Private Securities Litigation Reform Act
The United States Private Securities Litigation Reform Act of 1995, Pub. L. 104-67, 109 Stat. 737 (codified as amended in scattered sections of 15 U.S.C.) ("PSLRA") implemented several substantive changes affecting certain cases brought under the federal securities laws, including changes related to pleading, discovery
Discovery (law)
In, discovery is the pre-trial phase in a lawsuit in which each party, through the law of civil procedure, can obtain evidence from the opposing party by means of discovery devices including requests for answers to interrogatories, requests for production of documents, requests for...

, liability, class representation, and awards fees and expenses.

The PSLRA was designed to limit frivolous securities lawsuits. Prior to the PSLRA, plaintiffs could proceed with minimal evidence of fraud, then use pretrial discovery to seek further proof. This set a very low barrier to initiate litigation, which encouraged the filing of suits which were either weak or entirely frivolous. Defending against these suits could prove extremely costly, even where the charges were unfounded, and as a result, defendants often found it cheaper to settle than to fight and win. Under the PSLRA, however, plaintiffs need proof of fraud before they can initiate a suit. This makes it very difficult to file a frivolous suit, but it also makes it much harder to file legitimate ones, as plaintiffs are forced to present evidence of fraud before any pretrial discovery has taken place.

The PSLRA imposes new rules on securities
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...

 class action
Class action
In law, a class action, a class suit, or a representative action is a form of lawsuit in which a large group of people collectively bring a claim to court and/or in which a class of defendants is being sued...

 lawsuits. It allows judges to decide the most adequate plaintiff in class actions. It mandates full disclosure to investors of proposed settlements, including the amount of attorneys' fees. It bars bonus payments to favored plaintiffs, and permits judges to scrutinize lawyer conflicts of interest.

Background: Overview of securities fraud actions under Section 10(b) and Rule 10b-5

The Securities Exchange Act of 1934
Securities Exchange Act of 1934
The Securities Exchange Act of 1934 , , codified at et seq., is a law governing the secondary trading of securities in the United States of America. It was a sweeping piece of legislation...

 (commonly known as the "Exchange Act" or the "1934 Act") gives shareholders the right to bring a private action in federal court to recover damages the shareholder sustained as a result of securities fraud. The majority of securities fraud claims are brought pursuant to Section 10(b) of the Exchange Act (codified at 15 U.S.C. § 78j), as well as SEC Rule 10b-5, which the SEC promulgated under the authority granted to it by Congress under the Exchange Act. (This article refers to federal securities fraud actions as "Rule 10b-5 actions" or "Rule 10b-5 cases" as convenient shorthand.)

The Supreme Court has held that there are six elements that a plaintiff must allege and prove in order to prevail in a Rule 10b-5 action:

1. The defendant made a "material
Materiality (law)
Materiality is a legal term which can have different meanings, depending on context. When speaking of facts, the term generally means a fact which is "significant to the issue or matter at hand".-In the law of evidence:...

 misrepresentation or omission";

2. the defendant acted with "scienter
Scienter is a legal term that refers to intent or knowledge of wrongdoing. This means that an offending party has knowledge of the "wrongness" of an act or event prior to committing it. For example, if a man sells a car to his friend with brakes that do not work, and he does not know about the...

", or a "wrongful state of mind" (typically understood to mean that the defendant intended to make the material misrepresentation or omission, or acted with recklessness in making the misrepresentation or omission);

3. the material misrepresentation or omission was made "in connection with the purchase or sale of a security";

4. the plaintiff who was allegedly victimized by the fraud relied upon the material misrepresentation or omission (if the security is traded on a public stock exchange, such as the New York Stock Exchange
New York Stock Exchange
The New York Stock Exchange is a stock exchange located at 11 Wall Street in Lower Manhattan, New York City, USA. It is by far the world's largest stock exchange by market capitalization of its listed companies at 13.39 trillion as of Dec 2010...

The NASDAQ Stock Market, also known as the NASDAQ, is an American stock exchange. "NASDAQ" originally stood for "National Association of Securities Dealers Automated Quotations". It is the second-largest stock exchange by market capitalization in the world, after the New York Stock Exchange. As of...

