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Consequences, Intended and Unintended, of Securities Reform

by Edward Labaton
Stetson Law Review |

In the last three and one-half years, Congress has adopted two major laws designed - purportedly - to "reform" the law relating to civil claims for fraud in connection with market trading in securities. These two laws are the Private Securities Litigation Reform Act(1) (PSLRA), which became law over President Clinton's veto in December 1995, and the Securities Litigation Uniform Standards Act,(2) signed by President Clinton in November 1998.

Some view the word "reform" as a euphemism for an effort to dilute fundamental rights. I am concerned that more "reform" could undo some of the basic underpinnings of our securities markets. In talking about tort reform, Professor Marc Galanter, in a recent law review article, observed that most so-called law reforms reduce levels of accountability and "make it more difficult for individual claimants to use the system to challenge corporate entities."(3) He might as well have been writing about securities law reform.

But, accepting at face value the good intentions of the reformers, I would like to take a look at some of the consequences - intended and unintended - of the PSLRA, and guess at possible consequences not yet evident in that law and in the Uniform Standards Act, familiarly known as the "Preemption Bill."

This may be presumptuous. I am reminded of the conversation between Henry Kissinger and Zhou En-Lai, when Kissinger asked, "What is the historical significance of the French Revolution?" Zhou En-Lai responded, "It is yet too early to tell."(4) Before I speculate about consequences, I would like to give an overview of the law that was "reformed": the federal law relating to private civil actions for fraud in open market transactions.

Having said that mouthful, a visitor from Canada or Britain might well assume that there is a carefully delineated legislative scheme setting forth the standards of that law. No such legislative scheme exists. This does not mean that there are no federal remedies for open market fraud, no serious consequences for the perpetrators of fraud, or that the scope and limitations of those remedies are nonexistent. The rights, consequences, and remedies for open market securities fraud are found in a body of law that is not perfect, but has met the needs of a society with the largest, most sophisticated securities markets in history. That body of law was developed by the federal courts starting in 1946(5) and has evolved since then.


Before adoption of the federal securities laws in 1933 and 1934, no federal remedy existed for securities fraud victims. And when Congress, in the wake of the depression that followed the 1929 crash, adopted the Securities Act of 1933(6) and the Securities Exchange Act of 1934,(7) the foundations of our federal securities laws, it provided no private civil remedy for open market fraud. There were civil remedies for misstatements in registration statements filed with the Securities and Exchange Commission (SEC) for public offerings of securities.(8) There were remedies for limited types of insider trading(9) and there were other very limited remedies for misstatements in documents filed with the Commission.(10)

Beginning in 1946 this changed, not by an act of Congress, but by a decision in a civil case in the Eastern District of Pennsylvania, Kardon v. National Gypsum Co.(11) Judge Kirkpatrick looked to Rule 10b-5,(12) which made it illegal to make misstatements of fact or omit material facts in connection with the purchase or sale of securities.(13) This was a rule promulgated by the SEC to define criminal liability under Section 10(b) of the Securities Exchange Act.(14) Rule 10b-5 consists of one sentence of about 100 words.(15) It remains unchanged since its promulgation in 1942. Milton V. Freeman, then a staff member in the SEC Office of the General Counsel, wrote the rule. In 1967, Mr. Freeman recounted his recollection of Rule 10b-5's origin. He said:

It was one day in the year 1943, I believe. I was sitting in my office in the S.E.C. building in Philadelphia and I received a call from Jim Treanor who was then the Director of the Trading and Exchange Division. He said, "I have just been on the telephone with Paul Rowen," who was then the S.E.C. Regional Administrator in Boston, "and he has told me about the president of some company in Boston who is going around buying up the stock of his company from his own shareholders at $4.00 a share, and he has been telling them that the company is doing very badly, whereas, in fact, the earnings are going to be quadrupled and will be $2.00 a share for this coming year. Is there anything we can do about it?" So he came upstairs and I called in my secretary and I looked at Section 10(b) and I looked at Section 17, and I put them together, and the only discussion we had there was where "in connection with the purchase or sale" should be, and we decided it should be at the end.

We called the Commission and we got on the calendar . . . . All the commissioners read the rule and they tossed it on the table, indicating approval. Nobody said anything except Sumner Pike who said, "Well," he said, "we are against fraud, aren't we?" That is how it happened.(16)

This rule is the cornerstone of open market securities fraud law. In sum, Rule 10b-5 provides that it shall be unlawful, in connection with the purchase or sale of securities, to (1) employ a device, scheme, or artifice to defraud, (2) make an untrue statement of material fact or omit a material fact, or (3) engage in acts or practices which would effect a fraud or deceit on any person.(17) It contains no explicit provision for civil liability.(18) Judge Kirkpatrick held in Kardon, however, that a Rule 10b-5 violation implied a civil remedy to victims of that fraud.(19)

From that obscure decision by a United States district judge, a comprehensive body of common law developed to meet the needs of a growing securities market. Here is an idea of its growth: In 1960, 1143 companies were listed on the New York Stock Exchange and about 767 million shares were traded.(20) In 1995, 2675 companies were listed,(21) and trading volume exceeded 87 billion shares.(22) In 1960, NASDAQ did not exist.(23) In 1995, 5122 companies, including Microsoft, Intel, Dell Computer, Amgen and Cisco Systems, were NASDAQ companies, and trading volume exceeded 100 billion shares.(24)

The Supreme Court did not fully recognize Rule 10b-5 as a basis for civil liability until 1983.(25) By then, federal courts had already established a body of law relating to civil liability for fraud in open market transactions. That body of law is a complex mosaic created by hundreds of individual decisions in United States courts. Some of these decisions were by the United States Supreme Court which, over the years, has determined that:

  • Scienter is a prerequisite to liability. Mere negligence will not suffice.(26)

  • The statute of limitations, which in effect is borrowed from the Securities Act of 1933 provisions involving liability for false and misleading registration statements and prospectuses, is short.(27)

  • Persons who are not purchasers or sellers, but simply hold a security in reliance on misleading information, have no claim.(28)

  • No liability exists under Rule 10b-5 for aiding and abetting a securities fraud.(29)

