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Loyola University Chicago

Institute For Investor Protection

School of Law

Congress and Investor Protection

The federal securities laws consist of several statutes and their amendments that contain antifraud provisions and private rights of action. Investors should be aware of the following statutes:

• The Securities Act of 1933 (“1933 Act”)
• The Securities Exchange Act of 1934 (“1934 Act”)
• The Private Securities Litigation Reform Act of 1995 (“PSLRA”)
• The Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) 
• The Investment Company Act of 1940 (“Investment Company Act”).
• The Sarbanes-Oxley Act of 2002 (“SOX”).
• Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”)

For the text of these laws, click on the following link: http://www.sec.gov/about/laws.shtml.


WHAT IS A SECURITY?

The securities laws only apply to securities as defined under those laws. A “security” under the securities laws is a broad concept.

Section 2(a)(1) of the 1933 Act defines a security to include:
 [A]ny note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferrable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, or any interest or instrument commonly known as a security, or any certificate of interest or participating in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to purchase, any of the foregoing.

Substantially similar definitions appear in Section 3(a)(10) of the 1934 Act and Section 401(e) of the Investment Company Act. 
A share of stock will almost always be deemed a security so long as the inducement to purchase was to invest for profit. United Housing Found. v. Forman, 421 U.S. 837 (1975). But regardless of the purpose of the transaction, the sale of a business through a stock sale is always the sale of a security. Landreth v. Landreth, 471 U.S. 681 (1985). Options are specifically included in the definition of a security under the securities laws.
Notes are not always stock. Notes that are not securities include notes secured by a mortgage on a home, notes secured by accounts receivable, or notes evidencing loans by commercial banks for current operations. To determine whether a note is a security, courts will consider (1) the motivations of the lender and borrower in entering into the transaction; (2) whether the note is the subject of common trading for speculation or investment; (3) how the note would be perceived by reasonable members of the public; and (4) whether the transaction is subject to another regulatory scheme which makes application of the securities laws unnecessary. Reves v. Ernst & Young, 494 U.S. 56 (1990).

An “investment contract” is a catchall term. A court will deem an instrument to be an investment contract if a person invests money in a common enterprise and is led to expect profits solely from the efforts of the promoter or third party. SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

THE SECURITIES ACT OF 1933

The Securities Act of 1933 requires registration of certain securities. The 1933 Act aims to provide investors with sufficient, material information regarding those securities that are offered for sale and to prohibit deceit by the offerees. It regulates the public offering of securities. To assure that information contained in registration statements is complete and accurate, the 1933 Act grants a private right of action to securities purchasers against those who make material misstatements or omissions in registration statements in registered offerings, or through a prospectus or oral communication.

The text of the 1933 Act is here: http://www.sec.gov/about/laws/sa33.pdf.

• Section 11. Misleading Statements in Registration Statements for Initial Public Offerings

The securities laws grant investors a private right of action against persons who commit fraud in the registration statement of an initial public offering of a security. Under Section 11 of the 1933 Act, investors who buy securities in a registered public offering have a cause of action against those who misrepresent or omit material facts in a registration statement. Investors have been provided this private right of action to assure them that the information contained in a registration statement is accurate. To prevail, investors have to show only that the registration statement contained a material misrepresentation or omission.

Investors should be aware of certain limits to a cause of action for fraud in the registration statement under Section 11. First, purchasers of stock can sue only “participants” of the initial public offering. Participants include the issuer of the stock, the signers of the registration statement, the directors and officers of the issuing company, the underwriter of the initial public offering, and professionals such as accountants, engineers, appraisers, and attorneys who have made statements based on the authority of their profession. Second, Section 13 of the 1933 Act requires investors to sue within one year of when the investor should have discovered the fraud or three years when the fraud actually occurred, whichever comes first.

Investors should also be aware of the defendants “due diligence” defense. This defense is an affirmative defense, which means defendants have the burden of raising and proving it. Defendants, other than the issuer, may avoid liability by proving that they conducted a reasonable investigation, and after which, they had no reasonable grounds to believe that the parts of the registration statement attributable to them contained material misstatements or omissions. Defendants may also reduce damages by showing that factors other than their own material misstatement or omission caused the decline in value of the investor’s investment.

• Section 12. Misleading Statements in Prospectuses or Oral Communications in Initial Public Offerings

Under Section 12(a)(2) of the 1933 Act, Congress also granted investors a private right of action to any purchaser of a security against an offeror or seller who misrepresents or omits material facts in a prospectus or oral communication. Liability extends to sellers and any persons who successfully solicit the purchase of a security and are motivated at least in part by a desire to serve their own financial interests or those of the securities owner. Pinter v. Dahl, 486 U.S. 622 (1988). Investors should be aware that the liability under Section 12(a)(2) does not reach secondary trading or initial offerings that are made by means other than by use of a statutory prospectus. Gustafson v. Alloyd, 513 U.S. 561 (1995). Defendants also may avoid liability by showing that they did not know, and in the exercise of reasonable care, could not have known of the alleged untruth or omission.

