TESTIMONY OF ARTHUR LEVITT, CHAIRMAN U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING THE IMPLEMENTATION OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 BEFORE THE SUBCOMMITTEE ON FINANCE AND HAZARDOUS MATERIALS COMMITTEE ON COMMERCE UNITED STATES HOUSE OF REPRESENTATIVES October 21, 1997 Chairman Oxley, Congressman Manton and other Members of the Committee: I appreciate the opportunity to testify on behalf of the Securities and Exchange Commission ( Commission ) concerning the implementation of the Private Securities Litigation Reform Act of 1995 ( Reform Act or Act ).<(1)> The Reform Act made significant changes to the conduct of private securities litigation. We commend the Subcommittee for seeking to ensure that this important Act is serving its intended purposes. I. INTRODUCTION In December 1995, Congress passed the Reform Act in an effort to curtail what was perceived to be abusive securities class action litigation. In the less than two years since passage, the Commission has been monitoring developments under the Reform Act and the Act s impact on the effectiveness of the securities laws and on investor protection. Among other activities, we have closely followed all federal litigation under the Act, intervening as amicus curiae where important issues have been raised; we have monitored litigation in state courts that may affect the Reform <(1)> Pub. L. No. 104-67, 109 Stat. 737 (1995). Act s effectiveness; and we have reached out continuously and widely to those who are affected by the Reform Act -- issuers and their advisers, individual and institutional investors, plaintiffs and defendants counsel, as well as others. With nearly two years experience under our belts, we have learned much about certain provisions of the Reform Act. The Reform Act is still in its infancy, however, and many provisions have not yet been interpreted by the courts. Overall, we have not had enough practical experience with the Act to produce the data necessary for us to measure its success. In response to a request from President Clinton, the Commission directed the staff to prepare a Report to the President and the Congress on the First Year of Practice Under the Private Securities Litigation Reform Act of 1995 ( Staff Report ).<(2)> The Staff Report, which was prepared under the guidance of General Counsel Richard H. Walker, was submitted in April 1997. Although the Staff Report concluded that there was not enough data to make a definitive assessment of the Act s impact, it did identify certain areas where the Act had achieved positive results. In addition, the Staff Report identified three areas where the Reform Act was not yet achieving its intended goals. These areas warranting Congress particular attention are the lead plaintiff provision, the safe harbor for forward-looking statements, and the discovery stay. The key question raised at today s hearing is whether the Act is achieving its aims. To aid the Subcommittee in attempting to answer this question, I will cover the key findings of the <(2)> We are submitting copies of the Staff Report to the Subcommittee in connection with our testimony and respectfully request that it be included in the record. ======END OF PAGE 2====== Staff Report as well as developments arising since submission of the Report.***** II. THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 The Reform Act revised both the substantive standards and procedural rules governing private actions under the federal securities laws. The Act primarily affected class actions, which while often providing the only redress practically available to most small investors, are commonly thought to be the type of securities suits most prone to abuse. Class actions often involve expensive and time-consuming discovery, de facto control by plaintiffs lawyers, and the potential for substantial damages. Among the Act's principal provisions are: (i) a "safe harbor" for forward-looking statements; (ii) a stay of discovery while a motion to dismiss is being decided; (iii) heightened pleading standards requiring specific recital of facts giving rise to a strong inference of fraud; (iv) a "lead plaintiff" provision designed to wrest control of class action litigation from lawyers and to empower institutional shareholders; and (v) a system of proportionate, as opposed to joint and several, liability for defendants who are not found to have knowingly committed fraud. ***** III. STAFF REPORT TO THE PRESIDENT AND THE CONGRESS In January 1996, President Clinton wrote to me requesting that the Commission advise him and the Congress about the impact of the then newly passed Act on the effectiveness of the securities laws and on investor ======END OF PAGE 3====== protection, and on the extent and nature of any litigation under the Act. On April 15th of this year, I submitted the Staff Report to the President and the Congress. The Staff Report noted that there has been only limited experience with the Act s key provisions in the short time since its passage. In particular, the appellate courts have had virtually no opportunity to interpret the Act. No case has made its way to a jury, relatively