The Private Securities Litigation Reform Act of 1995

By Edward J. Boyle and Fred N. Knopf

In overriding President Clinton's veto and passing the Reform Act, Congress has provided welcome relief to a number of groups, including the accounting profession. However, the measure of relief is not as great as it started out to be and there are a number of unanswered questions that courts will have to decide in the future.

Tort Reform" was the battle cry of the 1980s. "Litigation Reform"-- much the same thing--is the mantra of the 1990s.

According to many news reports, the litigation reformers recently won a major battle. In late December 1995, both houses of Congress voted to override President Clinton's unexpected veto of the Private Securities Litigation Reform Act of 1995 (the Reform Act). This legislation, supported by numerous industry groups (including the AICPA), in theory, should limit abusive class action and securities laws litigation in a variety of ways helpful to the accounting profession.

In practical effect, however, because it was born out of legislative compromise, the Reform Act may not turn out to be a panacea for Federal securities litigation reform. Because the Reform Act is littered with ambiguous phraseology and exceptions that sometimes swallow the rule, the only thing certain for now is that several years of litigation will occur over the meaning of concepts and terms.

Summary of the Reform Act

Setting aside for the sake of analysis the pros and cons prognosticators have placed on the new law, as written, the Reform Act should serve as a powerful shield to accountants caught up as "peripheral defendants" in shareholder suits. By way of summary, relevant to the accounting profession, the law--

* modifies the "joint and several" liability doctrine for peripheral defendants, and establishes proportionate liability except in cases where defendants engage in "knowing" securities fraud.

* creates a safe harbor for forward-looking corporate statements that encourages the voluntary disclosure of more information to investors.

* codifies scienter (or intent) pleading and proof requirements and strengthens the rule of "loss causation."

* prevents abusive practices by eliminating bounty payments to plaintiffs, banning payment of plaintiff referral fees, and limiting "profession plaintiffs" to five class actions every three years.

* prohibits the Racketeer Influenced and Corrupt Organizations Act ("RICO") from being used in civil cases involving securities fraud.

* adds an AICPA-backed provision that expands auditors' responsibilities in reporting and detecting fraud by basically codifying existing auditing literature.

Class action and securities plaintiffs also enjoy certain benefits under the Reform Act that better protect their personal financial and litigation interests. Here, the law--

* gets more money recovered in a lawsuit to legitimate investors by limiting attorney's fees to a "reasonable" amount of the recovery. Currently, investors receive only 7 to 14 cents on the dollar.

* prohibits defendants from destroying documents and computer records once a complaint is filed.

Finally, it bears noting at the outset that the Reform Act does not apply to already-pending litigation, and became effective at the end of December 1995.

History of the Reform Act

The final version of the Reform Act is a dramatic departure from the original House of Representatives' proposal, which was part of the Republican "Contract with America." As originally proposed, the law would have effectively eliminated securities class actions with provisions that included requiring losing plaintiffs to pay all costs, giving complete protection to forward-looking statements, and requiring plaintiffs to prove a company made a fraudulent statement and that they relied on that statement when making the investment. This legislation was vigorously opposed by many consumer organizations and members of the plaintiff's bar.

At the same time, a more moderate Senate bill was being negotiated. Versions of this bill actually had been proposed for the past few years by its sponsors, Senators Dodd (D-CT) and Domenici (R-NM). The final text of the Reform Act contains arguably the best common elements of both the House and Senate bills.

Specific Provisions

As noted above, the primary purpose of the Reform Act is to curb the abusive practices that have developed in class action securities suits. These lawsuits tend to involve anyone who had any involvement, whether centrally or tangentially, with the underlying business entity, particularly the entity's accountants. Accountants are drawn into these matters due to the perception they are "deep pocket" defendants, capable of withstanding large damages awards.

Joint and Several Liability. Most significantly to the profession, the Reform Act provides for joint and several liability for defendants engaged in "knowing fraud" and proportionate liability for reckless behavior. In the past, solvent defendants, including accountants, were strapped with the burden of damage awards when the principal participants were judgment proof or otherwise non-responsive. Now, damages payable by "peripheral defendants," such as accountants, are limited to that amount determined to be directly attributable to the peripheral defendants' fault.