 

THE SECURITIES EXCHANGE ACT OF 1934

Congress passed the Securities Exchange Act of 1934 (the “1934 Act”) to regulate the secondary trading of securities. The text of the 1934 Act is here: http://www.sec.gov/about/laws/sea34.pdf. The 1934 Act established the SEC as well, which is responsible for administering The Securities Act of 1933. The provisions of the 1934 Act are enforced by the SEC and by private causes of action. Several notable private causes of action include those under Section 9(e), Section 16(b), and Section 18. The 1934 Act also contains a catchall antifraud measure in Section 10(b) under which the judiciary has implied a private right of action.

• Section 9. Market Manipulation

Section 9 is designed to prevent the rigging of markets and to create a market in which prices are established by the free and honest interplay between investment demand and investment supply. Thus, Section 9(e) makes it unlawful for any person to willfully engage in market manipulation of securities on registered stock exchanges. Manipulation includes the purchase or sale of stock with the knowledge that others are taking the other side of the transaction with the purpose of affecting stock prices, the sale and purchase of the same securities to give the appearance of an active market, the use of devices to fix stock prices, the dissemination of information by broker-dealers and others designed to affect stock prices, and abuses involving the trading of options to buy and sell securities. Any person who buys or sells a security at a price affected by the act or transaction may sue. 15 U.S.C. § 78i.

To prevail under Section 9, plaintiffs must show that they were damaged as a result of their (1) purchase or sale of a security, (2) registered on a national securities exchange, (3) at a price affected by, (4) an act or transaction in violation of Section 9(a) through (c), in which, (5) the defendant willfully participates. In terms of damages, plaintiffs are entitled to recover damages sustained as a result of the challenged misstatement or omission. 15 U.S.C. § 78i(e).

• Section 16(b). Recovering Short-Swing Profits from Insider Trading

To discourage officers, directors, and certain shareholders from using their positions to obtain information not available to others and then profit from it, Congress enacted Section 16(b). Section 16(b) allows a company to recover profits realized from short-swing trading in its stock by the issuer’s officers, directors, and those shareholders with more than 10% of the company. All that is necessary to recover under Section 16(b) is a showing that the defendant engaged in a sale transaction and a purchase transaction in a six-month period and that he or she realized a profit.

Section 16(b) provides in full: 
 Profits from purchase and sale of security within six months
For the purpose of preventing the unfair use of information which may have been obtained by such beneficial owner, director, or officer by reason of his relationship to the issuer, any profit realized by him from any purchase and sale, or any sale and purchase, of any equity security of such issuer (other than an exempted security) or a security-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act) involving any such equity security within any period of less than six months, unless such security or security- based swap agreement was acquired in good faith in connection with a debt previously contracted, shall inure to and be recoverable by the issuer, irrespective of any intention on the part of such beneficial owner, director, or officer in entering into such transaction of holding the security or security-based swap agreement purchased or of not repurchasing the security or security-based swap agreement sold for a period exceeding six months. Suit to recover such profit may be instituted at law or in equity in any court of competent jurisdiction by the issuer, or by the owner of any security of the issuer in the name and in behalf of the issuer if the issuer shall fail or refuse to bring such suit within sixty days after request or shall fail diligently to prosecute the same thereafter; but no such suit shall be brought more than two years after the date such profit was realized. This subsection shall not be construed to cover any transaction where such beneficial owner was not such both at the time of the purchase and sale, or the sale and purchase, of the security or security based swap agreement (as defined in section 206B of the Gramm-Leach Bliley Act) involved, or any transaction or transactions which the Commission by rules and regulations may exempt as not comprehended within the purpose of this subsection.
15 U.S.C. § 78p.

 
• Section 18. Fraud in Documents Filed with the SEC

Section 18 provides that any person who makes or causes to be made a materially false or misleading statement to be filed with the SEC shall be liable to any person who relied upon this statement in buying or selling a security at a price that was affected by the statement. 