Lower federal courts developed other doctrines applicable to Rule 10b-5 claims. In the early 1990s, for example, a series of district and circuit court opinions established the "bespeaks caution" doctrine, which protects companies and individuals from liability for forecasts or projections if the forward-looking statements are accompanied by meaningful cautionary statements.(30)

The development of Rule 10b-5 as an effective remedy for market fraud was facilitated by the 1966 amendments to the Federal Rules of Civil Procedure, which added a procedural vehicle, Rule 23, governing class actions.(31) Rule 23 could provide a remedy for the mass of open market purchasers or sellers damaged by fraudulent conduct. Rule 23 has developed its own large body of law, but suffice it to say that the class action is now a well-established device which can deal effectively with open market securities fraud claims affecting large numbers of persons. Among the most important decisions under Rule 23 was the acceptance of the "fraud on the market" theory.(32) Under that theory, in an established market such as the New York Stock Exchange or NASDAQ, the market itself is presumed to rely on a false or misleading statement.(33) In other words, if a company issues falsely inflated earnings statements the price of its stock will be higher than if the statements were true. This common sense principle solidified the feasibility of securities fraud class actions. It eliminated the need to prove individual reliance by each class member upon widely disseminated false financial statements.(34)

In the 1990s, a movement developed demanding "reform" of securities fraud class actions. Two principal forces were behind the demand for reform. First, the accounting profession, or more precisely the Big Six(35) (now the Big Five, and perhaps someday the Final Four), had suffered very large losses, not primarily in private securities actions, but because of the savings and loan debacle.(36) Between 1992 and 1994, Big Six firms paid about $1 billion to settle claims by federal agencies in connection with the savings and loan crisis.(37) These payments included more than $400 million by Ernst & Young,(38) more than $300 million by Deloitte & Touche,(39) and almost $200 million by KPMG Peat Marwick.(40) Second, Silicon Valley companies, despite the fact that they received enormous benefits from the availability of capital from public securities markets, were increasingly skittish about their exposure to litigation.(41) The public markets that provided computer technology firms with billions of capital dollars were trusted because of the regulatory structure and the existence of the SEC, an agency that represents the best of government.

The SEC repeatedly has noted that government regulation alone is not sufficient to keep markets honest.(42) It has consistently stated that the private civil remedy is a key element in establishing a trusted market in which individuals and pension funds could safely invest.(43)

By the early 1990s, several myths developed or were created by the forces seeking change: (1) drops of 10% of the price of a stock resulted automatically in a class action, (2) class actions were settled for a predictable amount irrespective of the merits, and (3) the number of class actions mushroomed in the 1980s and 1990s.(44) As demonstrated by a relatively short but factually complete article by Dean Joel Seligman in the Harvard Law Review,(45) these myths were indeed myths.

I do not pretend to be fully objective. I am an active litigator in the trenches on a day-to-day basis. But the facts, as shown by Professor Seligman and by others with no axe to grind, demonstrate that the number of lawsuits filed in the twenty years ending in 1994 was essentially flat.(46) This was despite the fact that the number of companies listed on the New York Stock Exchange and NASDAQ had doubled, and trading in those markets had increased exponentially from less than 5 billion shares on the New York Stock Exchange to more than 87 billion shares,(47) and from 1.4 billion shares on NASDAQ to more than 100 billion shares.(48) In the same period, the dismissal rate of securities class actions had substantially increased.(49) Empirical data also showed that lawsuits did not simply follow stock drops, and that settlements reflected real exposure.(50)

Perhaps most important is that securities class actions did not dampen American capital markets.(51) Instead, they flourished.(52) For example, from 1973 to 1976, 151 initial public offerings raised just over $2 billion.(53) In the four years ending December 31, 1993, 2081 initial public offerings raised more than $187 billion.(54) The Congress elected to enact the Contract with America;(55) however, it was less concerned with these facts than with catering to its key constituencies, and therefore in late 1995 it enacted the PSLRA.(56)


The law established heightened pleading requirements, the present scope which has yet to be defined.(57) It established the concept of the "lead plaintiff," which would be the person, group, or institution that had suffered the largest loss.(58) The lead plaintiff would direct the litigation.(59) For those who question the importance of academic writing, the genesis for the lead plaintiff provisions was a single law review article urging that pension funds and other institutional investors should be much more proactive in securities class actions.(60)

The PSLRA slowed cases down; first, with a waiting period to determine the "lead plaintiff,"(61) and second, by a stay of all discovery until after motions to dismiss had been decided.(62) It established a system of proportionate liability in place of joint and several liability, unless the false statements were knowingly made.(63) The accounting profession actively sought this provision.(64) It provided a broad safe harbor for "forward-looking statements," that is, projections, provided that "meaningful cautionary statements" were made.(65)

What were some of the goals of these provisions? And what has the statute actually achieved?

The lead plaintiff provisions were intended in part to reduce the role of the typical plaintiffs' firm.(66) Cases would be less lawyer-driven and the plaintiffs' securities bar would be weakened.(67) Milberg Weiss Bershad Hynes & Lerach, by far the largest plaintiffs' securities firm, was a target.(68) Bill Lerach, who heads the firm's west coast branch, was a poster boy for the proponents of "reform." That intention has been thwarted. Milberg Weiss is stronger than ever and has filed a larger percentage of securities class action cases than any other firm since the adoption of the PSLRA.(69) Also, the institutional investors have, for the most part, retained established plaintiffs' litigation firms.(70)

Another goal of the lead plaintiff provisions was that institutional investors would play a major role in prosecuting securities fraud claims.(71) By and large, this has not happened. Only a small fraction of the cases filed have had institutional investors as plaintiffs, and only a few institutional investors have had any incentive to serve as lead plaintiff.(72) In 1996 and 1997, institutional investors sought lead counsel status in only 17 of the 280 cases filed.(73) Statistics for 1998 are unavailable, but it does not appear that a significant change occurred in that year. To the extent the goal of involving institutional investors in securities litigation has been achieved, it may result in a consequence not sought by those who lobbied for the legislation. It may encourage those institutions who have entered the litigation arena to become even more active in that arena - to bring derivative suits for waste of assets where corporations have given large "golden parachute"(74) payments.

