SECURITIES LITIGATION REFORM
By overriding President Clinton's veto in the closing days of 1995, Congress enacted the Private Securities Litigation Reform Act of 1995. Proponents of the landmark legislation herald the new law as restoring common sense to federal securities laws by filtering out speculative lawsuits while protecting shareholders who have been defrauded. Opponents describe the legislation as encouraging fraud and leaving fraud victims helpless. In reality, although the new law will significantly affect how securities claims against D&Os and others are prosecuted, the legislation will likely result in only a modest change in the number of cases filed or dismissed and ironically will likely result in higher settlements for those cases which survive a motion to dismiss. In other words, the frequency of D&O securities claims will likely be reduced somewhat, but the severity will likely be increased, thus resulting in no material savings and probably increased liability for defendants and their insurers.
The following summarizes the five primary aspects of the new law which will have a meaningful impact on D&Os and their insurers. This new law applies to securities class actions filed after December 22, 1995.
A. REDUCE ABUSIVE LITIGATION PRACTICES
One of the primary goals of the legislation is to reduce the filing and prosecution of meritless securities law-suits without hindering the ability of fraud victims to pursue legitimate claims. To effectuate that goal, the new law contains various procedural requirements which are intended to increase the likelihood that the lead shareholder plaintiff who prosecutes the securities class action will adequately represent the interests of other shareholders in the class and will diligently oversee and control counsel for the plaintiff class. Those new procedures include the following:
1. Eliminate Race to Courthouse. Several new rules should effectively eliminate the current "race to the courthouse" by plaintiff lawyers. For example, the named plaintiff must file a sworn certified statement with the complaint indicating that the plaintiff (not just the plaintiff lawyer) reviewed and authorized the filing of the complaint, did not purchase the securities at the direction of counsel or in order to participate in a lawsuit, and is willing to serve as the lead plaintiff on behalf of the class. The certified statement must also identify any transactions by the plaintiff in the securities during the class period and any other lawsuits in which the named plaintiff has sought to serve as lead plaintiff in the last three years. These rules, when combined with other aspects of the new law relating to tightened pleading requirements, the somewhat increased potential for sanctions for filing a frivolous complaint, and the elimination of any benefit to being the first to file the complaint, should result in some delay but not a meaningful deterrent to the filing of a complaint.
2. Selection of Lead Plaintiff. The plaintiff first filing a securities class action must now notify members of the purported class within twenty days of filing the complaint regarding the claims alleged in the lawsuit and the purported class period. That notice, which must be published in a widely circulated business publication (including via wire, electronic or computer services) must also inform the potential class members that within sixty days any class member may petition the court to serve as the lead plaintiff. In addition, the new law restricts "professional plaintiffs" from serving as lead plaintiff by limiting a person from serving in that capacity more than five times in three years, absent special court approval.
Following published notice, the court must appoint a lead plaintiff who will be primarily responsible for the prosecution of the lawsuit. The new law requires courts to presume that among those class members requesting to serve as lead plaintiff, the class member with the largest financial stake in the lawsuit is the most appropriate lead plaintiff. Although this provision is intended to increase the likelihood of institutional investors serving as lead plaintiffs, it is doubtful that result will occur since institutional investors and other large independent shareholders appear to have little incentive to serve in that capacity. For example, the legislation prohibits the lead plaintiff from receiving any extra compensation for serving in that capacity. Therefore, the legislation will likely not significantly change the nature or identity of lead plaintiffs.
To the extent the legislation is successful in causing institutional investors to serve as lead plaintiffs, it is unclear whether defendants would be helped or hurt by that development. Although institutional investors may be more sympathetic to the business ramifications of the litigation, they also may be less willing than professional plaintiff lawyers to settle the class action in the typical range of ten to twenty percent of alleged loss. Unlike plaintiff lawyers, who provide services under a contingent fee arrangement and therefore would recover nothing if the case is successfully defended, large investors may see relatively little downside risk by not settling a case for a small percentage of their loss and instead "roll the dice" by forcing more cases to trial, thus gambling on much greater recoveries. If this dynamic is created, defendants will incur significantly increased defense costs and settlement amounts since few corporations and their D&Os are willing to also "roll the dice" in this type of litigation.
3. Selection of Class Counsel. The new law states that the court-appointed lead plaintiff retains class counsel, subject to court approval. If the legislation will not impact the ultimate lead plaintiff, the selection of class counsel should not be impacted either. However, to the extent the new law results in institutional or other large investors becoming lead plaintiffs, new alliances will likely be established between the professional plaintiff law firms specializing in this type of litigation and institutional investors. That alliance would likely result in institutional investors being named as co-defendants in fewer cases as well as an even greater consolidation of these cases in a select few plaintiff law firms.
