New Terrain, Strategies For Massachusetts Plaintiffs

By Michael A. Collora   
Send Email to: mcollora@dwyercollora.com    
   
  
This article first appeared in the January 8, 1996 edition of Massachusetts Lawyers Weekly

Lost among the widely publicized and successful effort of this current Congress' effort to make it more difficult for plaintiffs to succeed under the federal securities law is the little noticed fact that the federal courts are already limiting plaintiffs' ability to succeed in the courtroom. Regardless of the effect of the new securities bill, entitled the "Private Securities Litigation Reform Act" of 1995, P.L. 104-67, enacted over presidential veto just before Christmas, plaintiffs in the First Circuit already face substantial obstacles in bringing claims under the federal securities laws. This article charts the new terrain and suggests strategies to adapt, including, for Massachusetts plaintiffs, an examination of possible state law claims.

Effect of 1995 Amendments

The recently enacted Securities Act primarily affects the course of class actions, changing the way in which class action plaintiffs are chosen, favoring large and institutional investors as plaintiffs. It further regulates how plaintiffs' counsel are chosen, curbing the "race to the courthouse" by designating procedures to insure that lead plaintiff and lead counsel are chosen by the court only after notice to the class with restrictions on professional plaintiffs. In addition, counsel fees are now limited to a reasonable percentage of the recovery and lead counsel and class members will receive more information on proposed settlements.

In some respects the new Act affects all securities cases generally. For example, if motions to dismiss are filed, discovery is automatically stayed, although all relevant documents must be preserved. Congress also has made an effort to apportion damages among defendants in relation to their fault rather than joint and several. Forward looking statements as to projected profits, sales and the like are more protected by establishing a safe harbor, a provision sure to be litigated in the future. Further, Rule 11 of the Federal Rules of Civil Procedure was modified to permit sanctions against attorneys by requiring the court to make findings at the end of the litigation as to whether all parties complied with Rule 4 and permitting the court to order attorneys or parties to post a bond at the time the litigation ensues.

For private causes of action under the Securities Act, the new statute imposes a strict pleading standard similar to present First Circuit law, discussed below; each statement alleged to be misleading must have a factual basis or, if set forth on information and belief, the basis of such belief.

While the affect of the 1995 Act will be to restrict claims by plaintiffs involving securities litigation, and change who will be plaintiffs and their counsel, some of these restrictions have been ongoing for many years through development in the case law in this Circuit and in the Supreme Court. Some of these changes are examined below. 

Restrictions on Remedies

The standard weapon of choice for any seller or buyer of securities who is victimized by fraud is to allege a violation of Rule 10b-5, promulgated under section 10(b) of the 1934 Securities Exchange Act. Rule 10b-5 permits a suit in federal court so long as the plaintiff can allege and eventually prove that the defendant employed a scheme or artifice to defraud. Frequently, the fraud is perpetrated through false statements or material omissions.

Showing scienter or intent to defraud has always been the most difficult part of prevailing under a Rule 10b-5 claim. However, where the securities are sold through a prospectus, purchasers could have also brought a Section 12 claim under the 1933 Securities Act. Under that statute, if the security was sold publicly without registration, rescission could be had under Section 12(1) without proof of fraud. Even where a registration statement was filed, but where misstatements were alleged to occur in the prospectus, under Section 12(2) of the Act, 15 U.S.C. 771(2), a plaintiff could seek rescission or damages and need not prove reliance or fraud.

The law under both the 1933 Securities Act and the 1934 Exchange Act has been changing, limiting recovery. In the last term the Supreme Court made it more difficult to use Section 12(2) by limiting liability for false statements in a "prospectus" to only false statements in the offering document initially used by the company or controlling stockholders to sell a security to the public. It excluded from the definition of "prospectus" documents or communications used to sell a security in a private sale or in secondary trading. See Gustafson v. Alloyd Co., Inc., 115 S. Ct. 1061 (1995). The reasoning of the Supreme Court in Gustafson was that Congress intended only to impose liability on a party using a prospectus to the initial solicitation of the public to acquire that security. Id. at 1069.

The Gustafson decision had the effect of overruling a much older First Circuit case, Cady v. Murphy, 113 F.2d 988 (1st Cir.), cert. Denied 311 U.S. 705 (1940) (permitting claim under 12(2) against broker selling unregistered securities), and numerous local district court decisions, as well as several other Circuit courts. The effect of this will mean that plaintiffs must use 10b-5 if their purchase involved a secondary or private offering, even if a prospectus was involved. 

10b-5 Also Restricted

As noted, use of Rule 10b-5 carries a heavier burden since the plaintiff must plead and prove that the defendant acted with an intent to deceive, manipulate or defraud. Herman & MacLean v. Huddleston, 59 U.S. 375, 382 (1983). In addition, the courts have imposed a number of procedural hurdles before plaintiffs may succeed in their damage claim using this rule. 