few motions to dismiss have been decided, and there have been even fewer reported settlements. Important provisions such as the safe harbor s meaningful cautionary language requirement and the proportionate liability provision have yet to be addressed at any stage of the litigation process. The Staff Report nonetheless did make the following preliminary observations: * The number of companies sued in securities class actions in federal court declined in 1996, the first year following passage of the Reform Act. The Staff Report identified 105 companies sued in federal securities class actions during that year. By contrast, Securities Class Action Alert, a newsletter which tracks these actions, has reported that approximately 153 companies were sued during 1993, 221 during 1994, and 158 during 1995. The staff s subsequent research indicates that in 1997 there have been 124 federal securities class actions filed to date. This projects to 157 on an annualized basis. Accordingly, while there was a material drop-off in the number of suits filed in 1996, the rate has now rebounded to pre-Reform Act levels. As the Staff Report noted, however, meaningful conclusions ======END OF PAGE 4====== cannot be drawn about the effectiveness of the Reform Act purely from the raw number of filings. Numbers alone do not reveal whether the cases are meritorious or meritless. * The number of state filings increased for that same period, according to reports by outside parties that were reviewed by the staff, though the overall number (approximately 70) remained quite small. Moreover, many of the state cases were filed parallel to a federal court case in an apparent attempt to gain discovery in the state case for use in the federal case where the Reform Act s discovery stay would apply. * Most federal securities class action complaints filed in 1996 appeared to contain detailed factual allegations specific to the action. Only 12% were based solely on forecasts that did not prove accurate. The legislative history of the Reform Act indicates that such suits were a central concern of Congress. The majority of complaints were premised on allegations of either insider trading (48%) or accounting irregularities (43%).<(3)> A smaller percentage contained allegations of restatements of previously reported financial results (18%), government investigations (15%), or outright Ponzi schemes (2%). While the allegations found in the complaints generally appear to be substantial on their face, the merits of these cases can only be decided by judges and juries on the basis of the evidence. <(3)> A recent study found that prior to the Reform Act, 20.7% of securities class actions contained allegations of insider trading and 33.9% contained allegations of misrepresentations in financial statements. Laura E. Simmons, The Importance of Merit- Based Factors in 10b-5 Litigation, CORNERSTONE RESEARCH, tbl. 2 (Nov. 14, 1996). ======END OF PAGE 5====== * Based on the staff s review of a small sample of cases, the allegations contained in state court complaints were generally similar to those in the federal complaints, but state complaints having no parallel federal action were more likely to be based solely on failed forecasts. * Secondary defendants, such as accountants and lawyers, were being named much less frequently in federal securities class actions.<(4)> It is unclear, however, whether this decline can be attributed primarily to the Reform Act or to the Supreme Court's 1994 decision in the Central Bank of Denver case, which eliminated private liability for aiding and abetting in actions under Section 10(b) of the Securities Exchange Act of 1934 ( Exchange Act ).<(5)> <(4)> The staff s review of complaints in the 105 class actions filed in 1996 revealed that accounting firms have been named in six cases, corporate counsel in no cases, and underwriters in 19 cases. By contrast, a report of the Big Six accounting firms concluded that the number of audit-related suits filed in both state and federal court against these firms for the years 1990 to 1992, was 192, 172, and 141 respectively, Letter from Mark H. Gitenstein & Andrew J. Pincus, Mayer Brown & Platt, to Walter P. Schuetze, Chief Accountant, Securities and Exchange Commission, at 14, tbl. VIII, (June 11, 1993), although these numbers were not limited to securities class actions. Moreover, this report concluded that during these same years the number of cases either settled or dismissed against the Big Six firms which involved claims under Section 10(b) was 18, 35, and 58 respectively. Id. at 16, tbl. IX. A study by the National Economic Research Associates reported that during the period 1991 through June 1996, accountants were defendants in 52 reported settlements (as opposed to complaints), underwriters were defendants in 80, and law firms were defendants in seven. Denise N. Martin Et Al., National Economic Research Associates, RECENT TRENDS IV: WHAT EXPLAINS FILINGS AND SETTLEMENTS IN SHAREHOLDER CLASS ACTIONS?, tbl. IX (1996) (hereinafter NERA STUDY). <(5)> Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). ======END OF PAGE 6====== ù Institutional investors were not yet actively seeking to become involved in securities class actions, which continued to be controlled by plaintiffs' law firms. * The race to the courthouse to file a complaint slowed somewhat. Although a few cases were filed within days of the release of negative news by the issuer, most were filed after at least several weeks had passed.