THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995: … · 2009. 7. 31. · THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995: WHERE ARE WE THREE YEARS LATER? A Presentation

THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995:

WHERE ARE WE THREE YEARS LATER?

A Presentation to theInstitute For Corporate CounselMarch 4, 1999

Jonathan C. Dickey

William E. Thomson

Antoinette DeCamp

Gibson, Dunn & Crutcher LLP

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TABLE OF CONTENTS

TABLE OF CONTENTS..................................................................................................i

INTRODUCTION...........................................................................................................2

I. PLEADING SCIENTER UNDER THE REFORM ACT .....................................2

A. The Reform Act Has Imposed A Heightened Pleading Standard For Allegations Of Scienter2

1. Prior To The Reform Act, The Circuit Courts Were Sharply Divided On Pleading Requirements For Scienter............................2

2. The Reform Act Requires A Plaintiff To Plead Facts Sufficient To Raise A “Strong Inference” Of Scienter .........................................2

B. As Within The Federal Courts Generally, There Is Now A Split Of Authority Within The Ninth Circuit On Whether The Reform Act Adopted The Second Circuit’s Test For Pleading Scienter2

1. The Marksman Partners Line Of Cases Holds That The Reform Act Adopts The Second Circuit’s Pleading Standard In Its Entirety And Does Not Eliminate Liability For “Reckless” Conduct ............2

2. The Silicon Graphics Line Of Cases Holds That The Reform Act Strengthens The Second Circuit’s Pleading Standard By Rejecting The “Motive And Opportunity” Test, And Eliminates Liability For “Objectively Reckless” Conduct ....................................................2

3. A Third, Intermediate Line Of Cases Seeks To Steer A Course Between Silicon Graphics and Marksman Partners .......................2

4. Several Leading Cases Have Been Fully Briefed And Argued On Appeal...........................................................................................2

5. Congress Has Recently Attempted To Influence Judicial Construction Of The Reform Act By “Clarifying” The Legislative

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History In Connection With The Recently-Passed Uniform Standards Act................................................................................2

C. Insider Stock Sales As Alleged Indicia Of Scienter Under the Reform Act2

D. Insiders' Knowledge of "Internal Reports"2

II. PLEADING MISLEADING STATEMENTS WITH PARTICULARITY...........2

A. General2

B. “Information And Belief” Pleading2

1. Reform Act Requirements for Pleading "On Information and Belief" 2

2. What Does It Mean to Plead "On Information and Belief"?............2

3. What Is the Challenge for Pleading on "Information and Belief"? ...2

C. "Group Published" Pleading Doctrine2

D. A Future Battleground: What Evidence The Court May Consider On Motions to Dismiss2

III. THE SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS ...............2

A. Background2

1. Initial SEC Attempts to Encourage Publication of Forward-Looking Statements.......................................................................2

2. "Bespeaks Caution" Doctrine: .......................................................2

B. The Statutory Safe Harbor Under The Reform Act2

1. Statutory Text ...............................................................................2

2. Judicial Interpretations ..................................................................2

C. Impact of Safe Harbor2

1. Quantity of Information.................................................................2

2. Quality of Information ...................................................................2

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3. Several factors may have contributed to the continued reluctance of companies to disclose extensive forward-looking information ........2

IV. LIABILITY FOR STATEMENTS TO AND BY ANALYSTS ...........................2

A. Direct Liability2

B. "Entanglement"2

C. Adoption2

D. Application of the Statutory Safe Harbor to Statements Contained in Analysts' Reports.2

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INTRODUCTION

The Sound of Several Shoes Dropping

If one were to have made a forecast in late 1995 of how the securities class action landscape might look three years later, one might have conjured the following:

_ Significant reduction in new case filings in the federal court system; _ Active participation by pension funds, mutual funds, and other institutional

investors as class representatives; _ More competition among the plaintiffs' bar to serve as class counsel (and lower

fees); _ Quicker dispositions of cases, either by motion or by settlement; _ Tougher decisions from trial courts on motions to dismiss, and better

pleadings; _ Reduced defense and settlement costs.

nfortunately, none of these forecasts came true. Indeed, as we proceed into year four, we see a very different landscape than the one envisioned by Congress when it passed the Private Securities Litigation Reform Act in December 1995. Today we see:

_ A record number of new cases; _ Little involvement by institutional investors, except in the biggest and "worst"

cases; _ Little or no competition among the plaintiffs' bar; _ Long delays in case disposition; _ Trial court decisions "all over the map"; _ Higher defense and settlement costs.

ompounding the problems companies are experiencing in fulfilling the promise of reform -- the "other shoe dropping", as it were -- is the fact that in 1998 Congress and the SEC managed to weaken the legislative history of the Reform Act by adding gratuitous comments into the legislative history of the Uniform Standards Act, the apparent purpose of which is to convince the federal courts to believe that the explicit "heightened" pleading standards of the Reform Act are not heightened at all.

he next shoe to drop may be by the SEC, which is in the process of extensive rulemaking proceedings as this paper goes to press. Indeed, if the SEC's

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current "aircraft carrier" proposal ever becomes law, any hope of reforming private securities class actions through tougher pleading standards will be all but forgotten, replaced by a strict liability system and a barrage of private securities class action like nothing this country has ever seen.

hile the litigants in the first wave of Reform Act cases await the first courts of appeal rulings under the Reform Act, one can reasonably predict the probable outcome: just as was true in the pre-Reform Act decisional law, different jurisdictions will reach different –– and perhaps sharply conflicting –– conclusions on what Congress intended. Over the next year or two, the returns will come in: the Ninth Circuit will maintain its generally liberal bent, while the First and Second Circuits will issue rulings upholding tougher standards. The trial courts in the Ninth Circuit will remain popular venues for class action cases. And in California, plaintiffs' counsel may continue to take advantage of the state courts by filing parallel cases on behalf of friendly institutional investors (an exception to the preemptive scope of the Uniform Standards Act), and continue to whipsaw companies between federal and state court.

How Did We Get Here?

On December 22, 1995, Congress voted to override President Clinton’s veto and enacted the Private Securities Litigation Reform Act, Pub. L. No. 104-67, codified at 15 U.S.C. section 78u-4 (“Reform Act”). The Reform Act contains a variety of provisions designed to combat certain abusive practices associated with private securities litigation. Among the abusive practices identified by Congress were:

(1) the routine filing of lawsuits against issuers of securities and others whenever there is a significant change in an issuer's stock price, without regard to any underlying culpability of the issuer, and with only faint hope that the discovery process might lead eventually to some plausible cause of action; (2) the targeting of deep pocket defendants, including accountants, underwriters, and individuals who may be covered by insurance, without regard to their actual culpability; (3) the abuse of the discovery process to impose costs so burdensome that it is often economical for the victimized party to settle; and (4) the manipulation by class action lawyers of the clients whom they purport to represent.

The Reform Act was designed to address these problems by amending certain substantive and procedural provisions of the Securities Act of 1933 (the "Securities Act"), the Securities Exchange Act of 1934 (the "Exchange Act"), and certain other statutory provisions such as the Racketeering Influenced and

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Corrupt Organizations Act ("RICO"). Specifically, the Reform Act responds to the problem of abusive shareholder litigation by:

_ creating a new, heightened pleading standard;

_ creating a broader and more effective safe harbor for the disclosure of forward-looking information, such as projections of future financial results, dividends, and corporate objectives;

_ mandating a stay of discovery in almost all securities cases until after plaintiffs have demonstrated that a complaint has met basic requirements for pleading a cause of action;

_ providing for proportionate liability in all cases other than those involving knowing violations of the federal securities laws;

_ mandating that plaintiffs demonstrate loss causation between the alleged fraud and their own losses;

_ limiting windfall damages so that the maximum amount of damages in any case cannot exceed the difference between the purchase (or sale) price paid (or received) for the securities and the mean trading price during the 90-day period after the information correcting the false or misleading statement has been disseminated to the marketplace; and

_ limiting the role of "professional plaintiffs" by requiring the appointment of a "lead plaintiff" who is "the most capable of representing the interests of the class" and who will actually supervise the work of plaintiffs' counsel (including the power to hire and fire such counsel).

As is frequently the case with new legislation, trial lawyers have had a field day litigating the details of the new law, and many trial courts, while focusing on the details, have lost sight of the overall congressional intent. The results have been disappointing to advocates of reform. But the truest test of reform still awaits, namely, the views and opinions of the various courts of appeal, and ultimately the Supreme Court.

Scope of this Paper

This paper will examine four of the most important aspects of cases being litigated under the Reform Act: (1) the requirements for pleading facts sufficient to raise a “strong inference” of scienter; (2) pleading misrepresentations with particularity; (3) the safe harbor for forward-looking statements; and (4) liability for communications with analysts.

