Where Are We Three Years Later?

THE [COMMENT1]PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995:

WHERE ARE WE THREE YEARS LATER?

A Presentation to theInstitute For Corporate CounselMarch 4, 1999

Jonathan C. Dickey

William E. Thomson

Antoinette DeCamp

Gibson, Dunn & Crutcher LLP

TABLE OF CONTENTS

TABLE OF CONTENTS i

INTRODUCTION 2

I. PLEADING SCIENTER UNDER THE REFORM ACT 2

A.The Reform Act Has Imposed A Heightened Pleading Standard For Allegations Of Scienter2

1.Prior To The Reform Act, The Circuit Courts Were Sharply Divided On Pleading Requirements For Scienter 2

2.The Reform Act Requires A Plaintiff To Plead Facts Sufficient To Raise A “Strong Inference” Of Scienter 2

B.As Within The Federal Courts Generally, There Is Now A Split Of Authority Within The Ninth Circuit On Whether The Reform Act Adopted The Second Circuit’s Test For Pleading Scienter2

1.The Marksman Partners Line Of Cases Holds That The Reform Act Adopts The Second Circuit’s Pleading Standard In Its Entirety And Does Not Eliminate Liability For “Reckless” Conduct 2

2.The Silicon Graphics Line Of Cases Holds That The Reform Act Strengthens The Second Circuit’s Pleading Standard By Rejecting The “Motive And Opportunity” Test, And Eliminates Liability For “Objectively Reckless” Conduct 2

3.A Third, Intermediate Line Of Cases Seeks To Steer A Course Between Silicon Graphics and Marksman Partners 2

4.Several Leading Cases Have Been Fully Briefed And Argued On Appeal 2

5.Congress Has Recently Attempted To Influence Judicial Construction Of The Reform Act By “Clarifying” The Legislative History In Connection With The Recently-Passed Uniform Standards Act 2

C.Insider Stock Sales As Alleged Indicia Of Scienter Under the Reform Act2

D.Insiders' Knowledge of "Internal Reports"2

II. PLEADING MISLEADING STATEMENTS WITH PARTICULARITY 2

A.General2

B.“Information And Belief” Pleading2

1.Reform Act Requirements for Pleading "On Information and Belief" 2

2.What Does It Mean to Plead "On Information and Belief"? 2

3.What Is the Challenge for Pleading on "Information and Belief"? 2

C."Group Published" Pleading Doctrine2

D.A Future Battleground: What Evidence The Court May Consider On Motions to Dismiss2

III. THE SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS 2

A.Background2

1.Initial SEC Attempts to Encourage Publication of Forward-Looking Statements 2

2."Bespeaks Caution" Doctrine: 2

B.The Statutory Safe Harbor Under The Reform Act2

1.Statutory Text 2

2.Judicial Interpretations 2

C.Impact of Safe Harbor2

1.Quantity of Information 2

2.Quality of Information 2

3.Several factors may have contributed to the continued reluctance of companies to disclose extensive forward-looking information 2

IV. LIABILITY FOR STATEMENTS TO AND BY ANALYSTS 2

A.Direct Liability2

B."Entanglement"2

C.Adoption2

D.Application of the Statutory Safe Harbor to Statements Contained in Analysts' Reports.2

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iNtroduction

The Sound of Several Shoes Dropping

If one were to have made a forecast in late 1995 of how the securities class action landscape might look three years later, one might have conjured the following:

Significant reduction in new case filings in the federal court system;

Active participation by pension funds, mutual funds, and other institutional investors as class representatives;

More competition among the plaintiffs' bar to serve as class counsel (and lower fees);

Quicker dispositions of cases, either by motion or by settlement;

Tougher decisions from trial courts on motions to dismiss, and better pleadings;

Reduced defense and settlement costs.

