Securities Litigation

The Securities Exchange Act of 1934 (commonly known as the "Exchange Act" or the "1934 Act") gives shareholders the right to bring a private action in federal court to recover damages the shareholder sustained as a result of securities fraud. The majority of securities fraud claims are brought pursuant to Section 10(b) of the Exchange Act (codified at 15 U.S.C. § 78j), as well as SEC Rule 10b-5, which the SEC promulgated under the authority granted to it by Congress under the Exchange Act. (This article refers to federal securities fraud actions as "Rule 10b-5 actions" or "Rule 10b-5 cases" as convenient shorthand.)

The Supreme Court has held that there are six elements that a plaintiff must allege and prove in order to prevail in a Rule 10b-5 action:

1. The defendant made a "material misrepresentation or omission;"
2. The defendant acted with "scienter", or a "wrongful state of mind" (typically understood to mean that the defendant intended to make the material misrepresentation or omission, or acted with recklessness in making the misrepresentation or omission);
3. The material misrepresentation or omission was made "in connection with the purchase or sale of a security;"
4. The plaintiff who was allegedly victimized by the fraud relied upon the material misrepresentation or omission (if the security is traded on a public stock exchange, such as the New York Stock Exchange or NASDAQ, the law will typically presume that shareholders rely on the integrity of the market, and therefore that the price of the stock reflected material misrepresentation and that shareholders relied upon the integrity of the market);
5. The plaintiff suffered an economic loss as a result of the alleged fraud; and
6. The plaintiff can allege and prove "loss causation", which means that the allegedly fraudulent misrepresentation or omission caused the plaintiff's economic loss. See Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005).

Private Securities Litigation Reform Act

The Private Securities Litigation Reform Act of 1995 (PSLRA) implemented several significant substantive changes affecting certain cases brought under the federal securities laws, including changes related to pleading, discovery, liability, class representation and awards fees and expenses.  It allows judges to decide the most adequate plaintiff in class actions. It also mandates full disclosure to investors of proposed settlements, including the amount of attorneys' fees. It bars bonus payments to favored plaintiffs, and permits judges to scrutinize lawyer conflicts of interest.

In a the typical Rule 10b-5 claim, the plaintiff will commence the action by filing a complaint in federal court. The defendant will then file a motion to dismiss under Rule 12(b)(6) of the Federal Rules of Civil Procedure. A motion to dismiss under Rule 12(b)(6) is essentially an argument by the defendant that, even if all of the facts alleged in the complaint were assumed to be true, those facts would not be sufficient to give rise to liability under Rule 10b-5. If the court determines that the facts alleged in the complaint are sufficient to state a Rule 10b-5 claim, the plaintiff then becomes entitled to obtain "discovery" from the defendant -- which typically means the right to demand documentary evidence in the defendant's possession concerning the facts at issue, and the right to require the defendant (and other witnesses) to sit for depositions.

In a modern litigation context, the discovery process is protracted and very expensive, often involving production of millions of pages of documents and conducting depositions of dozens of witnesses, all of which can cost the defendant in a Rule 10b-5 case millions of dollars in legal fees. Thus, as a practical matter, the outcome of a motion to dismiss is an extremely important step in the life of a Rule 10b-5 case, as the stakes go up substantially when the motion to dismiss is denied.

If the plaintiff's complaint survives the defendant's Rule 12(b)(6) motion to dismiss, the next step is usually for the plaintiff to seek class certification under Rule 23 of the Federal Rules of Civil Procedure. If the court grants the plaintiff's motion for class certification, the case becomes a securities fraud class action lawsuit. At this point, the defendant usually faces enormous liability if the case goes to trial and the jury renders a verdict against the defendant. For example, if the plaintiff class is composed of 50,000 shareholders, and each shareholder owns on average 1,000 shares, and each shareholder claims to have sustained losses of $10 per share, the potential compensatory damages are $500 million. Therefore, as a practical matter, if a Rule 10b-5 case is not dismissed on a motion to dismiss, and if the case is certified as a class action, the defendant will face tremendous pressure to settle the case, even if the plaintiff has a relatively weak case. Even if there is a small chance of losing a jury verdict, a loss would be financially disastrous.