CALPERS,(75) the huge California pension fund, for example, has intervened in In re Walt Disney Co. Derivative Litigation,(76) appealing the decision that a $140 million severance payment to one person was a proper exercise of business judgment. CALPERS also intervened in a shareholder derivative suit involving W.R. Grace.(77) Additionally, the New York state pension fund is a plaintiff in a shareholder derivative suit brought on behalf of Columbia/HCA.(78) I believe that there may be additional interest in litigating in other areas involving lax corporate governance.

Another goal of the PSLRA was that fewer cases would be filed.(79) This too has not happened. The number of cases filed has remained at or higher than the levels of filings in the years preceding the PSLRA's enactment.(80) The Securities Class Action Clearinghouse, a Web site maintained by Stanford Law School,(81) reports that in 1998, 235 companies were sued in federal class action securities fraud cases.(82) This broke the record of 227 companies sued in 1997.(83) Considering the increased trading volume and the securities price volatility issued by some of those defendants, this is hardly a litigation explosion. In 1998, the trading volume on both NASDAQ and the New York Stock Exchange was twice the volume on those exchanges just three years earlier.(84)

Congress also intended that accounting firms would have less litigation exposure due to the heightened pleading requirements, limitations on discovery, and a proportionate liability system.(85) Whether this has occurred is difficult to say. Long before the adoption of the PSLRA courts always looked at accounting cases carefully, and particularly the Second Circuit, which several years ago imposed a high pleading standard for securities fraud claims.(86) There is considerable debate and a split in authority as to whether the PSLRA imposed an even more stringent pleading requirement.(87) In any event, there appear to be fewer claims filed against accountants than in the years prior to the adoption of the PSLRA. This may be due in part to the decision in Central Bank of Denver v. First Interstate Bank of Denver.(88) But in other circuits, a higher pleading standard may protect accounting firms from suits which in earlier years might have been brought.

One important consequence, whether intended or not, is the increase in the number of pleading motions made in class actions. This is due to two factors. The first is the pleading standard. Rule 8 of the Federal Rules of Procedure, which states that a complaint should consist of "a short and plain statement of the claim,"(89) is a dead letter in securities fraud actions. The second reason is that there is an automatic stay of discovery until the disposition of motions to dismiss.(90) This has resulted in long delays in prosecuting securities fraud actions. Whether or not this is an intended consequence, I cannot say. It is an unfortunate one if an objective of the law is to compensate fraud victims.

I do not think the proportionate liability provisions will give much solace to accountants. This is because of the novel definition of proportionate liability in the PSLRA, which the courts have not yet addressed. Proportionate liability under PSLRA has two prongs: (1) culpability - who was more guilty of egregious conduct, and (2) causation - what caused the injury.(91)

This two-pronged test came out of the forerunner to the PSLRA, the Dodd-Domenici bill, which included an identical proportionality definition.(92) The staff report for that bill explained the rationale for two-pronged standards:

[R]elative culpability may not always be the only appropriate indicator of responsibility in the case of egregious securities fraud. For example, an issuer may perpetrate a knowing fraud, while the issuer's agents, such as its independent auditors or law firm or financial adviser may contribute to the harm through less egregious conduct. Although the conduct of the agents may be less blameworthy than that of the primary violator, the agent's responsibility for harm to investors may nonetheless be considerable. The market may place far greater reliance on the judgment of an independent auditor, law firm, or investment bank than on the issuer, and the agent's actions may be more critical in causing injury to investors. Any attempt to fashion a system of proportionate liability should therefore consider both a defendant's degree of culpability and the causal connection between the defendant's role and the harm caused.(93)

Finally, in my view, Congress hoped that fewer suits would be filed against Silicon Valley companies. This cannot and will not happen as long as the public securities markets include unseasoned emerging technology companies where the culture of managers is entrepreneurial, where there are pressures to maintain high stock prices, and where the gatekeepers - the accountants, underwriters and lawyers - do not fulfill their responsibilities. In this environment there are often strong temptations to fudge facts or worse.


Another unintended but brief consequence of the PSLRA was the increase in filings of securities fraud class actions in state courts, particularly in California in 1996. In the first ten months of that year, seventy-nine securities class actions were filed in state courts, compared with forty-eight filed in the first ten months of 1995.(94) By 1997, state court filings dropped. Only nineteen were filed in the first four months of 1997 compared to forty in the first four months of 1996.(95) Although the 1996 filings appeared to be more of a blip than a trend, Silicon Valley expressed concern that exposure to such litigation would dilute the benefits of the PSLRA by weakening the safe harbor for forward-looking statements and depriving defendants of the discovery stay.(96) I question whether these concerns were really warranted. The California courts had not determined how they would treat a state case where a parallel federal case had been filed. Would they permit the state case to go forward? Would they stay the case pending disposition of a motion to dismiss? Would they require concurrent discovery?

But Silicon Valley, encouraged by its victory in Congress with the PSLRA, and by its victory in a California state initiative, which sought to broaden state court remedies for securities fraud, aggressively lobbied for pre-emption by the federal courts on securities fraud class actions.(97) The result was the Uniform Standards Act, a bill enacted late last year, and familiarly known as the Preemption Bill.(98)

The Act preempts all state securities fraud class actions relating to a company listed on the New York Stock Exchange, NASDAQ or other national exchanges.(99) It essentially eliminates state class actions for fraud, negligence, or breach of fiduciary duty in most cases.(100) As far as I can tell, this is the first time Congress has attempted to preempt the states' rights to protect their own citizens in favor of a body of law developed by the courts on a foundation consisting solely of a federal administrative agency rule. Some claims, such as those for breach of fiduciary duty and negligent misrepresentation, have been held not to be covered by Rule 10b-5 and cannot be asserted as a federal claim.(101) Prior to the adoption of the Uniform Standards Act, these claims were asserted in state court or in federal court as pendent to Rule 10b-5 claims.(102) Now, with limited exceptions, they are nonexistent as class actions.

I understand the rationale for Congress' preemption of state law in areas such as telecommunications or pensions where there are well-considered federal legislative schemes such as the Communications Act(103) or ERISA.(104) But when the Congress preempts in favor of a body of law built on a 100-word rule, isn't it flirting with irresponsibility?