, the law will typically presume that shareholders rely on the integrity of the market, and therefore that the price of the stock reflected material misrepresentation and that shareholders relied upon the integrity of the market);

5. the plaintiff suffered an economic loss as a result of the alleged fraud; and

6. the plaintiff can allege and prove "loss causation", which means that the allegedly fraudulent misrepresentation or omission caused the plaintiff's economic loss. See Dura Pharmaceuticals, Inc. v. Broudo, .

Each of these elements has been heavily litigated in thousands of cases over the past 70 years, and the courts have applied these six elements in a multitude of different factual situations.

Putting the PSLRA in context: The procedural course of a modern securities fraud action

In a the typical Rule 10b-5 claim, the plaintiff will commence the action by filing a complaint in federal court
United States district court
The United States district courts are the general trial courts of the United States federal court system. Both civil and criminal cases are filed in the district court, which is a court of law, equity, and admiralty. There is a United States bankruptcy court associated with each United States...

. The defendant will then file a motion to dismiss
Motion (legal)
In law, a motion is a procedural device to bring a limited, contested issue before a court for decision. A motion may be thought of as a request to the judge to make a decision about the case. Motions may be made at any point in administrative, criminal or civil proceedings, although that right is...

 under Rule 12(b)(6) of the Federal Rules of Civil Procedure. A motion to dismiss under Rule 12(b)(6) is essentially an argument by the defendant that, even if all of the facts alleged in the complaint were assumed to be true, those facts would not be sufficient to give rise to liability under Rule 10b-5. If the court determines that the facts alleged in the complaint are sufficient to state a Rule 10b-5 claim, the plaintiff then becomes entitled to obtain "discovery" from the defendant—which typically means the right to demand documentary evidence in the defendant's possession concerning the facts at issue, and the right to require the defendant (and other witnesses) to sit for depositions.

In a modern litigation context, the discovery process is protracted and very expensive, often involving production of millions of pages of documents and depositions of dozens of witnesses, costing the defendant as much as millions of dollars in legal fees. Thus, it is extremely important to the litigants whether a motion to dismiss is granted, as the costs of litigation increase substantially when the motion to dismiss is denied.

If the plaintiff's complaint survives the defendant's Rule 12(b)(6) motion to dismiss, the next step is usually for the plaintiff to seek class certification under Rule 23 of the Federal Rules of Civil Procedure. If the court grants the plaintiff's motion for class certification, the case becomes a securities fraud class action. At this point, the defendant usually faces enormous liability if the case goes to trial and the jury renders a verdict against the defendant. For example, if the plaintiff class is composed of 50,000 shareholders, each shareholder owns an average of 1,000 shares, and each shareholder claims to have sustained losses of $10 per share, the potential compensatory damages are $500 million. Therefore, as a practical matter, if a Rule 10b-5 case is not dismissed on a motion to dismiss, and if the case is certified as a class action, the defendant will face much pressure to settle the case. Even if the plaintiff has a relatively weak case, the expected value
Expected value
In probability theory, the expected value of a random variable is the weighted average of all possible values that this random variable can take on...

 of going to trial will put the defendant under pressure to settle. That is, the cost of significantly high damages, even when multiplied by a small chance of losing a jury verdict, may still be very high.

Thus, the outcome of a motion to dismiss in a Rule 10b-5 case essentially determines whether the case gets dismissed or whether it proceeds to discovery and, very often, results in class certification and a very large settlement. Because the motion to dismiss is a pivotal stage in the course of a Rule 10b-5 case, the attorneys for plaintiffs and defendants argue fiercely over the rules that govern such motion to dismiss. Plaintiff lawyers advocate less demanding standards, as such standards would result in a larger number of cases to proceed to discovery and higher amounts of settlements. Defense lawyers and the corporations they represent, on the other hand, advocate more demanding standards, for opposite reasons.

Both sides in this debate use rhetoric that claims the mantle of "justice". The defense bar generally contends that lower pleading standards will allow more frivolous lawsuits and extorted settlements that primarily benefit plaintiff lawyers, not shareholders. On the other hand, the plaintiffs' bar claims that higher pleading standards will enable corporate executives to loot their companies and defraud innocent shareholders with impunity.