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I. PLEADING SCIENTER UNDER THE REFORM ACT

A. The Reform Act Has Imposed A Heightened Pleading Standard For Allegations Of Scienter

1. Prior To The Reform Act, The Circuit Courts Were Sharply Divided On Pleading Requirements For Scienter

To state a claim for securities fraud, a plaintiff must allege scienter, that is, that the defendant acted with “a mental state embracing an intent to deceive, manipulate, or defraud.” Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194 n.12, 96 S. Ct. 1375, 1381 n.12, 47 L. Ed. 2d 668 (1976)). Prior to the Reform Act, the circuit courts diverged dramatically on what they required in order to plead this element. In the Ninth Circuit, for example, a plaintiff bringing suit was permitted to allege scienter generally -- in effect, simply by stating that scienter existed. See, e.g., In re GlenFed Sec. Litig., 42 F.3d 1541, 1546-1547 (9th Cir. 1994). On the other end of the spectrum, the Second Circuit required a plaintiff to plead facts raising a “strong inference” that the defendant acted with scienter. See, e.g., Acito v. IMCERA Group, Inc., 47 F.3d 47, 53 (2d Cir. 1995). Under Second Circuit caselaw, a plaintiff could plead scienter by alleging either (1) specific facts that “constitut[e] circumstantial evidence of reckless or conscious misbehavior,” or (2) that the defendant had a “motive and opportunity to commit fraud.” San Leandro Emergency Med. Group Profit Sharing Plan v. Philip Morris Cos., Inc., 75 F.3d 801, 812-13 (2d Cir. 1996); see also In re Time Warner Inc. Sec. Litig., 9 F.3d 259, 268-69 (2d Cir. 1993).

Although the Supreme Court has never squarely spoken on the issue, before the passage of the Reform Act, the circuit courts that had addressed the question had all held that recklessness was sufficient to constitute scienter under Section 10(b), although the circuits’ definitions of “reckless” behavior often differed markedly in the degree to which they required some type of intentional conduct.1 In the Ninth Circuit, “recklessness” was conduct

1 See, e.g., Cook v. Avien, Inc., 573 F.2d 685, 692 (1st Cir. 1978); Rolf v. Blyth Eastman

Dillon & Co., 570 F.2d 38, 47 (2d Cir. 1978); In re Phillips Petroleum Sec. Litig., 881 F.2d

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“involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.” Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569 (9th Cir. 1990) (en banc).

1236, 1244 (3d Cir. 1989); Broad v. Rockwell Int’l Corp., 642 F.2d 929, 961-62 (5th Cir. 1981) (en banc): Mansbach v. Prescott, Ball & Turben, 598 F.2d 1017, 1023-24 (6th Cir. 1979); Sunstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1044 (7th Cir. 1977); Van Dyke v. Coburn Enter. Inc., 873 F.2d 1094, 1100 (8th Cir. 1989); Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569-70 (9th Cir. 1990); Hackbart v. Holmes, 675 F.2d 1114, 1117-18 (10th Cir. 1982); McDonald v. Alan Bush Brokerage Co., 863 F.2d 809, 814 (11th Cir. 1989).

2. The Reform Act Requires A Plaintiff To Plead Facts Sufficient To Raise A “Strong Inference” Of Scienter

In passing the Reform Act, Congress clearly intended to raise the national standard for pleading scienter. Under the Reform Act, a plaintiff may no longer plead scienter generally, but rather must, “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.” Reform Act, § 21D(b)(2) (emphasis added). If this heightened pleading requirement is not met, the Reform Act mandates that the court dismiss the complaint. Id., § 21D(b)(3)(A).

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B. As Within The Federal Courts Generally, There Is Now A Split Of Authority Within The Ninth Circuit On Whether The Reform Act Adopted The Second Circuit’s Test For Pleading Scienter

There is no question that the Reform Act effected a substantial change in the pleading requirements within the Ninth Circuit. No longer may a plaintiff allege scienter simply by saying that scienter existed. There currently exists within the Ninth Circuit, however, as within the federal courts generally, a split of authority on the precise meaning of the scienter pleading standard adopted by the Reform Act. The courts have been divided on whether, or in what manner, the Reform Act adopted or “codified” the scienter pleading standard previously in force in the Second Circuit. The courts similarly have been divided on the question of whether the Reform Act raised the substantive requirements for scienter by eliminating liability for unintentional or “objectively” reckless conduct.

1. The Marksman Partners Line Of Cases Holds That The Reform Act Adopts The Second Circuit’s Pleading Standard In Its Entirety And Does Not Eliminate Liability For “Reckless” Conduct

The first case to address the new pleading standards, shortly after the adoption of the Reform Act, was Marksman Partners L.P. v. Chantal Pharm. Corp., 927 F. Supp. 1297 (C.D. Cal. 1996). In Marksman Partners, the plaintiff alleged that the issuer had overstated its revenues by impermissibly recognizing as current income transactions that were allegedly consignment sales, thereby inflating its stock price.

In seeking to dismiss the action, the defendant argued that the Reform Act had enacted a pleading standard even more rigorous than that employed by the Second Circuit and had altered the substantive standard for liability pursuant to Section 10(b) by eliminating liability for reckless conduct. Confronting an issue of first impression, the court noted that the Reform Act’s “strong inference” language was drawn from the Second Circuit’s test for pleading scienter and emphasized that this test was the most stringent standard in existence when Congress passed the Reform Act. After examining various references to the Second Circuit pleading standards set forth in the legislative history, especially the report of the Senate Banking Committee, the court concluded that in passing the Reform Act Congress had enacted the Second Circuit’s two-pronged test: “The Court has little doubt that when Congress wishes to supplant a judicially-created rule it knows how to do so explicitly, and in the body of the statute.” Id. at 1311.

The court also rejected the defendants’ contention that the Reform Act had abolished liability for merely reckless conduct. Id. at 1309 n.9.

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The Marksman court, in determining that the “motive and opportunity” test “ha[s] not been discarded” by the enactment of the Reform Act, Marksman, 927 F. Supp. at 1310-11, did so expressly because it found that the test as applied is “consistent with Congress’s intent that scienter be pled with more than conclusory or generic allegations”:

The test itself is an exacting analysis courts have employed to assess whether the quantum and quality of factual allegations in the complaint, beyond mere allegations that a material misrepresentation occurred, actually create an inference that a defendant acted with an intent to defraud. . . . [T]he plaintiff’s allegations must yield a “strong” inference of fraudulent intent.

Id. at 1311. In emphasizing that the end result of the “motive and opportunity” analysis must be the showing of the required “strong inference” of fraudulent intent, the Marksman Partners court took as its model for the Second Circuit standard the stringent application of Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1128 (2d Cir. 1994).

The court found that the complaint sufficiently alleged scienter under both the “motive and opportunity” and the “circumstantial evidence” tests. The Marksman Partners court emphasized that insider sales may support a strong inference of scienter -- but only if the sales are “unusual,” which “requires a showing that the trading was in amounts dramatically out of line with prior trading practices, at times calculated to maximize personal benefit from undisclosed inside information.” Id. at 1312 (citing Acito, 47 F.3d at 54, and Alfus v. Pyramid Tech. Corp., 764 F. Supp. 598, 605 & n.1 (N.D. Cal. 1991) (internal quotation marks omitted). The court found suspicious the insider sales of 300,000 shares of stock -- 20% of her total -- for a total amount of over $6,300,000, where the insider had not sold any stock in the previous three years. Id. at 1312-13.

At least two dozen decisions have agreed with the Marksman Partners court and concluded that the Reform Act (i) did not eliminate liability for reckless conduct and (ii) adopted the Second Circuit’s pleading standard, including the “motive and opportunity” test.2 Because the defendants are usually the top management in control of the day to day operations of the company, “opportunity” is seldom an issue in these cases, and almost all of the analysis focuses on what constitutes sufficient “motive.”

2 See “The Securities Litigation Uniform Standards Act of 1998: The Sun Sets On California’s

Blue Sky Laws,” 54 THE BUSINESS LAWYER 1, 34 n.185 (Nov. 1998).

