Senate Banking, Housing and Urban Affairs Committee

Securities Subcommittee

Hearing on S.1260,
"The Securities Litigation Uniform Standards Act of 1997"

INTRODUCTION

Enactment of broad-based legislation like S. 1260 that would preempt class actions for securities fraud under state law is neither advisable nor necessary. Moreover, as drafted, S. 1260 eliminates more fraud protections than just state securities laws, discriminates against small investors, would displace a significant part of transactional corporate law traditionally left to state regulation, and has numerous drafting shortcomings and potential constitutional problems.

Because the Private Securities Litigation Reform Act of 1995 ("PSLRA") is in its infancy and the courts may ultimately interpret it in a way to make recovery for fraud under federal law impossible, it would be premature to enact any legislation further restricting fraud recoveries at this time. Precipitously eliminating state remedies as S. 1260 would do could leave individual investors without any recourse for securities fraud.

The evidentiary case has not been made for elimination of actions under state law. State court filings thus far in 1997 are below 1994 and 1995 levels, before the PSLRA was enacted. And the number of securities class actions in state court is infinitesimal -- only some 55 cases a year nationwide out of some 15 million civil filings annually in state court. This is hardly a national concern that merits Congressional attention.

Moreover, almost two-thirds (over 60) of the roughly 105 cases filed in state court since the PSLRA was enacted have been in California. No other state has had more than seven securities class actions filed in the nearly two years since enactment. If this is a problem, it is for Sacramento, not Washington, to fix. Other states should be left free to decide how best to protect their own citizens from fraud.

Incredibly, S. 1260 will not even solve the purported "problems" its proponents allege exist, while the bill eliminates a whole host of important state securities fraud remedies for consumers about which no one has even complained. For example:

(1) S. 1260 is a sweeping preemption bill that would wipe out more than just state securities laws. S. 1260 more than merely preempts private rights of action for fraud under state securities statutes. It eliminates any class action based on state unfair or deceptive trade practices statutes, actions for state RICO violations and even actions under the common law of fraud. No matter how any state has chosen to protect its citizens from lying, cheating, manipulation, and deception, all such remedies would be eliminated so long as there is a security involved in the scheme.

(2) S. 1260 discriminates against small investors. Under S. 1260, small investors would not have the same choices of forum -- and the same chances of recovery -- as large institutions. Large institutions can afford to bring a case on their own and choose a forum - federal or state court -- that will provide the best chance of recovery. On the other hand, under S. 1260 an individual investor who does not have the resources to pursue litigation on his or her own must go to federal court as part of a class action of 25 or more. Thus, institutions will be able to take advantage of the benefits of many state laws -- longer statutes of limitations, aiding and abetting liability for those who assist in frauds against them, and full joint and several liability -- while individuals will be forced into federal court as part of a class action, where they may have no remedy at all. S. 1260 would literally create a two-tier justice system.

(3) S. 1260 would eliminate state remedies for purely transactional cases that do not belong in federal court. By preempting many state claims for breach of fiduciary duty, S. 1260 would constitute a significant step towards federalizing the obligations of corporate directors to their stockholders.

(4) S. 1260 would have numerous other unintended adverse consequences. For example, it would preclude states from hearing actions under the Securities Act of 1933, as they have done for decades; and it would prevent state actions by individual trustees, guardians and those in other custodial kinds of relationships.

(5) S. 1260 will not solve any of the problems that its proponents cite. S. 1260 would preempt gill state antifraud laws for all class actions involving securities traded on the national exchanges. Yet, only two perceived "problems" have been identified in Congressional testimony or public statements by the proponents of state preemption -allegations that attorneys for defrauded investors are using state law to circumvent the safe harbor for forward-looking statements provided under the PSLRA and, to a far lesser extent, the discovery stay under the PSLRA.

The bill is far too broad in preempting all other state antifraud remedies -- for example, longer statutes of limitations and liability for aiders and abettors -- when no problem with these state laws has even been alleged. If the "problem" is really only with the safe harbor and, possibly, discovery stays, state law should be preempted -- if at all -only with respect to those issues. In testimony before the House Commerce Committee last week, SEC Chairman Levitt made precisely this point. While arguing that it was premature to pass any legislation, Chairman Levitt insisted that "a total, broad-based preemption" would be particularly ill-advised. If Congress was to consider any new law, it should be "targeted" at identified problems such as the safe harbor and discovery stays, he argued.

(6) S. 1260's discrimination against small investors and its application to wholly intrastate transactions may violate the Constitution.

Congress should not move on S. 1260 without more information on the effects of the PSLRA, and, if legislation eventually appears called for, consider only a far more targeted approach to specifically identified problems. We should not close the state courthouse door before we know whether the federal courthouse door remains open.

