Rogue Missives Friday, June 20, 1997

The In-Securities Act
Part 3: Grounds for Litigation
-- Louis Corrigan  (RgeSeymour)

These Stanford professors come up with some other interesting findings about the effects of the Act, both expected and not. As might have been predicted, complaints using forward-looking comments as the sole basis of liability have dropped dramatically, from 14% of lawsuits before the new law to just 6.5%. If companies include the proper cautionary language and provide specific risks that might make results differ materially from what they project, plaintiffs simply have less room to claim they've been defrauded by such comments.

As a result, plaintiffs are directing more emphasis on accounting fraud, which was alleged in 67% of complaints (versus 34% before the new law). There's also been a rise in allegations that company insiders defrauded investors by trading on information unavailable to the public. Such charges are found in 57% of the recent class-action suits (versus 21% before). Perhaps because high-tech companies rely on stock options for such a significant proportion of their employees' compensation, trading by insiders was alleged in a whopping 73% of cases brought against these businesses.

Also, roughly a third of all class-action complaints were filed against high-tech companies, the same as before the new law. Given that Silicon Valley executives were among the strongest supporters of the Reform Act (and opponents of Prop 211), these numbers are clearly disappointing. The failure of the Act to stem the tide of suits against high-tech companies suggests any number of possibilities. The Stanford study does show that the average complaint followed a stock price decline of 31% (versus 19% before the new law), suggesting that litigation is more likely to follow more obvious disappointments. Given the risk of many high-tech ventures, and the market's habit of punishing those that disappoint, these companies are simply more susceptible to the huge drops in share price that invite class-action suits.

Plus, with less recourse to forward-looking statements, plaintiffs may find high-tech companies relatively more attractive targets now than before the new law. The high number of options exercised by insiders at high-tech firms means these companies provide more obvious evidence available for building a fraud case. Other statistics bear out this view.

For example, the Stanford study found that the market capitalization of the average company sued dropped to $529 million from over $2 billion before the new law. Much of this decline in target size resulted from a drop in suits against companies with a market cap above $5 billion, from 8.4% of all complaints to none in the post-Reform Act era. As the professors suggest, these larger firms are less likely sources for material accounting irregularities or significant trading by insiders, making them less likely to be named as defendants. (At the same time, large cap issues have outperformed smaller companies, making them less likely to have disappointed shareholders.)

At any rate, the Reform Act isn't working as its high-tech supporters had planned. Curiously, the new law actually appears to have benefited the guys it was designed to thwart: Bill Lerach and his partners at Milberg Weiss Bershad Hynes & Lerach, the principal supporters of Prop 211. The Stanford study found that the firm of Milberg Weiss now represents the plaintiffs in 59% of all class-action securities cases, up from just 31% before the new law took effect. In California, the firm plays a role in 83% of all cases.

The Stanford professors suggest that this one firm's increased dominance of the class-action securities business is a matter of simple economics. As the best capitalized law firm trying such cases, it's in the best position to bear the slowdown in litigation introduced by the Act's new provisions. Since Milberg Weiss has the most at stake in how the new law is interpreted, they're also the best situated to invest the resources necessary to ensure the judicial precedents interpreting the new law are favorable to their clients. Finally, the new law adds additional risks to the whole business of waging securities litigation. With the largest portfolio of client cases, Milberg Weiss is sufficiently diversified to bear the new risks.

If all of this sounds like reason for supporters of the 1995 Act to be annoyed, well, they are. But as the courts continue to lay down precedent-setting rulings, the practical force of the new law is only now being established. One of the key issues concerns the apparently heightened pleading standard introduced by the Act forcing plaintiffs to "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." In other words, it now appears a plaintiff must allege intention to defraud. The "strong inference" language comes from case law, but one of the main reasons Clinton vetoed the bill was the administration's fear that the Act would impose a more stringent standard than was already in place.

As Grundfest and Perino point out, one key question has been whether existing Second Circuit tests for proving a "strong inference" of fraud would survive. In six of seven cases, the courts have found these tests sufficient. For example, in the case of Marksman Partners, L.P. v. Chantal Pharmaceutical Corp., the Central District of California determined that the Act did not impose a more stringent pleading standard and that the "motive and opportunity" test and the "strong circumstantial evidence" test remained valid criteria for alleging fraud. For example, the allegation that the CEO of CHANTAL <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CHTL)") else Response.Write("(Nasdaq: CHTL)") end if %>, in her first stock sale in three years, had sold 20% of her stock during the class period (for $6.3 million) was sufficient to establish a strong inference of fraud.

By contrast, Judge Fern Smith, in a class-action suit filed in U.S. District Court in San Francisco against the workstation manufacturer SILICON GRAPHICS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SGI)") else Response.Write("(NYSE: SGI)") end if %>, found that the Reform Act indeed was intended to establish a higher pleading requirement. In her initial ruling, Smith argued that a plaintiff "must allege specific facts that constitute circumstantial evidence of conscious behavior by defendants" and that the plaintiffs' attempt "to couple allegations of defendants' awareness of negative internal reports with their false and misleading statements and stock sales "wasn't specific enough to satisfy the strong inference requirement, particularly given that the defendants' stock sales were not "unusual or suspicious."

Judge Smith also rejected the argument, upheld by other courts since the new law took effect, that the standard of reckless misconduct was still sufficient to allege fraud. The recklessness standard has been understood to mean corporate behavior that is highly unreasonable and has a high likelihood of misleading investors. Under this standard, a CEO who makes bullish comments about a company that are misleading, given information available in public financial filings, for example, would be a valid target of a shareholder suit. According to Smith's initial ruling, plaintiffs now needed to do more than point to false or misleading statements; they now needed to "create a strong inference of knowing misrepresentation on the part of the defendants."

Part 4: Raising the Bar

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