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2. The Silicon Graphics Line Of Cases Holds That The Reform Act Strengthens The Second Circuit’s Pleading Standard By Rejecting The “Motive And Opportunity” Test, And Eliminates Liability For “Objectively Reckless” Conduct

In In re Silicon Graphics, Inc. Sec. Litig., 970 F. Supp. 746 (N.D. Cal. 1997), the court held that in enacting the Reform Act Congress had not merely adopted the Second Circuit standard, but had intended to enact an even more stringent standard. After reviewing the text and the legislative history, the court concluded that Congress had discarded the Second Circuit’s “motive and opportunity” test, and had rejected liability based upon mere reckless conduct. In reaching these conclusions, the court relied extensively on the Conference Committee Report, which indicated the Conferees’ intention to surpass the existing Second Circuit standard:

Because the Conference Committee intends to strengthen existing pleading requirements, it does not intend to codify the Second Circuit’s case law interpreting this pleading standard. FN 23/ For this reason, the Conference Report chose not to include in the pleading standard certain language relating to motive, opportunity, or recklessness.

Id. at 756 (quoting Conf. Rep. at 41 & n.23). In holding that the Reform Act eliminated the Second Circuit’s “motive and opportunity” test, the court also placed considerable weight upon the fact that in President Clinton’s Veto Message “the President expressed concern that Congress had made ‘crystal clear’ its intent to raise the pleading standard beyond that of the Second Circuit.” Id. at 756.

The court also concluded that in rejecting the Second Circuit’s “motive and opportunity” test the Congress eliminated evidence of “objective” -- as opposed to “subjective” or “intentional” -- recklessness as a permissible way of alleging and proving scienter: “Knowing or intentional misconduct includes deliberate recklessness. . . . Motive, opportunity, and non-deliberate recklessness may provide some evidence of intentional wrongdoing, but are not alone sufficient to support scienter unless the totality of the evidence creates a strong inference of fraud.” Id. at 757.

At least eleven courts have followed Silicon Graphics in rejecting both recklessness as a basis for scienter under the Reform Act, and allegations of “motive and opportunity” as sufficient to plead a "strong inference of the required state of mind."3 See, e.g., Chan v. Orthologic, No. 96-Civ-1514-


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PHX-RCS (D. Ariz. April 5, 1998); Voit v. Wonderware Corp., 977 F.Supp. 363 (E.D.Pa. 1997); Havenick v. Network Express, 981 F.Supp. 480 (E.D. Mich. 1997); Novak v. Kasaks, 977 F.Supp. 425 (S.D.N.Y. 1998).


3. A Third, Intermediate Line Of Cases Seeks To Steer A Course Between Silicon Graphics and Marksman Partners

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A third group of cases steers a middle course between Silicon Graphics and Marksman Partners by agreeing with Marksman Partners’ conclusion that the Reform Act does not eliminate liability for reckless conduct, but agreeing with Silicon Graphics that allegations relating to “motive and opportunity” are insufficient to plead scienter under the Reform Act. At least seven courts thus far have so held.4

The court in In re Stratosphere Corp. Sec. Litig., 1 F. Supp. 2d 1096 (D. Nev. 1998), for example, rejected Silicon Graphics and held that pre-Reform Act recklessness is sufficient to state a federal claim for securities fraud. In re Stratosphere, 1 F. Supp. 2d at 1107. The court also found, however, that “motive and opportunity, alone does not presumptively prove the required state of mind under the PSLRA.” Id. In rejecting exclusive reliance upon “motive and opportunity,” the court emphasized that the totality of the allegations must raise a strong inference of the required scienter. See also In re Boeing Sec. Litig., (W.D. Wash. Sept. 8, 1998) (unpublished order) (rejecting Silicon Graphics’ liability standard but following its pleading standard); In re Health Management Sys., Inc. Sec. Litig., 1998 WL 283286 (S.D.N.Y. June 1, 1998) (same). A few courts, while using phrases such as "conscious recklessness" to describe the required state of mind, appear to merely reaffirm the pre-Reform Act Sunstrand recklessness standard. See, e.g., Queen Uno Ltd. v. Couer D'Alene Mines Corp., 1998 WL 195299 (D. Colo. 998).

A number of the courts that have applied the “motive and opportunity” analysis have deliberately refrained from deciding whether the Reform Act eliminated the test, as an issue that was deemed unnecessary to the court's decision. See, e.g., Plevy v. Haggerty, CV-97-9200-SVW, at 35 (C.D. Cal. Aug. 21, 1998) (sidestepping question of whether “motive and opportunity” test survives Reform Act on the grounds that the complaint’s allegations failed as a matter of law to meet either that test or the circumstantial evidence test); In re Ancor Communications, Inc. Sec. Lit., 1998 U.S. Dist. LEXIS 10988 (D. Minn. 1998); Werman v. Overland Data, 1998 (U.S. Dist. LEXIS 2009 (S.D. Cal. 1998); Cherednichenko v. Quarterdeck Corp., 1977 [CCH] ¶ 90, 108 (C.D. Cal. 1997).



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4. Several Leading Cases Have Been Fully Briefed And Argued On Appeal

Although no circuit court has yet addressed the pleading standards effected by the Reform Act, the issue of the continued viability of both the Second Circuit’s “motive and opportunity” test and liability for reckless conduct are now pending before the Ninth Circuit in the Silicon Graphics case (Ninth Circuit No. 97-16240). The case now has been fully briefed, argued, and submitted to the court for decision. As it had in the district court, the SEC has weighed into the appellate debate by filing an amicus brief arguing that the Reform Act merely codified the Second Circuit standard, thus leaving intact the “motive and opportunity” test, and did not eliminate liability for merely reckless conduct. On the other hand, the American Electronics Association -- a high tech industry trade group -- has advocated in its amicus brief the view that the Reform Act eliminated the Second Circuit “motive and opportunity” test. This closely-watched case promises to produce the first appellate decision interpreting the Reform Act’s pleading requirements and its effect on substantive securities law.

In addition to Silicon Graphics, Zeid v. Kimberley, 973 F. Supp. 910 (N.D. Cal. 1997), also is fully briefed and argued. In Zeid, the Northern District of California (Judge Williams) held that the Second Circuit "motive and opportunity" standard applied, but dismissed the complaint, holding that defendants' alleged motive to complete an acquisition on more favorable terms was insufficient. The Ninth Circuit panel has taken this case under submission pending the decision of another panel in Silicon Graphics.

In other jurisdictions, several important Reform Act cases have been fully or partially briefed. In Bryant v. Apple South, 1998 U.S. Dist. LEXIS 12125 (M.D. Ga. 1998), the trial court denied defendants' motion to dismiss, but permitted an interlocutory appeal under 28 U.S.C. § 1292(b). The defendant/appellants' opening brief in the Eleventh Circuit was filed in December 1998. And in In re Comshare, Inc. Sec. Lit., 1997 U.S. Dist. LEXIS 17262 (E.D. Mich. 1997) briefing in the Sixth Circuit is completed, and the case was set for oral argument on January 28, 1999.

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5. Congress Has Recently Attempted To Influence Judicial Construction Of The Reform Act By “Clarifying” The Legislative History In Connection With The Recently-Passed Uniform Standards Act

Interestingly, Congress has attempted to beat the courts of appeal to the punch on this issue by trying retrospectively to shed additional light on the legislative intent underlying the Reform Act. In connection with the Uniform Standards Act that Congress passed and President Clinton signed in November of 1998 (Pub. L. 105-103), the bill’s sponsors, the SEC, and the White House agreed to insert language into the legislative history clarifying that the Reform Act did not intend to rule out recklessness as a basis for scienter:

"It is the clear understanding of the managers that Congress did not, in adopting the Reform Act, intend to alter the standards of liability under the Exchange Act.

The managers understand, however, that certain Federal district courts have interpreted the Reform Act as having altered the scienter requirement. In that regard, the managers again emphasize that the clear intent in 1995 and our continuing intent in this legislation is that neither the Reform Act nor S. 1260 [the Uniform Standards Act] in any way alters the scienter standard in Federal securities fraud suits.

Additionally, it was the intent of Congress, as was expressly stated during the legislative debate on the Reform Act, and particularly during the debate on overriding the President's veto, that the Reform Act establish a heightened uniform Federal standard on pleading requirements based upon the pleading standard applied by the Second Circuit Court of Appeals. Indeed, the express language of the Reform Act itself carefully provides that plaintiffs must "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." The Managers emphasize that neither the Reform Act nor S. 1260 makes any attempt to define that state of mind."

Joint Explanatory Statement Of The Committee Of Conference, accompanying H.R. Rep. No. 105-803. (emphasis added)

It remains to be seen how much weight courts will give to this post hoc addition to the “legislative history” of the Reform Act. In light of the disagreement among the courts as to the proper interpretation of the Reform Act, however, and the deference sometimes given to Congress, courts may be willing to pay it more deference than might otherwise be expected. See, e.g., Schlagel v. Learning Tree Int’l, 1998 U.S. Dist. LEXIS 20306, at *42-46 (C.D. Cal. December 23, 1998) (relying upon above-quoted Statement of Managers to bolster court’s interpretation of Reform Act scienter requirement).