Section 18 states: 
 Liability for Misleading Statements.
(a) Persons liable; persons entitled to recover; defense of good faith; suit at law or in equity; costs, etc.
Any person who shall make or cause to be made any statement in any application, report, or document filed pursuant to this chapter or any rule or regulation thereunder or any undertaking contained in a registration statement as provided in subsection (d) of section 78o of this title, which statement was at the time and in the light of the circumstances under which it was made false or misleading with respect to any material fact, shall be liable to any person (not knowing that such statement was false or misleading) who, in reliance upon such statement, shall have purchased or sold a security at a price which was affected by such statement, for damages caused by such reliance, unless the person sued shall prove that he acted in good faith and had no knowledge that such statement was false or misleading. A person seeking to enforce such liability may sue at law or in equity in any court of competent jurisdiction. In any such suit the court may, in its discretion, require an undertaking for the payment of the costs of such suit, and assess reasonable costs, including reasonable attorneys’ fees, against either party litigant. 
15 U.S.C. § 78r(a)

To establish a prima facie case under section 18, investors must show (1) the purchase or sale of a security (2) in actual reliance upon (3) a materially misleading report filed under the 1934 Act (4) at a price affected by the misleading report (5) from which damages caused by the reliance flowed. Under Section 18, plaintiffs can recover litigation costs, including reasonable attorneys’ fees. 15 U.S.C. § 78r(a). Under Section 18, investors cannot maintain a private right of action unless they bring suit within one year after the discovery of the facts constituting the cause of action and within three years after this cause of action accrued. 15 U.S.C. § 78r(c).

• Section 10(b) and Rule 10b-5. Fraud in the Purchase or Sale of a Security.

Section 10(b) of the 1934 Act is the most significant private right of action. It makes it unlawful for any person, directly or indirectly, to commit a fraud on the market.

Section 10(b) provides in part:
Section 10. Manipulative and Deceptive Devices.
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)  (1) To effect a short sale, or to use or employ any stop-loss order in connection with the purchase or sale, of any security registered on a national securities exchange, in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.
(2) Paragraph (1) of this subsection shall not apply to security futures products.
(b)  To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act), any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.
15 U.S.C. § 78j(b).

Section 10(b) is a catchall remedy for fraud that was designed to address abuses that escape specific prohibitions found elsewhere in the securities laws. Section 10(b) does not by itself make anything unlawful unless the SEC adopts a rule prohibiting it. Thus, the SEC adopted Rule 10b-5, which broadly prohibits making any untrue statement of a material fact in connection with the purchase or sale of securities.

Rule 10b-5 states in full:
Rule 10b-5. Employment of Manipulative and Deceptive Devices.
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.
17 C.F.R. § 240.10b-5. 
When we deal with private actions under Rule 10b-5, we deal with a judicial oak which has grown from little more than a legislative acorn. Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 737 (1975).

The judiciary has implied a private right of action under Section 10(b) and Rule 10b-5, making Section 10(b) and Rule 10b-5 the most potent antifraud measure of the securities laws. The majority of securities fraud claims are brought under Section 10(b) and SEC Rule 10b-5.

To sustain a claim for a Rule 10b-5 violation, plaintiffs must allege and prove:  (1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.

Investors should be aware of certain limits to the private right of action under Rule 10b-5. First, plaintiffs must bring suit within 2 years of discovering the violation or 5 years of the violation. 28 U.S.C. § 1658(b). A plaintiff “discovers” a violation once the plaintiff actually discovers the facts constituting the violation or when a reasonably diligent plaintiff would have discovered the facts constituting the violation—whichever comes first. Second, the Supreme Court held in Morrison v. National Australia Bank, 130 S. Ct. 2869 (2010), that the private right of action under Section 10(b) and Rule 10b-5 applies only to transactions in securities listed on domestic exchanges and domestic transactions in other securities. Third, under Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011), Rule 10b-5(b), only persons who control the content and dissemination of publicly misleading statements can be liable. 

• Section 20(a)

Plaintiffs may bring a private right of action against a person for controlling another who violates the securities laws. Any person who controls a person is jointly and severally liable with the controlled person. 15 U.S.C. § 78. Section 20(a) makes it unlawful for any person to do indirectly through another person, what he or she cannot do directly. 15 U.S.C. § 78t(b). The controlling person may prevent liability, however, by showing that the he or she acted in good faith and did not induce the primary violation. 15 U.S.C. § 78t.

Section 20(a) states that “Every person who, directly or indirectly, controls any person liable under any provision of this title or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable, unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action.” 15 U.S.C. § 78t(a).

 

THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

In the 1990s Wall Street and Congress perceived a threat to the stability of American financial markets from what Congress perceived to be frivolous investor suits. In response, Congress passed the Private Securities Litigation Reform Act (“PSLRA”) of 1995. Through the enactment of the PSLRA, Congress sought to encourage the voluntary disclosure of information by corporate issuers, empower investors rather than lawyers, and encourage plaintiffs’ lawyers to pursue only merited claims. The PSLRA dramatically changed the way a securities fraud class action is litigated. According to some accounts, the PSLRA more than doubled the dismissal rate of securities fraud cases. The major changes wrought by the PSLRA are discussed below.

