Chairman Gramm, Senator Dodd, and Members of the Subcommittee:
It is an honor to appear before you today. As a securities
lawyer who has represented dozens of high-tech and biotechnology
companies in shareholder litigation, I wish to endorse S. 1260.
The Gramm-Dodd bill is needed to plug a loophole in the Private
Securities Litigation Reform Act of 1995 (the "Reform Act")
created by parallel state court shareholder lawsuits.(1)
I am a member of the law firm of Wilson Sonsini Goodrich & Rosati, P.C. We are located in Silicon Valley and number 450 lawyers. We are proud to represent some of the most innovative, successful companies in the United States. Our clients include leaders in computers (Apple, Dell, Hewlett-Packard, NEC Packard-Bell, Sun), semiconductors (Cypress, LSI Logic, Micron), disk drives (Quantum, Seagate), software (Autodesk, Netscape, Sybase), networking (3Com, Novell), aviation (Boeing), and biotechnology (Genentech). We currently represent over 250 public companies. We also represent hundreds of start-ups that are working to become leaders of their industry sectors tomorrow. In 1996 and 1997, Wilson Sonsini was involved in 198 public equity offerings (as counsel to the issuer or the underwriters), which raised about $11 billion in capital. In the last decade, Wilson Sonsini defended more securities class actions than any other law firm in the United States.
I have practiced in the area of securities litigation for nearly 12 years. I have represented dozens of companies in private securities class actions. My curriculum vita is attached to this testimony as Ex. A, along with a list of companies that I have represented.
My perspective on S. 1260 is not just based on defending companies
in shareholder litigation. A substantial portion of my practice
consists of advising companies on public disclosure issues. In
that capacity, I have seen first hand the chilling impact that
state court shareholder litigation has had on the types of forward-looking
disclosures that the Reform Act sought to encourage.
II. THE STATE COURT PROBLEM
Two years ago, Congress identified a serious problem in a particular type of litigation: securities class actions against publicly traded companies, especially cases filed against high-technology companies. Congress found "significant evidence of abuse in private securities lawsuits."(2) Among those abuses were "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."(3) Congress also found that private securities plaintiffs had "abuse[d] the discovery process to impose costs so burdensome that it is often economical for the victimized party to settle."(4) Congress reiterated that "the private securities litigation system is too important to the integrity of American capital markets to allow this system to be undermined by those who seek to line their own pockets by bringing abusive and meritless suits."(5) Congress concluded that "[i]nvestors always are the ultimate losers when extortionate 'settlements' are extracted from issuers."(6) Thus, Congress determined to put an end to the plague of non-meritorious class action lawsuits, which were contrary to the interests of shareholders and the private securities litigation system.
After extensive hearings and a full examination of the issues, Congress passed the Reform Act "to return the securities litigation system" to a "high standard."(7) The Reform Act enacted a number of measures designed to cure the existing abuses. The Reform Act created a heightened pleading standard; a more rigorous "strong inference" standard for pleading fraudulent intent; a safe harbor for forward-looking statements; special procedures for the appointment of a real plaintiff to act as "lead plaintiff" and oversee the litigation; and proportionate fault provisions to ensure that persons not knowingly involved in wrongdoing would not be held liable jointly and severally along with those guilty of fraud.
All of these comprehensive reforms were crafted to cure the existing abuses, without shutting the courthouse door to legitimate claims by persons who could allege specific, hard facts showing that a company had committed fraud. Balancing all the competing interests, Congress enacted these measures to make the litigation of private securities class actions fair and just.
Regrettably, all the hard work of two years ago is now in serious jeopardy. Since the Reform Act was passed, securities class actions -- particularly cases premised on failed forecasts -- have been migrating to the state courts. This appears to be a strategic response by the plaintiffs' bar to the Reform Act, and it threatens to undermine that Act. This strategic maneuver is especially acute in California, where Silicon Valley's high-technology companies have borne the brunt of the state court actions.
