Analyzing Post-Market Boom Jurisprudence in the Second and Ninth Circuits: Has the Pendulum Really Swung too Far in Favor of Plaintiffs?
| Author | Daniela Nanau |
| Position | B.A., Political Science |
| Pages | 943-976 |
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B.A., Political Science, Reed College, May 1997. J.D., Benjamin N. Cardozo School of Law, June 2005. Notes Editor, Cardozo Public Law, Policy, and Ethics journal. I want to express my thanks to Professor Daniel Crane for reviewing early drafts of this note and for providing me with guidance and encouragement. I also want to thank the staff of the Cardozo Public Law, Policy, and Ethics journal for their efforts in bringing this note to publication.
Page 943
The collapse of the late 1990s market bubble, and the subsequent revelations of corporate fraud that fueled the unprecedented growth, have spawned a new surge in securities litigation.1 Unlike shareholder class action litigation of the past, which primarily focused on the fraudulent conduct of corporate insiders, these lawsuits target a larger group of actors. Today's shareholder litigation seeks to hold both corporate issuers and their capital market gatekeepers liable for fraudulent practices that have implicated the integrity of every level of the securities industry.2
A number of fraudulent practices defined business as usual on Wall Street during the recent market boom. According to regulators and in-Page 944 vestors, the most common practices included: "laddering," a practice developed by investment firms and corporate executives who agreed to secretly buy and sell their initial public offering (IPO) shares at certain prices to spur demand;3biased accounting practices that failed to reflect the true financial health of the corporate issuer;4conflicts of interest resulting from the failure of analysts and investment bankers to observe the "Chinese wall" designed to separate them and prevent them from working together to attract clients;5and, a practice known as "spinning" where Wall Street firms handed out shares of sought-after IPO's to corporate executives and directors in exchange for high commissions and the promise of future business.6Even Wall Street officials acknowledge that the late 1990s was a period defined by corporate practices that often failed to comply with federal and state regulations.7Page 945
The information regarding many of these corporate transgressions came to light, in large part, because of the vigorous enforcement efforts of New York's Attorney General Elliot Spitzer and other attorneys general throughout the country.8Given the enormous loss of market capital that investors have shouldered as a result of the fraudulent practices described above,9it is not surprising that public officials have enhanced enforcement efforts. Regulators have focused a particularly scrutinizing eye on capital market gatekeepers.10However, budgetary restrictions have limited the enforcement efforts of federal and state regulators,11Page 946 which means that most of the corporate fraud that occurred during the late 1990s will come to light solely through the class action lawsuits filed on behalf of aggrieved investors.
Private enforcement of federal securities laws is premised on a private attorney's general model.12In essence, this model deputizes attorneys in private practice to search out fraud that might not otherwise come to light. Arthur Levitt, former Chairman of the Securities and Exchange Commission (SEC), affirmed the importance of private enforcement when he stated that "private rights of action are not only fundamental to the success of our securities markets, they are essential to the SEC's own enforcement program."13Even the United States Supreme Court has described private securities actions as a "necessary supplement" to the SEC's enforcement regime.14
Congress has taken a different view of the role private class action lawsuits play in the enforcement of federal securities laws. In an effort to protect the integrity of the capital markets from an alleged proliferation of "strike suits,"15Congress enacted the Private Securities Litigation Reform Act16(PSLRA or Reform Act) in 1995 to implement procedural hurdles that prevent all but the most obvious cases of corporate fraud from surviving past the pleading stage. However, in this post-Enron era, the spirit encouraging the passage of the Reform Act seems to have dissipated, and as a result, some courts are "stating explicitly that private litigation plays an important role in deterring fraud and must not be discouraged by overbroad barriers."
This note will argue that the pendulum has not swung too far in favor of plaintiffs, but merely corrected the imbalance created by the PSLRA's overly burdensome pleading requirements. To support this argument, Part II analyzes federal securities jurisprudence prior to the enactment of the PSLRA to illustrate the numerous safeguards the Supreme Court developed over the years to limit the threat of strike suits. Part III explores the legislative history of the PSLRA to assess Congress' motivation for enacting the reform legislation, which has made it more difficult to mount securities class actions. Part IV will examine the circuit split that has emerged regarding the scienter requirement mandated by the PSLRA through an analysis of the post-PSLRA case law that has developed in the Second and Ninth Circuits. These circuits represent opposite ends of the scienter spectrum, with the Second Circuit having the least restrictive standard and the Ninth Circuit having the most restrictive standard. This note will demonstrate how the Second Circuit's requirements for pleading scienter afford courts the flexibility needed to assess complex securities fraud lawsuits in a more equitable way. In so doing, the Second Circuit does a much better job of providing aggrieved investors with the opportunity to enforce federal securities laws, and thus prevent the kind of frauds that were so typical of the market in the 1990s from surfacing again any time soon. Finally, in light of the recent influx of relatively inexperienced investors in the securities marketplace, and the likelihood that this group will increase if the Bush Administration's plan to privatize social security is enacted, it will be argued that Congress should revisit the issue of the scienter standard and expressly adopt the Second Circuit's standard. Doing so will afford courts the flexibility needed to assess securities claims, which are complicated and enormously taxing on court resources.19Page 948
In Ernst & Ernst v. Hochfelder,20the Supreme Court attributes the initial emergence of federal statutes to regulate the securities markets to the stock market crash of 1929.21Although President Theodore Roosevelt and two subsequent presidents called upon Congress to develop federal corporate laws, the resolve to enact such statutes manifested itself only in the aftermath of the crash, with the onset of the Great Depression.22Unlike the states, which regulate corporations by defining the duties of directors and the rights of the shareholders, Congress chose a less intrusive method when it enacted the Securities Act of 1933 (the Securities Act)23and the Securities Exchange Act of 1934 (the Exchange Act).24Rather than regulate the board of directors, the locus of corporate decision-making power, or the shareholders, whose status as owners affords them special rights to constrain director action, federal securities law seeks to protect the integrity of the markets through the disclosure of accurate and complete corporate information.25Congress reasoned that the full disclosure of corporate information to investors would afford them protection against fraud, such as the manipulation of stock prices, and that the imposition of civil penalties to deter suchPage 949 fraud would encourage the promotion of ethical standards of honesty and fair dealing in securities markets.26To ensure compliance with federal securities law, Congress also established the Securities and Exchange Commission (SEC) with the implementation of the Exchange Act.27
In addition to the protection afforded to investors through SEC enforcement, federal securities law provides a number of private remedies for injured investors.28For example, the Exchange Act confers a private right of action in particular contexts29and a general antifraud provision at ß 10(b), which prohibits the employment of "manipulative or deceptive device[s]" in connection with the sale of securities.30However, the express causes of action within the Exchange Act are of limited use to injured investors, because liability attaches only to defendants who are directly responsible for the misstatement or omission.
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