Professor Joseph Grundfest, a former SEC Commissioner, now a professor at Stanford Law School and a strong supporter of the Uniform Standards Act, has written in the Harvard Law Review that the SEC has the power to "disimply" civil liability under Rule 10b-5.(105) Let us suppose that this five-member unelected commission did decide to disimply. By doing so, there would be no remedy, federal or state, for securities fraud perpetrated on the investing public. It may be far-fetched to suggest that the SEC would disimply. The Commission has a long history of acting responsibly to protect investors, and time and time again has articulated the importance of private civil litigation in the federal regulatory scheme. But there may come a day when the SEC may weaken and, like other federal and state regulatory agencies, be captured by those they purport to regulate.

Leaving that anomaly aside, there are more immediate concerns about the haste with which Congress acted in preempting state law. It left huge gaps in the rights of securities fraud victims. The most obvious example relates to liability for aiding and abetting a securities fraud. Until 1994, those who aided or abetted a securities fraud were liable in a civil action under Rule 10b-5.(106) All twelve circuits had so held.(107) But in April 1994, in a 5-4 decision, the Supreme Court held that Congress, in adopting Section 10(b) of the Securities Exchange Act,(108) did not intend to impose liability for those who aided and abetted a securities fraud.(109) This holding was curious since a reading of Section 10(b) provides no intention to impose any civil liability, including liability for primary violators.(110)

Why was aiding and abetting liability important? After all, aiding and abetting cases involve only secondary actors. But these secondary actors often have been accurately characterized as the gatekeepers of our securities markets. They are the lawyers, accountants, and investment bankers on whom the investing public relies to assure the honesty and integrity of the market. Many, perhaps most, securities frauds cannot be accomplished without the participation or inaction of these professionals.(111) Central Bank, however, has shielded them from civil liability under federal laws for aiding and abetting a securities fraud.(112) And since the Uniform Standards Act preempts state law with respect to securities fraud class actions, the gatekeepers appear to be free to open the gates without fear of any accountability to the investing public.

Well, not necessarily so. The Supreme Court in Central Bank left open the definition and extent of primary liability.(113) And the federal courts have wrestled with establishing the standards for such liability. Some courts have held that there is liability where a professional substantially participates in false and misleading statements disseminated by others.(114) Other courts have restricted primary liability to issuance of misleading statements (in, for example, legal opinions and accounting statements) by professionals themselves.(115)

I suggest (perhaps "hope" is a better word) that the law, like nature, abhors a vacuum. The courts, in the absence of any state remedy for aiding and abetting open market fraud, may eliminate the vacuum created by the combination of the Uniform Standards Act and Central Bank by favoring an expansive, yet realistic, reading of primary liability to assure that those upon whom our markets rely for their integrity are accountable for their conduct. Professor Jill Fisch, in a thoughtful article published in the June 1999 issue of the Columbia Law Review, suggests that the PSLRA and the Uniform Standards Act, together, will result in federal courts determining that there is primary liability for those secondary actors who play a vital role in protecting the integrity of securities markets.(116)


I would like to conclude by restating the basic theme I have tried to develop. The organic development of the law relating to fraud in securities by hundreds of court decisions has served our country well. Our federal courts, in the fifty years following World War II, fashioned a body of law necessary for the complex securities markets that were developing - almost exploding - in the country. That body of law has played a major role in establishing the integrity and the honesty of our securities markets. The American capital markets have maintained their preeminent position in the global economy because investors, worldwide, view these markets as very honest. Investor confidence in the fairness of American markets is bolstered by a system that permits private lawsuits for securities fraud. I confess that I have just plagiarized someone else's thoughts and words. The last two sentences were taken from a staff report prepared in May 1994 at the direction of Senator Christopher Dodd, a principal proponent of the PSLRA.(117)

In the face of the indisputable role of private litigation in protecting securities markets, Congress, without any real evidence of major defects in the basic structure of the law, and in response to heavy lobbying, has attempted to dilute, modify and to some extent codify aspects of that law. That, I believe, is a major mistake. There is sound wisdom in the adage: "If it ain't broke, don't fix it." When we depart from that wise principle, we often discover that the consequences are not those we had anticipated.

What concerns me more than what has happened is what may happen. If Congress continues to codify or tinker, then the magnificent body of law that has developed organically over the last fifty years may become rigid, inflexible, or unworkable. Flexible judicial doctrines which can change based on experience and need, and which have been enlightened by state court decisions, are a far better model than a code like the Internal Revenue Code which has tightly defined rules with exceptions, loopholes, arcane provisions and incomprehensible sentences, many of which serve special interests and weaken the confidence of the public.(118)

If some proponents of "reform" were somehow to achieve what I believe to be their real dream, freedom from exposure to private civil liability, then they might confront us with the worst of unintended consequences: securities markets not trusted by the investing public because they lack a basic safeguard. When that last occurred, this country suffered the great market crash of 1929 which, in the depths of the Great Depression, resulted in real securities law reform - the Securities Act of 1933 and Securities Exchange Act of 1934. I am not suggesting that history will repeat itself. It rarely does in precisely the same manner. But the consequence of markets that are not trusted is something that I prefer not to contemplate.


1 Private Securities Litigation Reform Act of 1996, Pub. L. No. 104-67, 109 Stat. 737 (codified as amended in scattered sections of 15 U.S.C.).

2 Securities Litigation Uniform Standards Act of 1998, Pub. L. No. 105-353, 112 Stat. 3227 (to be codified in scattered sections of 15 U.S.C.).

3 Marc Galanter, An Oil Strike in Hell: Contemporary Legends About the Civil Justice System, 40 Ariz. L. Rev. 717, 719 (1998).

4 Stephan Kux, Confederalism and Stability in the Commonwealth of Independent States, 1 New Eur. L. Rev. 387, 389 (1993).

5 See Kardon v. National Gypsum Co., 69 F. Supp. 512 (E.D. Pa. 1946).

6 Securities Act of 1933 (Securities Act), 48 Stat. 74 (codified as amended at 16 U.S.C. §§ 77a-77bbbb (1994 & Supp. III 1997)).