Former SEC Commissioner Joseph Grundfest, now a Professor at Stanford University, has been tracking state court filings around the country. According to Professor Grundfest's count, 103 class actions have been filed in state court on a nationwide basis, and approximately 62 of those class actions are pending in California state court.(8) The Securities and Exchange Commission's recent Report to the President and the Congress on the First Year of Practice Under the Private Securities Litigation Reform Act of 1995 also notes this disturbing trend: "This apparent shift to state court may be the most significant development in securities litigation post-Reform Act."(9) My firm's experience over the last eighteen months confirms this strategic shift from federal to state court -- albeit, with ebbs and flows, as the plaintiffs' bar has adjusted its tactics.
The migration of securities class actions to state court threatens the Reform Act in two ways. First, Congress intended that the Reform Act would eliminate abusive litigation by imposing uniform standards in federal court, where these cases historically had been brought. The migration of these cases to the state courts threatens to nullify all of the Reform Act's procedural and substantive protections, including the safe harbor. If plaintiffs find state courts to be a welcome sanctuary, and take most of their class actions there, the Reform Act will never be used.
Second, even if state law claims prove disappointing to plaintiffs,
there is still a problem. As both Arthur Levitt, Chairman of the
Securities & Exchange Commission, and Professor Grundfest
have testified before this Subcommittee, plaintiffs are filing
duplicative, parallel class actions in the federal and state courts,
with the objective of obtaining in state court the discovery they
otherwise are denied in federal court.(10)
This tactic threatens to subvert the Reform Act's special protections
designed to terminate frivolous litigation at the outset of a
case: the heightened pleading standards, and the automatic discovery
III. The Migration of Private Securities Class Actions
To State Court is Undermining the Reform Act's Safe Harbor
One obvious, immediate result of the migration of securities class actions to state court is that the safe harbor is being undermined. The safe harbor is one of the Reform Act's centerpieces, yet there are almost no reported decisions interpreting it. The reason is that the forecasting cases have largely migrated to state court -- meaning that there is no guidance from the federal courts about the type of disclosure sufficient to trigger the safe harbor's protections. As a result, companies are uncertain about making forward-looking statements. Companies are also less willing to speak about the future because they fear that they may be sued in state court, where there is no guarantee that the safe harbor will apply under state law.
SEC Chairman Levitt testified before this Subcommittee that the number of state court class actions alleging fraud, based on a company's failure to achieve a forecast, is double the number of class actions being filed in federal court under the Reform Act.(11) In my experience, most of the California state court cases allege claims of fraud arising out of little more than a failed forecast and a consequent stock price drop. I believe that this trend is actually much more pronounced than the SEC has found. Plaintiffs routinely include in these failed forecast cases some boilerplate, conclusory allegations of accounting improprieties, even where neither the company nor any financial journalist or securities analyst has reported any problem with the company's accounting. To the extent that such cases are excluded from the count of "failed forecast" cases, the trend of forecasting cases migrating to the state courts is even more pronounced. As a result of plaintiffs' filing failed-predictions cases in state court -- where there is no safe harbor protection -- public companies cannot be expected to make forward-looking statements. That result is squarely contrary to Congress' intent in enacting the safe harbor of "enhanc[ing] market efficiency by encouraging companies to disclose forward-looking information."(12)
The arrested development of the safe harbor is a significant
disappointment, one that directly contravenes Congress' intent
to encourage companies to make predictions about the future. The
Securities & Exchange Commission has counseled patience, arguing
that the federal courts eventually will develop a body of law
interpreting the safe harbor. I respectfully disagree. The state
court phenomenon pushes judicial implementation of the federal
safe harbor far into the future, and strongly weighs in favor
of legislation that will lead to the creation of uniform national
standards under the Reform Act.