4. Settlement Notice to Class. Historically, class members have received little information about a proposed settlement (other than the aggregate settlement amount) and thus have had no basis to evaluate a proposed settlement. The new law requires disclosure of more information to class members before any proposed settlement is approved by the court. For example, the notice of proposed settlement to class members must include, both in summary form and in greater detail, a statement of the average amount of damages per share that would be recoverable if plaintiffs prevailed in the lawsuit and the average proposed settlement amount per share. Thus, class members will be able to determine the percentage of potentially recoverable loss represented by the proposed settlement on a per share basis. In addition, the notice must explain the amount of plaintiff attorneys' fees and costs which are being sought, both on an aggregate and per share basis. This increased disclosure will likely further encourage class counsel to negotiate larger settlements since class counsel will want to negotiate a proposed settlement which not only will support a substantial attorney fee award, but will also appear reasonable to class members and the court in light of the potential recoverable loss on a per share basis.
5. Attorney Fees. The new law limits the award of attorney fees and costs for class counsel to a reasonable percentage of the amount of recovery awarded to the class. In smaller cases, this will also likely result in larger settlements since class counsel will no longer be allowed to settle the case for a rather modest amount but yet obtain a large percentage of that settlement in fees.
6. Fee Shifting. One of the most intensely debated issues in connection with the legislation was the notion of fee shifting (i.e. requiring the losing party to pay the legal fees and costs of the prevailing party). As enacted, the legislation does not adopt a fee shifting provision per se. Instead, increased emphasis is given to Rule 11 of the Federal Rules of Civil Procedure, which allows courts to impose sanctions against an attorney or party for filing or asserting a frivolous lawsuit or position. The new law requires the court to make specific findings at the conclusion of the lawsuit as to whether all parties and all attorneys have complied with the pleading and litigation requirements contained in Rule 11 (b). If the court concludes that Rule 11 (b) was violated, the legislation establishes a presumption that the appropriate sanction is an award to the prevailing party of all attorney fees and costs incurred by that party in the lawsuit. This sanction would be available, for example, if the court determined that the lawsuit was brought for an improper purpose, is unwarranted by existing law, is legally frivolous, or is not supported by facts. Because courts have been quite reluctant to impose any sanctions under Rule 11 to date, it is unlikely that courts will award these even harsher sanctions, particularly since compliance with Rule 11 is highly subjective.
B. PROPORTIONATE LIABILITY
Under current law, violators of the federal securities laws are jointly and severally liable for damages resulting from that violation. Thus, a defendant found to be 1% liable may be forced to pay 100% of the damages in the case. This joint and several liability created a perceived coercive pressure on largely innocent parties to settle meritless claims rather than risk exposing themselves to liability for a grossly disproportionate share of the damages in the case.
The new law eliminates joint and several liability among defendants who are held liable based upon reckless violations of the securities laws. Instead, those defendants are liable to pay only that portion of a judgment which is apportioned to each defendant based upon their "percentage of responsibility", measured as a percentage of the total fault of all persons who caused or contributed to the loss. In determining that percentage, the court must examine the nature of the conduct to each person and the nature and extent of the causal relationship between the conduct of each person and the damages incurred by the plaintiffs.
Three important exceptions exist in the legislation with regard to proportionate liability. First, full joint and several liability remains for defendants who engage in knowing violations of the securities laws. Second, all defendants are jointly and severally liable with respect to claims by plaintiffs who are entitled to damages exceeding ten percent of their net worth, provided such net worth is less than $200,000. Third, if a defendant cannot pay its allocable share of the damages due to insolvency, each of the other defendants must make an additional payment (up to fifty percent of their own liability) to make up the shortfall in the plaintiffs recovery.
In order to encourage early settlement of securities class actions, the legislation also provides that any claim for contribution by a non-settling defendant against a settling defendant is discharged. Thus, if one defendant settles with plaintiffs before another defendant, the settling defendant cannot be brought back into the litigation by a non-settling defendant pursuant to a claim for contribution.
Although this proportionate liability provision can be beneficial to D&O defendants in certain circumstances, it will likely have some adverse consequences as well. For example, accounting firms, law firms and other professionals who are co-defendants in the class action will likely be much more reluctant to make substantial settlement contributions in many cases in light of this proportionate liability provision, thus requiring greater settlement contributions by the corporation and the D&Os. In addition, this provision will create even greater uncertainty in the D&O insurance allocation context. Insurers will likely argue that this provision effectively overrules the "larger settlement rule" recently adopted by the Seventh and Ninth Circuit Federal Courts of Appeals since that allocation rule frequently results in the allocation of all or virtually all of a securities loss to the defendant D&Os and not to the company even though the company is a co-defendant with its own direct liability exposure.
C. FORWARD-LOOKING STATEMENTS
In recent years, D&O securities litigation has focused to a large extent upon projections and other forward-looking statements by D&Os. When those forward-looking statements prove to be incorrect based upon subsequent developments, securities law claims are frequently made, alleging the D&Os and the company violated the federal securities laws by not having a reasonable basis for making the forward-looking statements.
