March 30, 2000

Unintended Consequences

of the Private Securities Litigation Reform Act of 1995

Gwyn Quillen

Scott Vick

Mayra de Aguiar

Alschuler Grossman Stein & Kahan LLP

2049 Century Park East, 39th Floor

Los Angeles, California

(310) 277-1226

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TABLE OF CONTENTS

Page

I.INTRODUCTION...... 1

II.OVERVIEW OF THE REFORM ACT...... 2

A.Events Leading To The Reform Act...... 2

B.Key Provisions Of The Reform Act...... 3

1.Tougher Pleading Hurdle...... 3

2.Discovery Stay...... 4

3.“Safe Harbor” Provision For Forward-Looking Statements5

4.Lead Plaintiff...... 6

5.Proportionate Liability...... 7

C.The Uniform Standards Act of 1998...... 7

III.THE REFORM ACT’S INTENDED CONSEQUENCES...... 9

A.No Race To The Courthouse...... 9

B.Some Institutional Investors Are Taking A Significant Role...... 9

C.More Cases Are Being Dismissed At The Pleading Stage...... 9

D.Defendants Can Go To Trial...... 9

IV.REFORM ACT’S UNINTENDED CONSEQUENCES...... 10

A.Plaintiffs Are Filing More Lawsuits Than Ever Before...... 10

B.Plaintiffs Are Asserting Different Types of Claims...... 12

C.The Lead Plaintiff Provision Has Not Wrested Control From The Plaintiffs’ Bar, But Has Spawned Vigorous In-Fighting Between Plaintiffs’ Firms 14

D.Settlements...... 16

E.The SEC Is Taking A More Active Role In The Enforcement Of Securities Laws 17

F.The Plaintiffs’ Bar Is Branching Out...... 19

V.CONCLUSION...... 19

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Unintended Consequences

of the Private Securities Litigation Reform Act of 1995

I.INTRODUCTION.

“The permanent contribution of a thing . . . is seldom the intended effect,

but an unintended one. That is, the announced purpose of a thing

is seldom its ultimate contribution to history.”

The Private Securities Litigation Reform Act of 1995 (“Reform Act”) was enacted with great fanfare, particularly among high tech companies and accounting firms that found themselves the frequent target of the securities class action bar. It was thought that the Reform Act would reduce the number of lawsuits, stop the race to the courthouse, increase the numbers of cases dismissed, reduce the settlement value of cases, and eliminate the control that the plaintiffs’ class action bar had over class actions by empowering institutional investors.

Largely, it appears that these objectives have not been realized. More securities class actions are filed than ever before, although it is possible that the increase in securities litigation would have been even greater absent the Reform Act. Although plaintiffs are filing fewer lawsuits based on forward-looking statements, the lawsuits based on accounting fraud and insider trading make up the difference, and a lot more. Average settlements have remained steady, not decreased. The plaintiffs’ class action bar continues to exercise control over most class actions, as relatively few institutional investors have stepped forward to take control of class actions.

Nevertheless, the Reform Act has greatly impacted securities litigation, perhaps in ways that were never contemplated. In the battle to be appointed lead plaintiff, plaintiffs not only disclose their damage theories, they vigorously attack the damage theories of other lead plaintiff candidates. For defense counsel, the result is a treasure trove: an early preview of liability and damage theories, sworn declarations of experts attacking damage theories of other lead plaintiff candidates, and so on. Because the Reform Act replaces joint and several liability with proportionate liability, defendants can afford the risk of taking a case to trial.

In addition, much of the early jubilation about the Reform Act has given way as the Securities and Exchange Commission has become more critical of corporate financial reporting. The SEC has increased enforcement actions, changed the rules regarding “materiality,” and generally taken a more active role to ensure the quality and accuracy of financial information.