IV. State Court Securities Class Actions Are Subjecting
Companies to Expansive, Undefined Liabilities, Varying from State
Other critical provisions of the Reform Act will be nullified if cases continue to migrate to the state courts. The current situation in California provides an excellent example of how this could occur. (According to Professor Grundfest, there are class actions pending in the courts of 18 different states, so the California experience is not unique, and the damage will not be restricted to California's high-technology industry.(13)) In California, plaintiffs are seeking to assert causes of action on behalf of a nationwide class of investors under the California Corporations Code, the common law of fraud, and provisions of California's Business & Professions Code, which regulates "unfair business practices" and "false advertising." These state law claims are very broad and offer none of the protections of the Reform Act. These cases involve companies whose securities are traded on national exchanges and are regulated by the federal securities laws.
Plaintiffs' principal weapon is the California Corporations Code. According to plaintiffs, this claim is effectively the state law analog of Section 10(b) of the Securities Exchange Act (specifically, SEC Rule 10b-5). If plaintiffs can pursue securities class actions using these Corporations Code claims in state court, defendants will lose all the Reform Act's protections against abusive litigation. State courts have yet to develop a body of law applicable to these cases that requires rigorous scrutiny of the factual allegations of a complaint at the pleading stage. The discovery rules in California, moreover, are quite liberal. Plaintiffs have argued that they are entitled to discovery even where a court has held that their original complaint failed to state a single valid cause of action -- the classic fishing expedition that the Reform Act sought to eliminate. Other provisions of the Reform Act are also jeopardized, because the state courts, which have rarely faced this type of litigation, have yet to develop comparable safeguards. There is no certification requirement to prevent "professional plaintiffs" from filing multiple lawsuits. There is no requirement that the court appoint a lead plaintiff to allow an opportunity for substantial investors to take the helm. Moreover, the doctrine of collateral estoppel could mean that determinations made in California state court are binding on later actions filed in other states and, potentially, in federal court. Finally, the U.S. Supreme Court's decision in Phillips Petroleum Co. v. Shutts(14) leaves open the possibility that, where the claims of non-residents have "significant contact or significant aggregation of contacts" with the forum state, a class certified under the forum state's law may constitutionally include non-residents, where doing so would not be so "sufficiently arbitrary and unfair" as to exceed the parties' expectations.
Before the Reform Act, claims under the Corporations Code were
asserted so infrequently that there is no definitive California
state court precedent. The defense bar has argued that the Corporations
Code was intended to reach only intra-state securities
transactions. The issue is now before the California Supreme Court
in two cases.(15) Even if the
California Supreme Court limits the scope of the Corporations
Code, that may not terminate the California state court threat:
companies could still be vulnerable to multi-million dollar class
actions in California state court on behalf of a class of California
V. The Filing of Duplicative, Parallel Class Actions Will Allow Plaintiffs to Evade the Reform Act's Heightened Pleading Standards and Discovery Stay.
Professor Grundfest of Stanford University has identified 28 cases around the country in which plaintiffs have filed a state action and a duplicative, parallel federal class action. Of the 62 state class actions in California, Professor Grundfest has identified a parallel federal class action in 16 of those cases.(16) My firm has been closely tracking the filing of parallel class actions, and we have identified 40 cases in California in which plaintiffs have filed virtually identical federal and state class actions. In the Northern District of California alone, which includes Silicon Valley, there are 27 of these duplicative state and federal class actions. See Exhibit B (attached hereto).
Here is what has become the common practice in California. Plaintiffs first file an action in California state court, alleging claims arising under California state law. Plaintiffs launch massive demands for the production of documents against the company, and often against non-parties such as the company's accountants or underwriters.