7 Securities Exchange Act of 1934 (Exchange Act), 48 Stat. 881 (codified as amended at 15 U.S.C. §§ 78a-78 ll (1994 & Supp. III 1997)).

8 See 15 U.S.C. § 77k (Securities Act § 11) (imposing liability for misstatements or omissions in registration statements).

9 See id. § 78p (Exchange Act § 16) (imposing liability for "short-swing" profits).

10 See id. § 78r (Exchange Act § 18) (imposing liability for misleading statements in periodic reports filed with the SEC).

11 69 F. Supp. 512 (E.D. Pa. 1946).

12 17 C.F.R. § 240.10b-5 (1999).

13 See id. § 240.10b-5(b).

14 15 U.S.C. § 78j(b).

15 Rule 10b 5 reads as follows:
240.10b-5 Employment of manipulative and deceptive devices.
§ § It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
§ § (a) To employ any device, scheme, or artifice to defraud,
§ § (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
§ § (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

17 C.F.R. 4 240.10b 5.

16 Remarks of Milton Freeman, Conference on Codification of the Federal Securities Laws, 22 Bus. Law. 793, 922 (1967), quoted in Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 767 (1975) (Blackmun, J., dissenting).

17 See 17 C.F.R. 240.10b 5.

18 See id.

19 Kardon, 69 F. Supp. at 514.

20 Telephone Interview by David Goldsmith with NYSE Research Desk (Feb. 25, 1999).

21 See Merritt B. Fox, The Political Economy of Statutory Reach: U.S. Disclosure Rules in a Globalizing Market for Securities, 97 Mich. L. Rev. 696, 822 n.172 (1998).

22 See NYSE Data Library (last modified May 28, 1999) <>.

23 See The Evolution of NASDAQ (visited June 20, 1999) <>. Trading on NASDAQ, the National Association of Securities Dealers Automated Quotation system, began on February 8, 1971. See id.

24 See id.

25 See Herman & MacLean v. Huddleston, 459 U.S. 375, 380 (1983).

26 See Ernst & Ernst v. Hochfelder, 425 U.S. 185, 201 (1976). Although the Supreme Court has not defined 'scienter,' every circuit court that has considered the issue has held that recklessness is sufficient to meet the scienter requirement. See, e.g., Van Dyke v. Coburn Enters., Inc., 873 F.2d 1094, 1100 (8th Cir. 1989); SEC v. Carriba Air, Inc., 681 F.2d 1318, 1324 (11th Cir. 1982) Hackbart v. Holmes, 675 F.2d 1114, 1117 (10th Cir. 1982); Broad v. Rockwell Intl Corp., 642 F.2d 929, 961-62 (5th Cir.) ( en banc) (1981); McLean v. Alexander, 599 F.2d 1190, 1197 (3d Cir. 1979); Manabach v. Prescott, Ball & Turben, 598 F.2d 1017, 1024 (6th Cir. 1979); Nelson v. Serwold, 576 F.2d 1332, 1337 (9th Cir. 1978); Rolf v. Myth Eastman Dillon & Co., 570 F.2d 38, 46-47 (2d Cir. 1978); Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1044 (7th Cir. 1977).

27 See Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350, 361 (1991).

28 See Blue Chip Stamps, 421 U.S. at 753-55.

29 See Central Bank of Denver, NA. v. First Interstate Bank of Denver, NA., 511 U.S. 164, 177 (1994).

30 See In re Donald J. Trump Casino Sec. Litig., 7 F.3d 357, 371-73 (3d Cir. 1993); Sinay v. Lamson & Sessions Co., 948 F.2d 1037, 1040 (6th Cir. 1991); In re Convergent Technologies Sec. Litig., 948 F.2d 507, 515-16 (9th Cir. 1991) (applying but not explicitly referencing doctrine); I. Meyer Pincus & Assocs. v. Oppenheimer & Co., 936 F.2d 759, 763 (2d Cir. 1991); Romani v. Shearson Lehman Hutton, 929 F.2d 875, 879 (1st Cir. 1991); Polin v. Conductron Corp., 552 F.2d 797, 807 n.28 (8th Cir. 1977).

31 Fed. R. Civ. P. 23.

32 See Basic Inc. v. Levinson, 485 U.S. 224, 250 (1988).

33 See id. at 241-42.

34 See id. at 247.

35 See Battle of the Bean Counters: Accountancy Merger Mania - Part I: If Irelands Top Four Accounting Firms Are to Be Believed, Bigger Is Better, Bus. & Fin., Jan. 15, 1998, available in 1998 WL 10473582 (referring to Coopers & Lybrand, Price Waterhouse, KPMG, Ernst & Young, Deloitte & Touche, and Arthur Andersen as the Big Six accounting firms).

36 See William A. Sinacori, Comment, Bily v. Arthur Young & Co.: An Unnecessary Return to Privity in Cases of Auditor Negligence, 6 Hofstra Prop. L.J. 243 (1993).

37 See infra notes 38-40 and accompanying text.

38 See John H. Cushman, Jr., $400 Million Paid by S. & L Auditors, Settling U.S. Case, N.Y. Times, Nov. 24, 1992, at A6; Stephen Labaton, $400 Million Bargain for Ernst, N.Y. Times, Nov. 25, 1992, at D3.

39 See Barry Meier, Settlement by Deloitte on S. & L's, N.Y. Times, Mar. 15, 1994, at D6.

40 See Stephanie Strom, Accounting Firm Settles Federal Auditing Charges, N.Y. Times, Aug. 10, 1994, at D1.

41 See James Hamilton, Derivatives 1996: Avoiding the Risk and Managing the Litigation, in Private Securities Litigation Reform Act of 1996, at 475, 600 (PLI Corp. Law Practice Course Handbook Series No. 932, 1996).

42 See Denise Voigt Crawford, Coping with Broker-Dealer Regulation & Enforcement, in State Regulation, at 1041, 196 (PLI Corp. Law Practice Course Handbook Series No. 189, 1998).

