Private Securities Litigation Reform Act

Private Securities Litigation Reform Act

The United States Private Securities Litigation Reform Act of 1995 (PSLRA) implemented several 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.

The PSLRA imposes new rules on securities class action lawsuits. It allows judges to decide the most adequate plaintiff in class actions. It 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.

Background: Overview of Securities Fraud Actions Under Section 10(b) and Rule 10b-5

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, ussc|544|336|2005.

Each of these elements has been heavily litigated in thousands of cases over the past 70 years, and the courts have applied these six elements in a multitude of different factual situations.

Putting the PSLRA in Context: The Procedural Course of a Modern Securities Fraud Case

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.

Heightened Pleading Requirements

In adopting the PSLRA in 1995, Congress was persuaded that the arguments of the defense bar had merit. The legislative history reveals that Congress passed the PSLRA to curb the "abusive practices committed in private securities litigation" including "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." [ H.R. Rep. No. 104-369, at 41 (1995) (Conf. Rep.), reprinted in 1995 U.S.C.C.A.N. 730.]

To reduce the number of purportedly frivolous Rule 10b-5 lawsuits that survive motions to dismiss, the PSLRA raised the pleading standards (i.e., the specificity and strength of the factual allegations that must be contained in the plaintiff's complaint) in three specific ways. These changes are among the most significant aspects of the PSLRA.

Requirement That False Statements Be Pleaded "With Particularity"

The PSLRA requires a plaintiff to identify in his complaint "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). If a plaintiff's complaint does not specifically identify the allegedly fraudulent statements and explain why they were misleading, the complaint will be dismissed. By requiring plaintiffs to set forth their theory regarding why a particular statement was misleading, the PSLRA enables defendants to put forth arguments as to why the challenged statement was not, in fact, misleading.

Requirement That Pleading Create a "Strong Inference" of Scienter

The PSLRA also requires a plaintiff to allege that the defendant acted with the required state of mind, i.e., that he knew the challenged statement was false at the time it was made, or was reckless in not recognizing that the statement was false (the legal term of art for this state of mind is "scienter"). In alleging scienter under the PSLRA, the plaintiff 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." 15 U.S.C. § 78u-4(b)(2). This requirement allows defendants to obtain dismissal of cases where the plaintiff merely points to a false statement and declares that the defendant "must have known" that the statement was false, based upon his position within the company. This requirement has frequently proven difficult for plaintiffs to overcome because, without the benefit of discovery, plaintiffs often do not have access to witnesses or documents that might prove the defendant's state of mind in making the false statement.

U.S. Supreme Court Decision in "Tellabs v. Makor" (06/21/2007) set the bar higher and requires now a "Cogent Inference" of Scienter

The United States Supreme Court agreed in January 2007 to review a U.S. Court of Appeals for the Seventh Circuit decision that articulates an extremely lenient standard for determining whether the facts alleged in a complaint asserting a violation of the federal securities laws give rise to a "strong inference" that the defendant acted with the required state of mind. [ Makor Issues & Rights, Ltd. v. Tellabs, Inc., 437 F.3d 588 (7th Cir. 2006), cert. granted, 75 U.S.L.W. 32 WL 3207 (U.S. Jan. 5, 2007) (No. 06-484).]

The U.S. Circuit Courts had adopted substantially disparate tests for determining whether scienter is sufficiently pleaded.