<(6)> * The courts have strictly applied the discovery stay imposed by the Reform Act during the pendency of a motion to dismiss. Coupled with the heightened pleading standards, the stay has made it more difficult for plaintiffs to prosecute securities class action lawsuits. * Despite the new safe harbor, the staff received anecdotal reports that companies appeared to be reluctant to provide significantly more forward-looking disclosure beyond what they provided prior to enactment of the Act. ***** IV. AREAS OF CONCERN The Staff Report identified three areas where it appears that the Reform Act has not yet achieved its intended goals. First, the lead plaintiff provision has not encouraged institutions to become class representatives. Second, the safe harbor does not appear to have induced companies voluntarily to disclose more forward-looking information. Finally, parallel cases have been brought in state court where the <(6)> The average time between the end of the class period and the filing of the first complaint was 79 days as compared with an average lag of 49 days for 1991 to 1995. ======END OF PAGE 7====== discovery stay does not apply, thus permitting plaintiffs to obtain discovery that they could not get in federal court. Lead Plaintiff Provision The lead plaintiff provision creates a presumption that the plaintiff or group of plaintiffs with the largest financial stake in the lawsuit during the class period should be appointed as class representative, with the authority to choose class counsel. Congress adopted this provision in an effort to put shareholders, rather than plaintiffs' attorneys, in charge of class actions. This provision has not yet produced the results that Congress intended. The Staff Report found that in only eight of the 105 class actions filed during the Act's first year did institutions seek to be named lead plaintiff.<(7)> It appears that in 1997 institutions have continued to remain on the sidelines. In the 124 federal class actions filed to date, we are aware of <(7)> Cellstar Corp. (N.D. Tex.) (State of Wisconsin Investment Board); IVAX Corp. (S.D. Fla.) (Pennsylvania School Employees Retirement System Pension Fund); Fleming Cos. (W.D. Okla.) (City of Philadelphia, acting through its Board of Pensions and Retirement); In re Summit Techology Sec. Litig. (D. Mass.) (Teachers' Retirement System of Louisiana); Micro Warehouse, Inc. (D. Conn.) (Teachers Retirement System of Louisiana & Pennsylvania School Employees Retirement System Pension Fund); In re Cephalon, Inc. Sec. Litig. (E.D. Pa.) (Sands Point Partners, L.P.); Pepsi-Cola Puerto Rico Bottling Co. (S.D. Fla.) (Sweetwater Investments, Inc.); OrthoLogic Corp. (D. Ariz.) (City of Philadelphia). ======END OF PAGE 8====== only six in which institutions have sought lead plaintiff status.<(8)> Institutions have been active, however, in other ways. For example, institutions have monitored the conduct of class actions in which they did not seek to be named lead plaintiff. In a class action against an Albuquerque health care provider, two institutions recently objected to what they considered to be exorbitant attorneys fees. The State of Wisconsin Investment Board and the Colorado Public Employees Retirement Association objected to the one-third fee sought by the lawyers; the institutions asked the judge to award 17.5%. The judge ruled on September 12 that plaintiff s counsel fees would be reduced to 20%.<(9)> More evidence relevant to the effectiveness of the Reform Act s lead plaintiff provision will soon be available. Two Reform Act class actions in which institutional investors were named lead plaintiff have recently settled. The MicroWarehouse case settled for $30 million and the Medaphis case settled for $72.5 million. The amount of attorneys fees has yet to be determined. The attorneys fees awarded in these cases will be early <(8)> Boston Chicken (D. Colo.) (Teachers Retirement System of Louisiana); Molten Metals (D. Mass.) (Louisiana State Employees Retirement System); Mercury Finance (N.D. Ill.) (Minnesota State Board of Investment); Scholastic Corp. (S.D.N.Y.) (City of Philadelphia, acting through its Board of Pensions and Retirement); U.S.A. Detergents (D. N.J.) (City of Philadelphia, acting through its Board of Pensions and Retirement); Medaphis (N.D. Ga.) (Pennsylvania School Employees Retirement System Pension Fund). <(9)> See Dean Starkman, Institutions are Challenging Legal Fees, WALL ST. J. B14 (Sept. 30, 1997). ======END OF PAGE 9====== indicators of the impact that institutional involvement can have on the allocation of recoveries in securities class actions.