Securities Litigation and Incidents of Fraud

With the close of 2007, we have the final statistics on the number of securities fraud class actions filed for the year.  As usual, the data can be found on the Stanford Securities Site, along with a report written by Cornerstone Research.  The data shows that the number of suits spiked in the second half of the year, for a total of 169.  This compares with 118 last year.  Despite the increase, the 2007 totals are still the second lowest since 1996, the year after the adoption of the PSLRA. 

Cornerstone notes that a portion of the spike was attributable to the increased litigation arising out of the problems in the subprime market, a "one time" event that "may not be indicative of future filing activity."  While probably true, the discussion on the D&O Diary accurately notes that these "one time" events seem to be a regular occurrence.  "[E]ven if the subprime litigation wave can fairly be characterized as a "one-time" event, that is hardly sufficient to marginalize its continuing significance. The fact is the world of D & O liability has experienced a steady progression of "one time events" in recent years -- the bursting of the Internet bubble, the telecom crash, the IPO Allocation cases, the corporate scandals, the options backdating cases, and now the subprime crisis."   

There are many intriguing questions buried in this data.  One of the most interesting concerns the role of the PSLRA in the decrease in the number of suits. Specifically designed to reduce the number of securities fraud class action suits, the Act did so primarily by increasing substantially the pleading standards for scienter, an issue addressed in 2007 by the Supreme Court inTellabs.  At the same time, the Act provided for a stay of discovery pending resolution of any motion to dismiss. 

The approach seems to be working.  According to Cornerstone, from 1996 through 2001, 35% of all cases were dismissed.  Most dismissals come at the motion to dismiss phase (as opposed to summary judgment).  The percentage, however, is increasing.  Of the cases filed in 2003 and 2004, 42% and 43% have already been dismissed, a percentage that will likely increase (15% and 21% of the suits filed remain unresolved, neither dismissed nor settled).  Of the suits filed in 2006, 20% have already been dismissed, with 72% unresolved.  

So, the number of suits are down and of those filed, more and more are being dismissed at the motion to dismiss stage.  No doubt a substantial number of these cases were dismissed on the basis of the failure to plead scienter.

But is this approach the right one to weed out "frivolous" law suits?  Because scienter can be an intensely fact based determination and because plaintiffs do not have access to discovery (any smoking guns within the company will remain secret), the PSLRA effectively reduces the number of suits but not necessarily by eliminating those that lack merit.  The cases that go forward are the ones where plaintiff can marshal enough evidence from public sources (including, increasingly, informants) to show some type of elevated state of mind.  For the most part, these include cases involving allegations of unusual trading by insiders, GAAP violations, and, increasing, deficiencies in internal controls. 

This approach isn't limited to the federal system.  The Delaware courts have likewise developed a system of dismissing cases by imposing almost insurmountable hurdles at the pleading stage.  This occurs, for example, with respect to the efforts of plaintiffs to show a lack of board independence, a standard that generally requires evidence of subjective materiality.