43 For example, Richard C. Breeden, then-Chairman of the SEC, testified before Congress in 1991:

Private actions under Sections 10(b) and 14(a) of the Exchange Act have long been recognized as a "necessary supplement' to actions brought by the Commission and as an "essential tool" in the enforcement of the federal securities laws. Because the Commission does not have adequate resources to detect and prosecute all violations of the federal securities laws, private actions perform a critical role in preserving the integrity of our securities markets. The Commission devotes the bulk of its enforcement resources to the most serious forms of securities fraud - outright theft of investors' monies, insider trading, penny stock manipulation, and other egregious forms of financial fraud. Private actions augment those enforcement resources, and thereby provide additional deterrence against securities law violations.
Private actions are also necessary to compensate defrauded investors. Although the Commission seeks in its enforcement cases to obtain disgorgement of illicit profits, that amount can be much smaller than the damages suffered by investors - especially in cases involving fraudulent financial disclosure. More importantly, as noted above, the Commission is able to prosecute only a fraction of the cases in which investors have suffered losses.
Recent history underscores the need for preserving the effectiveness of private remedies against securities fraud.... Apparent instances of serious fraud and other wrongdoing involving Salomon Brothers in the US., Nomura, Nikko and other securities firms in Japan, and BCCI in the United Kingdom and elsewhere have raised serious questions as to the adequacy and effectiveness of controls against financial fraud of all types around the world. Given the critical need for public confidence in capital markets, weakening the protections against deliberate fraud could have serious consequences for both investors and our broader marketplace.

Securities Investor Protection Act of 1991: Hearing Before the Subcomm. on Securities of the Senate Comm. on Banking, Housing and Urban Affairs, 102d Cong. 15-16 (1991). The Statement of Managers contained in the joint House-Senate Conference Report on the PSLRA cites other testimony of Mr. Breeden in favor of limiting accountants' liability, and identifies him as a former SEC Chairman. See H.R. Rep. No. 104369, at 37 (1995), reprinted in 1995 U.S.C.C.A.N. 730, 736. At the time of that testimony, Mr. Breeden was a senior executive at the accounting firm of Coopers & Lybrand, which had been a defendant in a number of securities fraud actions and had lobbied heavily for the PSLRA. In 1991, Mr. Breeden was chairing the SEC rather than serving the Big Six.
The SEC also made its views known to the courts. See, e.g., Brief for the SEC as Amicus Curiae in Support of Partial Affirmance at 6, Herman & MacLean v. Huddleston, 459 U.S. 375 (1983) (Nos. 81-680 & 81-1076) ("Given the limited enforcement resources of the Commission, the private right of action is vital to effective enforcement of Section 10(b).").

44 See Joel Seligman, The Merits Do Matter, 108 Harv. L. Rev. 438, 442-44, 448-49 (1994).

45 See id.

46 See id. at 444.

47 See NYSE Data Library, supra note 22.

48 See E-mail from Paul Zaremba, NASDAQ, to David Goldsmith (Feb. 26, 1999) (on file with author).

49 See Seligman, supra note 44, at 440-46.

50 See id. at 442 n.19, 443-46.

51 See id. at 440.

52 See id.

53 See id. at 440 & n.11.

54 See id.

55 The Contract with America was the platform of the Republican Party in its successful drive to gain control of both Houses of Congress in the 1994 midterm elections.

56 See Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, 109 Stat. 737 (codified as amended in scattered sections of 15 U.S.C.).

57 See 15 U.S.C. § 78u-4(b)(2) (Supp. III 1997). The PSLRA requires plaintiffs to "State with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." Id. Courts and commentators are split on whether this provision was meant to codify or further heighten the stringent pleading standard set forth by the Second Circuit in Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1128 (2d Cir. 1994). See infra notes 86-87 and accompanying text.

58 See 15 U.S.C. § 78u-4(a)(3)(B)(iii)(I)(bb).

59 See Elliot J. Weiss & John S. Beckerman, Let the Money Do the Monitoring: How Institutional Investors Can Reduce Agency Costs in Securities Class Actions, 104 Yale L.J. 2053, 2096 (1995).

60 See id. at 2105.

61 15 U.S.C. § 78u-4(a)(3)(A)-(B).

62 See id. § 78u-4(b)(3)(B).

63 See id. § 78u-4(g)(2).

64 See Jeanne Calderon & Rachel Kowal, Auditors Whistle an Unhappy Tune, 76 Denv. U. L. Rev. 419, 420-21 (1998).

65 See 15 U.S.C. § 78u-5(c)(1)(A). The Act provides a safe harbor even if the projection is knowingly false provided that it is accompanied by meaningful cautionary statements. See id. I would assume that most courts would hold that, in the context of a knowingly false projection, the only meaningful cautionary statement would be a variant of an old Morey Amsterdam line: "You won't believe this because it's a lie." Nevertheless, the concept of a safe harbor for a knowingly false statement is regrettable.

66 See In re DonnKenny, Inc. Sec. Litig., 171 F.R.D. 156, 157 (S.D.N.Y. 1997).

67 See id.

68 See id. (noting that reducing plaintiffs' securities firm's involvement was one goal of the PSLRA); see also Joseph A. Grundfest & Michael A. Perino, Securities Litigation Reform: The First Year's Experience (last modified Feb. 27, 1997) <> (stating that Milberg Weiss is the largest of the nation's law firms specializing in class action securities fraud litigation").

69 See Grundfest & Perin, supra note 68, at 17.

70 See U.S. Securities and Exchange Commission, Office of the General Counsel, Sailing in "Safe Harbors": Drafting Forward-Looking Disclosures, in Report to the President and the Congress on the First Year Of Practice Under the Private Sec. Litig. Reform Act of 1995, at 61, 121 (PLI Corp. Law Practice Course Handbook Series No. 1020, 1997).

71 See S. Rep. No. 104-98, at 11 (1995), reprinted in 1996 U.S.C.C.A.N. 679, 690.

72 See David M. Levine & Adam C. Pritchard, The Securities Litigation Uniform Standards Act of 1998: The Sun Sets on California's Blue Sky Laws, 64 Bus. Law. 1, 48 (1998). The small number of institutional investor plaintiffs may be attributable in part to two unintended consequences of the lead counsel provisions: (1) contests about whether a large institutional holder can be a lead plaintiff where a number of individual plaintiffs aggregate their losses and seek to act as a "group," and (2) extensive discovery by the defendants as to the investment decision process of the institutional investor lead plaintiff, which can be time-consuming and disruptive. See 15 U.S.C. § 78u-4(a)(3)(B)(iii)(I) (stating most adequate plaintiff may be "person" or "group of persons"); § 78u-4(a)(3)(B)(v) (stating most adequate plaintiff shall "select and retain counsel to represent the class").