Shortly after filing the state case, the same plaintiffs, represented by the same lawyers, on behalf of the same class of investors, file a lawsuit in federal court against the same defendants, based on the same alleged wrongdoing. The only difference is that the federal lawsuit alleges claims arising under Section 10(b) of the Securities Exchange Act, which are subject to the Reform Act, while the state action alleges only claims arising under state law. Sometimes, there is a lag of several months between the filing of the state and federal actions. In a few cases, however, the plaintiffs have abandoned any pretense. In one case that my firm is defending, plaintiffs filed a class action in state court in San Jose, California; the next day, they walked a few blocks to San Jose federal court and filed a carbon-copy federal class action.(17) Plaintiffs have even gone so far that in several cases they have made the extraordinary offer that, after being certified as lead plaintiff and lead plaintiffs' counsel under the Reform Act, they would voluntarily stay their federal case to allow them to pursue discovery in state court.(18)
There can be no doubt that plaintiffs are pursuing this tactic to skirt the Reform Act's discovery stay in an effort to bolster their federal complaint. Plaintiffs are very candid about their intent: they openly admit that they believe they are entitled to use state court discovery to support their federal complaint. If this tactic continues unchecked, plaintiffs will be able to circumvent the Reform Act's discovery stay. The Reform Act's discovery stay was designed to spare defendants the expense of discovery until plaintiffs demonstrate that they have a viable case. Under the current system, however, companies are not being spared the expense. In addition, the Reform Act makes clear that plaintiffs must satisfy the heightened pleading standard from their own knowledge and investigation, not from discovery. If plaintiffs are able to obtain discovery in state court, that goal will not be achieved.
Legislation creating uniform national standards for these types of cases is the only solution to this problem. The state courts have been reluctant to act. In California, defendants have not been able to stop either the migration of class actions to state court, or the filing of parallel cases designed to circumvent the federal discovery stay. Let me briefly describe various actions taken by the defense bar that have to date failed to solve the problem.
First, defendants have moved to stay the state actions altogether, arguing that the federal courts should first determine whether defendants violated the federal securities laws, and that plaintiffs should not be permitted to maintain separate state actions to evade federal law. The California state courts have been unreceptive. A California Court of Appeal recently held that the "theme" that plaintiffs are trying to evade federal law "is irrelevant to our analysis because the current state of the law permits securities fraud plaintiffs to maintain [a] dual track litigation strategy."(19) Indeed, the Court of Appeal held that "the Private Securities Litigation Reform Act of 1995 effectively compels state class action plaintiffs to file parallel to 10b-5 action in federal court."(20) That the California courts refuse to stay parallel state class actions has led to the incongruous situation where a federal court has held that a complaint failed to allege facts showing that a company's statements were fraudulent, while a state court held that the same statements were actionable.(21)
Second, defendants have moved to strike the class action allegations from the state cases, thereby requiring the plaintiffs to bring all of their federal and state class claims in federal court subject to the Reform Act's protections. Such a solution would make sense because only the federal court can resolve all of the issues between the parties in one action because it has exclusive jurisdiction over claims arising under the Securities Exchange Act and supplemental jurisdiction over state law claims. The state courts again, however, were not willing to relinquish control of the state law claims.
Defendants have also moved in state court for a temporary stay of discovery until discovery is permitted in federal court or the federal case is dismissed. This would prevent plaintiffs from doing an end run around the Reform Act's discovery stay. The rationale is that the state courts should show appropriate comity for the significant federal interests embodied in the Reform Act. The state courts have generally not been responsive to this argument and, with limited exceptions, have refused to stay discovery.
This has left defendants with only one place to turn: federal court. But the federal courts may well be prohibited by the Federal Anti-Injunction Act(22) from enjoining the state court proceedings.
Finally, in passing the Reform Act, Congress expressed great
concern about the financial burden of these types of cases on
issuers and non-parties such as underwriters and accountants.(23) Requiring companies to fight
a two-front war of parallel state and federal class actions has
substantially increased that financial burden. Plaintiffs'two-front
war also burdens two different court systems, which have to litigate
the same disputes between the same parties.
The answer to this attack on the Reform Act is for Congress
to create uniform national standards for private securities class
actions, rendering all such actions subject to the requirements
of the Reform Act. I hope that the Senate will take that step
by enacting S. 1260.
1. I gratefully acknowledge the assistance of my colleagues, Bruce Vanyo, Jerome Birn, Laurie Smilan and Ignacio Salceda in preparation of this testimony. The views expressed are mine, not necessarily those of my firm.