<(10)> Why are more institutions not coming forward to be lead plaintiff? In preparing the Staff Report, the staff met with representatives of both public and private institutional investors. The institutions primary concern is litigation-related expense. They asserted that making key personnel available for lengthy testimony and opening the institution's books and records to both plaintiffs' and defendants' lawyers can exact a heavy toll. In addition, private institutions are reluctant to reveal their proprietary investment strategies in the course of litigation. Public institutions, on the other hand, generally do not share this concern because most states have laws requiring the disclosure of this information. Institutions also expressed concern that service as lead plaintiff could expose them to liability to other class members. For example, other class members could sue the lead plaintiff if the terms of the settlement were claimed to be inadequate. We also have been told that institutions often get a better return by proceeding with their own individual suits. This observation is backed up by the fact that at least six individual <(10)> A recent report by the National Economic Research Associates found that between January 1991 and June 1996 the average award of attorney fees in securities class actions, measured as a percentage of settlement, is as follows: 30.38% for settlements ranging $0 to $0.99 million; 31.88% for settlements ranging from $1.00 to $1.99 million; 32.11% for settlements ranging from $2.00 to $9.99 million; 31.72% for settlements ranging from $10 to $49.99 million; and 31.48% for settlements in excess of $50 million. NERA STUDY tbl. 9. Another study of the Reform Act was conducted by Joseph A. Grundfest & Michael A. Perino, Securities Litigation Reform The First Year s Experience, CORNERSTONE RESEARCH, Feb. 27, 1997. ======END OF PAGE 10====== securities actions have recently been brought by institutions.<(11)> Further, institutions have reported that, if they continue to hold shares, the costs to the company of defending the suit may outweigh any damages that the institution is likely to receive. The Commission will continue to monitor institutional involvement in securities class actions.<(12)> Safe Harbor for Forward-Looking Statements The Commission s Staff Report also reported that companies are not using the safe harbor to make more forward-looking disclosure. In preparing the Staff Report, the Commission s Office of the General Counsel spoke with issuers who stated that their primary concern is the lack of judicial guidance as to the sufficiency of the required "meaningful cautionary language. They are also waiting to see how other companies are making use of the safe harbor. Concern about potential liability under state law, where the statements may not be protected by the federal safe harbor, was another frequently cited reason for not including more forward- looking disclosure. Definitive appellate rulings on the Reform Act s safe <(11)> Bay Network (Florida State Board of Administration); Informix (Teachers Retirement System of Louisiana and Florida State Board of Administration each brought individual actions); Digi International (Louisiana State Employees Retirement System); MicroWarehouse (Florida State Board of Administration); Summit Medical (Teachers Retirement System of Louisiana); and Mercury Finance (T. Rowe Price). <(12)> Professor Elliott J. Weiss of the University of Arizona School of Law has joined the Commission s Office of the General Counsel as a consultant for the next year to study these issues. Professor Weiss is a co-author of the law review article serving as the foundation of the lead plaintiff provision. Elliott J. Weiss & John S. Beckerman, Let the Money Do the Monitoring: How Institutional Investors Can Reduce Agency Costs in Securities Class Actions, 104 YALE L.J. 2053 (1995). ======END OF PAGE 11====== harbor provision will provide more guidance to issuers and will enable us to better evaluate the safe harbor. Discovery Stay The Staff Report also notes that the discovery stay may be avoided by the filing of a parallel state action. Fifty-five percent of the state court cases (35 out of 55) have allegations that are essentially identical to those brought by the same law firm in federal court. Some observers believe that these cases were filed primarily to get discovery for use in the federal action.<(13)> ***** V. JUDICIAL DEVELOPMENTS The Commission s staff has been actively monitoring developments in the courts relating to the Reform Act. While many of the important provisions of the Reform Act have not yet been interpreted by the courts, notable decisions have been handed down addressing three provisions: (1) the notice provision; (2) the pleading standard; and (3) the mandatory Rule 11 sanctions inquiry. The Notice Provision A recent decision by the Northern District of California suggests courts may strictly construe the Reform Act s notice provision. In a class action brought against a California disc drive manufacturer, Judge Vaughn <(13)> State courts may offer advantages to plaintiffs other than discovery. These include, depending on the state: easier pleading standards, non-unanimous jury verdicts, joint and several liability, and aiding and abetting liability for secondary actors. ======END OF PAGE 12====== Walker deemed plaintiffs notice over the Business Wire, a business news service available on-line, to be insufficient, specifying four reasons: ù it was too sketchy to apprise class members of the claims asserted in the action; * it omitted the qualifications of the named plaintiffs to serve as class representatives; ù it did not delineate the precise date the fraud began and did not discuss the effects of multiple corrective statements issued by the defendant on the claims of each class member; and * it did not alert class members to potential intra-class conflicts of interest, as the named plaintiffs did not make their first purchase of their shares until midway through the designated class period.