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A test of how this "new" congressional intent will be viewed by the Court of Appeals will likely occur very shortly. In the few cases that are pending in the Court of Appeals, the SEC has sought to file supplemental amicus briefs arguing that the Uniform Standards legislation makes clear that the Second Circuit "motive and opportunity" test is still good law, and should be the governing standard under Reform Act. The appeals courts in Zeid v. Kimberly and Comshare, among others, have accepted the SEC supplemental briefs for filing, over the objections of defendants.

C. Insider Stock Sales As Alleged Indicia Of Scienter Under the Reform Act

The Ninth Circuit has long held that insider trading is probative of scienter only when stocks are sold “in suspicious amounts or at suspicious times.” In re Apple Computer Sec. Litig., 886 F.2d 1109, 1117 (9th Cir. 1989). There is a noticeable increase in the frequency with which plaintiffs are attempting to establish scienter based on allegations of insider sales of stock. Of the 537 securities fraud actions filed since the passage of the Reform Act, about 55% allege insider sales during the class period.5 In many cases, this is clearly due more to the ready public availability of this information than it is to the probative character of the evidence proffered.

5 “Class Action Securities Fraud Cases Hit New High In 1998,” Dow Jones Newswires,

(quoting Professor Joseph A. Grundfest).

Courts have differed on exactly whether the relevant benchmark against which the sales are to be measured is the available stock-holdings, or the total of the stock holdings and available options. The Silicon Graphics court looked to percentage of total stock holdings -- together with available options -- in order to determine whether the sales were “unusual.” Silicon Graphics, 970 F. Supp. at 768. Likewise, in Wenger v. Lumisys, Inc., 2 F. Supp. 2d 1231, 1251 (N.D. Cal. 1998), the court held that “stock sales alone cannot create a strong inference of scienter,” and that where the “officers retained the vast majority of their holdings and none of the sales occurred at suspicious times, such as immediately before a negative earnings announcement,” the complaint failed to allege scienter adequately. In Head v. Netmanage, Inc., 1998 WL 917794, *3-4 (N.D. Cal. Dec. 30, 1998), the court found allegations of sales of 5% of stock holdings of defendants as a group insufficient to raise strong inference of scienter, and rejected the plaintiffs’ contention that the gross dollar amount of the sales was relevant without taking into account the percentage sold. The court declined to consider the number of available options on the grounds that it was unnecessary in this case because the complaint’s allegations regarding available shares was itself insufficient to withstand the motion to dismiss. The court also found the sale of 76% and 94% of the stock holdings of certain

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defendants not to be suspicious where “these defendants actually sold more shares during the six months preceding the class period.” Id. at *5. See also Allison v. Brooktree, 999 F. Supp. 1342, 1352 n.2 (S.D. Cal. 1998) (emphasizing that scienter must be pleaded with respect to each defendant and analyzing each defendant’s stock sales; finding stock sales not suspicious where nearly 90% of all insider shares sold during the class period were sold 40% or more below the high price of the stock and occurred four to five months before the stock reached its class period high point).

In contrast, in Schlagel v. Learning Tree Int’l, 1998 U.S. Dist. LEXIS 20306 (C.D. Cal. December 23, 1998), the district court held that the complaint satisfied both the “motive and opportunity” and the “circumstantial evidence tests based largely upon the presence of insider stock sales. The court looked exclusively to the dollar amounts of the sales, without regard to the percentage of holdings of either stock or options that the sales represented. In addition, the court apparently found it unnecessary to determine whether the insiders’ sales were “unusual” by reference to any past sales by the individual sellers.

Decisions from other jurisdictions show significant conflicts over how to deal with stock sales in assessing scienter. In In re Stratosphere Corp. Sec. Lit., 1 F. Supp. 2d 1096 (D. Nev. 1998), the court said that stock sales may be sufficient to support an inference of scienter. In Bryant v. Apple South, large insider sales also were held sufficient. In Friedberg v. Discreet Logic, 959 F. Supp. 42 (D. Mass. 1997), "large" stock sales of approximately 12% were held sufficient to support allegations of conscious misbehavior. But in Lirette v. Shiva Corp., 1998 WL 8912696 (D. Mass. 1998), the court held that plaintiff had the burden to prove that any insider trading was suspicious, and must consider all insider sales before and after the class period. Similarly, in Myles v. Midcom Communications Inc., (N.D. Wash. 1996), the court held that the defendant officers' retention of shares, instead of selling, rebuts any inference of scienter.

D. Insiders' Knowledge of "Internal Reports"

A frequent pleading technique in Reform Act cases is to allege that insiders "knew" they were making misrepresentations because they were aware of and had access to "internal reports" setting forth contrary information. Most often, plaintiffs' counsel do not identify specific internal reports, except sometimes to label them generically as "flash" reports or the like. How the appellate courts address this issue under the Reform Act could have a profound impact on future cases, since a plaintiffs' ability to plead scienter may easily be satisfied if generalized pleading of knowledge of "internal reports" is acceptable. This issue is ripe for decision by the Ninth Circuit in the Silicon Graphics case.

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Trial courts within the Ninth Circuit for the most part have rejected allegations of scienter based upon unspecified internal reports. Besides Silicon Graphics, in In re Oak Technology Sec. Lit., 1997 WK 448168 (N.D. Cal. 1997), the trial court held that allegations about "regularly prepared" internal reports were insufficiently specific. See also Hockey v. Medhekar; 1997 [CCH] ¶¶ 99, 465 (N.D. Cal. 1997) Wenger v. Lumisys, 2 F. Supp. 2d 1231 (N.D. Cal. 1998).

Other jurisdictions are in conflict on this issue. Compare, for example, Lirette v. Shiva Corp. 1998 WL 812696 (D. Mass. 1998) (rejecting allegations of unspecified internal reports) with Bryant v. Apple South, Inc. 1998 U.S. Dist. LEXIS 12125 (M.D. Ga. 1998) (allegations of insiders' awareness of unidentified monthly financial reports held sufficient).

II. PLEADING MISLEADING STATEMENTS WITH PARTICULARITY

The Reform Act seeks to impose rigorous pleading standards in cases brought pursuant to the federal securities laws -- standards expressly designed to provide the federal courts with the tools necessary to weed out baseless lawsuits at their inception, before defendants are forced to shoulder the costly burden of discovery. See S. Rep. No. 98, 104th Cong., 1st Sess., at 6, 7, 14 (1995), reprinted in 1996 U.S.C.C.A.N. (109 Stat.) 679, 685. Notwithstanding this strong congressional intent, "the jury is out" on whether complaints brought under the Reform Act are any more particular now than under prior law.

A. General

Although Federal Rule of Civil Procedure 9(b) already required particularity in pleading a claim of fraud, the Reform Act imposes greater particularity requirements on claims made on "information and belief," on claims made against individual officers and directors, and on claims requiring heightened pleading of scienter (discussed above).

1. Although legislative history clearly indicates that the purpose of the Reform Act was to raise the bar on pleading claims of fraud and to unify the standard, there still appears to be differences among courts as to what suffices to meet this heightened standard.6

6 In one particularly misguided opinion, the District of Minnesota indicated a belief that the

PSLRA applied only to class actions. In re Digi International Sec. Litig., 1998 U.S. Dist. LEXIS 8320 at *11 (D. Minn. May 22, 1998).

16

2. Generally, the Reform Act requires that a plaintiff "specify each statement alleged to have been misleading" and "the reason or reasons why a statement is misleading." 15 U.S.C. § 78u-4(b)(1). As was true under pre-Reform Act jurisprudence, however, courts differ in their interpretations of what will suffice to meet this standard.

a. Even before the Reform Act, the Ninth Circuit had required that plaintiffs not only identify the allegedly false and misleading statement, but also that the complaint explain why those statements were misleading. See, e.g., In re Glenfed Inc. Sec. Litig., 42 F.3d 1541, 1549 (9th Cir. 1994). Accordingly, the Reform Act is not likely to have much substantive impact on how courts in the Ninth Circuit assess the adequacy of allegations of falsity, except perhaps in differentiating between and among defendants (unlike the "group published" pleading doctrine discussed below). See, also, Queen Uno Ltd. v. Couer D'Alene Mines, 1998 WL 195299 (D.Colo. 1998) (Reform Act is in large part a codification of preexisting 10th Circuit law).

b. An example of how pleading of falsity within the Ninth Circuit has fared under the Reform Act is with respect to the pleading of financial fraud, and specifically improper revenue recognition practices. Under pre-Reform Act cases, plaintiffs frequently were required to allege the details of specific transactions in terms of amount, time, and other details. After passage of the Reform Act, the Ninth Circuit issued a decision in a pre-Reform Act case, Cooper v. Pickett, 122 F.3d 1186 (9th Cir. 1997), which essentially held that such pleading particularity was not required under Rule 9(b). Several Reform Act cases have now followed Cooper v. Pickett, and allowed generalized allegations of "bad" revenue recognition to survive motions to dismiss. Indeed, in a few cases these same generalized allegations also were held to support the pleading of scienter. See, e.g., Marksman Partners, supra.

c. Several cases from other jurisdictions are in the same vein. In re Ancor Communications, Inc. Sec. Lit., 1998 U.S. Dist. LEXIS 10988 (D. Minn. 1998) (GAAP violations support inference of conscious misbehavior); In re Digi International Sec. Lit., 1998 U.S. Dist. LEXIS 8320 (D. Minn. 1998).

d. The court in In re Boston Tech. Sec. Litig. deemed sufficient allegations that simply set forth a series of omissions allegedly applicable to "[all] statements made by defendants during the Class Period" and "[all] Defendants' representations set forth [in the Complaint]," despite the plaintiffs' failure to explain what about specific omissions made specific statements misleading. 1998 WL 340402 at *6 (D. Mass. Feb. 5, 1998).By contrast, the court in Havenick v. Network Express, Inc., 981 F. Supp.