73 See Levine & Pritchard, supra note 72, at 48.

74 Black's Law Dictionary 692 (6th ed. 1990) (defining golden parachute" as a "slang term which shelters executives from the effects of a corporate change in control. Such an agreement generally provides for substantial bonuses and other benefits for top management and certain directors who may be forced to leave the target company or otherwise voluntarily leave upon a change in control" (citation omitted)).

75 See Gail Diane Cox, Corporate Severance Pay Attacked: Disney Suit the Latest to Allege Payouts Waste Assets, Nat'l L.J., Jan.. 27, 1997, at B1. CALPERS, the California Public Employees Retirement System, is among the largest state pension funds, and accordingly one of the largest institutional investors. See id.

76 No. 15452, 1998 Del. Ch. LEXIS 186, at *5, 101 (Del. Ch. Oct. 7, 1998) (holding that the plaintiffs failed to adequately rebut the presumption of the business judgment rule).

77 See Weiser v. Grace, 179 Misc. 2d 116, 683 N.Y.S.2d 781 (N.Y. Sup. Ct. 1998); see also Article 9 Class Actions in 1996, Feb. 6, 1997, N.Y.L.J. at 1.

78 See Morse v. McWhorter, No. 3:97-0370, 1998 U.S. Dist. LEXIS 19063, at *8 (M.D. Tenn. June 30, 1998); Kurt Eichenwald, Columbia/HCA Directors Sued by Pension Fund, N.Y. Times, Aug. 15, 1997, at D5.

79 See S. Rep. No. 104-98, at 4.

80 S ee Grundfest & Peron, supra note 68, at 5-6.

81 See Stanford Securities Class Action Clearinghouse (visited June 16, 1999) <> (digitizing and linking the full text of complaints, motions, judicial opinions, and other major class action filings).

82 See Securities Fraud Litigation Sets Record in 1998 (visited June 17, 1999) <>.

83 See id.

84 NASDAQ trading volume increased from one billion to two billion during this three year period. See E-mail from Paul Zaremba, NASDAQ, to David Goldsmith (Feb. 26, 1999) (on file with author). New York Stock Exchange trading volume increased from 87 million shares to 170 million shares. See NYSE Data Library, supra note 22.

85 See Richard M. Phillips & Robyn J. Lipton, Insider Trading, Fraud, and Fiduciary Duty Under the Federal Securities Law Cosponsored by the Securities Law Committee of the Federal Bar Association, in Impact of the Reform Act on Federal Securities Class Action, at 351, 356, 368 (A.L.I.-A.B.A. Course of Study No. SC88, 1998).

86 See Shields, 25 F.3d at 1128 (requiring plaintiff, in order to satisfy scienter requirement, to allege either (a) "facts to show that defendants had both motive and opportunity to commit fraud, or (b) . . . facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness"). The Second Circuit, in adopting its more stringent pleading requirement, departed from the common sense of its own earlier decision, which recognized the difficulty of a plaintiff confronted with substantial evidence of fraudulent conduct to be able, without discovery, to plead specifics of the state of mind of the perpetrators of the fraud. See id. at 1128 (citing to Mills v. Polar Molecular Corp., 12 F.3d 1170, 1176 (2d Cir. 1993)). Thus in Schoenbaum v. Firstbrook, 405 F.2d 215, 218 (2d Cir. 1968), the court reversed a decision granting summary judgment, noting that in cases where issues of motive and intent are important, the proof is largely in the hands of the alleged wrongdoers. In adopting stringent pleading requirements as to scienter, the Second Circuit and Congress have ignored human experience that those who commit fraud usually try to conceal their motive and intent.

87 Compare, e.g., Adair v. Bristol Technology Sys., Inc., 179 F.R.D. 126, 135 (S.D.N.Y. 1998); Zuckerman v. Foxmeyer Health Corp., 4 F. Supp. 2d 618, 622 (N.D. Tex. 1998); Allison v. Brooktree Corp., 999 F. Supp. 1342, 1343 (S.D. Cal. 1998); City of Painesville v. First Montauk Fin. Corp., 178 F.R.D. 180, 187 (N.D. Ohio 1998); In re Health Management, Inc. Sec. Litig., 970 F. Supp. 192, 201-03 (E.D.N.Y. 1997); OnBank & Trust Co. v. FDIC, 967 F. Supp. 81, 88 & n.4 (W.D.N.Y. 1997); Pilarczyk v. Morrison Knudsen Corp., 965 F. Supp. 311, 320 (N.D.N.Y. 1997); In re Wellcare Management Group, Inc. Sec. Litig., 964 F. Supp. 632, 641 (N.D.N.Y. 1997); Fugman v. Aprogenex, Inc., 961 F. Supp. 1190, 1195 (N.D. Ill. 1997); Rehm v. Eagle Fin. Corp., 954 F. Supp. 1246, 1252-53 (N.D. Ill. 1997); Zeid v. Kimberley, 930 F. Supp. 431, 434 (N.D. Cal. 1996); Marksman Partners, LP. v. Chantal Pharm. Corp., 927 F. Supp. 1297, 1308-10, 1309 n.9 (C.D. Cal. 1996) (applying Second Circuit pleading standard and holding that recklessness is sufficient basis for pleading scienter), with, e.g., Havenick v. Network Express, Inc., 981 F. Supp. 480, 528 (E.D. Mich. 1997); Voit v. Wonderware Corp., 977 F. Supp. 363, 374 (E.D. Pa. 1997); In re Silicon Graphics Inc. Sec., Inc. Litig., 970 F. Supp. 746, 757 (N.D. Cal. 1997); Norwood Venture Corp. v. Converse Inc., 959 F. Supp. 205, 208 (S.D.N.Y. 1997); Powers v. Eichen, 977 F. Supp. 1031, 1039 (S.D. Cal. 1997); Friedberg v. Discreet Logic Inc., 959 F. Supp. 42, 48-49 (D. Mass. 1997) (applying stricter standard than Second Circuit and rejecting recklessness as basis for pleading scienter).