Chairman Gramm and Members of the Subcommittee, thank you for the opportunity to testify today.

My name is Herb Milstein and I am the senior partner at Cohen, Milstein, Hausfeld & Toll, P.L.L.C., a firm of 21 lawyers with its principal office in Washington, D.C. Over the years, my firm has been involved in many federal and some state class actions in the securities area, most notably in recent years Lincoln Savings and Loan, Centrust, and National Health Labs. My firm has prosecuted numerous non-securities class actions as well, including those that recovered substantial damages for the victims of racial discrimination by Texaco earlier this year and for Alaskan natives injured by the Exxon Valdez oil spill. We are also representing Jewish families who were victims of the Nazis and whose property was taken by the Swiss banks after World War I 1. I am appearing here today on behalf of the National Association of Securities and Commercial Law Attorneys ("NASCAT').

In July, NASCAT submitted testimony to this Subcommittee on the operation of the Private Securities Litigation Reform Act of 1995 ("PSLRA"). Although that testimony did not focus specifically on the legislation you are considering today, S. 1260, the "Securities Litigation Reform Act of 1997," NASCAT argued that because the PSLRA is in its infancy and the courts may ultimately interpret it in a way to make recovery for fraud under federal law impossible, it would be premature to enact any legislation further restricting fraud recoveries at this time. The SEC also counseled caution in legislating in this area without more information on the PSLRA. NASCAT was particularly concerned about preemption legislation like S. 1260, pointing out that precipitously taking away state remedies might leave investors without any recourse for securities fraud at all.

NASCAT, like the SEC, noted that the PSLRA is in its infancy. In the 22 months since its passage, the new law has barely been tested, with no trials, no appellate decisions on substantive provisions, no summary judgments and few decisions on any of its terms. It will take more time to assess the PSLRA's impact as the courts struggle to interpret it.

NASCAT also pointed out that court decisions thus far on the PSLRA make the risks of eliminating state remedies clear. Whether intended by Congress or not, it is a fact that fraud defendants in nearly every case are arguing that the PSLRA should be interpreted in ways that make recoveries nearly impossible. Unfortunately, some courts are accepting these arguments. A number of federal district courts have issued rulings so restrictive that they threaten almost all private enforcement. In one case, Silicon Graphics, the court imposed an impossible pleading standard and initially held that reckless wrongdoers are no longer liable to their victims under the PSLRA. The SEC took the significant step of entering the case to file a brief in the district court to protest the ruling, arguing that such a result would essentially end enforcement of the federal securities laws by individual citizens.

In addition, NASCAT asserted that the evidentiary case has not been made for elimination of actions under state law. A recent study found that state court filings thus far in 1997 are -below 1994 and 1995 levels, before the PSLRA was enacted. And the number of securities class actions in state court is infinitesimally small -- only some 55 cases a year nationwide out of some 15 million civil filings annually in state court, slightly more than one filing out of every 300,000 cases. Because the number of cases is so small, they are hardly a national concern that Congress needs to address. As even Senator Dodd, one of the primary sponsors of S. 1260, conceded in a floor statement the day the bill was introduced, "I do not want to suggest to my colleagues that we have some overwhelming problem on our hands."'

Moreover, the large majority of the roughly 105 cases filed in state court since the PSLRA was enacted -- 62 -- have been in California. No state other than California has had more than seven securities class actions filed in the nearly two years since enactment. If this is a problem, it is for Sacramento, not Washington, to fix and California already has established a legislative commission to study its laws and to make changes if necessary. Other states should be left free to decide how best to protect their own citizens from fraud -- including broadening protections or adopting the PSLRA as state law, as some states have done.

Finally, a number of key California state court interpretations could make California investor protection laws inapplicable to out-of-state purchases, and thereby largely eliminate the need for any federal legislation. This issue is at the heart of the most notable case, Diamond Multimedia, now before the California Supreme Court. If the court decides that California investor protection law only protects stock purchases in the state and that out-of-state purchasers cannot bring suit under California law, investors could not file national class actions in California courts -- thus eliminating the vast majority of the few state cases filed nationwide.

Although we strongly believe adopting preemption legislation at this point would be exceedingly dangerous, we wish to be responsible voices in your debate. In that spirit, we would offer the following comments regarding S. 1260:

(1) S. 1260 is a sweeping preemption bill that would wipe out more than just state securities laws. S. 1260 more than merely preempts private rights of action for fraud under state securities statutes. It eliminates any class action based on any "statutory or common law of any State or subdivision thereof" alleging "an untrue statement or omission of a material fact" or "any manipulative or deceptive device or contrivance" in connection with the purchase or sale of a covered security. This means that actions under state unfair or deceptive trade practices statutes, actions for state RICO violations and even actions under the common law of fraud also are preempted. No matter how any state has chosen to protect its citizens from lying, cheating, manipulation, and deception, all such remedies would be eliminated so long as there is a security involved in the scheme.