Professionals should not be fooled, however, by reports that the Reform Act does away with joint and several liability and imposes a rule where each defendant only pays its own share of the loss. Although original drafts of the law almost did away with joint and several liability, as enacted, the Reform Act includes numerous compromises that limit the impact and applicability of the new system of determining liability, which is called "proportionate liability."

Akin to the changes involving joint and several liability, the Reform Act also contains approximately 40 parts and subparts that address the effect of settlements. Here, however, for each provision potentially reducing liability of "deep pocket" defendants, another provision softens the impact of the change.

Under general principles of joint and several liability in Federal securities litigation, a plaintiff may elect to collect its full loss from the defendant with the deepest pocket, whether or not that defendant is in any sense the most serious wrongdoer. The comparatively innocent defendant then bears the burden of seeking contribution against the other "more culpable" defendants. In practice, the most serious wrongdoers often turn out to be judgment-proof, with the result that, in at least some cases, parties with low levels of culpability, like accountants, bear a large share of the loss. The Reform Act replaces this system with what is called a "fair share" system of proportionate liability.

Section 201 of the Reform Act sets forth the new rules of proportionate liability, which apply to claims under the Securities Exchange Act of 1934 and to claims against "outside directors" under Section 11 of the Securities Act of 1933. If there is a specific finding that a defendant "knowingly committed a violation of the securities laws," that defendant remains jointly and severally liable for the plaintiff's damages. Otherwise, a defendant accountant will now be liable "solely for the portion of the judgment that corresponds to [his or her] percentage of responsibility."

Under the new procedure, the "trier of fact"--either a judge or jury--will determine the percentage of responsibility, not only as to those named defendants present at trial, but also as to any settling parties, and to any other persons claimed by any of the parties to have caused or contributed to the plaintiff's damages.

The Reform Act then explains how the risk of insolvent defendants is shared among the plaintiff and solvent defendants. Here, defendants not found to be knowing violators may be held responsible for part of the uncollectible damages, up to a limit of an additional 50% of their proportionate share of liability. In addition, if a plaintiff establishes that (i) its recoverable damages are at least 10% of its net worth, and (ii) its net worth is less than $200,000, then all defendants will be jointly and severally liable for the uncollectible share.

Separately, the Reform Act also contains provisions on how to treat the percentage of fault attributed to a defendant who settles before trial. The new law adopts the "capped" proportionate share claim reduction approach to partial settlements. Any judgment against a nonsettling defendant(s) shall be reduced by the greater of (i) an amount that corresponds to the responsibility of the settling defendant; or (ii) the amount actually paid to the plaintiff by the settling defendant.

It is expected plaintiffs will likely respond to these changes by focusing more on available state law claims. Most states have some combination of common law fraud claims, "blue sky" laws, state RICO statutes, and other statutory and common law claims that come without the baggage of many of the new Federal restrictions.

Safe Harbor. It has been observed for the past decade that fledgling companies have drawn back from issuing predictive/forward-looking statements because these statements have become the basis of numerous actions asserting that the new company has failed to meet the "expectations" of the predictive statement. The predictive statement is alleged to have been negligently or recklessly prepared, or part of a fraudulent scheme between the company and the accountant that rendered an opinion on such statement.

Many firms ceased or severely limited their engagements to provide opinions on predictive statements. The Reform Act provides a "safe harbor" for predictive statements so that an accounting firm will not be held liable for the statement to the extent it contains projections, estimates or describes future events, and clearly makes reference to the estimations and the risks of nonrealization.

The core provision in the safe harbor provides as follows:

Except as provided in subsection (b), in any private action arising under this title that is based on an untrue statement of a material fact or omission of a material fact necessary to make the statement not misleading, a person referred to in subsection (a) shall not be liable with respect to any forward-looking statement, whether written or oral, if and to the extent that--

(A) the forward-looking statement is--

(i) identified as a forward-looking statement, and is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement; or

(ii) immaterial; or

(B) the plaintiff fails to prove that the forward-looking statement--

(i) if made by a natural person, was made with actual knowledge by that person that the statement was false or misleading; or

(ii) if made by a business entity, was--

(i) made by or with the approval of an executive officer of that entity; and

(ii) made or approved by such officer with actual knowledge by that officer that the statement was false or misleading.