Generally, under the Federal Rules of Civil Procedure 8, plaintiffs must plead only a short and plain statement of the claim, and for fraud under Rule 9, plaintiffs must state with particularity the circumstances constituting fraud or mistake but state of mind can be alleged generally. One of the most powerful reforms in the PSLRA is its heightened pleading requirement. Under the PSLRA, plaintiffs must plead with particularity a strong inference that the defendant acted with scienter.

The heightened pleading provision states as follows: 
 (1) Misleading statements and omissions 
In any private action arising under this chapter in which the plaintiff alleges that the defendant—
(A) made an untrue statement of a material fact; or 
(B) omitted to state a material fact necessary in order to make the statements made, in the light of the circumstances in which they were made, not misleading; 
the complaint shall specify 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.
 (2) Required state of mind 
In any private action arising under this chapter in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, 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)(1)-(2). 
  

 

To judges raised on notice pleading, the idea of drawing a “strong inference” from factual allegations is mysterious. Makor Issues & Rights, Ltd. v. Tellabs Inc., 513 F.3d 702, 705 (7th Cir. 2008).

To allege facts with particularity, plaintiffs should allege the who, what, where, and how of the fraud. Alleging a strong inference of scienter (the defendant’s culpable state of mind) is a more difficult task. According to the federal courts of appeals, scienter means either that the defendant intentionally set out to defraud investors or the defendant acted recklessly when making misleading statements. To determine recklessness, courts will generally consider the materiality of the facts misrepresented. If the facts are material, there is likely a strong inference that senior-level management either knew the truth, or was reckless in failing to know the truth or reckless in speaking about a material fact without knowing the truth. This can be further refined to include an assessment of the (1) magnitude of the fraud, (2) the proximity of the misleading statements to the revelation of the fraud, and (3) the atypicality of the facts alleged such that the defendant should have been aware of them.

 

• The Stay of Discovery

Ordinarily discovery proceeds despite a motion to dismiss. When Congress passed the PSLRA, Congress was concerned that the cost of discovery often forced innocent parties to settle securities class actions. In response to these abuses, Congress provided that courts must stay all discovery pending any motion to dismiss, including any discovery in a state court proceeding that will influence the federal litigation. The PSLRA does explicitly provide that during the stay a party with actual notice of the allegations must treat all discoverable evidence within that party’s control as if it were subject to a continuing request for production of documents under the Federal Rules. 

At times plaintiffs may except their discovery requests from the PSLRA’s stay. The PSLRA provides an exception if the court finds that particularized discovery is necessary to either (1) preserve evidence;  or (2) prevent undue prejudice to that party.

The PSLRA states: 
 (3) Motion to dismiss; stay of discovery 
. . . 
(B) Stay of discovery
In any private action arising under this chapter, all discovery and other proceedings shall be stayed during the pendency of any motion to dismiss, unless the court finds upon the motion of any party that particularized discovery is necessary to preserve evidence or to prevent undue prejudice to that party.
(C) Preservation of evidence
(i) In general During the pendency of any stay of discovery pursuant to this paragraph, unless otherwise ordered by the court, any party to the action with actual notice of the allegations contained in the complaint shall treat all documents, data compilations (including electronically recorded or stored data), and tangible objects that are in the custody or control of such person and that are relevant to the allegations, as if they were the subject of a continuing request for production of documents from an opposing party under the Federal Rules of Civil Procedure.
(ii) Sanction for willful violation A party aggrieved by the willful failure of an opposing party to comply with clause (i) may apply to the court for an order awarding appropriate sanctions.
(D) Circumvention of stay of discovery
Upon a proper showing, a court may stay discovery proceedings in any private action in a State court, as necessary in aid of its jurisdiction, or to protect or effectuate its judgments, in an action subject to a stay of discovery pursuant to this paragraph.
15 U.S.C. § 78u-4(b)(3).

Under the Federal Rules of Civil Procedure 11, attorneys must, among other things, not present any filing for an improper purpose (such as to harass, cause unnecessary delay, or needlessly increase the cost of litigation); they must ensure that their claims, defenses, and legal contentions are nonfrivolous; the y must ensure that their factual contentions have evidentiary support. In securities fraud litigation, courts must make specific findings as to the compliance by all parties and attorneys with Rule 11. Congress felt that Rule 11 did not deter abusive securities litigation, and that courts did not impose sanctions even when they were warranted.  In addition, Congress worried that when Rule 11 sanctions were imposed, they did not make the victim whole because the amount of sanctions allowed under Rule 11 is limited to the amount necessary for deterrence, but courts were unable to apply Rule 11 to compensate the victim for all attorney’s fees and costs incurred in defending against the frivolous claim.