(2) S. 1260 discriminates against small investors. Under S. 1260, small investors would not have the same choices of forum -- and the same chances of recovery -- as large institutions. Large institutions can afford to bring a case on their own and choose a forum - federal or state court - that will provide the best chance of recovery. On the other hand, under S. 1260 an individual investor who does not have the resources to pursue litigation on his or her own must go to federal court as part of a class action of more than 25. Thus, institutions will be able to take advantage of the benefits of many state laws -- longer statutes of limitations, aiding and abetting liability for those who assist in frauds against them, and full joint and several liability - while individuals will be forced into federal court as part of a class action, where they may have no remedy at all. S. 1260 would literally create a two-tier justice system.

The simple economics of complex cases means that individual litigation is an option only for large investors; small investors must use class actions in which they can aggregate their claims to limit their individual legal costs. While, strictly speaking, state law approaches will not be fully closed to any investors under S. 1260, as a matter of economics and necessity, that door will only be open to the largest investors. Recent news accounts demonstrate that some institutional investors have pursued cases under the federal securities laws on their own; they will continue to be able to file on their own in state court under S. 1260. Individual consumers will not.

Investor choice and protection of small investors were two of the claimed benefits of the PPSLRA Congressman Christopher Cox, one of the principal architects of the PPSLRAon the House side, directly stated that one of the goals of the legislation was to afford small investors a choice about whether to pursue claims in federal court or state court:

So if you were a plaintiff, who like any lplaintiffhas a choice of forum, and if you were one of the investors who were defrauded in Orange County, for example, you might file your suit in State court or in Federal court depending on how you saw your advantage.

But if you filed in State court, you would get a winner-pays rule; while if our bill were to pass, if you filed in Federal court, you would get a lloser pays rule. So, in fact, from the standpoint of the merits of your case - how strong you thought it was; whether you could afford to pay a lawyer up front; or whether you wanted to put pressure on the defendant to pay all of your fees at the end - if this bill were to pass, you would have more options, you could pick your forum and thus pick whether or not you wanted a winner pays rule or a loser-pays rule.'

Clearly, S. 1260 would discriminate against small investors by reducing -- and for all intents and purposes eliminating -- their ability to avail themselves of state remedies for securities fraud while allowing large investors to recover their losses in state court.

(3) S. 1260 would eliminate state remedies for purely transactional cases that do not belong in federal court. As drafted, S. 1260 would displace a significant part of transactional corporate law traditionally left to state regulation. Many class actions challenging mergers, tender offers, recapitalizations, or similar transactions approved by boards of directors often assert that stockholder action has been procured by means of false and misleading statements and involve breaches of fiduciary duties. Such breach of fiduciary duty claims are a recognized and traditional part of state corporate law. By preempting such claims, S. 1260 would constitute a significant step towards federalizing the obligations of corporate directors to their stockholders.

(4) S. 1260 would have numerous other unintended adverse consequences.

a. S. 1260 includes a provision that would require "[a]ny class action brought in any State court involving a covered security" to be transferred from state to federal court. This provision is not limited to cases under "state statutory or common law" and would eliminate even federal cases from being heard in state courts. The Securities Act of 1933 has always provided for concurrent jurisdiction of cases filed under the statute and prohibited removal of such cases filed in state courts. Under S. 1260, just the opposite would be true. The states would be precluded from hearing actions under the 1933 Act, as they have done for decades. This has nothing to do with preemption of inconsistent state laws. It is simply closing another courthouse door on injured investors.

b. The "class action" definition in S. 1260 is too broad. It includes "any single lawsuit... or group of lawsuits filed or pending in the same court, involving common questions of law or fact" in which: "(A) damages are sought on behalf of more than 25 persons; (B) one or more named parties seek to recover damages on a representative basis on behalf of themselves and other unnamed parties similarly situated; or (C) one or more of the parties seeking to recover damages did not personally authorize the filing of the lawsuit." This definition could encompass a number of circumstances that the proponents do not intend.

For example, the definition of class action would appear to encompass actions of individual trustees, guardians and those in other custodial kinds of relationships. In such cases, a trustee or other representative party might seek to recover on a "representative basis on behalf of themselves and other parties similarly situated" or the beneficial owners of the claim might not be able to "personally authorize the filing of the lawsuit." This might prevent a suit in state court by a legal guardian seeking to recover for a child or institutionalized person who could not give his or her own authorization.