Unfortunately, none of these forecasts came true. Indeed, as we proceed into year four, we see a very different landscape than the one envisioned by Congress when it passed the Private Securities Litigation Reform Act in December1995. Today we see:

A record number of new cases;

Little involvement by institutional investors, except in the biggest and "worst" cases;

Little or no competition among the plaintiffs' bar;

Long delays in case disposition;

Trial court decisions "all over the map";

Higher defense and settlement costs.

Compounding the problems companies are experiencing in fulfilling the promise of reform -- the "other shoe dropping", as it were -- is the fact that in 1998 Congress and the SEC managed to weaken the legislative history of the Reform Act by adding gratuitous comments into the legislative history of the Uniform Standards Act, the apparent purpose of which is to convince the federal courts to believe that the explicit "heightened" pleading standards of the Reform Act are not heightened at all.

The next shoe to drop may be by the SEC, which is in the process of extensive rulemaking proceedings as this paper goes to press. Indeed, if the SEC's current "aircraft carrier" proposal ever becomes law, any hope of reforming private securities class actions through tougher pleading standards will be all but forgotten, replaced by a strict liability system and a barrage of private securities class action like nothing this country has ever seen.

While the litigants in the first wave of Reform Act cases await the first courts of appeal rulings under the Reform Act, one can reasonably predict the probable outcome: just as was true in the pre-Reform Act decisional law, different jurisdictions will reach different –– and perhaps sharply conflicting –– conclusions on what Congress intended. Over the next year or two, the returns will come in: the Ninth Circuit will maintain its generally liberal bent, while the First and Second Circuits will issue rulings upholding tougher standards. The trial courts in the Ninth Circuit will remain popular venues for class action cases. And in California, plaintiffs' counsel may continue to take advantage of the state courts by filing parallel cases on behalf of friendly institutional investors (an exception to the preemptive scope of the Uniform Standards Act), and continue to whipsaw companies between federal and state court.

How Did We Get Here?

On December 22, 1995, Congress voted to override President Clinton’s veto and enacted the Private Securities Litigation Reform Act, Pub. L. No. 104-67, codified at 15 U.S.C.section78u-4 (“Reform Act”). The Reform Act contains a variety of provisions designed to combat certain abusive practices associated with private securities litigation. Among the abusive practices identified by Congress were:

(1) the routine filing of lawsuits against issuers of securities and others whenever there is a significant change in an issuer's stock price, without regard to any underlying culpability of the issuer, and with only faint hope that the discovery process might lead eventually to some plausible cause of action; (2) the targeting of deep pocket defendants, including accountants, underwriters, and individuals who may be covered by insurance, without regard to their actual culpability; (3) the abuse of the discovery process to impose costs so burdensome that it is often economical for the victimized party to settle; and (4) the manipulation by class action lawyers of the clients whom they purport to represent.

The Reform Act was designed to address these problems by amending certain substantive and procedural provisions of the Securities Act of 1933 (the "Securities Act"), the Securities Exchange Act of 1934 (the "Exchange Act"), and certain other statutory provisions such as the Racketeering Influenced and Corrupt Organizations Act ("RICO"). Specifically, the Reform Act responds to the problem of abusive shareholder litigation by:

creating a new, heightened pleading standard;

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creating a broader and more effective safe harbor for the disclosure of forward-looking information, such as projections of future financial results, dividends, and corporate objectives;

mandating a stay of discovery in almost all securities cases until after plaintiffs have demonstrated that a complaint has met basic requirements for pleading a cause of action;

providing for proportionate liability in all cases other than those involving knowing violations of the federal securities laws;

mandating that plaintiffs demonstrate loss causation between the alleged fraud and their own losses;

limiting windfall damages so that the maximum amount of damages in any case cannot exceed the difference between the purchase (or sale) price paid (or received) for the securities and the mean trading price during the 90-day period after the information correcting the false or misleading statement has been disseminated to the marketplace; and

limiting the role of "professional plaintiffs" by requiring the appointment of a "lead plaintiff" who is "the most capable of representing the interests of the class" and who will actually supervise the work of plaintiffs' counsel (including the power to hire and fire such counsel).