The importance of the ratification of the PSLRA in 1995 can be fully appreciated only when one notes such long-running debate between the plaintiff bar and the defense bar over the applicable standards governing Rule 12(b)(6) motions to dismiss in Rule 10b-5 claims.

Heightened pleading requirements

In adopting the PSLRA in 1995, Congress was persuaded that the arguments of the defense bar had merit. The legislative history reveals that Congress passed the PSLRA to curb the "abusive practices committed in private securities litigation" including "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."

To reduce the number of purportedly frivolous Rule 10b-5 lawsuits that survive motions to dismiss, the PSLRA raised the pleading standards (the specificity and strength of the factual allegations that must be alleged in the plaintiff's complaint) in three specific ways. These changes are among the most significant aspects of the PSLRA.

Requirement that false statements be pleaded "with particularity"

The PSLRA requires a plaintiff to identify in his complaint "each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed." 15 U.S.C. § 78u-4(b)(1). If a plaintiff's complaint does not specifically identify the allegedly fraudulent statements and explain why they were misleading, the complaint will be dismissed. By requiring plaintiffs to set forth their theory regarding why a particular statement was misleading, the PSLRA enables defendants to put forth arguments as to why the challenged statement was not, in fact, misleading. Note that the Federal Rules of Civil Procedure already required that allegations of fraud be pleaded with particularity; Fed.R.Civ.Pro. 9(b).

Requirement that pleading create a "strong inference" of scienter

The PSLRA also requires a plaintiff to allege that the defendant acted with the required state of mind, i.e., that he knew the challenged statement was false at the time it was made, or was reckless in not recognizing that the statement was false (the legal term of art for this state of mind is "scienter"). In alleging scienter under the PSLRA, the plaintiff must, "with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." 15 U.S.C. § 78u-4(b)(2). This requirement allows defendants to obtain dismissal of cases where the plaintiff merely points to a false statement and declares that the defendant "must have known" that the statement was false, based upon his position within the company. This requirement has frequently proven difficult for plaintiffs to overcome because, without the benefit of discovery, plaintiffs often do not have access to witnesses or documents that might prove the defendant's state of mind in making the false statement.

Tellabs v. Makor (06/21/2007) set the bar higher

The United States Supreme Court agreed in January 2007 to review a U.S. Court of Appeals for the Seventh Circuit decision that articulates an extremely lenient standard for determining whether the facts alleged in a complaint asserting a violation of the federal securities laws give rise to a "strong inference" that the defendant acted with the required state of mind.

The U.S. Circuit Courts had adopted substantially disparate tests for determining whether scienter is sufficiently pleaded.

Four circuits, the First, Fourth, Sixth and Ninth, require a direct comparison of the plausibility of competing inferences. Unless the culpable inference is the “most plausible,” it is not “strong” and the complaint should be dismissed. Two circuits, the Eighth and the Tenth, consider all inferences, both of scienter and of an innocent mental state, using the innocent inferences to test whether the culpable interest is strong, but do not directly weigh one against the other. The Second and Third circuits divide the factual allegations bearing on a defendant’s mental state into categories, “motive and opportunity” and “strong circumstantial evidence” of knowing or reckless conduct, either of which may independently satisfy the strong inference requirement. And, the Seventh Circuit...did not consider competing inferences, but concluded that if an inference of culpability exists, the pleading is sufficient.

On June 21, 2007, in an opinion written by Justice Ruth Bader Ginsburg, the US Supreme Court ruled that the plaintiffs would have to show a "cogent inference" of an intent to deceive or defraud, which is "at least as compelling as any opposing inference of nonfraudulent intent," thereby raising the national pleading requirements for all plaintiffs in securities litigation matters.

Requirement that plaintiff prove loss causation

Finally, the PSLRA also makes clear that a plaintiff in a Rule 10b-5 case "shall have the burden of proving that the act or omission of the defendant...caused the loss for which the plaintiff seeks to recover damages." 15 U.S.C. § 78u-4(b)(4). At one time, there was a question over whether this requirement actually applied at the motion to dismiss stage. The statute says the plaintiff must "prove" loss causation. It does not say the plaintiff must "allege" loss causation. However, after the Supreme Court's decision in Dura Pharmaceuticals v. Broudo, it is now clear that a plaintiff must allege loss causation in its complaint.