Fraud With Particularity

The First Circuit in particular has imposed a high procedural barrier for those seeking redress under Rule 10b-5, in imposing a more severe pleading requirement on plaintiffs alleging securities fraud than it imposes on other plaintiffs alleging breach of contract or even some other type of fraud. This restriction began at least as early as Wayne Investment Inc. v. Gulf Oil Corp., 739 F.2d 11 (1st Cir. 1984), which involved an allegation of fraud in connection with Gulf Oil's aborted purchase of the Cities Service Company. The plaintiff's complaint was dismissed on the grounds that it did not comply with Rule 9(b) of the Federal Rules of Civil Procedure in that it did not allege fraud with particularity. On appeal, in upholding the dismissal, the First Circuit reasoned that the use of Rule 9 will restrict the possibility that a 10b-5 plaintiff with a largely groundless claim will take discovery in order to increase the settlement value of the case. In fact, allegations based "upon information and belief" will be insufficient, unless they set forth the facts on which that belief is founded, even if the information is solely within the knowledge of the opposing party. Wayne Investment at 13-14.  Top

The new Securities Act has followed the law in this circuit in its new pleading requirements. To see how this will affect litigation, it is useful to trace how the Courts have interpreted Wayne Investment. For example, in Lefkowitz v. Smith, Barney, Harris Upham & Co., 804 F.2d. 154 (1st Cir. 1986), the First Circuit upheld the dismissal of a 10b-5 claim in a suit brought against a broker by a customer, then deceased, when the allegations were in large part based upon information and belief since the customer was then dead. In a case regarding the purchase of limited partnership interests in a horsebreeding enterprise, the Court said that the complaint contained no factual allegation supporting a reasonable inference that at the time of the offering, adverse circumstances existed or were known to exist, or were deliberately disregarded by the defendants. See Romani v. Shearson Lehman Hutton, 929 F.2d 875 (1st Cir. 1991). The Court went on to say:

We have been especially rigorous in demanding such factual support in the securities context to minimize the chance 'that a plaintiff with a largely groundless claim will bring a suit and conduct extensive discovery in the hopes of obtaining an increased settlement, rather than in hopes that the process will reveal relevant evidence.'

Large losses by shareholders in New England banks drew little sympathy from the Court. In Serabian v. Amoskeag Bank Shares,Inc., 24 F.3d 357 (1st Cir. 1994), the plaintiff alleged that the bank failed to disclose its true financial condition, had inadequate reserves, and poor internal controls. After dismissal below, the First Circuit asserted that recovery may not be had under 10b-5 for poor business practices, nor for projections, accurate when made, which in hindsight were off the mark. The First Circuit panel carefully reviewed the 63 paragraphs of allegations, and ultimately permitted plaintiffs to go forward on a limited portion of the complaint, but not without a warning that it was far from clear that the plaintiffs could actually prove securities fraud. Id. at 365-366. 

Aiding and Abetting

In an effort to restrict the group of potential defendants, the Supreme Court recently imposed a further limitation on recovery by finding that an aider and abettor of one engaged in a 10b-5 fraud will not be liable under this rule. Central Bank v. First Interstate Bank, 114 S. Ct. 1439 (1994). This holding overturned many earlier circuit decisions, including the First Circuit's holding in Cleary v. Perfectune, Inc., 700 F.2d 772, 777 (1st Cir. 1983) and decisions by numerous lower district courts. See, e.g. Austin v. Bradley, Barry & Tarlow, P.C., 836 F. Supp. 36 (D. Mass. 1993). The Central Bank majority reached its conclusion by a strict construction of Section 10 of the 1934 Act, under which Rule 10b-5 was adopted, saying the statute was intended to impose liability only on those directly or indirectly engaged in the making of a material misstatement or a manipulative act, not those giving aid to one who does. Central Bank., 114 S. Ct. at 1447-48. The Court was unwilling to extend the scope of the Act or the Rule even to someone who admittedly was aware of the misstatement in an offering document, and rendered the primary violator substantial assistance. So far, Central Bank has resulted in the dismissal of several claims in the First Circuit. See, e.g., In Re Kendall Square Research Corp. Sec. Lit., 868 F. Supp. 26 (D. Mass. 1994).

Left unclear by Central Bank is whether one may be liable as a conspirator or under any theory of secondary liability , if not as an aider and abettor. Such liability seems doubtful, given the language of Central Bank. See, e.g., In re Ross Systems Sec. Litigation, 1994 WL 583114 (N.D. Cal. 1994) (no such liability). The new Securities Act does not change the holding in Central Bank. 