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  1. OVERVIEW OF THE REFORM ACT.
  1. Events Leading To The Reform Act. Congress enacted the Reform Act to curb certain abuses concerning the prosecution of private securities lawsuits, including the following:
  1. “Fraud By Hindsight” Lawsuits And The Race To The Courthouse. Plaintiffs would frequently race to the courthouse to file a lawsuit following a significant decline in the price of a stock without regard to the issuer’s culpability and with the hope that, through discovery, a viable claim could be discovered. See H.R. Conf. Rep. No. 104-369, at 31 (1995), reprinted in 1995 U.S.C.C.A.N. 730.
  1. Joint And Several Liability Of “Deep Pocket” Defendants. Deep pocket defendants, such as large accounting and securities firms, would be named without regard to their culpability. By virtue of the rules of joint and several liability, if a deep pocket defendant could be found to be have even 1 percent of the responsibility, that defendant could be forced to pay all of the damages. See H.R. Conf. Rep. No. 104-369 (1995), reprinted in 1995 U.S.C.C.A.N. 730.
  1. Oppressive Discovery. Once a complaint was filed, plaintiffs would commence discovery, thereby imposing massive costs (both in terms of management time and attention and attorney’s fees) on defendants. Prior to the Reform Act, management would devote an average of 1,000 hours of their time on matters related to the class action. The discovery would disrupt the operations of the business and distract management from running the business. Faced with these costs, and the potential for a ruinous damage verdict, companies were forced to pay large amounts to settle lawsuits, even if the lawsuit was frivolous and the company completely innocent of wrongdoing. Securities Laws and Corporate Governance: The Advent of a Meltdown?, Panel Discussion and Q&A hosted by Reliance National, World Trade Center, San Francisco, CA, May 13, 1999; See H.R. Conf. Rep. No. 104-369, at 34 (1995), reprinted in 1995 U.S.C.C.A.N. 730; 141 Cong. Rec. H13699 (daily ed. Nov. 28, 1995).

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  1. Lawyer Driven Litigation. Securities litigation had become a “lawyer-driven” enterprise. The shareholders who were injured rarely exercised any control over the litigation. See H.R. Conf. Rep. No. 104-369, at 32 (1995), reprinted in 1995 U.S.C.C.A.N. 730; S. Rep. No. 104-98, at 5 (1995), reprinted in 1995 U.S.C.C.A.N. 679.
  1. Key Provisions Of The Reform Act. The goal of the Reform Act was to reduce these abuses through enactment of the following provisions, among others:
  1. Tougher Pleading Hurdle. The Reform Act requires that the complaint meet tough new pleading standards.
  1. Plaintiff Must Specify Specific Misleading Statements. The Reform Act requires that the complaint “specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.” 15 U.S.C. §78u-4(b)(1).
  1. Plaintiff Must Satisfy the “Strong Inference” Standard. When a plaintiff asserts a claim under the Exchange Act seeking damages that are available only upon a showing that the defendant acted with a particular state of mind, the plaintiff must "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." 15 U.S.C. §78u-4(b)(2) (emphasis added).
  1. Courts have articulated essentially three different interpretations of this standard:

(1)First Approach.Plaintiff must allege facts which give rise to the 'strong inference' of scienter through a showing of either 'motive and opportunity' or recklessness.

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Greebel v. FTP Software, Inc., 194 F.3d 185 (1st Cir. 1999); Press v. Chemical Investment Services Corp., 166 F.3d 529 (2d Cir. 1999); In re Advanta Corp. Sec. Litig., 180 F.3d 525, 535 (3d. Cir. 1999); Phillips v. LCI Int’l, Inc., 190 F.3d 609 (4th Cir. 1999); Williams v. WMX Techs., Inc., 112 F.3d 175, 178 (5th Cir. 1997).

(2)Second Approach. Plaintiff must allege facts which give rise to the 'strong inference' of scienter through a showing of either recklessness or intent, BUT the bare pleading of motive and opportunity does not, standing alone, constitute the pleading of a strong inference of scienter.