As is frequently the case with new legislation, trial lawyers have had a field day litigating the details of the new law, and many trial courts, while focusing on the details, have lost sight of the overall congressional intent. The results have been disappointing to advocates of reform. But the truest test of reform still awaits, namely, the views and opinions of the various courts of appeal, and ultimately the Supreme Court.

Scope of this Paper

This paper will examine four of the most important aspects of cases being litigated under the Reform Act: (1)the requirements for pleading facts sufficient to raise a “strong inference” of scienter; (2)pleading misrepresentations with particularity; (3)the safe harbor for forward-looking statements; and (4)liability for communications with analysts.

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I. PLEADING SCIENTER UNDER THE Reform act

A.The Reform Act Has Imposed A Heightened Pleading Standard For Allegations Of Scienter

1.Prior To The Reform Act, The Circuit Courts Were Sharply Divided On Pleading Requirements For Scienter

To state a claim for securities fraud, a plaintiff must allege scienter, that is, that the defendant acted with “a mental state embracing an intent to deceive, manipulate, or defraud.” Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194 n.12, 96 S.Ct.1375, 1381 n.12, 47 L. Ed. 2d 668 (1976)). Prior to the Reform Act, the circuit courts diverged dramatically on what they required in order to plead this element. In the Ninth Circuit, for example, a plaintiff bringing suit was permitted to allege scienter generally -- in effect, simply by stating that scienter existed. See, e.g.,In re GlenFed Sec. Litig., 42 F.3d 1541, 1546-1547 (9th Cir. 1994). On the other end of the spectrum, the Second Circuit required a plaintiff to plead facts raising a “strong inference” that the defendant acted with scienter. See, e.g.,Acito v. IMCERA Group, Inc., 47 F.3d 47, 53 (2d Cir. 1995). Under Second Circuit caselaw, a plaintiff could plead scienter by alleging either (1) specific facts that “constitut[e] circumstantial evidence of reckless or conscious misbehavior,” or (2) that the defendant had a “motive and opportunity to commit fraud.” San Leandro Emergency Med. Group Profit Sharing Plan v. Philip Morris Cos., Inc., 75 F.3d 801, 812-13 (2d Cir. 1996); see alsoIn re Time Warner Inc. Sec. Litig., 9 F.3d 259, 268-69 (2d Cir. 1993).

Although the Supreme Court has never squarely spoken on the issue, before the passage of the Reform Act, the circuit courts that had addressed the question had all held that recklessness was sufficient to constitute scienter under Section 10(b), although the circuits’ definitions of “reckless” behavior often differed markedly in the degree to which they required some type of intentional conduct.[1] In the Ninth Circuit, “recklessness” was conduct “involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.” Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569 (9th Cir. 1990) (en banc).

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2.The Reform Act Requires A Plaintiff To Plead Facts Sufficient To Raise A “Strong Inference” Of Scienter

In passing the Reform Act, Congress clearly intended to raise the national standard for pleading scienter. Under the Reform Act, a plaintiff may no longer plead scienter generally, but rather must, “with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” Reform Act, §21D(b)(2) (emphasis added). If this heightened pleading requirement is not met, the Reform Act mandates that the court dismiss the complaint. Id., §21D(b)(3)(A).

B.As Within The Federal Courts Generally, There Is Now A Split Of Authority Within The Ninth Circuit On Whether The Reform Act Adopted The Second Circuit’s Test For Pleading Scienter

There is no question that the Reform Act effected a substantial change in the pleading requirements within the Ninth Circuit. No longer may a plaintiff allege scienter simply by saying that scienter existed. There currently exists within the Ninth Circuit, however, as within the federal courts generally, a split of authority on the precise meaning of the scienter pleading standard adopted by the Reform Act. The courts have been divided on whether, or in what manner, the Reform Act adopted or “codified” the scienter pleading standard previously in force in the Second Circuit. The courts similarly have been divided on the question of whether the Reform Act raised the substantive requirements for scienter by eliminating liability for unintentional or “objectively” reckless conduct.

