CALIFORNIA PROPOSITION 211: COUNTER-ATTACK BY THE SECURITIES PLAINTIFF BAR
As discussed in the April 1996 ACE Report, the Private Securities Litigation Reform Act of 1995 sought to eliminate various perceived abusive litigation practices by the plaintiffs' bar in shareholder class actions under the federal securities laws. As predicted, one of the consequences of that new federal legislation has been a significant increase in the number of securities class action lawsuits filed in state court. The provisions of the new federal legislation are generally inapplicable to those state proceedings.
Many unresolved issues exist with respect to these state court cases. For example, can one state exercise jurisdiction over shareholders or defendants who reside in another state; does the "fraud-on-the-market" doctrine (which has been adopted in federal cases to presume reliance by investors on communications to the securities marketplace) apply to state securities claims; do certain state securities laws create private causes of action? Depending on how the state courts deal with these and other issues, plaintiffs may or may not find the state court forum to be a more effective venue for litigating securities claims against directors, officers and the corporation.
In an effort to assure a pro-plaintiff resolution of these issues and in a blatant attempt to circumvent the new federal legislation, the plaintiffs' bar has successfully placed on the November 6, 1996 California ballot Proposition 211, which if passed would adopt a series of new California statutes that would make California state courts the preferred forum for securities class action lawsuits which have any reasonable nexus with California.
It is difficult to overstate the importance of this initiative on virtually every publicly-held company, their directors and officers and the D&O insurance industry. Not only would the initiative restore the D&O liability environment to a condition existing prior to the recent federal legislation, but in many respects would create unprecedented new liability exposures for defendants. In addition, these new statutes would be administered by elected state judges who typically have too limited resources, experience and time to handle complex securities class action litigation and who may be more tempted than an appointed federal judge to err in favor of the electorate (i.e. the plaintiff class).
The initial title of this initiative was the "Retirement Savings and Consumer Protection Act" in an attempt to cater to voters who are retirees or who are saving for retirement. However, the California Attorney General's office disallowed that title as being self-serving and potentially misleading to voters and instead approved the title "Attorney-Client Fee Arrangement Securities Fraud Initiative."
Some of the more important provisions of Proposition 211 and their potential impact are summarized below:
A. PROHIBITED CONDUCT
If enacted, Proposition 211 would amend the California Corporations Code to create a new state cause of action against any person or for-profit entity who, directly or indirectly, in connection with the purchase or sale of securities, (i) willfully, knowingly or recklessly make or cause to be made untrue statements of material facts or omit to state material facts necessary to make the statements non-misleading, or (ii) participate or assist in any deceptive practice, statement, course of conduct or scheme. Such wrongful conduct is actionable under the new statute only if it results in loss to any pension fund, retirement fund or retirement savings (although recovery is not limited to that loss). Those terms are broadly defined to include any form of retirement savings, however denominated and in whatever form, by a person over 40 years of age if the retirement savings had been in existence for at least one year or had a value of at least $1,000 before suffering the subject loss. Thus, the "retirement" condition in the statute is virtually meaningless.
This new cause of action is broader than existing California law and is even broader than Section 10(b) of the Securities Exchange Act of 1934 prior to enactment of the new federal reform legislation. For example, under the most analogous existing California statute, a plaintiff must prove the defendant acted "willfully" in attempting to manipulate the securities market through misrepresentations. Proposition 211 creates liability not only for willful misrepresentations, but also "reckless" misconduct. Existing California case law suggests that the term "reckless" may be broadly defined by California courts to encompass conduct tantamount to simple negligence, in which case liability far broader than preexisting Section 10(b) liability would be created.
B. FRAUD-ON-THE-MARKET
The initiative would adopt a fraud-on-the-market doctrine both for purposes of the new cause of the action created by the initiative and for purposes of common law fraud and deceit claims under California law. That doctrine creates a rebuttable presumption that the price of a security traded in an active and efficient market reflects all statements made by the defendants and therefore class members need not prove individual reliance upon the alleged misrepresentations by the defendants. This aspect of the initiative overrules existing California case law which rejected the fraud-on-the-market doctrine and required plaintiffs in a class action alleging common law fraud and deceit to prove individual reliance by each member of the class. The initiative, in adopting a version of the doctrine which is much
broader than that recognized under federal law, would permit defendants to rebut the presumption of reliance only by establishing that the security would have been purchased or sold even if plaintiffs had known of the misconduct. Federal law also permits the presumption to be rebutted by a showing that the market was informed of the truth through other sources or that plaintiffs traded for reasons other than the integrity of the market. By removing those additional bases for refuting the presumption, the initiative denies the defendants a defense commonly invoked in federal securities litigation. Also, by applying the fraud-on-the-market doctrine to common law fraud and deceit claims, the initiative would create frightening class action liability exposure for mere negligent misrepresentations or omissions since California courts have ruled that the common law fraud and deceit action applies to mere negligent misrepresentations.
