It is the nightmare of many CEOs and general counsel. Often due to events beyond a company's control, the company's share price drops. Within days, if not hours, a class action lawsuit is filed alleging violations of the federal securities laws and seeking huge monetary damages. The complaint's allegations are tissue-paper thin and unfounded, and the company promptly moves to dismiss the lawsuit. While the motion is being decided, however, the company is forced to spend substantial amounts of time and money responding to an avalanche of discovery demands. The company soon learns that the supposed "class representative," who owns only a handful of shares, has been the plaintiff in several other class action suits, working with the same law firm and sometimes receiving special bounties for serving as the class representative. The company is also advised that most of these suits have settled for a fraction of the damages originally sought. Thus, the company is confronted with the unfortunate choice of spending significant resources defending its name against the frivolous claims, or settling with the plaintiff and his or her lawyers for a sum that may be less than the anticipated costs of defending the action.(see endnote 1)

Preventing this and similar types of abusive litigation is the goal of a controversial bill currently pending in Congress. This bill, the Private Securities Litigation Reform Act of 1995 (see endnote 2), seeks to alter the landscape of securities litigation in an effort to curb the proliferation of nuisance actions which lurk among the hundreds of securities class action lawsuits filed each year (see endnote 3). Over the last few years, similar proposals failed even to make it out of committee. Now, however, the new GOP-controlled Congress has pressed forward with the current initiatives, including litigation reform in the Republican "Contract With America" and moving it high on the list of legislative priorities.

First, in March 1995, the House of Representatives passed its reform bill - H.R. 1058 - by a margin of 325 to 99. Although somewhat diluted from the original version of the bill, H.R. 1058 represented a major step toward providing some of the relief the industry has been seeking from vexatious strike suits. To the dismay of its opponents, H.R. 1058 heralded a controversial provision for the shifting of litigation fees from one party to the other under certain circumstances. Shortly after H.R. 1058 was passed, the Senate's version of a securities litigation reform bill - S.240 - met with overwhelming approval by a vote of 69 to 30. The Senate bill included many of the provisions of the House bill, but did not contain, for example, the aggressive fee-shifting provision of H.R. 1058. In late November, after months of behind-the-scenes negotiations, a House-Senate conference committee agreed upon a compromise bill to present to Congress. Although at the time of this writing (November 1995) neither the House nor Senate has approved the compromise bill, Washington insiders remain optimistic that this compromise securities litigation reform bill will be passed by both houses of Congress in its current form and presented to the President in the near future.

The conference committee bill presented to Congress includes many long-awaited provisions to curb blatant abusive litigation practices, such as the following conduct:

Bonus Payments - The proposed legislation seeks to prohibit the payment of so-called "bonus fees" or "bounties" to persons who agree to serve as class representatives.

Referral Fees - The reform bill prohibits the payment of referral fees to brokers for assisting attorneys in procuring clients to bring lawsuits under the federal securities laws.

Professional Plaintiffs - The conference committee bill seeks to prohibit the filing of lawsuits by plaintiffs who have very little at stake in the litigation, and who often are called upon time and again by the same law firm to bring class action lawsuits. Except as otherwise permitted by the court, these "professional plaintiffs" would be limited to filing five class actions every three years. The bill also seeks to discourage actions by plaintiffs with no "real interest" in the litigation by requiring a named plaintiff to file a certification with the complaint stating, among other things, that he or she did not purchase the security at issue to participate in the lawsuit, and identifying other lawsuits during the last three years in which he or she sought to serve as a class representative.

Holdings by Plaintiffs' Counsel - The proposed legislation requires courts to determine whether holdings in the security at issue by an attorney for the purported class constitutes a conflict of interest sufficient to disqualify the attorney from representing the class.

Class Settlements - The compromise bill specifies certain information that must be disclosed to class members when cases are settled, including the amount of damages recoverable were the plaintiff class to prevail on the claims and the amount of fees and costs being sought by class counsel. The legislation also restricts attorney's fees and expenses awarded by the court to a "reasonable percentage" of the amount of damages and interest actually paid to the class.