This safe harbor provision actually has two parts. First, subsection "A" of the safe harbor precludes liability for an oral or written forward-looking statement if the statement is either identified as forward-looking and is accompanied by "meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those" in the statement or is otherwise "immaterial."

Second, under subsection "B," if the plaintiff fails to prove the statement was made with knowledge that it was false or misleading, there is no liability. If the statement was made by a business entity, there is no liability unless it was made or approved by an executive officer of the entity with actual knowledge that the statement was false or misleading.

As written, subsection "A" will be judicially tested as being ambiguous and will result in litigation to define or clarify its interpretation and application. For example, while subsection "B" says that actual knowledge is required, subsection "A" is unclear as to whether some level of knowledge must be established. Also, the legislation provides no guidance with respect to the meaning of the phrase "meaningful cautionary statements identifying important factors that could cause results to differ materially." Because this key language is undefined, no one can readily predict whether the safe harbor will actually reduce litigation concerning forward-looking statements. The legislation will ultimately reduce exposure associated with forward-looking statements.

The safe harbor also contains several significant limitations. First, it applies only to issuers subject to reporting requirements under sections 13(a) and 15(d) of the 1934 Act, persons acting on behalf of issuers, and underwriters with respect to information provided by, or derived from, issuers.

Second, the safe harbor excludes forward-looking statements that are (1) included in financial statements prepared in accordance with generally accepted accounting principles; (2) made in connection with a tender offer; (3) made in connection with a partnership, limited liability company or direct participation program offering; (4) made in connection with an initial public offering; or (5) made in beneficial ownership disclosure statements filed with the SEC under section 13(d) of the 1934 Act.

Third, the safe harbor does not extend to a forward-looking statement where (1) the issuer had been convicted of certain felonies or misdemeanors or was the subject of a decree or order involving a violation of the securities laws during the three-year period preceding the date on which the statement was first made; (2) the statement is made in connection with an offering of securities by a "blank check" company, a "rollup" transaction, or a "going private" transaction; or (3) the issuer issues penny stock.

The Reform Act also contains certain technical provisions intended to streamline the litigation of cases involving forward-looking statements. The legislation generally provides rules for the substantive interpretation of statements in connection with motions to dismiss and motions for summary judgment, as well as a stay of discovery during the pendency of these motions.

Finally, the safe harbor provides that nothing in it "shall impose upon any person a duty to update a forward-looking statement." It is unclear, however, whether this language eliminates an affirmative duty to update or correct what may be imposed under existing law.

Scienter and Loss Causation. The Reform Act also imposes stricter pleading and proof requirements on plaintiffs for them to prevail in securities fraud actions. In particular, the Reform Act strengthens the requirement of scienter (that is, the defendant's state of mind) and loss causation. In essence, liability will only be levied on proof that the accounting defendant either directly or indirectly made the fraudulent statement, had an intent to deceive, and knowingly or recklessly made the fraudulent statement.

According to the U.S. Supreme Court, scienter, or "a mental state embracing intent to deceive, manipulate, or defraud," is a required element of an action brought under section 10(b) of the 1934 Act. A variety of lower Federal courts have said the scienter requirement can be established if a plaintiff shows "reckless" conduct, although different definitions of recklessness have been adopted. Although the Supreme Court has not recognized the recklessness standard, the Reform Act arguably dissuades a recklessness standard for scienter, thus making proof of liability more stringent. First, the safe harbor provides that plaintiffs must prove that the defendant had "actual knowledge" that a forward-looking statement was false or misleading. Second, the proportionate liability provisions impose, with exceptions, joint and several liability only on defendants who are found to have acted "knowingly." Lastly, the Reform Act grants defendants the right to request jury submission of a written interrogatory "on the issue of each such defendant's state of mind at the time the alleged violation occurred."