To strengthen Rule 11 in the private securities litigation context, Congress required courts to include in the record specific findings, at the conclusion of the trial, whether the parties and their attorneys complied with the requirements of Rule 11(b). 15 U.S.C. § 78u-4(c). If the court determines that there is a “substantial failure” of the parties to comply with Rule 11(b)’s provisions, the court is directed to impose sanctions in accordance with Rule 11.

One of the most controversial provisions of the PSLRA is the “safe harbor” that is afforded to forward-looking statements. Many expressed concern that this provision would provide immunity to those who made intentionally fraudulent forward-looking statements. To encourage issuers and registrants to make forward-looking statements about the company’s prospects, the PSLRA provides a “safe harbor” for these statements so long as they are accompanied by meaningful cautionary language. 15 U.S.C. § 78u-5. Generally, a forward-looking statement includes: (1) a statement containing a projection of revenue, earnings per share, capital expenditures, dividends, and other financial items; (2) a statement of the plans and objectives of management in future operations; (3) a statement of future economic performance; and (4) a statement of the assumption underlying the statements described here. Forward-looking statements do not include forward-looking statements (1) in financial statements prepared in accordance with generally accepted accounting principles; (2) in an initial public offering registration statement; (3) in connection with a tender offer; (4) in connection with a partnership, limited liability company or direct-participation offering; and (5) in a beneficial ownership disclosure statement filed with the SEC.

The safe harbor provision protects written and oral forward-looking statements made by issuers, persons retained or acting on behalf of issuers, and underwriters to the extent they provide forward-looking information derived from information provided by the issuer. Brokers do not enjoy a safe harbor for their forward-looking statements.

Ordinarily, under Federal Rule of Civil Procedure 23, one may act as lead plaintiff so long as that person adequately represents the class. To encourage that the most capable plaintiffs to participate in securities fraud class action litigation and to supervise and control the lawyers for the class, Congress changed the standard for selecting and appointing the lead plaintiff. The PSLRA establishes a two-step process for selecting a lead plaintiff. First, the court must identify the presumptive lead plaintiff, and second, the court must then determine whether any member of the class has rebutted the presumption.

Under the first step, the court identifies the presumptive lead plaintiff. Under the PSLRA, the movant with the largest financial interest in the relief sought by the class is the presumptive lead plaintiff. The main effect of this provision has been to increase the likelihood that institutional investors will act as lead plaintiffs. To determine who has the largest financial interest, courts consider the number of shares the movant bought during the class period, the total net funds expended by the plaintiffs during the class period, and the approximate losses suffered by the plaintiffs.

Once the court identifies the presumptive lead plaintiff, the court then asks whether the presumption has been rebutted. Only class members may rebut the presumption, and the court does not consider any arguments by defendants or non-class members. Once the presumption is triggered, to rebut the presumption one must prove that the presumptive lead plaintiff will not do a fair and adequate job. To make this showing, a movant must show that the presumptive lead plaintiff either will not fairly and adequately protect the interests of the class or is subject to unique defenses that render the presumptive lead plaintiff incapable of adequately representing the class.

 

This publication requirement is usually satisfied when the plaintiff issues a press release on, for example,Business Wire or Globe Newswire. The description of the claims must be consistent with the allegations in the complaint; otherwise, courts may order plaintiffs to resend notice.

Under the PSLRA, not later than 20 days after the date on which the complaint is filed, the plaintiff must publish, in a widely circulated national business-oriented publication or wire service, a notice advising members of the purported plaintiff class (1) of the pendency of the action, the claims asserted therein, and the purported class period; and (2) that, not later than 60 days after the date on which the notice is published, any member of the purported class may move the court to serve as lead plaintiff of the purported class. 15 U.S.C. § 78u-4(a)(3)(A).

 

The PSLRA states:
 (i) In general
Not later than 20 days after the date on which the complaint is filed, the plaintiff or plaintiffs shall cause to be published, in a widely circulated national business-oriented publication or wire service, a notice advising members of the purported plaintiff class--
(I) of the pendency of the action, the claims asserted therein, and the purported class period; and
(II) that, not later than 60 days after the date on which the notice is published, any member of the purported class may move the court to serve as lead plaintiff of the purported class.
 (ii) Multiple actions
If more than one action on behalf of a class asserting substantially the same claim or claims arising under this chapter is filed, only the plaintiff or plaintiffs in the first filed action shall be required to cause notice to be published in accordance with clause (i).
 (iii) Additional notices may be required under Federal rules
Notice required under clause (i) shall be in addition to any notice required pursuant to the Federal Rules of Civil Procedure. 
15 U.S.C. § 78u-4(a)(3)(A). 

