether state courts or legislatures will endorse efforts to create nationwide classes of plaintiffs in state court, and if so, whether the defendants in these suits will have significant contacts with the state in question; and (6) whether state court litigation interferes with use of the federal safe harbor (the answer appears to be that it does not). If problems in one or more of these areas prove insurmountable at the state level, Congress may have to address such problems in the future, but Congress should do so only with a thorough understanding of the problem to be addressed and with far more narrowly written legislation than the bills currently under consideration.

Notes:

1. On Wednesday, February 18, 1998, I was notified by telephone call and letter that I was invited to testify today. I was also requested to submit 100 copies of this statement to this Committee by Friday, February 20, 1998. In view of the time constraints, this statement is shorter than it might otherwise be. I will also distribute to various members of the Committee copies of my law review article on this same topic, Sounding a False Alarm: The Congressional Initiative to Preempt State Securities Fraud Litigation. Portions of this Statement are taken from that article as well as from the two letters to Congress that I drafted in January.

2. See Letter, dated January 23, 1998, to Senators and Members of Congress from Ian Ayres, Stephen M. Bainbridge, Douglas M. Branson, William W. Bratton, John C. Coffee, Jr., James D. Cox, Charles M. Elson, Merritt B. Fox, Tamar Frankel, Theresa A. Gabaldon, Nicholas L. Georgakopoulos, James J. Hanks, Jr., Kimberly D. Krawiec, Fred S. McChesney, Lawrence E. Mitchell, Donna M. Nagy, Jennifer O'Hare, Richard W. Painter, William H. Painter, Margaret V. Sachs, Joel Seligman, D. Gordon Smith, Marc I. Steinberg, Celia R. Taylor, Robert B. Thompson, Manning G. Warren III, and Cynthia A. Williams. Another longer Letter to Senators and Members of Congress, also dated January 23, 1998, was signed by 23 of the foregoing professors and explained in more detail some of the reasons the signatories opposed preemption of state causes of action at this time. The two letters are attached hereto as Exhibit A.

3. See S. 1260, 105th Congress, 1st Sess. (1997) (the Securities Litigation Uniform Standards Act of 1997); and HR 1689, 105th Congress, 1st Sess. (1997).

4. I have not done paid consulting work since I began my academic career in 1993, and I have received no compensation or reimbursement of expenses in connection with my testimony here today.

5. The modern class action suit had its genesis in actions brought under the common law and corporate law, and later the securities law, of the various states. New York, for example, in 1924 permitted joinder into a single proceeding of common law fraud claims brought by 123 investors against promoters who sold stock by use of a misleading prospectus. Akely v. Kinnicutt, 238 N.Y. 466, 144 N.E. 682 (1924) (finding that New York civil procedure statute permitted joinder because common questions of law and fact predominated among the plaintiffs).

6. Testimony of Professor Joseph Grundfest, Hearings on Securities Litigation Abuses, Subcommittee on Securities, United States Senate Committee on Banking, Housing and Urban Affairs, July 24, 1997; Testimony of Michael A. Perino Before the House Commerce Committee, Finance and Hazardous Materials Subcommittee, October 21, 1997, citing statistics compiled by Stanford's Class Action Clearinghouse and reported on a World Wide Web page. The Stanford Web site is funded in part by private industry. See http://securities.stanford. edu/about/caveat.html ("This project is made possible through the vision and generosity of our sponsors: George Roberts [a founding partner of Kohlberg, Kravis, Roberts and Co.] provided the 'seed capital' for this venture; the National Center for Automated Information Research which provides the largest source of our sustaining support; Netscape Communications which donated the software for the sight; and Sun Microsystems and Apple Computer which donated the hardware for this site."). Some of these sponsors are not entirely disinterested in securities litigation. Weighing in favor of the reliability of the Stanford data, however, is the fact that it was compiled under the supervision of two highly respected scholars of securities law: Joseph Grundfest, a former SEC Commissioner, and Michael Perino, an accomplished scholar on this subject in particular. See Michael A. Perino, Fraud and Federalism: Preempting Private State Securities Fraud Causes of Action, __ Stan. L. Rev. (forthcoming 1998).

7. See Todd S. Foster, Frederick C. Dunbar, Denise N. Martin, and Vinita M. Juneja, Federal Shareholder Class Action Filings Rise to Pre-Reform Act Levels as State Filings Fall, National Economics Research Associates (July, 1997) ("NERA 1997 Study") (reporting 23 state court filings in the first five months of 1995, 53 in the first five months of 1996 and 21 in the first five months of 1997) .

8. See Price Waterhouse Securities Litigation Study 1 (1998) ("Price Waterhouse Study") (reporting 67 state cases in 1994, 52 in 1995, 66 in 1996 and 44 in 1997) (from data supplied by Securities Class Action Alert).

9. NERA 1997 Study (reporting 69 federal court filings in the first five months of 1995, 47 in the first five months of 1996 and 78 in the first five months of 1997), and Price Waterhouse Study, supra (reporting 219 federal cases in 1994, 164 in 1995, 112 in 1996 and 171 in 1997).