Concerning loss causation, the Reform Act adds a subsection to section 12 of the 1933 Act, which limits the amount recoverable as damages to the diminution in value of the security that was purchased in reliance upon a misleading prospectus or oral communication.

Procedure. In addition to addressing scienter, the Reform Act further expounds on the "particularity" pleading requirement. The Reform Act requires that plaintiffs in private actions under the 1934 Act "in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind" allege facts "giving rise to a strong inference that the defendant acted with the required state of mind." Allegations made on "information and belief" must set forth the basis of such belief.

The procedural provisions of the Reform Act also address perceived abusive practices by plaintiffs' counsel and the perceived need for greater control by plaintiffs in securities litigations.

Specifically, the Reform Act--

* prohibits payment of fees to brokers or dealers for client referrals;

* provides for court determination as to whether plaintiff counsel's ownership of the securities sued upon creates "a conflict of interest sufficient to disqualify the attorney";

* limits plaintiff counsel's attorneys' fees to a "reasonable percentage" of the relief awarded;

* bars distribution of SEC disgorgement funds to pay plaintiff counsel for actions seeking the funds; and

* attempts to encourage courts to more actively impose sanctions (including the award of attorneys' fees) on parties and lawyers for inappropriate conduct.

In shareholder class actions, plaintiffs must also file certifications with their complaints that, for example, they have reviewed and authorized the complaint and will not accept payment beyond their pro rata share of recovery except by court order. The Act also contains provisions for the appointment of a "lead plaintiff" and regulating the procedures with respect to class action settlements.

These proof and pleading provisions will require further investigative efforts on the part of plaintiffs prior the commencement of securities suits. It is anticipated that these stringent pleading requirements will serve to eliminate the many meritless lawsuits that are brought on an ever increasing basis.

Reporting Changes. Although the legislation is generally favorable for the accounting profession, it does impose a certain burden on the accountant. The Reform Act retains the basic requirement that was included in both the House and Senate bills for the auditor to notify Federal regulators upon discovery of fraud or other material illegal acts during audits of public companies if the boards of those public companies fail to take appropriate remedial action. While this "whistleblower" provision raises serious confidentiality concerns, in the final analysis, it should not present problems for accountants who are charged with remaining independent in the performance of their duties. The legislation provides protection from liability for auditors who follow its whistle-blowing provisions.

The same section of the Reform Act sets forth the requirement that each audit under the provisions of the Reform Act include, in accordance with generally accepted auditing standards as may be modified by the SEC--

* procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts;

* procedures designed to identify related party transactions that are material to the financial statements or otherwise require disclosure therein; and

* an evaluation of whether there is substantial doubt about the ability of the issuer to continue as a going concern during the ensuing fiscal year.

Thus, the Reform Act puts into law certain aspects of generally accepted auditing standards and gives the SEC the authority to modify them, a right it already possesses. But with this elevation into law of these procedures, it becomes extremely important that these aspects of the audit of every public company be done thoroughly and fully documented.

More Reform Needed

All in all, as enacted, the Reform Act contains limitations on accountants' liability that have been long awaited by the profession. It certainly will take months, if not years, for all the dust to settle after courts have an opportunity to refine some of the details of the legislation. Accordingly, accountants should continue to track all relevant developments.

Despite the seemingly positive developments on the Federal level, accountants should remain vigilant in their pursuit of effective legal liability reform on the state level. After all, accountants remain the targets of significant litigation. Ironically, on the very day Congress overrode the President's veto to enact the Reform Act, Orange County, California filed a $3 billion lawsuit against its auditors. And, in late November, Diawa Bank's shareholders commenced a $1.1 billion suit against the company's auditors in Japan. Accountants at all levels of practice continue to be targets of lawsuits and the "protections" provided to the innocent accused are woefully deficient. The fact that the Reform Act did get enacted despite presidential veto is encouraging and only underscores the importance of continuing to support the accounting profession's pursuit of further legal liability reform on the state and national level. In today's legislative environment, the opportunity to seek a more level playing field should not be missed. *