New Law To Curtail Securities Fraud Lawsuits

Jonathan Cain

By Jonathan Cain

Bringing a class action lawsuit against a company or individuals for alleged securities fraud has just gotten tougher.

Earlier this month, President Clinton signed into law more restrictions on class action lawsuits against companies and individuals alleged to have participated in fraudulent, manipulative or otherwise deceptive conduct in the purchase and sale of stocks. The so-called Securities Litigation Uniform Standards Act extended a bar against such class action lawsuits from the federal courts to all state courts.

In 1995, a legislative effort widely supported by information technology and biotech companies resulted in the enactment of the Private Securities Litigation Reform Act. That law made it much more difficult to bring class action lawsuits in federal courts if they alleged fraud or deceptive conduct in violation of federal securities laws.

Supporters of the 1995 law argued successfully that they were being harassed by suits based on good-faith statements about prospects for their embryonic high-tech products that failed to materialize.

When investors bought stock in anticipation of the development of products that never succeeded in the market, or which failed to overcome technical problems in development and never made it to the market at all, they brought class action claims against the companies and their officers for the resulting stock losses.

The 1995 act raised the bar for class action plaintiffs in federal securities fraud cases, and enabled companies to delay or avoid altogether the expenses of discovery. It also created a "safe harbor" for forward-looking statements by company officers involving financial projections ? precisely the kind of information most needed and relied upon by investors in technology growth companies.

In response to the 1995 act, supporters of the 1998 act argued that plaintiffs began filing more class action stock fraud suits in state courts under state securities statutes and state common law prohibiting misrepresentation and deceit. The factual basis for that claim is suspect.

A study conducted by a national accounting firm this year determined the number of state class action securities lawsuits remained essentially constant between 1991 and 1997. In fact, there were fewer such state suits filed in 1997, after the act took effect, than had been filed in 1995. This record was compiled in a period when funds raised in IPOs reached new highs ? $50 billion in 1996 and $39 billion in 1997.

Nevertheless, supporters of the 1995 act went back to Congress and demanded that it close the "loophole" left by the 1995 act. Congress jumped.

The 1998 act says that if a class action is brought in a state court, the defendant may have the suit taken from the state court, transferred to a federal court and then dismissed by the federal judge. The 1998 act also permits federal judges to control the discovery proceedings in any state court securities suit.

By eliminating the right to bring securities fraud cases under state law, Congress also made it more difficult for plaintiffs in other ways. Statutes of limitations, for example, are longer under state law in more than 30 states than federal law allows for securities fraud cases.

By comparison, the 1995 act was mild. The 1998 act gives federal courts powers to supervise and overrule state courts in a manner rarely found elsewhere in federal law. Whether state courts will tolerate this challenge to their sovereignty without a fight remains to be seen.

On a practical level, however, even the 1998 statute contains so many conditions that it will be important in only a narrow range of potential class action cases.

First, it only applies to companies whose stock trades on the New York or American stock exchanges or on the Nasdaq. It does not apply to companies that trade privately or to the purchase and sale of securities in companies that have not yet achieved national exchange registration.

Second, it applies only to class actions, or to actions in which more than 50 individuals seek damages, based on a common set of misrepresentations by the company or its officers.

Third, the 1998 act does not bar state law claims based upon the conduct of the company in the purchase or sale of securities exclusively from or to its shareholders, or which involve communications from the company to its shareholders on matters involving the voting of their shares on company business.

These issuer-to-shareholder representations are still governed by state law requiring truthfulness in direct communications between corporate officers and the company's shareholders.

Jonathan Cain chairs the Technology Practice Group of Mays & Valentine LLP, McLean, Va. His e-mail address is

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