10. For example, out of the fifty-five 1996 state securities class action complaints obtained and reviewed by the staff of the SEC, 78% (43 complaints) were filed in one state alone, California, and only 7% (4 complaints) were filed in states where the issuer was not incorporated or did not have a principal place of business. Testimony of Arthur Levitt Before the House Commerce Committee, Finance and Hazardous Materials Subcommittee, October 21, 1997, at 16.

11. See Proposition 201, Shareholder Litigation Reform Act (defeated in general election Mar. 26, 1996), reprinted in 2 Cal. Legis. Service A-22 to A-27 (West 1996); See Proposition 211 (defeated in general election of November 1996 by a 3 to 1 margin), reprinted in 3 Cal. Legis. Serv. (West 1996).

12. Diamond Multimedia v. Superior Court, No. S058723 (1997).

13. Some California courts have been imposing their own stays on discovery in circumstances where federal courts would do likewise, thus frustrating plaintiffs who file parallel state and federal actions to gain an advantage in obtaining discovery. See Milano v. Auhll, No. SB 213 476 (Cal. Super. Court, Santa Barbara County, Oct. 2, 1996), where both state and federal claims were brought, discovery was stayed pending a motion to dismiss. Even in Sperber v. Bixby, No. 699812 (Cal. Super. Court, San Diego County, Oct. 25, 1996), where only state claims had been brought, defendants successfully argued that the court should look to the federal law as persuasive authority for deciding whether to impose a stay. In Marinaro v. Superior Court of Santa Clara, 1996 Cal. LEXIS 6105 (October 30, 1996), the California Supreme Court ordered an appellate court to reconsider a motion for stay where it appeared that plaintiffs sought discovery to gain an advantage in other actions filed in federal court. All of these cases are discussed in a paper written by Professors Grundfest and Perino, Securities Litigation Reform: The First Year's Experience, Release 97.1, pages 45-46 (Cornerstone Research, February 27, 1997). Other California cases suggest a more liberal attitude toward discovery in state proceedings. See Oak Technology v. Superior Court of Santa Clara County, H016141, slip op. (Cal. 6th App. Aug. 14, 1997) (denying stay of discovery in three separate state court class actions); Pass v. Hyung Hwe Huh, No. CV758927 (Cal. Super. Court, Santa Clara County 1997) (denying Diamond Multimedia's motion to stay proceedings pending resolution of a parallel federal suit in the Northern District of California).

14. See Prepared Statement of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission Before the Senate Committee on Banking, Housing and Urban Affairs Subcommittee on Securities Concerning the Impact of the Private Securities Litigation Reform Act of 1995, July 24, 1997, citing Ariz. Rev. Stat. §§ 44-2081-2087; 1997 Mt. Laws § 468; Ohio Rev. code Ann. §§ 1707.432438.

15. Prepared Testimony of Bruce G. Vanyo Before the House Committee on Commerce Subcommittee on Finance and Hazardous Materials, October 21, 1997 ("Since the Reform Act was passed, securities class actions have been migrating to the state courts. . . . My experience over the last eighteen months more than bears out this strategic shift from federal to state court. . . .[P]laintiffs are filing duplicative parallel class actions in the federal and state courts, with the objective of obtaining in state court the discovery they otherwise are denied in federal court.")

16. The Securities Class Battlefield Circa 1998, http://www.wsgr.com/Resources/Sec Lit/Recent/battle.htm (February 12, 1998).

17. Richard W. Painter, Sounding a False Alarm: The Congressional Initiative to Preempt State Securities Fraud Causes of Action (manuscript distributed to various members of this Committee along with this statement).

18. See Boris Feldman, Financial Fraud in the Era of Securities Reform, http:www.wsgr.com at /Resource/Sec_Lit/Recent/finfraud.htm (February 12, 1998) ("The safe harbor will go far toward eliminating the classic fraud-by-hindsight suit filed when a company fails to satisfy quarterly earnings expectations."); Boris Feldman, Cal. Law: A Briefing Provided by Wilson, Sonsini Goodrich & Rosati, id. at wilson/wilson7.html (February 12, 1998) ("The safe harbor seeks to encourage public companies to disclose forward-looking information by protecting them from suit if that information does not come to pass. Corporate counsel and investor relations personnel will want to review their companies' disclosure practices to ensure thorough implementation of the safe harbor's requirements. The statute's protection is worth the effort."). All of the articles appearing on Wilson, Sonsini's Web page are followed by a statement that they are "not legal advice." Despite this disclaimer, the articles are obviously intended for reading by an audience comprised mainly of clients, potential clients and lawyers advising the firm's clients. Also, Wilson, Sonsini presumably would not give legal advice to clients that contradicted statements that a senior partner of the firm is making on the firm's Web page.

19. Marilyn Johnson, Ron Kasznik and Karen Nelson, The Impact of Securities Litigation Reform on the Disclosure of Forward-Looking Information by High Technology Firms (January 2, 1998). See also id at 23. "We find that there was a significant post-Act increase in both the frequency of firms issuing forecasts and the mean number of forecasts issued."