The Dura decision and loss causation

The Dura decision held that a plaintiff in a Rule 10b-5 case had not adequately pleaded loss causation by merely alleging that he "paid artificially inflated prices for Dura securities" at the time of purchase. The Supreme Court observed that an investor who purchases a stock at an artificially inflated price suffers no economic loss at the time of purchase. The loss occurs only when the truth is disclosed and the stock price falls as a result. Thus, a plaintiff who sells his shares "before the relevant truth begins to leak out" does not suffer any economic damage. The plaintiff in Dura failed to allege that the "share price fell significantly after the truth became known", and therefore the complaint had not alleged loss causation.

How a court defines the "relevant truth" that the defendant fraudulently withheld often determines the outcome of a 10b-5 case. The stock analyst cases provide a good example of the importance of how the "relevant truth" is defined. The claim in most stock analyst cases has been that the analyst dishonestly touted a particular stock as a good investment when that was not the analyst's genuine belief. Under Dura, these cases have often been dismissed because, in most instances, the analyst’s dishonesty never comes to light until after the price of the stock in question has declined substantially. By that point, the "bad facts" about the company have already been absorbed by the market, and therefore plaintiffs cannot show that the disclosure of the analyst's dishonesty caused any further decline in the stock price.

Stay of discovery

To prevent discovery until a court has deemed a securities fraud complaint sufficient, the PSLRA also imposes a stay of all discovery "during the pendency of any motion to dismiss." This stay operates against all parties, including both plaintiffs and defendants.

The Securities Litigation Uniform Standards Act
Securities Litigation Uniform Standards Act
The Securities Litigation Uniform Standards Act of 1998 is a federal legislative act in the United States regarding private class action lawsuits for securities fraud...

 amends this provision to allow a federal court to impose the discovery stay on related securities suits in state court.

Legislative history

The PSLRA was enacted into law by the U.S. Congress over a veto
A veto, Latin for "I forbid", is the power of an officer of the state to unilaterally stop an official action, especially enactment of a piece of legislation...

 by President
President of the United States
The President of the United States of America is the head of state and head of government of the United States. The president leads the executive branch of the federal government and is the commander-in-chief of the United States Armed Forces....

 Bill Clinton
Bill Clinton
William Jefferson "Bill" Clinton is an American politician who served as the 42nd President of the United States from 1993 to 2001. Inaugurated at age 46, he was the third-youngest president. He took office at the end of the Cold War, and was the first president of the baby boomer generation...

. The U.S. House of Representatives
United States House of Representatives
The United States House of Representatives is one of the two Houses of the United States Congress, the bicameral legislature which also includes the Senate.The composition and powers of the House are established in Article One of the Constitution...

 approved the bill by a 319-100 margin, and the U.S. Senate
United States Senate
The United States Senate is the upper house of the bicameral legislature of the United States, and together with the United States House of Representatives comprises the United States Congress. The composition and powers of the Senate are established in Article One of the U.S. Constitution. Each...

 approved it 68-30. Every Republican in the House voted in favor of the legislation, and only four Republicans in the Senate voted against it: William Cohen
William Cohen
William Sebastian Cohen is an author and American politician from the U.S. state of Maine. A Republican, Cohen served as Secretary of Defense under Democratic President Bill Clinton.-Early life and education:...

, John McCain
John McCain
John Sidney McCain III is the senior United States Senator from Arizona. He was the Republican nominee for president in the 2008 United States election....

, Richard Shelby
Richard Shelby
Richard Craig Shelby is the senior U.S. Senator from Alabama. First elected to the Senate in 1986, he is the ranking member of the United States Senate Committee on Banking, Housing, and Urban Affairs and was its chairman from 2003 to 2007....

, and Arlen Specter
Arlen Specter
Arlen Specter is a former United States Senator from Pennsylvania. Specter is a Democrat, but was a Republican from 1965 until switching to the Democratic Party in 2009...