The new law creates a safe harbor to protect corporations and their D&Os when making written or oral forward-looking statements. The legislation states that no liability will exist with respect to a forward-looking statement that when made is identified as forward-looking and is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those projected in the statement. The cautionary statement need not identify all important factors, although it is unclear under the statute how many factors are sufficient and the effect of intentionally omitting to disclose some important factors. With respect to oral forward-looking statements, the safe harbor applies if the person making the statement not only identifies the statement as forward-looking, but also states that results may differ materially from those projected and identifies a "readily available" written document which contains factors that could cause results to differ materially.
As an alternative safe harbor, the new law also provides that a person making a written or oral forward-looking statement will not be liable for that statement unless a plaintiff proves that the person made the statement with actual knowledge that it was false or misleading.
These safe harbors do not apply to forward-looking statements contained in financial statements prepared in accordance with GAAP, contained in an IPO registration statement, made in connection with a tender offer, made in connection with a partnership, LLP or direct participation program offering or partnership roll-up transaction, made in certain change-in-control disclosure statements filed with the SEC, made in connection with a going private transaction, or made by a non-SEC reporting company.
For most publicly-held corporations, these safe harbors provide meaningful protection against claims arising out of forward-looking statements. The protection is particularly helpful in the high-tech industry. However, it is likely that plaintiffs will be able to successfully plead around the safe harbor in most cases by alleging the defendants failed to disclose material facts which subsequently caused the company's stock price to drop. In other words, by converting the alleged wrongdoing from a misrepresentation in connection with a forward-looking statement to an omission of material facts, plaintiffs will likely circumvent the protections provided by the safe harbor.
D. DISMISSAL OF MERITLESS CLAIMS
The legislation seeks to encourage the dismissal of meritless claims early in the litigation with minimal cost to the defendants. For example, the new law codifies for the first time a pleading standard for securities fraud and eliminates a split among the Circuit Courts on this issue. The legislation generally adopts the existing Second Circuit requirement that the plaintiff allege facts in the complaint with particularity and that those alleged facts must give rise to a "strong inference" of the defendants' fraudulent intent. Although this provision docs not change the law in the Second Circuit, it does significantly tighten the pleading requirement as recognized in some other Circuits, most notably the Ninth Circuit (i.e. California and surrounding states). Therefore, depending upon the Circuit, the new law may result in a larger number of cases being dismissed as inadequately plead. However, courts typically permit plaintiffs to replead their claims even if the original complaint is dismissed. Therefore, this provision of the new law, standing alone, is not likely to significantly reduce ultimate liability exposure in many cases.
A second provision, though, when combined with the codified pleading requirement, may prove helpful for defendants. To prevent "fishing expeditions" by plaintiffs in lawsuits, the new law requires courts to stay all discovery in the lawsuit pending a ruling on a motion to dismiss, which is typically filed by defendants at the beginning of the case. Courts may under exceptional circumstances permit particularized discovery if necessary to preserve evidence or to prevent undue prejudice to a party. This discovery limitation should reduce defense costs in those cases which are ultimately dismissed and should prevent plaintiffs from discovering facts through discovery to support unsubstantiated claims before the court rules on the adequacy of the pleadings.
E. DAMAGES
The historical method of calculating damages in securities class action cases under the Securities Ex-change Act of 1934 has been complex and uncertain. Typically, plaintiffs and defendants retained separate expert witnesses who each calculate vastly different damage amounts. The new law seeks to create greater simplicity and certainty, as well as avoid overestimating damage exposure, by requiring that damages be calculated based upon the difference between the value of the security on the date the plaintiff originally bought or sold the security and the average value of the security during the 90-day period after dissemination of information to the market which corrects the misleading statement or omission. Although seemingly simple, this damage provision, at least initially, will likely create much debate and disagreement as to its application under various complex factual situations. Generally, though, the provision should reduce in most cases the potential damage exposure of defendants.
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In summary, at this early date it would be imprudent for corporations, D&Os and insurers to materially change their loss prevention and risk management practices or expect significant pricing or coverage enhancements in the D&O insurance policy as a result of the legislation. Until plaintiff and defense lawyers subject the legislation to their creative analysis and courts have established predictable precedent in applying the new law, little comfort should be taken from the new enactment. Instead, several of the new provisions appear likely to increase defendants' ultimate loss in securities class action litigation.
If defendants remain unwilling to submit securities cases to trial, thereby forcing plaintiffs to prove their allegations of wrongdoing, defendants will continue to have little negotiating leverage with plaintiffs in the settlement context. Without that leverage, defendants will be subjected to class counsel simply "dialing up" a larger settlement number in response to the legislation. At best, after the various uncertainties of the new law are resolved, history will probably view the Private Securities Litigation Reform Act of 1995 much like the director liability limitation statutes enacted in most states in the late 1980s-more illusory than real.