C. The definition of "covered security" also appears overly broad. It would include mutual funds even though all the claims of "problems" so far deal with national, publicly-traded stock.

(5) The bill will not solve any of the problems that its proponents cite. S. 1260 would preempt all state antifraud laws for all class actions -- defined as cases in which damages are sought on behalf of more than 25 persons -- involving securities traded on the national exchanges. Yet, only two perceived "problems" have been identified in Congressional testimony or public statements by the proponents of state preemption -allegations that attorneys for defrauded investors are using state law to circumvent the safe harbor for forward-looking statements provided under the PSLRA and, to a far lesser extent, the discovery stay under the PSLRA.

The bill is far too broad in preempting all other state antifraud remedies -- for example, longer statutes of limitations and liability for aiders and abettors -- when no "problem" with these state laws has even been alleged. If the "problem" is really only with the safe harbor and, possibly, discovery stays, state law should be preempted -- if at all -only with respect to those issues. In testimony before the House Commerce Committee last week, Chairman Levitt made precisely this point. While arguing that it was premature to pass any legislation, Chairman Levitt insisted that "a total, broad-based preemption" would be particularly ill-advised. If Congress was to consider any new law, it should be "targeted" at identified problems such as the safe harbor and discovery stays, he argued.

(a) The safe harbor. Most of the testimony in the July 24 Securities Subcommittee hearing and the hearing held in the House last week has focused on the so-called "chilling" effect on corporate forward-looking statements arising from the lack of a "safe harbor" immunity under state law. According to S. 1260 proponents, corporate executives have not made full use of the "safe harbor" because of a fear of state court litigation.' A major poll commissioned by the proponents of the legislation purports to support this conclusion.

But, S. 1260 preempts only state court "class actions." It does not preempt individual suits under state law or suits by the SEC or state regulators. It is certainly foreseeable that large institutional investors will continue to use state court avenues.7 So, if corporate executives have thus far been chilled by the threat of even one state court securities fraud suit by consumers -- as claimed by some proponents -- S. 1260 will do nothing to warm them up.

(b) Discovery. A second complaint of the proponents of S. 1260 involves discovery. The PSLRA contains an automatic stay of discovery during the pendency of a defendant's motion to dismiss the complaint. According to PSLRA supporters, a discovery stay is allegedly necessary to prevent plaintiffs from coercing a settlement by forcing defendants to engage in production of documents and other materials in a case in which the complaint might ultimately be dismissed. But, S. 1260 will not prevent state court discovery. Again, S. 1260 preempts only "class actions;" suits under state law by less than 25 plaintiffs are still permitted. Therefore, such plaintiffs could file a case in state court and obtain any discovery benefits that state law permitted. If it is true that plaintiffs' lawyers are circumventing the PSLRA by going to state court for discovery, nothing in S. 1260 would prevent those lawyers from continuing to engage in the same practice. It is noteworthy, however, that most states permit their judges to stay discovery and that a recent California ruling afforded state judges wide latitude in staying discovery if that was consistent with the interests of justice.

Thus, S. 1260 is both overly broad -- in preempting all state antifraud laws for all class actions when only two alleged "problems" have been identified -- and overly narrow in not fixing what its proponents claim needs fixing.

(6) S. 1260's discrimination against small investors and its application to wholly intrastate transactions may violate the Constitution. As noted above, S. 1260 permits non-class actions to go forward in state court while class actions can only go forward in federal court. Because state laws sometimes provide broader remedies, investors who have no choice other than to sue by class action may have no remedy, while individual investors who pursue state actions may have the ability to recover. This discrimination could raise constitutional issues. At the same time, preempting class actions involving purely intrastate transactions could also raise constitutional issues.

We do not believe that enactment of S. 1260 or similar broad-based legislation that would preempt class actions for securities fraud under state law is advisable or necessary. Moreover, as drafted, S. 1260 eliminates more than just state securities laws, discriminates against small investors, would displace a significant part of transactional corporate law traditionally left to state regulation, and has numerous drafting shortcomings and potential constitutional problems.

Incredibly, S. 1260 will not even solve the purported "problems" its proponents allege exist, while the bill eliminates a whole host of state securities fraud remedies for consumers about which no one has even complained.

We urge you not to move on S. 1260 without more information on the effects of the PSLRA, and, if legislation eventually appears called for, to consider only a far more targeted approach to specifically identified problems. We should not close the state courthouse door before we know whether the federal courthouse door remains open.

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