17

480, 526 (E.D. Mich. 1997) dismissed with prejudice a complaint that "simply compiled a long list of block quotes" and then "line[d] these statements up against a conclusory list of omissions and pronounce[d] that fraud exists." See also Chan v. Orthologic Corp., No. 96-Civ-1514-PHX-RCS at 28 & n.11 (D. Ariz. Feb. 5, 1998) ("laundry list" of factors insufficient to explain what is misleading about alleged misstatements); In re Oak Tech. Sec. Litig., 1997 WL 448168 at *4-5 (N.D. Cal. July 1, 1997) (expressing disapproval of "puzzle-style" pleading).

B. “Information And Belief” Pleading

1. Reform Act Requirements for Pleading "On Information and Belief"

Even before the Reform Act, Rule 9(b) required that facts pleaded on the basis of information and belief must set forth basis for the belief. However, some cases viewed the standard as "relaxed" where the facts were particularly within defendants' control. See, e.g., In re Burlington Coat Factory Sec. Litig., 114 F.3d 1410, 1417-18 (3d Cir. 1997). The Reform Act heightened the requirements for pleading on "information and belief," mandating that the plaintiff "state with particularity all facts on which that belief is formed." 15 U.S.C. § 78u-4(b)(1) (emphasis added).

a. Despite this clear language and the clear intention to raise the pleading standard, some cases applying the Reform Act have nevertheless assumed that allegations made on "information and belief" warrant a "relaxed" pleading standard. See, e.g., Queen Uno Ltd. v. Coeur D'Alene Mines Corp., 1998 WL 195299 (D. Colo. Apr. 13, 1998) ("Although Plaintiffs could have stated they were seeking to plead on information and belief, and consequently sought entitlement to an assumed relaxation of the Reform Act's particularity requirements, they have not done so."); Howard Gunty Profit Sharing Plan v. Quantum Corp., 1997 WL 514993 at *3 (N.D. Cal. Aug. 14, 1997) ("Because Plaintiffs' allegations [based on "investigation of counsel"] are not based on information and belief, the Court will not relax the pleading requirements of Rule 9(b).").

b. Given the purposes of the Reform Act, it seems inappropriate to view allegations of "information and belief" as entitled to a "relaxed" standard. As the Reform Act makes clear, allegations made on "information and belief" must comply not only with the general requirement of pleading the circumstances of fraud with particularity, but also must set forth with particularity the basis for the plaintiff's asserted "belief." The only thing that is "relaxed" about this standard is that the plaintiff need not have personal knowledge of the statements alleged.

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2. What Does It Mean to Plead "On Information and Belief"?

a. Some courts have adopted a very narrow reading of the statute, saying a complaint is not pleaded on "information and belief" unless the plaintiff expressly says so. See, e.g., Howard Gunty Profit Sharing Plan v. Quantum Corp., Civ. No. 96 20711 SW at 8 (N.D. Cal. Apr. 6, 1998). This approach, however, elevates form over substance, and would allow plaintiffs to continue to advance claims of fraud based on nothing more than unsubstantiated speculation.

b. Others courts have taken a much broader approach, saying that if it is not within the plaintiff's personal knowledge, it is necessarily on "information and belief." See, e.g., In re Boston Tech. Sec. Litig., 1998 WL 340402 at *3 (D. Mass. Feb. 5, 1998) (referring to pleading on information and belief 'either explicitly or implicitly"); Chan v. Orthologic Corp., No. 96-Civ-1514-PXH-RCS at 34 (D. Ariz. Feb. 5, 1998) (requiring specific statement of sources underlying allegations pertaining to meeting where "Plaintiffs have no apparent first-hand knowledge of the meeting").

c. There is also discrepancy as to whether statements alleged based on "investigation of counsel" are on information and belief./belief.

i. Some courts take the position that any allegations not made on personal knowledge are, by necessity, made on "information and belief." See, e.g., In re Silicon Graphics Sec. Litig., 970 F. Supp. 746, 763 (N.D. Cal. 1997) ("Because the sources...do not provide plaintiffs with personal knowledge, the complaint must be based on information and belief -- that is the only alternative.").

* A number of courts, following Silicon Graphics, have held that allegations based on the "investigation of counsel" are, by definition, based on "information and belief". See, e.g., Hockey v. Medhekar, supra; Wenger v. Lumisys; supra; Polk v. Fritz, (N.D. Cal. 1998); Head v. Netmanage, (N.D. Cal. 1998).

* The court in Havenick v. Express Network, Inc. expressed a remarkably strong view of the particularity requirements of pleading on information and belief, stating that "the law now requires a plaintiff to draw a specific nexus between the allegedly fraudulent statements and the facts upon which the allegation of fraud is dependent, or, at least, a clear statement of why and how the plaintiff has reached the conclusion that a particular statement is fraudulent." 981 F. Supp. 480, 526 (E.D. Mich. 1997) (complaint alleged on investigation of counsel).

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ii. Several others hold that allegations based on investigation of counsel are not pleaded on information and belief. See, e.g., Queen Uno Ltd. v. Coeur D'Alene Mines Corp., 1998 WL 195299 at *8 (D. Colo. Apr. 13, 1998); Warman v. Overland Data Inc., 1998 U.S. Dist. LEXIS 2009 (S.D. Cal. Feb. 23, 1998); Schlagel v. Learning Tree Int'l, No. CV 98-6384 ABC, Fed. Sec. L. Rep. ¶ 90,403 at 91,814 n.4 (C.D. Cal. Dec. 23, 1998) (citing cases); Howard Gunty Profit Sharing Plan v. Quantum Corp., 1997 WL 514993 (N.D. Cal. Aug. 14, 1997).

iii. In a remarkable example of leniency toward plaintiffs, the District of Arizona recently ruled that allegations of an "extensive" investigation by plaintiffs' attorneys, "mentioning" the documents reviewed by the attorneys, was sufficient to delineate the source of a plaintiff's information and belief. In re Employee Solutions Consol. Sec. Litig., No. Civ 97-545-PHX-RGS-OMP (D. Ariz. Sept. 29, 1998) (also deeming sufficient allegations that each defendant "knew" of inadequate reserves, allegedly targeting "riskiest" clients and overstating revenues, stating "It's difficult to demand more of plaintiffs before they've conducted meaningful discovery.").

iv. To ensure that the objectives of the Reform Act are accomplished, courts are better advised to look at the substance, rather than the form, of allegations, and require a plaintiff with no first-hand knowledge of events to set forth the basis for the allegations of fraud. Permitting a plaintiff to cite only the "investigation of counsel" does nothing more than substitute the speculation of the plaintiff for the speculation of his counsel, particularly where (as is often the case) the counsel's "investigation" consists of little more than a review of SEC filings and other publicly-available information. See, e.g., In re Health Management Sys. Sec. Litig., 1998 WL 283286 at *3 (S.D.N.Y. June 1, 1998) (dismissing complaint that failed to particularize what publicly available information the plaintiffs and their attorneys allegedly reviewed).

3. What Is the Challenge for Pleading on "Information and Belief"?

A key question arising out of the "information and belief" pleading debate is: so what? What will be required of plaintiffs that is different from the level of pleading specificity required under the Reform Act for allegations based on personal knowledge?