In re Comshare Inc. Sec. Litig., 183 F.3d 542, 549 (6th Cir. 1999); Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1283 (11th Cir. 1999).

(3)Third Approach. Plaintiff must allege facts which give rise to the strong inference that the defendants acted with a heightened form of recklessness, i.e., deliberate or conscious recklessness. Motive and opportunity pleading is not sufficient to survive a motion to dismiss.

In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 974, 979 (9th Cir. 1999).

  1. Dismissal Required. A complaint that fails to comply with these standards must be dismissed. 15 U.S.C. §78u-4(b)(3).
  1. Discovery Stay. Under the Reform Act, a plaintiff cannot commence discovery during the pendency of any motion to dismiss unless the court finds that particular discovery is necessary to preserve evidence or prevent undue prejudice. 15 U.S.C. § 77z-1(b)(3).

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  1. “Safe Harbor” Provision For Forward-Looking Statements. The Reform Act creates a statutory “Safe Harbor” to prevent claims based on certain forward-looking statements. The “Safe Harbor” is designed to encourage open and frank discussion by issuers to investors without fear of liability. See H.R. Conf. Rep. No. 104-369, at 43 (1995), reprinted in 1995 U.S.C.C.A.N. 730. A defendant will not be liable for a forward-looking statement if: (a) it is accompanied by meaningful cautionary statements, (b) is immaterial, or (c) the defendant did not have “actual knowledge” of the falsity of the statement. The Reform Act provides:

[A defendant] shall not be liable with respect to any forward-looking statement, whether written or oral, if and to the extent that . . . the forward-looking statement is . . . identified as a forward-looking statement, and is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement.

15 U.S.C. § 78u-5(c)(1)(A).

  1. Forward-Looking Statement. A "forward-looking statement" is (1) a statement containing a projection of revenues, income or other financial items; (2) a statement of management's plans and objectives for future operations (including products or services); (3) a statement of future economic performance; (4) a statement of the assumptions underlying any of such statements; (5) any report issued by an outside reviewer retained by the issuer that assesses a forward-looking statement made by the issuer; or (6) a statement containing projections or estimates of such other items as the Commission may specify. 15 U.S.C. § 78u-5(i)(l).

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  1. Meaningful Cautionary Statement. Mere boilerplate warnings will not suffice. Cautionary statements must contain company-specific warnings tailored to the risks. An issuer need not identify all factors that could cause results to differ, and the factor that ultimately does cause a difference between an optimistic projection and the final results need not have been one of those identified. See 141 Cong. Rec. 413, 699-705 (daily ed. Nov. 28, 1995); Harris v. IVAX Corp., 998 F. Supp. 1449, 1454 (S.D.Fla. 1998).
  1. Lead Plaintiff. The lead plaintiff provisions were included in the Reform Act to reduce the incentive of plaintiffs to rush to file a suit before the case’s merits had been adequately researched. The lead plaintiff provisions were expected to delay filings, and ultimately, to decrease the number of filings on the theory that less meritorious claims would be dropped in favor of stronger ones. S. Rep. No. 104-98, at 5-6 (1995), reprinted in 1995 U.S.C.C.A.N. 679.
  1. Rebuttable Presumption. Under the Reform Act, there is a rebuttable presumption that the most adequate lead plaintiff is the class member or group of members that has the largest financial interest in the relief sought in the case and who desires to act as the lead plaintiff. 15 U.S.C. § 78u-4(a)(3)(B)(iii). The provision was designed to encourage institutional investors, who often had the largest interest, to take control of the litigation. The hope was that institutional investors would more adequately protect the interests of class members than would the plaintiffs’ class action bar. H.R. Conf. Rep. No. 104-369, at 34 (1995), reprinted in 1995 U.S.C.C.A.N. 730, 731-33.