<(14)> In strictly scrutinizing the notice, Judge Walker stated that the notice standards under the Federal Rules of Civil Procedure ( FRCP ) are the baseline against which the Reform Act notice must be judged. FRCP 23(c)(2) requires the best notice practicable under the circumstances. The Pleading Standard The staff has identified 40 rulings on motions to dismiss federal actions filed after passage of the Reform Act. The results are as follows: 16 actions have been dismissed with leave to replead; 7 have been dismissed without leave to replead; 2 have been dismissed in part; and 15 have been <(14)> Ravens v. Iftikar, Nos. C-96-1224-VRW, C-96-1926-VRW, 1997 WL 405110 (N.D. Cal. July 16, 1997). ======END OF PAGE 13====== denied. Thus, more than 59% of the motions to dismiss have been granted at least in part. These motions have focused mainly on the Act s strict pleading standards that require that the complaint "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." The courts are divided over the proper interpretation of this language, based primarily on their differing views of the legislative history. Fourteen courts have adopted the traditional Second Circuit standard for pleading scienter, one of the essential elements of all securities fraud suits.<(15)> This standard allows plaintiffs to plead facts giving rise to a strong inference that the defendants acted either knowingly or recklessly, or that the defendants had a motive and opportunity to commit the fraud. <(15)> Marksman Partners, L.P. v. Chantal Pharmaceuticals Corp., 927 F. Supp. 1297 (C.D. Cal. 1996); Zeid v. Kimberley, 930 F. Supp. 431 (N.D. Cal. 1996); STI Classic Fund v. Bollinger Indus., Inc., No. 3:96-CV-823-R, 1996 WL 866699 (N.D. Tex. Nov. 12, 1996); Fischler v. AmSouth Bancorporation, No. 96-1567-CIV-T-17A, 1996 WL 686565 (M.D. Fla. Nov. 14, 1996); Rehm v. Eagle Fin. Corp., 954 F. Supp. 1246 (N.D. Ill. 1997); Fugman v. Aprogenex, Inc., 961 F. Supp. 1190 (N.D. Ill. 1997); In re The Wellcare Management Group, Inc. Sec. Litig., 964 F. Supp. 632 (N.D.N.Y. 1997); Page v. Derrickson, No. 96-842-CIV-T-17C, 1997 WL 148558 (M.D. Fla. Mar. 25, 1997); Galaxy Inv. Fund, Ltd. v. Fenchurch Management, Ltd., 1997 U.S. Dist. LEXIS 13207 (N.D. Ill. Aug. 29, 1997); Pilarcyzk v. Morrison Knudsen Corp., 965 F. Supp. 311 (N.D.N.Y. 1997); OnBank & Trust Co. v. FDIC, 967 F. Supp. 81 (W.D.N.Y. 1997); In re Health Management, Inc. Sec. Litig., No. CV 96-889, 1997 WL 413895 (E.D.N.Y. July 21, 1997); Gilford Ptnrs. L.P. v. Sensormatic Elec. Corp., 1997 U.S. Dist. LEXIS 13724 (N.D. Ill. Sept. 10, 1997); Weikel v. Tower Semiconductor Ltd., No. 96-3711 (D.N.J. Oct. 2, 1997). ======END OF PAGE 14====== At least six other decisions have adopted a more stringent standard. These decisions hold that only conscious misrepresentations or omissions,<(16)> or in one case deliberate recklessness, <(17)> satisfy the Reform Act's pleading standard. Two other decisions treat motive and opportunity as factors to be considered in determining whether the plaintiff has adequately pleaded scienter.<(18)> While these decisions address the pleading requirements of the Reform Act, they indirectly may affect the substantive liability requirements of the securities laws themselves. We do not believe that this was Congress intent. At the time the Reform Act was enacted, the law was well established in each of the ten federal appellate courts that had considered the issue that proof of recklessness satisfies the scienter requirement and can establish liability under the antifraud <(16)> In re Silicon Graphics, Inc. Sec. Litig., C 96-0393, 1997 WL 337580 (N.D. Cal. June 5, 1997); Friedberg v. Discreet Logic Inc., 959 F. Supp. 42 (D. Mass. 1997); Powers v. Eichen, No. 96- 1431-B (AJB) (S.D. Cal. Mar. 13, 1997); Norwood Venture Corp. v. Converse Inc., 959 F. Supp. 205 (S.D.N.Y. 1997); Voit v. Wonderware Corp., No. CIV.A. 96-CV-7883, 1997 WL 570710 (E.D. Pa. Sept. 8, 1997); In re Comshare Inc. Sec. Litig., Case No. 96- 73711-DT (E.D. Mich. Sept. 18, 1997). <(17)> In re Silicon Graphics, Inc. Sec. Litig., C 96-0393, 1997 WL 337580 (N.D. Cal. June 5, 1997). <(18)> In re Baesa Sec. Litig., 969 F. Supp. 238 (S.D.N.Y. 1997); Press v. Quick & Reilly, 1997 U.S. Dist. LEXIS 11609, at *5 (S.D.N.Y. Aug. 8, 1997). ======END OF PAGE 15====== provisions of Section 10(b) of the Exchange Act.