• Joint and Several Liability vs. “Fair Share” Liability

Generally, courts can impose liability on one party for injury caused by another, referred to as joint and several liability. Under the PSLRA, however, a defendant’s liability is limited to the defendant’s percentage of responsibility, or the “fair share.” If a defendant knowingly makes a material misrepresentation or omission with actual knowledge that the information is false, then the defendant is subject to joint and several liability. 15 U.S.C. § 78u-4(f)(2). The PSLRA also codified defendants’ right of contribution. 15 U.S.C. § 78u-4(f)(5).

There are two key exceptions to the “fair share” rule, however. First, all defendants are jointly and severally liable if the plaintiff is entitled to damages exceeding 10 percent of his net worth and his net worth is less than $200,000. 15 U.S.C. § 78u-4(f)(4). Second, if the defendant cannot pay his allocable share because of insolvency, then each defendant must pay an additional amount up to 50 percent of their own liability. 15 U.S.C. § 78u-4(f)(4).

• The Damages Cap

Under the PSLRA, the measure of damages may not exceed the difference between the transaction price and the “mean” trading price of the security within the 90-day period following the date on which the misstated or omitted fact is disclosed to the market. The “mean” trading price of the security is the average of the closing prices of the security throughout the 90-day post-disclosure period. If the plaintiff sells or repurchases the security before the expiration of the 90-day post-disclosure period, damages are measured as the difference between the transaction price and the mean trading price in the post-disclosure period ending on the date of sale or repurchase.

The PSLRA provides:
    (e) Limitation on damages
(1) In general
Except as provided in paragraph (2), in any private action arising under this chapter in which the plaintiff seeks to establish damages by reference to the market price of a security, the award of damages to the plaintiff shall not exceed the difference between the purchase or sale price paid or received, as appropriate, by the plaintiff for the subject security and the mean trading price of that security during the 90-day period beginning on the date on which the information correcting the misstatement or omission that is the basis for the action is disseminated to the market.
(2) Exception
In any private action arising under this chapter in which the plaintiff seeks to establish damages by reference to the market price of a security, if the plaintiff sells or repurchases the subject security prior to the expiration of the 90-day period described in paragraph (1), the plaintiff’s damages shall not exceed the difference between the purchase or sale price paid or received, as appropriate, by the plaintiff for the security and the mean trading price of the security during the period beginning immediately after dissemination of information correcting the misstatement or omission and ending on the date on which the plaintiff sells or repurchases the security.
(3) “Mean trading price” defined
For purposes of this subsection, the “mean trading price” of a security shall be an average of the daily trading price of that security, determined as of the close of the market each day during the 90-day period referred to in paragraph (1).
15 U.S.C. § 78u-4(e). 

THE SECURITIES LITIGATION REFORM ACT OF 1998 

 

The effort to deter or at least quickly dispose of those suits whose nuisance value outweighs their merits placed special burdens on plaintiffs seeking to bring federal securities fraud class actions. But the effort also had an unintended consequence: It prompted at least some members of the plaintiffs' bar to avoid the federal forum altogether. Rather than face the obstacles set in their path by the Reform Act, plaintiffs and their representatives began bringing class actions under state law, often in state court. . . . To stem this shift from Federal to State courts and prevent certain State private securities class action lawsuits alleging fraud from being used to frustrate the objectives of the Reform Act, Congress enacted SLUSA.
Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 U.S. 71, 82 (2006) (internal quotation omitted). 

The PSLRA proved deficient, however, and while the filing rate for securities class actions declined in federal court, the decline was because plaintiffs were now filing in state court. Plaintiffs were merely substituting federal court for the more favorable state court forum.  So in 1998, as a supplement to the PSLRA, Congress enacted the Securities Litigation Uniform Standards Act  (“SLUSA”) that made federal court the exclusive venue for class actions alleging fraud in the sale of certain securities. The text of SLUSA is here: http://thomas.loc.gov/cgi-bin/bdquery/z?d105:S1260.