88 511 U.S. 164 (1994); see infra text accompanying notes 108-114.

89 Fed. R. Civ. P. 8(a)(2).

90 See 15 U.S.C. § 78u-4(b)(3)(B).

91 See id. § 78u-4(f(3)(C)(i)-(ii).

92 See S. 1976, 103d Cong. § 203 (1994) (proposing to create Exchange Act § 41).

93 Private Securities Litigation: Staff Report Prepared at the Direction of Senator Christopher J. Dodd (D-Conn.), Chairman, Subcomm. on Securities of the Comm. on Banking, Housing and Urban Affairs, United States Senate 130 (May 17, 1994) (emphasis in original) [hereinafter Staff Report].

94 See S. Rep. No. 105-182, at 11 (1998).

95 See id.

96 See id.

97 See Leslie Eaton, The Silicon Valley Gang: An Influential Industry with Lots of Money Is Getting Its Way on Capitol Hill, N.Y. Times, June 11, 1998, at Dl.

98 See Securities Litigation Uniform Standards Act of 1998, Pub. L. No. 105-353, 112 Stat. 3227.

99 See id. at 3228.

100 See 16 U.S.C. § 77p(b)-(c).

101 See Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 477-79 (1977) (regarding breach of fiduciary duty); Hochfelder, 425 U.S. at 201 (regarding negligent misrepresentation).

102 See Lampf, 501 U.S. at 350. One reason for the assertion of such claims was the short statute of limitations applicable to Rule 10b-5 claims. See id. at 354-55. Lampf limited Rule 10b 5 fraud actions to one year from the date of discovery with an absolute actual limit of three years. See id. at 360. In Lampf, the SEC in its amicus curiae brief argued for a five-year statute of limitations. See id. at 355.

103 See 47 U.S.C. § 151 (1994).

104 See 29 U.S.C. § 1001 (1994).

105 See Joseph A. Grundfest, Disimplying Private Rights of Action Under the Federal Securities Laws: The Commission's Authority, 107 Harv. L. Rev. 961, 963 (1994).

106 See S. Rep. No. 105482, at 19.

107 See, e.g., Farlow v. Peat, Marwick, Mitchell & Co., 956 F.2d 982, 986 (10th Cir. 1992); K & S Partnership v. Continental Bank, NA, 952 F.2d 971, 977 (8th Cir. 1991); Levine v. Diamanthuset, Inc., 950 F.2d 1478, 1483 (9th Cir. 1991); Schatz v. Rosenberg, 943 F.2d 485, 495 (4th Cir. 1991); Fine v. American Solar King Corp., 919 F.2d 290, 303-04 (5th Civ. 1990); Schlifke v. Seafirst Corp., 866 F.2d 935, 947 (7th Cir. 1989); Schneberger v. Wheeler, 869 F.2d 1477, 1480 (11th Cir. 1988); Moore v. Fenez, Inc., 809 F.2d 297, 303 (6th Cir.), cert. denied sub nom. Moore v. Frost, 483 U.S. 1006 (1987); Cleary v. Perfectune, Inc., 700 F.2d 774, 777 (let Cir. 1983); ITT v. Cornfeld, 619 F.2d 909, 922 (2d Cir. 1980); Monsen v. Consolidated Dressed Beef Co., 579 F.2d 793, 799-800 (3d Cir. 1978). The District of Columbia Circuit had squarely recognized aiding and abetting in a Section 10(b) action brought by the SEC, see Dirks v. SEC, 681 F.2d 824, 844 (D.C. Cir. 1982), rev'd on other grounds, 463 U.S. 646 (1983), and had suggested that such a claim would be available in private action. See Zoelsch v. Arthur Andersen & Co., 824 F.2d 27, 35-36 (D.C. Cir. 1987).

108 See 15 U.S.C. § 78j(b).

109 See Central Bank, 511 U.S. at 191.

110 See 15 U.S.C. § 78j(b).

111 In the notorious Lincoln Savings and Loan fiasco, Judge Sporkin posed some particularly apposite rhetorical questions:

Where were these professionals, a number of whom are now asserting their rights under the Fifth Amendment, when these clearly improper transactions were being consummated?
Why didn't any of them speak up or disassociate themselves from the transactions?
Where also were the outside accountants and attorneys when these transactions were effectuated?

Lincoln Savings & Loan Ass'n v. Wall, 743 F. Supp. 901, 920 (D.D.C. 1990).

112 511 U.S. at 165.

113 See id. at 191.

114 See, e.g., Klein v. Boyd, Nos. 97-1143 & 97-1261 [1997-98 Transfer Binder] Fed. Sec. L. Rep. (CCH) 1 90,136, at 90,317 (3d Cir. Feb. 12, 1998), vacated on grant of reh'g, Nos. 97-1143 & 97-1261, 1998 U.S. App. LEXIS 4121 (3d Cir. Mar. 9, 1998). The parties settled after the Third Circuit vacated the decision and ordered reargument en banc, leaving open the question of the scope of secondary liability.

115 See, e.g., Wright v. Ernst & Young LLP, 152 F.3d 169, 175 (2d Cir. 1998), cert. denied, 119 S. Ct. 870 (1999).

116 See Jill E. Finch, The Scope of Private Securities Litigation: In Search of Liability Standards for Secondary Defendants, 99 Colum. L. Rev. 1293, 1315 (1999). Professor Fisch observes that the Supreme Court in Central Bank left to lower courts the task of developing standards for imposing liability on secondary defendants. See id. at 1318. She notes that the adoption of the PSLRA and the Uniform Standards Act "should be read as explicit congressional endorsements of private securities litigation" and therefore the courts should not establish narrow, constrictive standards in determining gatekeeper responsibility. Id.

117 See Staff Report, supra note 93, at 10.

118 I do not here suggest that there is never a need to legislate. Congress could consider enlarging the statute of limitations or establishing civil liability for aiding and abetting a fraud. But this is far different from micro-managing litigation in areas such as the lead plaintiff provisions and delineating specific pleading requirements, areas in which flexibility and judicial discretion are far more effective than a tightly drawn code.