<(19)> The Reform Act did not change this standard. The Commission has consistently supported a recklessness standard of liability because such a standard is needed to protect investors from fraudulent conduct. We are closely monitoring the decisions under the Reform Act which hold that allegations of recklessness do not satisfy the Act s pleading requirements. We participated in the Silicon Graphics case to urge the Northern District of California trial court to follow well- established case law upholding recklessness as a basis for liability. We restated our position recently in Zeid v. Kimberley (the Firefox Communications class action) in the Ninth Circuit Court of Appeals. <(19)> Cook v. Avien, Inc., 573 F.2d 685, 692 (1st Cir. 1978); Rolf v. Blyth Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir. 1978); In re Phillips Petroleum Sec. Litig., 881 F.2d 1236, 1244 (3d Cir. 1989); Broad v. Rockwell Int'l Corp., 642 F.2d 929, 961- 62 (5th Cir.), cert. denied, 454 U.S. 965 (1981); Mansbach v. Prescott, Ball & Turben, 598 F.2d 1017, 1023-24 (6th Cir. 1979); Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1044 (7th Cir.), cert. denied, 434 U.S. 875 (1977); Van Dyke v. Coburn Ent., Inc., 873 F.2d 1094, 1100 (8th Cir. 1989); Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569-70 (9th Cir. 1990), cert. denied, 499 U.S. 976 (1991); Hackbart v. Holmes, 675 F.2d 1114, 1117-18 (10th Cir. 1982); McDonald v. Alan Bush Brokerage Co., 863 F.2d 809, 814 (11th Cir. 1989). ======END OF PAGE 16====== Mandatory Rule 11 Inquiries The Reform Act requires mandatory sanctions for violations of Rule 11(b) of the Federal Rules of Civil Procedure.<(20)> Upon final adjudication, the court is required to make a finding of compliance with Rule 11(b) with respect to any complaint, responsive pleading, or dispositive motion. Failure to comply results in mandatory sanctions against a party or an attorney. Payment of the other party's reasonable attorneys' fees and expenses directly relating to the violation is presumed to be the appropriate sanction. To date, two reported decisions have made this mandatory inquiry; neither has imposed sanctions. In Hart Brewing, the District Court for the Southern District of California granted the defendant s motion to dismiss, but the court found "that no parties violated the pleading requirements of F.R.C.P. 11(b) in this matter. Sanctions are therefore not appropriate in this case."<(21)> In Richter v. Achs, the court granted defendants motion for summary judgment, but the court s original order did not make a <(20)> 1933 Act  27(c), 15 U.S.C.  77z-1(c); 1934 Act  21D(c), 15 U.S.C.  78u-4(c). FRCP 11(b) provides, in relevant part, that by presenting to the court a pleading, written motion or other paper, the attorney is certifying that the claims, defenses and other legal contentions therein are warranted by existing law or by a nonfrivolous argument for the extension, modification or reversal of that law or the establishment of new law; and that the allegations and other factual contentions have, or after discovery are likely to have, evidentiary support. <(21)> Order Granting Defendants' Motion to Dismiss, Steckman v. Hart Brewing, Inc., [Current Transfer Binder] Fed. Sec. L. Rep. (CCH) 99,420, at 96,745 (Dec. 24, 1996). ======END OF PAGE 17====== Rule 11 inquiry.<(22)> Defendants subsequently requested the court to amend the judgment and grant sanctions. The court declined to do so. VI. ANALYSIS OF STATE COURT COMPLAINTS As part of our ongoing efforts to monitor the progress of the Act, the Commission's staff has been studying securities class actions brought in state courts. Some commentators have suggested that the Act has led to a migration of cases to state courts where federal reforms do not apply. Unlike federal class actions, notice is not required when shareholders file actions in state court. As a result, tracking state court cases is more difficult and less precise. Nonetheless, Stanford University s Securities Class Action Clearinghouse has identified approximately 103 securities class actions that have been brought in state courts since passage of the Reform Act, approximately 62 of which have been brought in California.<(23)> The staff has obtained and reviewed a total of 55 state securities class action complaints. While this sample may not be representative, the staff s review of those complaints discloses the following: * The state court suits have primarily been brought in California -- 78% of the cases (43 out of 55) have been brought in this state; and * Companies are being sued in states where they are either incorporated or have their principal place of business. Very few -- 7% (4 out of 55) -- have been sued in states where they do not have such ties. <(22)> No. 96 CIV. 6403 CBM, 1997 WL 425764 (S.D.N.Y. July 28, 1997). <(23)> Securities Class Action Clearinghouse -- State Complaints (last modified Sept. 15, 1997) (located at http://securities.stanford.edu). ======END OF PAGE 18====== A study released by the NERA in July of this year concludes that the number of state securities fraud class actions filed thus far in 1997 is significantly lower than in 1996. In fact, NERA finds that the number of 1997 state cases is roughly equivalent to the average number filed in the five years prior to the Reform Act. Raw numbers aside, we have uncovered other interesting data about state lawsuits. The Staff Report analyzed a small sample of 1996 state court complaints.