The plaintiffs' bar argues that an overly strict reading of the "information and belief" pleading standard would require them to divulge confidential sources, such as former employees or other "consultants." The courts have not really come to grips with this issue, except in a few cases. In Novak v. Kasaks, 997 F. Supp. 425 (S.D.N.Y. 1998), the trial court held that

20

plaintiffs must name sources when pleading on information and belief. By contrast, in In re Digi International Sec. Lit., 1998 U.S. Dist. LEXIS 8320 (D. Minn. 1998), the court reached the opposite conclusion, holding that pleading on information and belief does not require disclosure of underlying evidence.

Will cases not be brought if plaintiff are forced to divulge sources? Doubtful. Will the appellate courts require such disclosure? Also doubtful.

C. "Group Published" Pleading Doctrine

The Reform Act also casts some doubt on the continuing validity of the "Group Published" Pleading Doctrine.

1. The group-published doctrine essentially replaced the particularity requirements of Rule 9(b) with a presumption that information contained in certain documents, such as prospectuses, registration statements, annual reports, and SEC filings, was part of a collective work.

A plaintiff invoking the group-published doctrine did not need to attribute an allegedly false or misleading statement directly to a defendant, but instead only had to allege that the defendant "either participated in the day-to-day corporate activities or had a special relationship with the corporation, such as participation in preparing or communicating group information at particular times." See, e.g., Allison v. Brooktree Corp., 999 F. Supp. 1342, 1350 (S.D. Cal. 1998) (quoting In re GlenFed, Inc., 60 F.3d 591, 593 (9th Cir. 1995).

2. Since the enactment of the PSLRA, some courts have questioned the continued vitality of the group-publishing doctrine, noting that the PSLRA requires a plaintiff to make specific allegations as to each defendant. See, e.g., Allison v. Brooktree Corp., 999 F. Supp. 1342, 1350 (S.D. Cal. 1998) ("To permit a judicial presumption as to particularity simply cannot be reconciled with the statutory mandate that plaintiffs must plead specific facts as to each act or omission by the defendant."). See also Chan v. Orthologic Corp., No. 96 Civ. 1514-PHX-RCS at 21 n.9 (D. Ariz. Feb. 5, 1998) (complaint insufficiently particular "[e]ven assuming that the group pleading doctrine applies").

3. Others have continued to apply the group publishing doctrine to sustain complaints that do not specify the precise connection between a defendant and the alleged misstatement or omission See, e.g., In re Digi Int'l Sec. Litig., 1998 U.S. Dist. LEXIS 8320 at *32-33 (D. Minn. May 22, 1998). See generally Zuckerman v. Foxmeyer Health Corp., 4 F. Supp. 2d 618, 622 (N.D. Texas 1998) (citing the "rule that senior executives of a corporate defendant may be held personally liable for misrepresentations contained in a public statement issued for the corporation").

* For example, the Central District of California very recently upheld a complaint that failed to attribute statements to specific individuals on the ground that the complaint "tailor[ed]" the allegations to include "only" the

21

executives, rather than every officer of the company, and finding it adequate to have alleged that the executives ran the company on a day-to-day basis. Schlagel v. Learning Tree, Inc., No. CV 98-6384 ABC, Fed. Sec. L. Rep. ¶ 90,403 at 91,815-16 (C.D. Cal. Dec. 23, 1998) (leaving it up to defendants to identify which executives made which statements).

Notably, the Schlagel court sustained the complaint despite finding that it did not contain any specific allegations with respect to three defendants, although it "remind[ed] Plaintiffs that they will have to make individual allegations as to the statements made by these individuals personally in order to survive summary judgment." Id. at 91816 n.5 (emphasis added). This approach, however, defeats the purpose of the Reform Act to deter plaintiffs from filing complaints just to access discovery which, they hope, will provide support for their allegations.

4. Still other courts (most notably in the Northern District of California) have applied the group-published doctrine, but have required plaintiffs to "plead with particularity defendants' participation in the day-to-day control of the corporation and their participation in the preparation of the allegedly false statements." Head v. Netmanage, No. C 97-4385 (CRB) (N.D. Cal. Feb. 24, 1998) (citing In re Oak Tech. Sec. Litig., 1997 WL 448168 at *10-11 (N.D. Cal. July 1, 1997)); In re Informix Corp. Sec. Litig., No. C 97-1289 CRB (N.D. Cal. Nov. 6, 1998); Molinari v. Symantec Corp., 1998 WL 78120 at *10-11 (N.D. Cal. Feb. 17, 1998).

D. A Future Battleground: What Evidence The Court May Consider On Motions to Dismiss

An important issue in future cases will be how much information trial courts will consider at the pleading stage, beyond that which is literally alleged in the complaint. Prior to the Reform Act, most courts would at least consider copies of documents specifically mentioned in the complaint, such as 10-Q's, press releases, analyst reports, and the like. Although the Reform Act does not address this subject, defendants have become more aggressive since passage of the Reform Act in asking trial courts to consider more "exotic" items at the pleadings stage, such as (i) Form 4's reflecting defendants' trading, (ii) stock price data, (iii) proxy statements showing total holdings by defendants, (iv) transcripts of analyst conference calls, etc. To date, trial courts have been "all over the map" on this issue. For example, in Plevy v. Haggarty, the court considered a variety of SEC filings, press releases, etc., on the grounds that they were generally averred to have been part of the plaintiffs' "basis of allegations." In Polk v. Fritz, the court even agreed to consider auditors' workpapers. But some courts, such as the court in Bryant v. Apple South, take a more conservative view, and will only consider that which is explicitly referenced in the complaint.

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III. THE SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS

A. Background

1. Initial SEC Attempts to Encourage Publication of Forward-Looking Statements

In 1979, the SEC promulgated Rule 175 under the Securities Act and Rule 3b-6 under the Exchange Act, creating safe harbor protection for specific forward-looking statements. These rules, which applied only to statements made, reaffirmed or later published in documents filed with the SEC, shifted the burden of proof to the plaintiff, and shielded statements made in good faith with a reasonable basis. Although the issuer was not required to state the assumptions underlying the covered statements, the assumptions, if stated, would also fall within the scope of the safe harbor.7 Nevertheless, issuers were reluctant to take advantage of the safe harbor, and the rules did not spur the quantity or quality of forward-looking disclosures that the SEC had desired.

7 See Release No. 33-6084, 44 F.R. 33810 (June 25, 1979).

2. "Bespeaks Caution" Doctrine:

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a. This judicially-created doctrine provided issuers with additional protection against lawsuits based on forward-looking information. In essence, the doctrine holds that certain types of predictions may be rendered immaterial as a matter of law if accompanied by appropriately specific cautionary language. As articulated by the Ninth Circuit in 1994, 'the doctrine, when properly construed, merely represents the pragmatic application of two fundamental concepts in the law of securities fraud: materiality and reliance."8 The doctrine has enjoyed widespread acceptance in the courts.9

b. Although courts have not hesitated in accepting the "bespeaks caution" doctrine, they have differed in the extent to which they take into account the defendant's good faith or reasonable belief in the truth of the statement.

i. Thus, for example, the Third Circuit in In re Donald J. Trump Casino Sec. Litig. affirmed the District Court's dismissal of an

8 In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1414 (9th Cir. 1994), cert. denied, 116 S.

Ct. 185 and 116 S. Ct. 277 (1995).

9 See, e.g., Romani v. Shearson Lehman Oppenheimer & Co., Inc., 929 F.2d 875, 879 (1st Cir.

1991); Olkey v. Hyperion 1999 Term Trust, Inc., 98 F.3d 2 (2d Cir. 1996); In re Donald J. Trump Casino Sec. Litig., 7 F.3d 357, 364, 371-73 (3d Cir. 1993), cert. denied, 510 U.S. 1178 (1994); Rubenstein v. Collins, 20 F.3d 160, 166-68 (5th Cir. 1994); Sinay v. Lamson & Sessions CO., 948 F.2d 1037, 1040-41 (6th Cir. 1991); Parnes v. Gateway 2000, Inc., 1997 WL 448153 (8th Cir. Aug. 8, 1997); In re Worlds of Wonder Sec. Litig., 35 F.3d 1407 (9th Cir. 1994), cert. denied 116 S. Ct. 277 (1995); Grossman v. Novell, 120 F.3d 1112 (10th Cir. 1997).

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action based on the "abundant and meaningful cautionary language contained in the prospectus."10

10

7 F.3d 357, 372 (3d Cir. 1993), cert. denied, 510 U.S. 1178 (1994). See also Brown v. E.F. Hutton Group, Inc., 991 F.2d 1020 (2d Cir. 1993) (holding an investor's recklessness may preclude recovery for false and misleading statements and declining to impose liability for allegedly false and misleading oral statements where prospectus and partnership brochure disclosed the risks of the venture).

