A Case for Amending the Private Securities Litigation Reform Act: Why Increasing Shareholders’ Rights to Sue Will Help Prevent the Next Financial Crisis and Better Inform hhe Investing Public

• Author: Neil Pandey-Jorrin
• Position: J.D. 2009, American University Washington College of Law
• Pages: 04

Neil Pandey-Jorrin. J.D. 2009, American University Washington College of Law; B.A., International Relations and Political Science, 2005, The University of Illinois at Urbana-Champaign. I would like to thank my family and friends. I also thank Professor Kenneth Anderson for providing his guidance throughout this entire process. Lastly, a thank you to the editors on the Business Law Brief for their work on this piece.

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I Introduction

The Private Securities Litigation Reform Act of 1995¹ (“PSLRA” or “Act”) drastically altered private securities litigation by erecting a high barrier against fraud-based shareholder lawsuits and burdening shareholders with additional pleading requirements when shareholders sue. Motivated by overwhelming episodes of abusive litigation² that unduly burdened companies,³ Congress overrode President Clinton’s veto⁴ to enact the PSLRA and instituted heightened pleading standards for fraud-based shareholder lawsuits. As a result, federal securities fraud actions have noticed notable changes.

The PSLRA statutory changes primarily impacted shareholder suits by enhancing the pleading requirements a shareholder complaint must meet in two primary ways. First, a complaint must “plead with particularity” (1) each statement alleged to have been misleading, (2) the reason why the statement was misleading, and (3) all facts on which that belief is formed.⁵ Secondly, any allegation as to the state of mind must state with “particularity” facts amounting to “a strong inference” that the defendant acted with the required state of mind.⁶

In light of recent episodes concerning corporate mismanagement,⁷ Congress would be well advised to reconsider lowering the pleading requirements it imposed upon shareholders when enacting the PSLRA and creating guidelines that impose higher Rule 11 sanctions when there has been abusive litigation. More compelling still is that statistical data has concluded that the PSLRA has been ineffective in curbing abusive litigation,⁸ and other commentators have discussed the “procedural catch 22”⁹ that the demanding procedural requirements place upon plaintiffs while depriving them of discovery. Lowering the pleading requirements would provide greater oversight for stockholders and encourage sound management by exposing poor corporate practices. Even in cases where shareholders lose at trial, the investing public would be better informed by the increased corporate transparency resulting from the discovery process—both goals advanced by the Securities Exchange Acts of 1933 and 1934.¹⁰ Concerns about vexatious litigation and in terrorem complaints can be addressed by increased Rule 11 sanctions already in the Act. Like sentencing guidelines used in criminal cases, Congress should set up guidelines that classify different degrees of Rule 11 violations and escalate penalties as the violation is deemed more egregious by a court. This will address concerns of abusive litigation by tailoring a violation to the degree of the penalty while also not unfairly inhibiting plaintiffs from entering the courthouse doors.

Lowering the pleading requirements would provide greater oversight for stockholders and encourage sound management by exposing poor corporate practices.

II Background to the PSLRA and Congress’ Efforts to Correct Abusive Litigation Practices

A In Terrorem Complaints and Abusive Litigation which Concerned Congress before they Enacted the PSLRA

One of the primary concerns which led Congress to enact the PSLRA was the danger posed by vexatious litigation, sometimes initiated merely whenever a stock price declined. The Court first noted this danger in Blue Chip Stamps v. Manor Drug Stores,¹¹ where the Court observed existing dangers¹² with the possibility of broadly expanding the range of plaintiffs that could sue under Section 10(b) of the Exchange Act. In Blue Chip, the Court considered whether offerees of a stock, made pursuant to an antitrust consent decree, could maintain a private cause of action under 10(b) when the offerees neither purchased nor sold any of the offered shares.¹³ While Blue Chip predates the PSLRA, the Court’s opinion signals one of the first instances where liberal pleading rules in securities litigation received criticism after abusive litigation was employed.

It was precisely this abusive litigation that Congress sought to dispose of when they enacted the PSLRA, because Congress largely reasoned that meritless suits were “a social cost, rather than a benefit.”¹⁴ More precisely, Congress sought to deter meritless suits which had value to plaintiffs simply because theyPage 16 could consume large amounts of time and detract from business activity.¹⁵ Congress noted that “professional plaintiffs” who would own only nominal amounts in a wide array of companies and would thereby possess standing to sue a broad array of issuers.¹⁶ Such complaints, often initiated only after a company’s stock price would drop, would amount to nothing more than “fishing expeditions,”¹⁷ where plaintiff’s counsel would seek to obtain any damaging evidence against the defendant in the suit, often without good faith anticipation of any wrongdoing. Thus, the settlement value of the claim was often proportional to the money required to mount a defense. These complaints are precisely those which the Court described as in terrorem¹⁸ because they were filed merely to generate fear and were limited in value insofar as they implicated a cost to the defendant in preparing a defense. In addition to these abusive practices motivating suits, plaintiffs would often initiate a “race to the courthouse” in order to be lead plaintiff and obtain the financial benefits of that designation.

B How Congress Addressed these Problems when it Enacted the PSLRA

In response to these concerns, Congress devised three amendments within the PSLRA to curb the problems associated with abusive and vexatious litigation. First, Congress required that plaintiffs state with particularity the facts constituting the alleged violation, and to “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”¹⁹ Second, Congress sought to eliminate problems generating a “race to the courthouse” by specifying criteria to determine the “most adequate plaintiff,”²⁰ mainly relating to the institutional investor owning the largest portion of the issuer’s stock. Third, Congress addressed Rule 11 sanctions against attorneys who bring suits without merit, in hopes of awarding a sufficient sanction to make the defendant whole once the action terminates.

1. Pleading with Elements “Particularity” and Alleging “Strong Inference” of the Required State of Mind While Denying Discovery

In order to avoid dismissal of a cause of action, Congress required that a complaint, “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”²¹ In Tellabs, Inc. v. Major Issues & Rights, Ltd.,²² the Court elaborated upon the language of “rising to a strong inference” to give litigants more context as to what would be a sufficiently plead complaint. In Tellabs, the Court held that in order for an inference to qualify as “strong” as required under 15 U.S.C. §78 u-4 (b), such an inference must be cogent and equally “as compelling as any opposing inference of nonfraudulent intent.”²³ Moreover, the Court added that in determining whether a complaint sufficiently alleged a “strong inference,” a complaint had to be viewed in its entirety and opposing inferences, ones weighing against the legally required state of mind, had to be considered by the court.²⁴ In addition to the changes concern pleadings, the PSLRA limits a plaintiff’s access to information by requiring that discovery be stayed, pending the resolution of all dispositive motions.²⁵

Tellabs involved a group of shareholders suing under Section 10(b) of the Exchange Act while claiming that the issuer falsely represented the value of its stock.²⁶ In their complaint, the investors alleged that Tellabs, “falsely reassured public investors... that Tellabs was continuing to enjoy strong demand for its products and earning record revenues,” and that in doing so, Tellabs falsely represented the company’s financial health. The...