<(24)> In the chart that follows, we compare the allegations in federal complaints with the allegations found in all of the state complaints in our sample, and with the state complaints that have no parallel federal action: Allegations Federal Stand-Alone Stand-Alone Complaints plus Parallel State State Complaints Complaints Solely Failed 12% 15% 25% Forecasts Insider 48% 46% 25% Trading Accounting 43% 38% 31% Irregularities Financial 18% 15% 13% Restatement Government 15% 8% 6% Investigation Ponzi Scheme 2% 0% 0% <(24)> The sample consisted of 26 complaints. ======END OF PAGE 19====== The small sample size (26) does not allow for a definitive assessment of the state complaints. The staff analyzed these complaints merely to categorize the nature of the factual allegations, and could not attempt to judge the merits of the lawsuits. But the chart is nevertheless instructive. While the allegations in the state court complaints overall are substantially the same as allegations in federal complaints, the stand- alone state complaints contain a somewhat different mix of allegations. For example, the percentage of state failed forecast cases is double the federal percentage, and the percentage of state insider trading cases is approximately half that of the federal complaints. The parallel state court complaints contain allegations nearly identical to their federal court counterparts. The stand-alone complaints in the sixteen cases reviewed by the staff, which are not subject to the federal pleading standards, are more likely to be based solely on a failed forecast. What caused the increase in state court filings in 1996? Some observers believe that the main reason is the availability of discovery. As noted, many of the state cases were filed parallel to a federal case, presumably for the purpose of seeking discovery that would not otherwise be available in the federal action due to the discovery stay. The increase in 1996 state court filings may have resulted from efforts to avoid the federal safe harbor for forward-looking statements. Fifty-three percent (29 out of 55) of the state cases the staff charted include claims based on forward-looking statements, as well as other claims; while 11% (6 out of 55) of the cases are primarily based on forward-looking statements. ======END OF PAGE 20====== Another factor which makes state court lawsuits increasingly attractive is the Supreme Court's decision in Matsushita Electric Industry Co. v. Epstein.<(25)> This decision, handed down a few months after passage of the Reform Act, held that a state court judgment dismissing a state class action pursuant to a settlement agreement could include a provision barring federal securities fraud actions arising out of the same transaction. By allowing defendants to obtain a global settlement in state court, Matsushita made state court class actions more advantageous for plaintiffs. Accordingly, it is possible that there would have been an increase in state court classactions even if the Reform Act hadnot been enacted. California has been the most popular forum for these state court filings. At least two factors contribute to California's popularity. The first is the absence of a requirement -- which most states have -- that an individual plaintiff prove that he relied on a misstatement or an omission. Proving individual reliance makes a class action unwieldy because individual questions of fact would predominate over the questions common to the class. In Mirkin v. Wasserman, the California Supreme Court stated that plaintiffs need not plead or prove actual reliance in an action under the state's securities law.<(26)> California s elimination of the <(25)> 116 S.Ct. 873 (1996). <(26)> 858 P.2d 568, 580 (Cal. 1993). At least three other states do not require reliance for blue sky fraud actions, see Rosenthal v. Dean Witter Reynolds, Inc., 908 P.2d 1095, 1106 (Colo. 1996); State v. Superior Court of Maricopa Cty., 599 P.2d 777 (Ariz. 1979), overruled on other grounds, State v. Gunnison, 618 P.2d 604, 607 (Ariz. 1980) (en banc); Weatherly v. Deloitte & Touche, 905 S.W.2d 642, 648-49 (Tex. Ct. App. 1995), while one state trial court has adopted the fraud-on-the-market doctrine under that state's blue sky law, see Bierman v. Thompson, No. DV- 96-124A (Mont. 11th Jud. Ct., Flathead Cty., Oct. 15, 1996). ======END OF PAGE 21====== reliance requirement makes possible a state class action for securities fraud. The other factor is the availability of jurisdiction over high- technology firms, who are frequently named as defendants in securities suits. Silicon Valley contains the largest concentration of high- technology firms in the United States. Those firms tend to have a volatile share price. In addition, those firms often compensate their officers and directors in company stock and stock options, which means that these individuals will be more likely to sell shares during a period of volatility. Insider sales and price drops are frequently relied upon by plaintiffs when pleading fraud. Thus, California state courts may provide an attractive venue for securities class actions. ***** VII. POTENTIAL STATE DEVELOPMENTS California state court actions may not remain a viable long-term alternative to filing in federal court. Already three other states -- Arizona, Montana, and Ohio -- have enacted their own versions of the Reform Act.