25

ii. By contrast, the Sixth Circuit in Mayer v. Mylod held that an action should not have been dismissed based solely on the presence of cautionary statements because "[m]aterial statements which contain the speaker's opinion are actionable under Section 10(b) of the. . .Exchange Act if the speaker does not reasonably believe the opinion and the opinion is not factually well grounded."11

iii. As explained below, the Private Securities Litigation Reform Act makes it clear that a defendant may not be held liable for a statement if the statement is either accompanied by "meaningful cautionary language" or made without actual knowledge of its falsity or misleading nature.

c. There was also some discrepancy as to how closely the cautionary language must correlate to the challenged forward-looking statement in order to "bespeak caution."

i. Some courts required that the cautionary statements be "substantive and tailored to the specific future projections, estimates or opinions" challenged by plaintiffs. E.g., Kline v. First Western Government Securities, Inc., 24 F.3d 480 (3d Cir. 1994), cert. denied, 513 U.S. 1032 (1994).

ii. Others took a much broader view, going so far as to hold that cautionary statements in one document may shield forward-looking statements in other documents. E.g., Grossman v. Novell, 120 F.3d 1112 (10th Cir. 1997).

iii. The Ninth Circuit has drawn a distinction between the "bespeaks caution" doctrine and the "truth-on-the-market" defense, noting

11

988 F.2d 635, 639-41 (6th Cir. 1993). See also Rubenstein v. Collins, 20 F.3d 160, 168 (5th Cir. 1994) ("The appropriate inquiry is whether, under all the circumstances, the omitted fact or the prediction without a reasonable basis 'is one [that] a reasonable investor would consider significant in [making] the decision to invest, such that it alters the total mix of information available about the proposed investment."); Havsy v. Just Toys, Inc., 1994 WL 381447 at *3 (S.D.N.Y. 1994) (asserting that bespeaks caution doctrine "insulates good-faith projections from liability").

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that truth-on-the-market requires the disclosed information to have entered the market in such a way as to "counterbalance" the alleged misstatements, whereas the "bespeaks caution" doctrine focuses on whether cautionary language in a particular document is sufficient to render the "total mix of information" not misleading. See Provenz v. Miller, 102 F.3d 1478, 1492-93 (9th Cir. 1996).

B. The Statutory Safe Harbor Under The Reform Act

In an attempt to encourage companies to disclose projections and other "soft" information, and to impose some uniformity of expectations, Congress included as part of the Reform Act a statutory "safe harbor" for certain forward-looking statements. It was hoped that, by reducing the threat of liability, Congress could increase the quantity and quality of forward-looking information disseminated to investors.

1. Statutory Text

The "safe harbor" codifies parts of the "bespeaks caution" doctrine,12 and immunizes forward-looking statements that are "accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially...." See 15 U.S.C. § 78u-5(c)(1)(A)(i).

a. Under the safe harbor, oral statements may also qualify for protection if they (1) identify the statement as forward-looking; (2) state that actual results could differ materially; and (3) identify a "readily available" written document containing additional factors that could cause results to differ materially from the forward-looking statement. 15 U.S.C. § 78u-5(b)(2)

b. Significantly, the "safe harbor" expressly disclaims imposing any duty to update any forward-looking statements. 15 U.S.C. § 78u-5(d). There may, however, be a duty to update if statements imply, by their terms, continuing validity and subsequent events render the initial statement false or materially misleading. See, e.g., Backman v. Polaroid Corp., 910 F.2d 10, 17 (1st Cir. 1990) (en banc).

12

See Joint Explanatory Statement of the Committee of Conference, H.R. Report No. 104-369, 104th Cong., 1st Sess. at 43 (safe harbor is based on aspects of the "bespeaks caution" doctrine).

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2. Judicial Interpretations

a. Courts applying the statutory safe harbor have indicated that a company need not identify "all" factors that might affect the validity of a projection, as long as it discloses some of them. See, e.g., Rasheedi v. Cree Research, Inc., 1997 U.S. Dist. LEXIS 16968 at *1 (M.D.N.C. Oct. 17, 1997).

b. However, as was true under the "bespeaks caution" doctrine, general, "boilerplate" warnings will not suffice to immunize a forward-looking statement. See, e.g., Harris v. IVAX Corp., 1998 WL 159195 (S.D. Fla. March 30, 1998). Thus, in several Reform Act cases, trial courts have denied motions to dismiss, finding that the cautionary statements are not sufficiently particular. Cherednichenko v. Quarterdeck Corp., 1997 [CCH] ¶90, 108 (C.D.Cal. 1997); In re Stratosphere Sec. Lit., 1 F.Supp.2d 1096 (D.Nev. 1998); In re Employee Solutions Sec. Lit., (D. Ariz. 1998).

c. A very few courts have held that claims based on forward-looking statements should be dismissed for failure to allege "actual knowledge." See, e.g., Hockey v. Medhekar, supra; In re Advanta Corp. Sec. Lit, 1998 WL 38 7595 (E.D.Pa. 1998).

d. Although misstatements of historical fact are not protected by the safe harbor, the clause in the Act providing coverage for "assumptions underlying or relating to" forward-looking statements has led at least one court to conclude that historical facts that were intertwined with forward-looking statements were themselves entitled to safe-harbor protection. Hockey v. Medhekar, 1997 WL 203704 (N.D. Cal. Apr. 15, 1997).

C. Impact of Safe Harbor

The prevailing view thus far has been that the statutory safe harbor has not had the desired effect of increasing the quantity or quality of published forward-looking information.13

13

See Committee on Securities Regulation, Forward-Looking Statements and Cautionary Language After the 1995 Private Securities Litigation Reform Act, The Record, Vol. 53, No. 6 at 726 (Nov/Dec. 1998) (citation omitted).

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1. Quantity of Information

Although companies appear to be relying on the safe harbor for oral statements, it seems that companies are continuing -- and possibly increasing -- to resort to analysts and institutional investors to disclose forward-looking information, taking advantage of the ability to cross-reference published risk disclosures to immunize their oral statements. Ironically, the ease of shielding oral statements minimizes the incentives for companies to make written forward-looking statements, as there is no institutional pressure to do so. A recent study has concluded that there was "no meaningful change in the nature or extent of written forward-looking statements" as a result of the PSLRA.14

14

Id. at 736.

2. Quality of Information

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The SEC has criticized the cautionary language used in various disclosure documents as "boilerplate" and overly general, and has indicated a desire to see companies provide more forward-looking information and improve the quality of the cautionary statements.15

3. Several factors may have contributed to the continued reluctance of companies to disclose extensive forward-looking information

a. First, there is still some confusion in the courts as to what constitutes "meaningful" cautionary statements sufficient to immunize a forward-looking statement. Because the Reform Act codified a version of the "bespeaks caution" doctrine, courts may rely on pre-Reform Act precedent, which, as described above, imposed varying standards of what types of warnings are sufficient to immunize a predictive statement.

b. Second, the Safe Harbor does not apply to actions brought by the SEC, leaving companies open to enforcement actions.

c. Third, because the Reform Act applied only to federal claims, issuers remained subject to liability under the state law.

IV. LIABILITY FOR STATEMENTS TO AND BY ANALYSTS

In addition to being held liable for statements they make directly to the public, companies may also face liability for statements made to and by analysts under three theories: direct liability, "entanglement," or adoption.16 At the heart of each of these theories is a judgment that a company should not be permitted to do indirectly, through analysts, what it cannot do directly. Accordingly, a company may be held accountable for actions that lend the impression that statements made by other persons are really the statements of the company itself.

15

Id. at 728.

16

Although these are three distinct theories of liability, courts have sometimes collapsed the

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theories into one another. For example, the Northern District has indicated that a plaintiff seeking to impose liability based on analysts' statements must show "adoption" by alleging specific reports and the name of the insider who adopted them, specific interactions between the insider and analyst, and dates on which the interactions occurred — hallmarks of what must be pled to show entanglement. See Fischer v. Acuson Corp., 1995 WL 261439 at *7 (N.D. Cal. Apr. 26, 1995).

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A. Direct Liability

This theory holds companies liable for statements made directly to analysts, so that they will be responsible for the consequences of the analysts' repetition or republication of these statements to the market.

1. The Ninth Circuit articulated the reasoning behind holding companies responsible for fraudulent statements made to analysts: "[defendants] cannot escape liability simply because [they] carried out [their] alleged fraud through the public statements of third parties." Cooper v. Pickett, 122 F.3d 1186, 1193 (9th Cir. 1997) (quotation omitted); Warshaw v. Xoma Corp., 74 F.3d 955 (9th Cir. 1996).