Plaintiffs With an Interest in the Litigation - To avoid lawsuits that seem principally to benefit class counsel, the legislation seeks to encourage class representatives to have an active involvement in the litigation. Although the current bill has dropped an earlier proposal requiring the appointment of a class action steering committee to "direct" counsel for the class, the bill establishes procedures for appointing the "most adequate plaintiff" to represent the class, including a presumption that in cases where several class members are seeking to serve as lead plaintiffs, the member with the largest financial interest in the relief sought would be best suited.

Fee Shifting - One of the most controversial issues raised in connection with the reform legislation is whether, under certain circumstances, a losing party to a securities lawsuit should be required to pay the prevailing party's fees. The House bill originally included an automatic fee-shifting provision, but ultimately settled on fee-shifting only when claims are deemed not "substantially justified." Facing intense pressure and the threat of a presidential veto, the Senate backed further away from the issue, requiring only a court determination as to whether general rules prohibiting unfounded claims, defenses or motions have been violated, and creating a presumption that where a violation has occurred, attorney's fees and expenses should be awarded. The compromise version of the bill now being considered generally tracks the Senate's language.

In addition to these provisions aimed at curbing abusive practices which seem to plague securities class action litigation, the reform legislation also seeks to remedy certain shortcomings in the governing federal laws themselves. Certain revisions are basically non-controversial, such as amending the Racketeering Influenced and Corrupt Organization Act ("RICO"), which contains a provision that has permitted treble damage awards in garden-variety securities cases, to remove securities fraud as a basis for liability under most circumstances. The pending bill also would limit a defendant's liability under the Exchange Act of 1934, under most circumstances, to only its proportionate share of responsibility for plaintiffs' damages, except where a defendant knowingly engages in fraudulent activity. The legislation also prohibits plaintiffs' counsel from sharing in funds disgorged as the result of an action brought by the SEC. Also, in an effort to reduce the costs of defending claims brought under the securities laws, the reform legislation provides for discovery to be postponed while certain motions to dismiss the claims are pending.

More controversial is the bill's provision creating a "safe harbor" from liability for a company's forward-looking statements. Under this provision, certain statements, such as projections, descriptions of plans and objectives for future operations, and statements of future economic performance, whether written or oral, generally will not be actionable if such statements (1) are "identified" as forward-looking and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement; (2) are immaterial; or (3) are not made with actual knowledge that the statement was false or misleading. Importantly, the legislation raises the required level of scienter necessary to impose liability from recklessness to "actual knowledge," and places the burden on plaintiffs to prove that a defendant possessed such knowledge. Although SEC Chairman Arthur Levitt had expressed concerns about earlier drafts of the safe harbor provision, he now supports the compromise version as representing a "workable balance" that should encourage forward-looking information to investors while limiting abuses.

Significantly, the reform bill rejects attempts to lengthen the time period plaintiffs would have to commence lawsuits under the securities laws, an item sought by the White House. Congress also refused to amend the statutes to reverse the effect of the Supreme Court's recent decision in Central Bank of Denver N.A. v. First Interstate Bank of Denver N.A., (see endnote 4) which held there is no aiding and abetting liability in certain securities actions brought by private plaintiffs.

Thus, Congress has taken a major step forward in strengthening the arsenal of weapons available to companies faced with unfounded securities class action lawsuits. While taking these steps to curb abusive litigation, however, Congress has also attempted to safeguard the provisions necessary to protect investors from fraudulent conduct.

ENDNOTES

1. The United States Supreme Court has taken note of the fact that in 83% of securities misrepresentation cases major accounting firms (who are often secondary actors) pay $8 in legal fees for every $1 paid in claims.

2. "Private Securities Litigation Reform Act of 1995," November 28, 1995, available in LEXIS, Legislative Library, BLText File.

3. For example, according to Class Action Reports, 290 securities class actions were filed in 1994. This is generally consistent with the number of cases filed over the past few years.

4. 114 S. Ct. 1439 (1994).

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