20. Congress rejected President Clinton's effort to nationalize health insurance in the proposed Health Security Act, S. 1757, 103d Cong., 1st Sess. (1993); H.R. 3600, 103d Cong., 1st Sess. (1993).

21. See Personal Responsibility and Work Opportunity Reconciliation Act of 1996, Pub. L. No. 104-193, 110 Stat. 2105 (1996) (codified in scattered sections of 8 U.S.C. and 42 U.S.C.) (returning power over welfare to the states).

22. See Unfunded Mandates Reform Act of 1995, Pub. L. No. 104-4, 109 Stat. 48 (1995) (codified in 2 U.S.C. 1501-1571 (1996)) (prohibiting new unfunded mandates from Congress to the states). See also Terry E. Branstad, Governor of Iowa, Balancing the Budget: What Washington Can Learn From the States, Heritage Foundation Reports, May 13, 1997 ("In just a little over two years, this Republican Congress has shifted the discussion in Washington, D.C. toward a balanced budget -- something what was a rarity during the years of Democrat control. Furthermore, a debate over federalism and returning power to the states was unheard of in the past.").

23. 15 U.S.C. § 77(k).

24. 15 U.S.C. § 77(l).

25. 15 U.S.C. § 78j.

26. See Section 16 of the 1933 Act, 15 U.S.C. § 77p ("The rights and remedies provided by this Act shall be in addition to any and all other rights and remedies that may exist at law or in equity"); and Section 28(a) of the 1934 Act, 15 U.S.C. § 78bb(a) ("The rights and remedies provided by this Act shall be in addition to any and all other rights and remedies that may exist at law or in equity"). Double recovery, however, is not allowed. Id. ("[B]ut no person permitted to maintain a suit for damages under the provisions of this Act shall recover, through satisfaction of judgment in one or more actions, a total amount in excess of his actual damages on account of the act complained of.").

27. Central Bank v. First Interstate Bank, 511 U.S. 164 (1994).

28. Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350 (1991).

29. Blue Chip v. Manor Drug Stores, 421 U.S. 723 (1975) (holding that a plaintiff has no standing to sue under Section 10-b of the 1934 Act unless an actual purchaser or seller of securities).

30. See Blue Chip Stamps, supra at 737 ("When we deal with private actions under Rule 10b-5, we deal with a judicial oak which has grown from little more than a legislative acorn."); Central Bank, supra at 171 (just as Blue Chip Stamps declined to impute to Congress an intent to expand the plaintiff class for a judicially implied cause of action, "it would be just as anomalous to impute to Congress an intention in effect to expand the defendant class for 10b-5 actions.")

31. See e.g. Blue Chip Stamps, supra at 738, n.9 (1975) (pointing out that disadvantages imposed on investors by the Court's holding "are attenuated to the extent that remedies are available to nonpurchasers and nonsellers under state law. Cf § 28 of the 1934 Act, 15 U.S.C. § 78bb." ).

32. See e.g. 15 U.S.C. § 78u-4(b) (pleading requirements); 15 U.S.C. §§ 77z-1(b), 78u-4(b)(3)(B) (stay of discovery); and 15 U.S.C. § 78u-5 (safe harbor for forward looking statements).

33. See colloquy of Representative Christopher Cox with Professor Daniel Fischel, Hearings Concerning the Common Sense Legal Reform Act. Subcommittee on Telecommunications and Finance, House Committee on Commerce, January 19, 1995, at 110 ("Mr. Cox. So if you were a plaintiff, who like any plaintiff has a choice of forum, and if you were one of the investors who were defrauded in Orange County, for example, you might file your suit in State court or in Federal Court, depending on how you saw your advantage. . . . Mr. Fischel. Yes, you would still have the same choice of forums.").

34. See e.g. In re Silicon Graphics, Inc. Sec. Lit., 1996 U.S. Dist. LEXIS 16989, 1996 WL 664639 (N.D. Cal. 1996) (reaffirmed on motion to reconsider at 1997 WL 285057). The Silicon Graphics case is currently on appeal to the Ninth Circuit, and the SEC has filed an amicus brief protesting the district court's departure from the recklessness standard. See Brief of the Securities and Exchange Commission, amicus curiae, In re Silicon Graphics Sec. Litig., Fed. Sec. L. Rep. 99, 325 (N.D. Cal. 1996) (No. 96-0393).

35. Joseph A. Grundfest, Disimplying Private Rights of Action under the Federal Securities Laws: The Commission's Authority, 107 Harv. L. Rev. 963 at 1009 (1994). Ironically, Professor Grundfest explicitly states in that article, published only four years ago, that there is little prospect that Congress will preempt the state private rights of action that would limit changes to federal law "through administrative disimplication." While Congress "has the power to oust state regulation from the field, that power has not been exercised, and Congress has given no indication that it intends to exercise it." Id. See also, Joseph A. Grundfest, Why Disimply, 108 Harv. L. Rev. 740 (1995).

36. See Roberta Romano, Empowering Investors: A Market Approach to Securities Regulation, __ Yale Law Journal __ (forthcoming 1998) (suggesting that competitive federalism would be as viable an alternative in securities regulation as it is in corporate law).

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