2. Some courts, however, have indicated that anonymous statements in analysts' reports that are not attributable to a specific source within the company may not be actionable. For example, the Second Circuit has noted that "investors tend to discount information in newspaper articles and analyst reports when the author is unable to cite specific, attributable information from the company." In re Time-Warner, Inc. Sec. Litig., 9 F.3d 259 (2d Cir. 1993). See also Oppenheimer v. Novell, 851 F. Supp, 412, 416 (D. Utah 1994) (citing Time Warner and indicating company cannot be held liable for anonymous statements).

3. Whether or not "anonymous" statements are actionable, however, it is clear that allegations of direct liability must always be pleaded with the particularity required by Rule 9(b) and the Reform Act. Accordingly, the court in Time-Warner deemed insufficient a complaint which failed to specify which individuals in the company were allegedly responsible for making statements to analysts. 9 F.3d 259 (2d Cir. 1993).

4. Several Reform Act decisions explicitly uphold claims alleging that companies used analysts as "conduits." See Bryant v. Apple South, Inc., 1998 U.S. Dist. LEXIS 12125 at *30-31 (M.D. Ga. July 29, 1998) (finding allegations sufficient); Molinari v. Symantec, 1998 WL 78120 (N.D. Cal. 1998); Robertson v. Strassner, (N.D. Tex. 1998).

B. "Entanglement"

This theory holds companies responsible for analysts' statements on which they have placed their "imprimatur" before release by the analysts.

1. The Ninth Circuit has indicated that there must be a "two-way flow" of information between the insider and the analyst preparing the challenged statement. See, e.g., In re Caere Corp. Sec. Litig., 837 F. Supp. 1054, 1059 (N.D. Cal. 1993); see also In re Syntex Corp. Sec. Litig., 855 F. Supp. 1086, 1096 (N.D. Cal. 1993).

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a. In addition, courts in the Ninth Circuit have also required that the officer involved with the analyst have known that the information as false or unreasonable yet have failed to disclosed the falsity or unreasonableness to investors. See In re Caere, 837 F. Supp. at 1060. Under this test, information is presumptively reasonable unless there was "no reasonable basis for it at the time in which it was made." Id.

2. Other jurisdictions accepting the "entanglement" theory have not insisted on a two-way flow of information, but have looked to similar interactions demonstrating the company's involvement in preparing the analyst's report.

3. Still others, relying on Central Bank of Denver, have rejected entirely the notion of "entanglement" as a basis of liability. These courts have adopted a "bright-line" rule that "no matter how extensive a corporation's review and approval of statements in an analyst's report, that review and approval does not imply that the corporation, in effect, has 'made' [those] statements" for purposes of liability under § 10(b). In re ICN/Viratek Sec. Litig., 1996 WL 164732 at *5 (S.D.N.Y. Apr. 9, 1996).17

4. In jurisdictions that accept "entanglement" as a basis of liability, the plaintiff must plead such entanglement with the particularity required by Rule 9(b), and now, the Reform Act. See, e.g., In re Boston Tech. Sec. Litig., 1998 WL 340402 at *8-9 (D. Mass. Feb. 5, 1998).

a. As applied by courts in the Ninth Circuit, this means the plaintiff must "(1) identify specific forecasts and name the insider who adopted them, (2) point to specific interactions between the insider and the analyst which gave rise to the entanglement; and (3) state the dates on which the acts which allegedly gave rise to the entanglement occurred." In re Caere, 837 F. Supp at 1059; see also In re Syntex Corp. Sec. Litig., 855 F. Supp. 1086, 1096 (N.D. Cal. 1993).

b. Other courts have taken a more flexible (yet still specific) approach to the pleading requirements, requiring a complaint to allege, as a whole, "a significant and specific, not merely a casual or speculative, entanglement between the defendants and the analysts with respect to the statements at

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See also In re Kendall Square Research Corp. Sec. Litig., 868 F. Supp. 26, 28 (D. Mass. 1994); Vosgerichian v. Commodore Int'l, 862 F. Supp. 1371 (E.D. Pa. 1994); Walco Instruments, Inc. v. Thenen, 881 F. Supp. 1576, 1582 (S. D. Fla. 1995); In re College Bound Consol. Litig., 1994 WL 172408 (S.D.N.Y. May 4, 1994).

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issue." Schaffer v. Timberland Co., 924 F. Supp. 1298, 1310 (D.N.H. 1996) (citation omitted).

5. There is very little uniformity, however, on what allegations of involvement are sufficient to confer liability based on entanglement.

a. Some courts have found no "entanglement" where companies have formal "no comment" policies, even where there was some interaction with analysts. See, e.g., In re Caere, 837 F. Supp. at 1059; In re Seagate Tech. II Sec. Litig., [1994-95 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 98, 530 (N.D. Cal. 1996); In re Cypress Semiconductor Sec. Litig., 891 F. Supp. 1369, 1377 (N.D. Cal. 1995), aff'd sub nom Eisenstadt v. Allen, 113 F.3d 1240 (9th Cir. 1997).

b. Others have found "entanglement" based on information provided to analysts or reviews of analysts reports, even where the company did not review the final report. See, e.g., In re ICN/Viratek Sec. Litig., 1996 WL 164732 at *7 (S.D.N.Y. Apr. 9, 1996); Schaffer v. Timberland Co., 924 F. Supp. 1298, 1321 (D.N.H. 1996).

c. Reform Act cases continue to reflect conflict among the district courts. Compare Allison v. Brooktree, 999 F. Supp. 1342 (S.D. Cal. 1998) (some entanglement found), Wenger v. Lumisys (no entanglement), Genna v. Digital Link Corp. (N.D. Cal. 1997) (entanglement found), and In re Stratosphere Sec. Lit. (some entanglement).

C. Adoption

Under this theory, statements by analysts may be attributable to the company if, after the analyst has made the statement, the company endorses the statement, either by distributing it widely, repeating it, or expressing approval of it. Once again, courts differ on what conduct is sufficient to show adoption.

1. Some courts have found certain expressions of "comfort" insufficient. For example, the CFO in In re Adobe Systems, Inc. Sec. Litig., 787 F. Supp. 912, 915 (N.D. Cal. 1992), aff'd, 5 F.3d 535 (9th Cir. 1993), indicated during a conference call with analysts that he would be "more comfortable" with an earnings estimate of $2.10 rather than with higher estimates currently in the market. Despite the fact that internal reports estimated earnings at $1.47 to $1.68 per share, the court granted summary judgment on the grounds that the company's statement was not misleading.

2. Distributing analysts' reports may confer liability. See, e.g., In re Presstek, Inc., Exchange Act Release No. 39472 (Dec. 22, 1997) (company included analysts' reports in investor packets and mailings to company mailing list); In re Cypress, 891 F. Supp. at 1377 ("Distributing analysts' reports to potential investors may, depending on the circumstances, amount to an implied representation that the

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reports are accurate.") (finding no liability because the distribution was not wide enough for the information to reach the market).

3. In this age of Internet technology, companies must also beware the risk of "adoption" by including on their company web page a link to an analyst's report. Faced with a similar issue, the SEC recently indicated disapproval of posting a preliminary prospectus on the Internet along with links to research reports. Interpretive Release, 60 SEC Docket (CCH) 1100 at Example 16.

D. Application of the Statutory Safe Harbor to Statements Contained in Analysts' Reports.

Although no case has yet taken this position, a company charged with fraud based on statements made to or by analysts arguably should be granted the same safe harbor protection -- and the "actual knowledge" standard of scienter -- it would enjoy if the statements were made by it directly.

1. The Reform Act specifically extends the statutory safe harbor to any person acting on behalf of the issuer. Although analysts and underwriters may argue that they do not act "on behalf of" the issuer, the chief rationale for holding a company liable for statements made to or by analysts is that companies should not be permitted to shield misstatements by passing them through an intermediary — in essence, that they should not be immunized for using an agent. See, e.g., In re Presstek, Exchange Act Release No. 39472 (Dec. 22, 1997)]

The converse, however, is equally true: companies should be entitled to the same safe-harbor protection for statements they "made" through analysts as they would for statements they made directly to the public. Accordingly, the same standards of adequate cautionary language, actual knowledge, and no duty to update should apply equally to statements contained in analysts' reports that are somehow attributable to the company itself.

2. Despite the "actual knowledge" standard of the Reform Act, the SEC has taken a far more strict position, holding that "if an issuer knows, or is reckless in not knowing, that the information it distributes is false or misleading, it cannot be insulated from liability because management was not actively involved in the preparation of that information." Presstek, Exchange Act Release No. 39472 at 10 (Dec. 22, 1997) (emphasis added).

3. The SEC has also indicated that entanglement or adoption carries with it a duty to update materially misleading information. Positions such as this may well undermine the effectiveness of the safe harbor to encourage disclosure of forward-looking information.

PSLRA ICC Presentation.doc

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