(1)Aggregation of Individual Plaintiffs. There is a difference of opinion as to whether parties may aggregate their losses for purposes of showing the largest financial interest and being selected as the lead plaintiffs. Courts have reached different conclusions as to whether aggregation is permitted. Compare Gluck v. CellStar Corp., 976 F. Supp. 542 (N.D.Tex. 1997); In re Advanced Tissue, 184 F.R.D. 346 (S.D.Cal. 1998); In re Diamond Multimedia Sys., Inc. Sec. Litig., No. C-96-2644-SBA (slip op. at 2-4 (N.D.Cal. Jan 13, 1997), which allow for aggregation, with In re Donnkenny Inc. Sec. Litig., 171 F.R.D. 156 (S.D.N.Y. 1997), which does not permit aggregation.

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(2)Multiple Lead Plaintiffs. Courts have adopted a case-by-case approach in deciding whether to appoint multiple lead plaintiffs. See In re Oxford Health Plans Inc. Sec. Litig., 182 F.R.D. 42 (S.D.N.Y. 1998); Reiger v. Altris, 1998 U.S. Dist. LEXIS 14705 (S.D.Cal. 1998); D’Hondt v. Digi Int’l Inc., 1997 U.S. Dist. LEXIS 17700 (D.Minn. 1997).

  1. Rebutting The Presumption. The presumption may be rebutted by proof that the presumptive plaintiff will not fairly and adequately protect the interests of the class or is subject to unique defenses foreclosing adequate representation. 15 U.S.C. 78u-4(a).
  1. Selection of Lead Counsel. The lead plaintiff selects counsel for the class, subject to court approval. 15 U.S.C. § 78u-4(a)(3)(13)(v). This provision was enacted with the belief that institutional investors, as the largest investors, would act as the lead plaintiff and control of the securities class actions would be transferred from lawyers to investors. See H.R. Conf. Rep. No. 104-369, at 32-35 (1995), reprinted in 1995 U.S.C.C.A.N. 730.
  1. Proportionate Liability. Under the Reform Act “covered defendants” are jointly and severally liable only if they "knowingly committed a violation" of the securities laws. 15 U.S.C. § 78u-4(g)(2)(B). Each covered defendant who does not knowingly commit a violation of the securities laws is liable only to the extent of their percentage of responsibility. 15 U.S.C. § 78u-4(g)(2)(B)(i). If a defendant's share cannot be collected from that defendant or from a defendant who is jointly and severally liable, each proportionately liable defendant is then liable for a proportionate share of the uncollectible amount, up to an amount equal to an additional 50% of such defendant's initial share. 15 U.S.C. § 78u-4(g)(4)(A).
  1. The Uniform Standards Act of 1998. In 1998, Congress enacted the Securities Litigation Uniform Standards Act of 1998, which preempted certain state common law and statutory law claims.

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  1. Preemption of State Law Claims. The Uniform Standards Act preempts private actions for state law statutory or common law claims based on an allegedly untrue statement or omission of material fact made in connection with the purchase or sale of a covered security (generally, a security traded on a national exchange), or upon the allegation that the defendant used or employed a manipulative or deceptive device or contrivance in connection with the purchase or sale of a covered security. 15 U.S.C. § 77-p(b); 15 U.S.C. § 78bb(f)(1).
  1. Covered Actions. The Uniform Standards Act applies to the following actions:
  1. Actions seeking damages on behalf of more than 50 persons. 15 U.S.C. § 78bb(f)(5)(B)(i).
  1. Actions by one or more persons seeking damages for themselves and others similarly situated. Id.
  1. A group of lawsuits filed in the same court seeking damages for more than 50 persons which are joined in a single action. 15 U.S.C. § 78bb(f)(5)(B)(ii).
  1. Actions Not Covered.
  1. Derivative Actions. 15 U.S.C. § 78bb(f)(5)(C).
  1. Actions by state or local governments, political subdivisions or state pension plans, or a class action on behalf of a class comprised solely of such entities. 15 U.S.C. § 78bb(f)(3)(B)(i).
  1. Actions against corporate officers arising out of a tender offer or exchange offer and brought in the state in which the issuer of security is incorporated. 15 U.S.C. § 78bb(f)(3)(A).
  1. Actions to enforce a contractual agreement between an issuer and an indenture trustee. 15 U.S.C. § 78bb(f)(C)(3).