 

 

THE INVESTMENT COMPANY ACT OF 1940

Congress passed the Investment Company Act of 1940 to regulate the growing number of investment companies and mutual funds. See 15 U.S.C. § 80a-1. The explosive growth of mutual funds in the 1950s and 1960s caused Congress to commission studies to evaluate the Act’s effectiveness in protecting investors. These studies, however, indicated that investment company boards sometimes inappropriately influenced the compensation received by investment advisers. So Congress amended the Investment Company Act of 1940 in 1970 to address the independence of mutual fund boards of directors. Although the emphasis of the securities laws is on disclosure, Congress’s focus in the Investment Company Act was regulatory and remedial. First, Congress required that no more than 60% of a fund’s directors be “interested persons,” meaning that these persons must have no affiliation with the fund’s investment adviser. 15 U.S.C. §§ 80a-2(a)(19), 10(a). These “disinterested” board members serve as independent watch dogs who supply an independent check upon the management. Burks v. Lasker, 441 U.S. 471, 484 (1979). Second, Congress also adopted Section 36(b) of the Investment Company Act, which imposed upon mutual fund advisers a “fiduciary duty” with respect to compensation received from the mutual fund, and Congress granted a private right of action to investors for breach of this duty. 15 U.S.C. § 80a-35(b).

Investors should be aware of several limits of the private cause of action for excessive management fees. First, Section 36(b) claims are limited to breaches of fiduciary duty for an adviser’s receipt of compensation. Second, Section 36(b) gives private litigants a short, one-year limitations period in which to bring suit. 15 U.S.C. § 80a-35(b)(3). Third, damages are limited to the amount of fees received by the adviser in the year before. Fourth, at least one federal court of appeals has held that investors do not have a right to trial by jury under Section 36(b) because the cause of action is equitable in nature. Krinsk v. Fund Asset Management, Inc., 875 F.2d 404, 414 (2d Cir.1989). Last, litigation in excessive fee cases has resulted almost uniformly in judgments for the defendants, although sometimes investors procure settlements wherein the defendants agree to reduce their fee schedule.

 

THE SARBANES-OXLEY ACT OF 2002

In response to the collapse of Enron, WorldCom, and other corporate giants amid accusations of fraud, Congress enacted the Sarbanes-Oxley Act of 2002 to protect investors by improving the accuracy and reliability of corporate disclosures made under the securities laws. SOX did not create new causes of action, but some of the more significant reforms under SOX that affect private rights of action include certification requirements for corporate officers, an extended statute of limitations for private rights of action, protection for whistleblowers, and an exception to bankruptcy that renders damages from securities law violations nondischargeable.

• Certification Requirements

Sections 302 and 906 of SOX require CEOs and CFOs of public companies to certify that period reports filed with the SEC fully comply with the securities laws. These certifications are significant in that they should help plaintiffs establish deliberate recklessness, or the defendant’s state of mind. Section 302 in particular requires CEOs and CFOs to certify in each annual and quarterly report filed under the 1934 Act that: (1)the officer has reviewed the report; (2) based on the officer’s knowledge, the report does not contain any untrue statement of material fact or omit to state a material fact necessary to make the statements not misleading; (3) based on the officer’s knowledge, the financial statements and other information fairly present in all material respects the financial condition and results of operations of the company. Also under Section 302, these officers must establish, maintain and evaluate internal controls to ensure that material information relating to the company is prepared, and that if there are any significant deficiencies in these internal controls, these deficiencies are disclosed to the company’s auditors and audit committee.

• The Statute of Limitations for the Private Right of Action under Section 10(b)

Section 804(b) of SOX extended the statue of limitations for private rights of action for securities fraud claims to the earlier of two years after discovery of the violation or five years after the occurrence of the violation. The earlier statute of limitations was one year from the date of discovery and in no event later than three years from the fraud violation itself.

Section 804(b) of SOX states: 
A private right of action that involves a claim of fraud, deceit, manipulation, or contrivance in contravention of a regulatory requirement concerning the securities laws, as defined in Section 3(a)(47) of the Securities Exchange Act of 1934, may be brought not later than the earlier of 2 years after the discovery of the facts constituting the violation or five years after such violation.

 

This extension is significant for two reasons: First, a longer window of opportunity in which a securities violator can be caught increases the deterrent effect of the securities laws. Second, a longer time to bring suit gives plaintiffs more time to try to meet the PSLRA’s heightened pleading requirements.

• Whistleblower Protection.

Section 806 of SOX prohibits public companies and their agents from discriminating against employees who provide information or assist in an investigation or participate in actions regarding violations of securities laws or fraud. This Section states that a company cannot “discharge, demote, suspend, threaten, harass, or in any other manner discriminate” against a whistleblower. Section 1107 also imposes fines and imprisonment against anyone who knowingly, with the intent to retaliate, takes any harmful action against a person who provided information regarding the possible violation of the securities laws. SOX even requires a channel for anonymous whistleblowing. Under Section 301 of SOX, audit committees must establish whistleblowing procedures that enable employees to anonymously submit issues of concern regarding questionable accounting or auditing matters. The scope of whistleblower protection is broad: it covers current and former employees, and applicants. SOX prohibits retaliation by not only the company, but also its agents, who may include contractors and subcontractors.