Four circuits, the First, Fourth, Sixth and Ninth, require a direct comparison of the plausibility of competing inferences. Unless the culpable inference is the “most plausible,” it is not “strong” and the complaint should be dismissed. Two circuits, the Eighth and the Tenth, consider all inferences, both of scienter and of an innocent mental state, using the innocent inferences to test whether the culpable interest is strong, but do not directly weigh one against the other. The Second and Third circuits divide the factual allegations bearing on a defendant’s mental state into categories, “motive and opportunity” and “strong circumstantial evidence” of knowing or reckless conduct, either of which may independently satisfy the strong inference requirement. And, the Seventh Circuit...did not consider competing inferences, but concluded that if an inference of culpability exists, the pleading is sufficient. [ Gold, Sarah, Spinogatti, Richard, "Pleading 'Strong Inference' of Scienter Under PSLRA", New York Law Journal, February 14, 2007. ]

On June 21, 2007, in an opinion written by Justice Ruth Bader Ginsburg, the US Supreme Court ruled that the plaintiffs would have to show a "cogent inference" of an intent to deceive or defraud, thereby raising the national pleading requirements for all plaintiffs in securities litigation matters.

Requirement That Plaintiff Prove Loss Causation

Finally, the PSLRA also makes clear that a plaintiff in a Rule 10b-5 case "shall have the burden of proving that the act or omission of the defendant...caused the loss for which the plaintiff seeks to recover damages." 15 U.S.C. § 78u-4(b)(4). At one time, there was a question over whether this requirement actually applied at the motion to dismiss stage. The statute says the plaintiff must "prove" loss causation. It does not say the plaintiff must "allege" loss causation. However, after the Supreme Court's decision in [ "Dura Pharmaceuticals v. Broudo"] , it is now clear that a plaintiff must allege loss causation in its complaint.

The Dura Decision and Loss Causation

The "Dura" decision held that a plaintiff in a Rule 10b-5 case had not adequately pleaded loss causation by merely alleging that he "paid artificially inflated prices for Dura securities" at the time of purchase. The Supreme Court observed that an investor who purchases a stock at an artificially inflated price suffers no economic loss at the time of purchase. The loss occurs only when the truth is disclosed and the stock price falls as a result. Thus, a plaintiff who sells his shares "before the relevant truth begins to leak out" does not suffer any economic damage. The plaintiff in Dura failed to allege that the "share price fell significantly after the truth became known", and therefore the complaint had not alleged loss causation.

How a court defines the "relevant truth" that the defendant fraudulently withheld often determines the outcome of a 10b-5 case. The stock analyst cases provide a good example of the importance of how the "relevant truth" is defined. The claim in most stock analyst cases has been that the analyst dishonestly touted a particular stock as a good investment when that was not the analyst's genuine belief. Under Dura, these cases have often been dismissed because, in most instances, the analyst’s dishonesty never comes to light until after the price of the stock in question has declined substantially. By that point, the "bad facts" about the company have already been absorbed by the market, and therefore plaintiffs cannot show that the disclosure of the analyst's dishonesty caused any further decline in the stock price. [ See Bertrand S. Sellier and John H. Snyder, "The Fight Over The Loss Causation Burden Isn't Over", "National Law Journal", April 16, 2007. ]

Legislative History

The PSLRA was enacted into law by the U.S. Congress over a veto by President Bill Clinton. The U.S. House of Representatives approved the bill by a 319-100 margin, and the U.S. Senate approved it 68-30. Every Republican in the House voted in favor of the legislation, and only four Republicans in the Senate voted against it: William Cohen, John McCain, Richard Shelby, and Arlen Specter. Prominent liberals in the Democratic Party like senators Tom Harkin, Ted Kennedy, Claiborne Pell, and Carol Moseley Braun voted in favor of the legislation while many conservative-to-moderate Democrats such as senators John Breaux, Robert Byrd, Fritz Hollings, and Sam Nunn and representatives such as John Murtha and Gene Taylor voted against it. Both the current Senate majority leader, Harry Reid, and the current Speaker of the House, Nancy Pelosi, voted for the bill. This event was one of two times during Bill Clinton's entire two terms in office that Congress successfully overrode one of his 37 presidential vetoes to enact a bill into law.

The PSLRA was originally developed as part of Newt Gingrich's Contract With America. Its principal authors in the House were Representatives Thomas Bliley, Jack Fields and Chris Cox. Senators Chris Dodd and Pete Domenici sponsored the legislation in the Senate.


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