Re-evaluating holder actions: giving defrauded securities holders a fighting chance.

• Author: Taylor, Robert W.

INTRODUCTION

On November 8, 2001, Enron admitted that it had overstated its profit by more than half a billion dollars over the previous five years. (1) For many months leading up to this admission--and even the day of--the vast majority of securities analysts, relying on the fraudulent information provided by Enron, had recommended buying or holding Enron's stock. (2) Less than a month after investors learned the truth about Enron's financial condition, the company filed for Chapter 11 bankruptcy. (3)

While the destructive fallout from Enron's collapse is difficult to overstate, perhaps no one suffered more direct and palpable harm than those who relied on Enron's fraudulent misrepresentations and invested in the company. (4) Enron's shareholders included not only independent individual and corporate investors, but also those who held shares in mutual funds--which widely invested in Enron (5)--and thousands of Enron employees, who had significant portions of their retirement savings tied up in Enron stock and held in their 401 (k) accounts. (6)

Thousands of Enron investors turned to the judicial system for relief, bringing class action suits to seek redress for the losses they suffered because of Enron's fraud. (7) While these actions initially achieved a considerable amount of success, (8) later efforts at recovery were thwarted by recent developments in federal law, leaving countless defrauded shareholders with little recourse. (9)

The problem largely centers on the existence and application of the "purchaser-seller rule," or the Birnbaum rule, in federal law. (10) Originally articulated by the Second Circuit in Birnbaum v. Newport Steel Corp. (11) and later endorsed by the U.S. Supreme Court in Blue Chip Stamps v. Manor Drug Stores, (12) the rule holds that a person who is neither a purchaser nor a seller of securities may not bring an action under the Securities and Exchange Commission's (SEC) Rule 10b-5. (13) In other words, a company's fraudulent misrepresentation regarding its financial condition must induce the plaintiff to either purchase or sell that company's securities in order for the plaintiff to have standing to sue under federal securities law. (14)

This rule was intended to prevent various problems believed to be inherent in securities fraud suits that are not tied to a specific transaction. In establishing the rule, courts primarily feared "strike suits'' (15) or vexatious litigation brought for the purpose of forcing an inequitable settlement as well as conjectural or speculative claims. (16) While the rule may have been the product of good intentions, its effect has been to severely limit meritorious "holder" causes of action--that is, actions where the shareholder-plaintiff alleges that the defendant's misrepresentation induced him to continue holding his stock when he would have otherwise purchased or sold and seeks to recover for the diminished value of the stock suffered as a result. (17) Since holders of stock are neither purchasers nor sellers for purposes of Rule 10b-5, (18) the Birnbaum rule and subsequent judicial and congressional actions have deprived countless numbers of shareholders of redress for their injuries. And while the injuries suffered by holders do not stem directly from an induced purchase or sale of stock, they are no less palpable. In the case of Enron, the company's stock traded near ninety dollars per share at its height in August 2000--when the company was artificially inflating its stock prices through fraudulent statements (19)--but by December 2002, after the fraud had been disclosed, the price fell to just over six cents. (20) For long-term stockholders who had invested significant portions of their wealth in the company, Enron's fraudulent scheme was devastating. (21)

While many of the concerns that courts have expressed about holder actions are legitimate, (22) the dangers of such actions are largely overstated, and as this Note will show, taking away holders' right to sue creates far greater dangers and potential for injustice. Part I addresses the development of the law in this area while Part II illustrates the current state of the problem, and Part III suggests possible judicial and legislative solutions.

1. BACKGROUND AND DEVELOPMENT OF THE LAW

   1. Rule 10b-5 and the Blue Chip Stamps Doctrine

      Securities and Exchange Commission Rule 10b-5 states:

      It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

      (a) To employ any device, scheme, or artifice to defraud,

      (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

      (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security. (23)

      Although not explicitly stated, courts have long held that the rule implies a private cause of action that allows individuals to supplement the SEC's enforcement with private lawsuits. (24) However, this implied cause of action has been limited from very early on in its existence. Since the Birnbaum rule was first articulated in 1952, courts have interpreted the "in connection with the purchase or sale" language to require that a fraudulent statement must induce either a specific purchase or sale of securities in order to be actionable under Rule 10b-5. (25)

      Courts have offered various justifications for the Birnbaum rule. In the seminal case, the Second Circuit based its reasoning largely on legislative history and intent, (26) while the Supreme Court in Blue Chip Stamps offered a justification that was primarily based on policy considerations. (27) The Court was concerned that permitting causes of action outside the narrow purchaser-seller context would invite vexatious litigation and strike suits, (28) encourage the "extensive discovery and disruption of normal business activities," (29) and create "conjectural and speculative" recoveries because the number of shares a plaintiff in a holder action alleges he would have sold is a "subjective hypothesis." (30)

   2. The Private Securities Litigation Reform Act of 1995

      Judicial concerns about plaintiffs abusing private securities litigation (31) soon brought about legislative action as well. In the mid 1990s, the corporate lobby went to Washington to petition for stricter federal regulations on securities litigation, complaining that its members were being harassed by frivolous class action lawsuits brought by securities holders who were more concerned with the suits' settlement values than their merits. (32) Despite the inconclusive nature of the evidence purportedly supporting a "securities litigation crisis," (33) Congress soon passed the Private Securities Litigation Reform Act of 1995 ("Reform Act") (34) over President Clinton's veto. (35)

      The Reform Act "continue [d] a judicial trend toward narrowing the availability of relief for investors under the federal securities laws" (36) by making a number of significant changes to the private securities fraud class action litigation system. (37) Among the most significant changes implemented by the Reform Act were (1) a "safe harbor" for forward-looking statements that were not known to be false when made or were accompanied by meaningful cautionary language; (38) (2) heightened pleading standards, whereby plaintiffs must plead facts which give rise to a "strong inference" that the defendant acted with the required state of mind for fraud; (39) (3) a stay of discovery provision that prohibits plaintiffs from having access to discovery while a motion to dismiss is pending; (40) and (4) a lead plaintiff presumption, which designates the plaintiff with the largest financial stake in the litigation as the lead plaintiff and allows that lead plaintiff to select counsel for the class, subject to court approval. (41)

      The Reform Act's restrictions on federal shareholder class actions, coupled with Blue Chip Stamps and Other recent Supreme Court cases limiting the ability of shareholders to sue in federal court, (42) led defrauded shareholders to seek redress for their grievances in state court. (43) Holder actions in state courts initially achieved a considerable amount of success because state common law often recognized holder claims, or state securities fraud statutes--more commonly known as "blue sky laws" (44)--specifically provided for them. (45) However, this avenue of relief did not remain as favorable to shareholders for long.

   3. The Securities Litigation Uniform Standards Act of 1998

      Not long after significantly curtailing investors' right and ability to sue in federal court, Congress limited their ability to sue in state courts as well. After the passage of the Reform Act, the corporate lobby, led by Silicon Valley, returned to Washington to petition for further legislative action in response to what it viewed as the plaintiffs' bar using state law to circumvent the restriction of the Reform Act. (46) Congress responded by passing the Securities Litigation Uniform Standards Act of 1998 ("Uniform Standards Act"). (47)

      The Uniform Standards Act expressly preempts certain state law securities class actions by providing for automatic removal to federal court, followed by dismissal. (48) The Act applies to any "covered class action" that alleges

      (A) a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security; or

      (B) that the defendant used or employed any manipulative or deceptive device or contrivance in connection with the purchase or sale of a covered security. (49)

      The Act defines "covered class actions" as

      (i) any single lawsuit in which--

      (I) damages are sought on behalf of more than 50...