1. The Marksman Partners Line Of Cases Holds That The Reform Act Adopts The Second Circuit’s Pleading Standard In Its Entirety And Does Not Eliminate Liability For “Reckless” Conduct

The first case to address the new pleading standards, shortly after the adoption of the Reform Act, was Marksman Partners L.P. v. Chantal Pharm. Corp., 927 F. Supp. 1297 (C.D. Cal. 1996). In Marksman Partners, the plaintiff alleged that the issuer had overstated its revenues by impermissibly recognizing as current income transactions that were allegedly consignment sales, thereby inflating its stock price.

In seeking to dismiss the action, the defendant argued that the Reform Act had enacted a pleading standard even more rigorous than that employed by the Second Circuit and had altered the substantive standard for liability pursuant to Section 10(b) by eliminating liability for reckless conduct. Confronting an issue of first impression, the court noted that the Reform Act’s “strong inference” language was drawn from the Second Circuit’s test for pleading scienter and emphasized that this test was the most stringent standard in existence when Congress passed the Reform Act. After examining various references to the Second Circuit pleading standards set forth in the legislative history, especially the report of the Senate Banking Committee, the court concluded that in passing the Reform Act Congress had enacted the Second Circuit’s two-pronged test: “The Court has little doubt that when Congress wishes to supplant a judicially-created rule it knows how to do so explicitly, and in the body of the statute.” Id. at 1311.

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The court also rejected the defendants’ contention that the Reform Act had abolished liability for merely reckless conduct. Id. at 1309 n.9.

The Marksman court, in determining that the “motive and opportunity” test “ha[s] not been discarded” by the enactment of the Reform Act, Marksman, 927 F. Supp. at 131011, did so expressly because it found that the test as applied is “consistent with Congress’s intent that scienter be pled with more than conclusory or generic allegations”:

The test itself is an exacting analysis courts have employed to assess whether the quantum and quality of factual allegations in the complaint, beyond mere allegations that a material misrepresentation occurred, actually create an inference that a defendant acted with an intent to defraud. . . . [T]he plaintiff’s allegations must yield a “strong” inference of fraudulent intent.

Id. at 1311. In emphasizing that the end result of the “motive and opportunity” analysis must be the showing of the required “strong inference” of fraudulent intent, the Marksman Partners court took as its model for the Second Circuit standard the stringent application of Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1128 (2d Cir. 1994).

The court found that the complaint sufficiently alleged scienter under both the “motive and opportunity” and the “circumstantial evidence” tests. The Marksman Partners court emphasized that insider sales may support a strong inference of scienter -- but only if the sales are “unusual,” which “requires a showing that the trading was in amounts dramatically out of line with prior trading practices, at times calculated to maximize personal benefit from undisclosed inside information.” Id. at 1312 (citing Acito, 47 F.3d at 54, and Alfus v. Pyramid Tech. Corp., 764 F. Supp. 598, 605 & n.1 (N.D. Cal. 1991) (internal quotation marks omitted). The court found suspicious the insider sales of 300,000 shares of stock -- 20% of her total -- for a total amount of over $6,300,000, where the insider had not sold any stock in the previous three years. Id. at 1312-13.

At least two dozen decisions have agreed with the Marksman Partners court and concluded that the Reform Act (i)did not eliminate liability for reckless conduct and (ii)adopted the Second Circuit’s pleading standard, including the “motive and opportunity” test.[2] Because the defendants are usually the top management in control of the day to day operations of the company, “opportunity” is seldom an issue in these cases, and almost all of the analysis focuses on what constitutes sufficient “motive.”