Thus, the outcome of a motion to dismiss in a Rule 10b-5 case essentially determines whether the case goes away or whether it proceeds to discovery and, very often, results in class certification and a very expensive settlement. Because the motion to dismiss is a pivotal stage in the course of a Rule 10b-5 case, with tens or even hundreds of millions of dollars resting in the balance, the plaintiff's bar and the defense bar battle fiercely over the rules that govern such motions to dismiss. Plaintiff lawyers obviously advocate less demanding standards, as this results in more cases proceeding to discovery and more lucrative settlements. Defense lawyers and the corporations they represent, on the other hand, advocate more demanding standards, for similar reasons.

Obviously, both sides in this debate use rhetoric that claims the mantle of "justice." The defense bar generally contends that lower standards will only allow more frivolous lawsuits and extorted settlements that primarily benefit plaintiff lawyers, not shareholders; while the plaintiff bar claims that higher standards will enable corporate executives to loot their companies and defraud innocent shareholders with impunity. This article takes no position on the relative merits of these competing claims.

The adoption of the PSLRA in 1995 can be fully appreciated only when viewed with an understanding of the long-running debate between the plaintiff bar and the defense bar over the applicable standards governing Rule 12(b)(6) motions to dismiss in Rule 10b-5 claims.

Securities Litigation Uniform Standards Act

In 1995, Congress passed the Private Securities Litigation Reform Act (PSLRA), claiming that the class action device was being used to injure "the entire U.S. economy" through nuisance filings, targeting of deep-pocket defendants, vexatious discovery requests, and "manipulation by class action lawyers of the clients whom they purportedly represent." The PSLRA accordingly imposed new restrictions that included a heightened pleading standard for securities class actions, damage caps, and mandatory sanctions for frivolous litigation.

The consequence was that many securities fraud plaintiffs sought to escape the new strictures under the PSLRA by avoiding federal court altogether. While historically securities cases were rare in state court, state law-based class actions for securities fraud now became common. Congress conducted a hearing in 1997 to evaluate these effects of the PSLRA, and subsequently enacted SLUSA to stem this "shift from Federal to State courts" and "prevent certain State private securities class action lawsuits alleging fraud from being used to frustrate the objectives of" the Reform Act.

The Securities Litigation Uniform Standards Act of 1998 (SLUSA) is a federal legislative act in the United States regarding private class action lawsuits for securities fraud. SLUSA amended portions of the Securities Act of 1933 and the Securities Exchange Act of 1934 to preempt certain class actions that alleged fraud under state law "in connection with the purchase or sale" of securities. Such lawsuits are therefore barred from being filed in state courts, or from being brought in federal court under state law.  The core provision of SLUSA reads as follows:

Class Action Limitation. -- No covered class action based upon the statutory or common law of any State or subdivision thereof may be maintained in any State or Federal court by any private party alleging --

(A) a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security; or
(B) that the defendant used or employed any manipulative or deceptive device or contrivance in connection with the purchase or sale of a covered security.
Another key provision of the statute makes all "covered class actions" filed in state court removable to federal court, which it defines as a lawsuit in which damages are sought on behalf of more than 50 people. A "covered security" is one traded nationally and listed on a regulated national stock exchange.

SLUSA exempts from its preemption coverage certain class actions that are based on the law of the state in which the issuer of the security is incorporated. It also excludes any actions brought by a state agency, a state pension plan, actions under contracts between issuers and indenture trustees, and derivative actions brought by shareholders on behalf of a corporation.[6]SLUSA also expressly preserves state court jurisdiction over state agency enforcement proceedings.

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