<(27)> California has introduced a similar bill.<(28)> Judicial developments also may affect the ability of plaintiffs to bring state class actions. Most significantly, the California Supreme Court has a case pending before it, Pass v. Diamond Multimedia,<(29)> <(27)> Ariz. Rev. Stat.  44-2081-2087; 1997 Mt. Laws 468; Ohio Rev. Code Ann.  1707.432-438. <(28)> SB No. 35 (introduced by Senator John Vasconcellos on December 2, 1996). <(29)> Case No. CV-758927 (Santa Clara Cty. Sup. Ct.). ======END OF PAGE 22====== which calls upon the court to decide the currently unsettled question of whether the state's securities laws apply to transactions taking place outside of California. If the court rules in favor of the defendant issuer, then nationwide class actions will be unavailable in California. Plaintiffs' lawyers would be unlikely to look to state court if they could not bring a nationwide class action. In addition, the California Supreme Court has before it a number of petitions seeking review on the question of whether state court class actions should be stayed during the pendency of a parallel federal class action.<(30)> Such a stay would have the practical effect of staying discovery in state court, thus preventing the use of state courts to obtain discovery not available in federal court due to the Reform Act s discovery stay provision. ***** VIII. PREEMPTION OF STATE ACTIONS Three bills have been introduced that would preempt private state antifraud actions. Two of those bills have been introduced here in the House of Representatives, one by Representatives Campbell, Klug, and Dooley,<(31)> and another by Representatives Eshoo and White.<(32)> A bill has also been introduced in the Senate, <(30)> Diamond Multimedia Systems, Inc. v. Superior Court of Santa Clara County, Case No. S0634480 (Sept. 23, 1997); IMP, Inc. v. Superior Court of Santa Clara County, Case No. S064480 (Sept. 23, 1997). <(31)> H.R. 1653. <(32)> H.R. 1689. ======END OF PAGE 23====== sponsored by Senators Gramm, Dodd, Domenici, Boxer, Faircloth, Feinstein, Hagel, Reid, Wyden, Allard, Moseley-Braun, Murray, Lieberman, and Bennett.<(33)> These bills go beyond addressing the problem areas that the Commission has identified, and would preempt state fraud class actions involving nationally-traded securities. These bills would create uniform national standards for lawsuits alleging fraud against companies whose securities are nationally traded, but could have unintended effects, including the preemption of certain types of cases arising from transactions in which both the state and federal governments have a strong interest. For example, they could preempt state class actions for damages based on material misstatements or omissions in proxy and tender offer materials in connection with an extraordinary transaction which may give rise to claims under both state corporate law and federal securities law. Shareholders who bring suit challenging such transactions in actions against target-company management and directors often allege a breach by these persons under state corporate law, including the duty of disclosure. Such actions now may be brought in either state or federal court, or both. If state law actions were preempted, plaintiffs would be forced to split their claims between two suits, one in federal court with their disclosure claims and one in state court with their corporate claims that have not been preempted. Alternatively, they could bring all of their claims in federal court. The latter option, however, raises significant concerns. Many state courts, particularly those in Delaware, have developed expertise and a coherent body of case law which provides guidance to companies and lends <(33)> S. 1260. ======END OF PAGE 24====== predictability to corporate transactions. Broad preemption would diminish the value of this body of precedent as a tool for structuring corporate transactions and resolving corporate disputes. ***** While it is true that investors are not well served by frivolous lawsuits which raise the cost of capital and in no way deter fraud, the Commission has long maintained that private actions provide valuable and necessary additional deterrence against securities fraud, thereby supplementing the Commission's own enforcement activities. Moreover, private suits are the primary method for compensating defrauded investors. This hearing addresses important questions concerning the effectiveness of the Reform Act. The Commission has been actively monitoring the implementation of the Act and its interpretation by the courts. As always, the Commission will be pleased to work with the Committee as it goes forward in evaluating the implementation of the Reform Act. ### ======END OF PAGE 25======