. Prominent liberals in the Democratic Party like senators Tom Harkin
Tom Harkin
Thomas Richard "Tom" Harkin is the junior United States Senator from Iowa and a member of the Democratic Party. He previously served in the United States House of Representatives ....

, Ted Kennedy
Ted Kennedy
Edward Moore "Ted" Kennedy was a United States Senator from Massachusetts and a member of the Democratic Party. Serving almost 47 years, he was the second most senior member of the Senate when he died and is the fourth-longest-serving senator in United States history...

, Claiborne Pell
Claiborne Pell
Claiborne de Borda Pell was a United States Senator from Rhode Island, serving six terms from 1961 to 1997, and was best known as the sponsor of the Pell Grant, which provides financial aid funding to U.S. college students. A Democrat, he was that state's longest serving senator.-Early years:Pell...

, and Carol Moseley Braun
Carol Moseley Braun
Carol Elizabeth Moseley Braun is an American feminist politician and lawyer who represented Illinois in the United States Senate from 1993 to 1999. She was the first and to date only African-American woman elected to the United States Senate, the first woman to defeat an incumbent senator in an...

 voted in favor of the legislation while many conservative-to-moderate Democrats such as senators John Breaux
John Breaux
John Berlinger Breaux is a former United States senator from Louisiana who served from 1987 until 2005. He was also a member of the United States House of Representatives from 1972 to 1987. He was considered one of the more conservative national legislators from the Democratic Party...

, Robert Byrd
Robert Byrd
Robert Carlyle Byrd was a United States Senator from West Virginia. A member of the Democratic Party, Byrd served as a U.S. Representative from 1953 until 1959 and as a U.S. Senator from 1959 to 2010...

, Fritz Hollings, and Sam Nunn
Sam Nunn
Samuel Augustus Nunn, Jr. is an American lawyer and politician. Currently the co-chairman and Chief Executive Officer of the Nuclear Threat Initiative , a charitable organization working to reduce the global threats from nuclear, biological and chemical weapons, Nunn served for 24 years as a...

 and representatives such as John Murtha
John Murtha
John Patrick "Jack" Murtha, Jr. was an American politician from the U.S. state of Pennsylvania. Murtha, a Democrat, represented Pennsylvania's 12th congressional district in the United States House of Representatives from 1974 until his death in 2010....

 and Gene Taylor
Gene Taylor
Gary Eugene "Gene" Taylor is the former U.S. Representative for , serving from 1989 until 2011. He was defeated for re-election in 2010 by State Rep. Steven Palazzo, who gained 52% of the vote compared to Taylor's 47%. He left office in January 2011. He is a member of the Democratic Party...

 voted against it. This event was one of two times during Bill Clinton's presidency that Congress successfully overrode one of his 37 vetoes to enact a bill into law.

The PSLRA was originally developed as part of Newt Gingrich
Newt Gingrich
Newton Leroy "Newt" Gingrich is a U.S. Republican Party politician who served as the House Minority Whip from 1989 to 1995 and as the 58th Speaker of the U.S. House of Representatives from 1995 to 1999....

's Contract With America
Contract with America
The Contract with America was a document released by the United States Republican Party during the 1994 Congressional election campaign. Written by Larry Hunter, who was aided by Newt Gingrich, Robert Walker, Richard Armey, Bill Paxon, Tom DeLay, John Boehner and Jim Nussle, and in part using text...

. Its principal authors in the House were Representatives Thomas Bliley
Thomas J. Bliley, Jr.
Thomas Jerome "Tom" Bliley, Jr. is a United States Republican politician and former U.S. Representative from the state of Virginia.-Background:...

, Jack Fields
Jack Fields
Jack Milton Fields, Jr. , is a Texas businessman and a former Republican member of the United States House of Representatives from a Houston-based district....

 and Christopher Cox. Senators Chris Dodd and Pete Domenici
Pete Domenici
Pietro Vichi "Pete" Domenici is an American Republican politician, who served six terms as a United States Senator from New Mexico, from 1973 to 2009, the longest tenure in the state's history....

sponsored the legislation in the Senate.

External links

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