C. DERIVATIVE LAWSUITS
The initiative would permit lawsuits alleging violations of the new statute to be brought either as class actions or "derivatively, without regard to any limitations or requirements currently imposed on derivative actions." The initiative eliminates various procedural safeguards which currently apply to shareholder derivative suits for the protection of the corporation and its directors and officers. For example, the current requirement that a shareholder makes demand on the board of directors and defers to the informed decision of disinterested directors as to whether the claim on behalf of the corporation should be prosecuted, would not apply under the initiative. Directors and officers would thus be denied a valuable and commonly invoked defense which is currently available. In addition, shareholders may argue that the business judgment rule and the director liability limitation state statute constitute "limitations" currently imposed on derivative lawsuits and therefore are voided by the initiative. Although it appears doubtful that such an argument would succeed with respect to liability protections created under another state's law, such an argument may apply with respect to a California corporation.
D. AIDING AND ABETTING LIABILITY
The initiative imposes liability not only on persons who make the misrepresentations, but also on persons who cause, participate in or assist the prohibited conduct. This provision is intended to create aiding and abetting liability even though the U.S. Supreme Court in 1994 held that no such secondary liability existed under Section 10(b) of the Securities Exchange Act of 1934. Thus, the initiative would allow claims against third parties, such as accountants, attorneys and underwriters, who merely assist the primary wrongdoers even though such claims are now unavailable under the federal securities laws. The initiative would also broaden existing California law, which recognizes liability for anyone who "materially assists" certain violators of California securities statutes if the person is found to have acted with intent to deceive or defraud. Mere reckless wrongdoing would create liability under the initiative.
E. JOINT AND SEVERAL LIABILITY
The initiative would impose joint and several liability on each defendant who violates the new statute. This provision allows the plaintiffs to pursue any one defendant for the entire amount of the incurred loss regardless of the relative degree of fault of that defendant. The recent federal reform legislation eliminated joint and several liability and adopted a proportionate liability standard unless the defendant committed a knowing violation. By returning to a joint and several liability approach, the initiative arguably restores the "larger settlement rule" methodology for determining insurance allocation issues between defendant D&Os and the defendant corporation if the D&O insurance policy does not otherwise address the issue. Also, this aspect of the initiative allows plaintiffs to recover their entire loss as long as any one culpable defendant or its insurer has a sufficiently deep pocket.
F. DAMAGES
The initiative contains no limit on, or precise measure of, compensatory damages. Thus, the initiative appears to authorize larger damage awards than available under Section 10(b), which, as a result of the recent reform legislation, limits recoverable damages to the difference between the purchase price paid by the plaintiff and the mean trading price of the security during the 90 day period beginning on the date on which the information correcting the misstatement is disseminated to the market.
In addition, the initiative creates the potential for "additional civil damages" or "civil penalties" if the defendants' conduct was willful, outrageous or despicable. The amount of such additional damages or penalties is to be determined by the finder of fact and paid, less fees and expenses, to the General Fund of the Treasury of the State of California. Because the initiative refers to these additional amounts as both "additional civil damages" and "civil penalties," it is unclear whether such amounts would be excluded from the typical D&O insurance policy as fines or penalties or would otherwise be insurable. Many "dishonesty" exclusions would also exclude coverages for these amounts.
G. INDEMNIFICATION
The initiative would prohibit the indemnification of any "principal executive officer," director or controlling person for violation of the new statute. This provision is of critical importance to the D&O insurance industry because it impacts whether or not the corporate reimbursement retention will be applicable to claims under the new California statute and whether D&O-only coverage, such as provided by CODA, would respond to such litigation. Unfortunately, the language of the initiative creates an ambiguity as to when the indemnification prohibition applies.