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  1. THE REFORM ACT’S INTENDED CONSEQUENCES.
  1. No Race To The Courthouse. Although some plaintiffs’ firms remain notorious for filing class actions within hours or days of a significant drop in the price of a company’s stock, class action firms are generally taking more time to investigate, identify the parties with the largest financial interest, and prepare complaints.
  1. Some Institutional Investors Are Taking A Significant Role. While institutional investors do not frequently take control of a class action, they are coming forward when companies lose a significant amount of their capitalization. For example, an institutional investor was appointed lead plaintiff after Cendent Corporation lost $14 billion in market capitalization. Institutional investors also took control of the litigation after McKesson HBOC lost $9 billion in market capitalization.
  1. More Cases Are Being Dismissed At The Pleading Stage. Since the Reform Act, the likelihood of a company obtaining a dismissal has increased from 12 percent to 25 percent. Todd S. Foster, Denise N. Martin, Vinita M. Juneja, and Frederick C. Dunbar, Trends In Securities Litigation and the Impact of the PSLRA, National Economic Research Associates, Inc. (1999).
  1. Defendants Can Go To Trial. Prior to the Reform Act, it was virtually unheard of for a securities class action to proceed to trial. Since the Reform Act, at least one defendant was encouraged to take a case to trial. On October 26, 1999, a Uniondale, New York jury cleared BDO Seidman, auditors for Health Management, Inc. of an alleged accounting fraud. Prior to the Reform Act, BDO Siedman’s alleged reckless failure to detect fraud might have been sufficient to invoke joint and several liability, making it impractical for BDO Siedman to try the case. However, because the Reform Act required plaintiffs to prove BDO Siedman’s knowing participation in order to trigger joint and several liability, BDO Siedman believed that it could afford the risk of trying the case.

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  1. REFORM ACT’S UNINTENDED CONSEQUENCES.

“Everything has both intended and unintended consequences.

The intended consequences may or may not happen;

the unintended consequences always do.”

Dee W. Hock

  1. Plaintiffs Are Filing More Lawsuits Than Ever Before. Although the intent of the Reform Act was to reduce the number of lawsuits filed by raising the pleading standards, more securities class actions are being filed than ever before.
  1. Number of Suits Filed. Prior to the Reform Act, an average of 176 securities class action lawsuits were filed annually. An all-time record of 244 companies were sued in 1998, and 216 companies were sued in 1999. See Stanford Securities Class Action Clearinghouse <
  1. Initially, Plaintiffs Were Running To State Court. Immediately after passage of the Reform Act, and in an effort to avoid the stringent pleading requirements imposed by the Reform Act, plaintiffs filed a large number of class actions in state courts, based on state law securities claims, rather than in federal courts. However, since enactment of the Uniform Standards Act, state court filings have returned to their pre-Reform Act levels. Todd S. Foster, Denise N. Martin, Vinita M. Juneja, and Frederick C. Dunbar, Trends In Securities Litigation and the Impact of the PSLRA, National Economic Research Associates, Inc. (1999).
  1. A Company’s Chances of Being Sued Have Increased. While the number of publicly-traded companies has increased by 4% since 1995, the number of market-adjusted federal filings has increased by 61%. Todd S. Foster, Denise N. Martin, Vinita M. Juneja, and Frederick C. Dunbar, Trends In Securities Litigation and the Impact of the PSLRA, National Economic Research Associates, Inc. (1999). A publicly-traded company’s likelihood of being sued has increased by 58% since passage of the Reform Act. Id.

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