If a company retaliates against a whistleblower, that whistleblower may file a complaint with the Secretary of Labor. If the agency does not render a decision within 180 days, the whistleblower can bring a private civil suit against the company. Originally, a whistleblower had 90 days to file the complaint with the Secretary of Labor, but the Dodd-Frank Act extended this time to 180 days.

The U.S. Department of Labor provides an excellent guide to filing whistleblower complaints under SOX:http://www.osha.gov/Publications/osha-factsheet-sox-act.pdf.

• Nondischargeable Damages

In the past, defendants in securities fraud cases could file for bankruptcy protection from securities fraud judgments. This would relieve them of their obligation to satisfy debts incurred as a result of liability. Thus, Section 803 of SOX recognized that this bankruptcy protection was preventing plaintiffs from collecting their due remedy incurred as a result of securities fraud. Section 803 of the Act amended the bankruptcy code to prevent the use of bankruptcy to avoid liability incurred as a result of the securities laws. Section 803 adds 11 U.S.C. §523(a)(19) to prohibit defendants from discharging debts that are for the violation of the federal securities laws or common-law fraud in connection with the purchase or sale of a security.

 

THE DODD-FRANK WALL-STREET REFORM AND CONSUMER PROTECTION ACT

In 2010 Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, the most sweeping change to financial regulation since the 1933 and 1934 Acts.  (available here:http://www.gpo.gov/fdsys/pkg/PLAW-111publ203/content-detail.html.)  The Act requires 243 new rules and 67 studies. Many of these changes directly affect protection afforded to investors under the securities laws. Some of the more significant reforms instituted by the Dodd-Frank Act include the establishment of a new government agency charged with protecting consumers from deceptive trade practices, an extended private right of action against credit ratings agencies, enhanced whistleblower protection, and new executive compensation “clawback” rules.

• The Consumer Financial Protection Bureau

The Dodd-Frank Act established the Consumer Financial Protection Bureau (“CFCB”). The CFCB supervises banks, credit unions, and other financial institutions. The agency aims to make markets for consumer financial products and services work for Americans—whether they are applying for a mortgage, choosing among credit cards, or using any number of other consumer financial products. The agency protects consumers from hidden fees, abusive terms, and deceptive trade practices. This is an ostensibly independent government agency, housed within the Federal Reserve. Whether the CFCB will play an essential role in protecting investors from deceptive practices involving securities, or mortgage- or asset-backed securities, remains to be seen. The CFCB’s website is here: http://www.consumerfinance.gov/.

• The Private Right of Action Against Credit Ratings Agencies

Credit ratings agencies generally act as gatekeepers to financial markets. By providing assessments of the creditworthiness of financial instruments, credit ratings agencies can greatly affect the value of a particular security. Section 933 of the Dodd-Frank Act provides that statements by credit ratings agencies are subject to the same restrictions under the securities laws as registered public accounting firms and securities analysts. In other words, Section 933 expands the potential scope of liability for credit ratings agencies. For example, Section 933 likely affords investors a private right of action under Section 18 of the 1934 Act against credit ratings agencies. Second,

• Enhanced Whistleblower Protection

The Dodd-Frank Act provides substantial incentives and protections to whistleblowers who report securities laws violations to regulators. First, Section 922(a) provides that, where information provided by a whistleblower leads to an SEC enforcement action that results in a monetary sanction of more than $1 million, the SEC must pay that person a bounty of between 10 and 30 percent of the sanction amount. To receive a bounty, the whistleblower must voluntarily provide “original information” based on the whistleblower’s independent knowledge or analysis that leads to a successful enforcement action. Second, Section 922(a) also provides whistleblowers a private right of action against employers who retaliate for double back-pay with interest, reinstatement, litigation fees, and other relief. Whistleblowers have six years (sometimes more) to bring a retaliation claim. They may bring a retaliation claim even if their tip does not result in a successful government action.

• The Executive Compensation “Clawback” Rules

Section 954 of the Dodd-Frank Act requires all companies listed with national exchanges to enact “clawback” policies to recover any incentive-based compensation (including stock options) from current or former executive officers for the prior three years in the event of a financial  restatement because of material noncompliance with any financial reporting requirement under the securities laws. Recovery is limited to the difference between the incentive-based compensation received and what should have been received under the restated financial results. This provision is enforceable by the SEC and by private right of action in derivative cases if the company does not seek clawback relief.

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