The provision states that the prohibition applies with respect to any "principal executive officer" (which is an undefined term), director or controlling person "who is found individually liable for knowingly or recklessly engaging in deceptive conduct" as prohibited by the new statute. By applying the prohibition only to situations where the person is "found individually liable," the initiative arguably adopts the indemnification rule which has been espoused by the SEC and many federal courts under the federal securities laws for a number of years. Under that rule, indemnification is permitted in cases which are settled before there is a finding of individual liability. However, the initiative further provides that the indemnification prohibition applies not only to any judgment against and defense costs incurred by that person, but also "amounts paid in settlement." When read literally, the prohibition against settlement indemnification appears to apply only when the settlement occurs after the defendant is found individually liable, although one could argue that the prohibition applies to any settlement payment before or after a finding of liability.
Like state indemnification statutes and the federal indemnification rule, the initiative expressly permits corporations to purchase insurance on behalf of its directors, officers, employees or agents to cover liability which is not indemnifiable.
H. OMITS NUMEROUS FEDERAL REFORM PROVISIONS
The initiative omits a number of the reform provisions contained within the new federal legislation. For example, the initiative contains no safe harbor with respect to forward-looking statements, no heightened pleading requirements, no stay of discovery pending a ruling on a motion to dismiss, no provision relating to who the lead plaintiff may be, and no prohibition against payment of a bounty to the lead plaintiff.
I. ATTORNEY FEES
Not surprisingly, the initiative is peppered with provisions which seek to preserve large attorney fee awards to plaintiffs' counsel. Several provisions state that fee arrangements between plaintiffs and their counsel "shall not be restricted" and that the "validity of such contracts [shall not] be impaired," except that the ability of the courts to prohibit "illegal" or "unconscionable" fees is preserved. These provisions are apparently intended to avoid any fee-capping law that may be imposed in the future and contrast with the new federal reform legislation, which limits attorney fee awards to "a reasonable percentage of the amount of any damages and pre-judgment interest actually paid to the class."
J. AMENDMENTS TO NEW STATUTE
The initiative states that its provisions may be amended only upon approval by the electorate, thus prohibiting the California legislature from repealing or amending any of its provisions.
K. JURISDICTION
The most important unresolved issue under the initiative is the effect the new law would have upon plaintiff class members or defendants located outside of California. The initiative does not expressly address that issue and therefore it appears that the only limitation upon its geographic reach will be constitutional limitations. That constitutional analysis is highly fact intensive and subjective, so these jurisdiction issues will need to be litigated in each case. Because class actions are typically settled before a class certification ruling by a trial court can be appealed, in most cases defendants will be stuck with the trial court's ruling.
Plaintiffs will likely file class actions in California against corporations and their D&Os who are located outside of California if the defendants have any minimal contact with California and will likely seek class action certification for all shareholders injured by the alleged deceptive conduct regardless of where those plaintiff shareholders reside. This strategy will, at best, result in substantial additional defense costs in fighting the jurisdiction issues, and, at worst, subject defendants across the United States (and perhaps the world) to this dangerous new statute.
L. SUMMARY
Some of the more significant effects of this initiative, if adopted, follow:
- Filing: Most securities class action suits will be filed in California, at least until the jurisdiction issues are better resolved.
- Loss: Settlements and expenses will be substantially higher in securities class actions pursuant to the initiative because of the lower liability standards, higher measure of damages, uncertainty of new law and increased potential for uninsured and non-indemnified personal liability of D&Os if the case proceeds to trial.
- Willingness to Serve: Because of the increased potential for uninsured and non-indemnified personal liability, some outside directors may be less willing to serve, particularly if the corporation is clearly subject to California jurisdiction.
- Limits: Corporations may choose to purchase higher D&O limits of liability to minimize the risk of uninsured and non-indemnified loss.
- Terms & Pricing: D&O insurers may respond either to the increased liability exposure or the potential loss of the corporate reimbursement retention by adding new terms or adopting new pricing structures, depending upon the perceived risk that the new initiative would apply to the insured company.
Early polling results indicate that the vote for passing the initiative will be quite close, despite the stated opposition to the initiative by President Clinton and presidential candidate Bob Dole. Both the securities plaintiffs' bar and the California corporate community are mounting expensive campaigns in support and opposition to the initiative. All eyes should be on California on November 6, 1996, since passage of Proposition 211 could profoundly affect the future economic health of both California and non-California corporations, their directors, officers and insureds.