2. H.R. Conf. Rep. No. 104-369, 104th Cong., 1st Sess. 31 ("Conf. Rep.").
6. Id. at 32.
7. Id. at 31.
8. See <http://securities.stanford.edu/tables/state-table.html>.
9. U.S. Securities and Exchange Commission, Report to the President and the Congress on the First Year of Practice Under the Private Securities Litigation Reform Act of 1995, at 69 (Apr. 1997).
10. Chairman Levitt testified: "Fifty-five percent of the state court cases . . . have allegations that are essentially identical to those brought by the same law firm in federal court. It is reasonable to assume that these cases were filed primarily to get discovery for use in the federal action." See Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning the Impact of the Private Securities Litigation Reform Act of 1995, Before the Subcommittee on Securities, of the Committee on Banking, Housing, and Urban Affairs, United States Senate, July 24, 1997 ("Levitt Testimony") (emphasis added). Professor Grundfest testified: "[P]laintiffs' own litigation conduct demonstrates an obvious effort to avoid the mandatory discovery stay through state court litigation. Plaintiffs' actual conduct is therefore inconsistent with the proffered rationalizations for increased state court activity. Accordingly, the most reasonable explanation for the undisputed increase in state court litigation is plaintiffs' desire to evade the Reform Act provisions." See Joint Written Testimony of Joseph A. Grundfest and Michael A. Perino, Before the Subcommittee on Securities, of the Committee on Banking, Housing, and Urban Affairs, United States Senate, July 24, 1997 (emphasis added).
11. See Levitt Testimony, Section IV, "Analysis of State Court Complaints."
12. Conf. Rep. at 43.
13. Professor Grundfest identifies class actions pending in Alabama, Arizona, California, Colorado, Connecticut, Delaware, Florida, Georgia, Illinois, Maryland, Montana, Nevada, New Jersey, New Mexico, New York, Ohio, and Texas. See <http://securities.stanford.edu/tables/state-table.html>.
14. 472 U.S. 797, 821-22 (1984).
15. StorMedia Inc. v. Santa Clara County Superior Court, No. S062661 (review granted, Aug. 20, 1997); Diamond Multimedia, Inc. v. Santa Clara Superior Court, No. H016376 (review granted, Mar. 27, 1997).
16. See <http://securities.stanford.edu>.
17. Head v. NetManage, Inc., No. 07763295 (Santa Clara Super. Ct., filed Jan. 9, 1997); Head v. NetManage, Inc., No. C-97-20061-JW (N.D. Cal., filed Jan. 10, 1997).
18. See Goldman v. FileNet Corp., No. SACV-97-261-GLT(EEx) (Plaintiffs' Motion for Order Staying Action) (filed Sept. 3, 1997); Head v. NetManage, Inc., No. C-97-20061-JW (N.D. Cal.) (Plaintiffs' Opposition to Defendants' Motion To Enforce The Mandatory Discovery Stay of the Private Securities Litigation Reform Act of 1995) (filed Sept. 26, 1997). One federal court on its own initiative has stayed a federal action. Cheney v. Quality Systems, Inc., No. SACV-97-549-LHM (EEx) (C.D. Cal. Aug. 13, 1997).
19. Oak Technology, Diamond Multimedia Sys. Inc., & IMP Inc. v. Superior Court, Nos. H016141, H016186, H16281, slip op. at 9 (Cal. App., Sixth Dist., Aug. 14, 1997).
20. Id. at 13-14 (emphasis added).
21. Compare Howard Gunty Profit Sharing v. Quantum Corp., No. 96-20711-SW, 1997 WL 514993 (N.D. Cal. Aug. 14, 1997) (granting motion to dismiss with leave to amend), with Howard Gunty Profit Sharing v. Quantum Corp., No. CV760370 (Santa Clara Super. Ct. Jul. 8, 1997) (overruling demurrer in part).
22. 28 U.S.C. § 2283.
23. Conf. Rep. at 31.