Statute of Limitations

In 1991 the Supreme Court ended years of uncertainty among the appellate courts, including to some extent disagreement among the First Circuit courts, by adopting a uniform statute of limitations for Rule 10b-5, holding one may bring an action only within one year of discovery of the facts constituting the violation, and in any event not more than three years after the violation. See Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350 (1991). According to the Court, the three year outer limit may not be extended by equitable tolling as that would be inconsistent with the three year outer limit of repose. Id. at 364.

The gap between the one year discovery and the three year outer limit period may be difficult for some plaintiffs to bridge, given the likely vigorous enforcement anticipated by the First Circuit of that one year period. Long before the Lampf case, the First Circuit had adopted a three year statute of limitations, derived from the state tort law, which began running when a plaintiff was on inquiry notice that a fraud had been committed. The rule was set forth in Maggio v. Gerard Freezer & Ice Co., 824 F.2d 123, 127 (1st Cir. 1987), where the Court explained that tolling will occur until the fraud is discovered only if the party injured by the fraud remains ignorant of it without any fault or want of diligence or care on his part.

Presumably that reasoning will now apply to claims under 10b-5 made between the one year and three year period, with the plaintiff shouldering the burden of persuasion that the statute has not run. Cf. Greenfield v. Shuck, 856 F. Supp. 705, 710 (D. Mass. 1994). The First Circuit will also make it difficult to bring a claim if the offering memorandum had "storm warnings" within it, even if the verbal pitch accompanying the sale was misleading. See Kennedy v. Josepthal, 814 F.2d 798 (1st Cir. 1987) (investors on notice as of date of sale they were likely to lose all their money). 

Other Restrictions

The above statutes require that the false statement or omission be material. While materiality normally is an issue for the jury, see Milton v. Van Dorn Co., 961 F.2d 965, 969 (1st Cir. 1992), this requirement gives rise to the possibility that the defendants may on summary judgment, convince the district court that the allegations could not have affected the reasonable investor. On occasion, that motion has been successful.

Also, the plaintiff must allege that the defendant was under a duty of disclosure to plaintiff; that duty is inherent with new offerings, but more problematic when the company is in possession of material, non-public information and simply chooses not to disclose it. Absent the company trading in its own stock, a statute or regulation requiring disclosure, or correcting a previously correct, but now incorrect company statement, the First Circuit will not permit a complaint to go forward if all that is alleged is nondisclosure. See Roder v. Alpha Industries, Inc., 814 F.2d 22 (1st Cir. 1987). 

RICO

The Racketeer and Corrupt Organization Act ("RICO"), part of the 1970 Organized Crime Control Act, contains a civil section, 18 U.S.C. 1964(c), permitting the victim who has suffered an injury from a violation of the Act to sue in federal court for treble damages. Hostility to the civil aspects of the Act has pervaded the judiciary. The new Securities Act eliminates securities and mail and wire fraud as predicate offenses justifying a RICO claim. In addition, the First Circuit had in any event imposed pleading limitations on a RICO plaintiff similar to those it had imposed upon plaintiffs who alleged violations of federal securities laws.

In New England Data Services, Inc. v. Becher, 829 F.2d 286 (1st Cir. 1987), a claim involving an underlying fraudulent transfer in a stock transaction, the plaintiff alleged mail and wire fraud as predicate acts supporting the RICO claim, but had no specific information as to these acts. Reviewing the 9(b) cases in securities actions, the First Circuit said that the reasoning of those cases applied to RICO allegations, noting "RICO is increasingly being used by plaintiffs as a vehicle for securities fraud actions, or in combination thereof, since one of RICO's predicate acts is 'fraud in the sale of securities.'" Id. at 291. However, while holding RICO plaintiffs to the same standard as securities plaintiffs, the Court elected to permit limited discovery as to mail and wire use where the knowledge of such was in control of the defendants. Nonetheless, it admonished the district courts to keep in mind the purposes of the rule, including avoiding groundless claims and strike suits, the potential damage to a defendant's reputation, and ensuring that defendants have been adequately put on notice. 

Remedies

How then does a plaintiff, discovering he or she has suffered a substantial securities loss, overcome the above judicially and statutorily imposed limitations on a cause of action?

One way to overcome the ruling in Central Bank is to allege that the defendant acted as a principal, and was directly or indirectly involved in the manipulation. As the Central Bank Court itself suggested:

Any person or entity, including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller relies may be liable as a primary violator under 10b-5, assuming all of the requirements for primary liability... are met.... In any complex securities fraud, moreover, there are likely to be multiple violators....

Id. at 1455.
This was successfully accomplished in Vosgerichian v. Commodore International, 862 F. Supp. 1371 (E.D. Pa. 1994), where the court found the claim against Arthur Andersen, an accounting firm, to be sufficient as a principal because the firm issued an unqualified opinion in a scheme to assist the issuer in inflating the value of the issuer's stock. To find Ernst and Young liable in the collapse of a carpet company, the court in In re ZZZZ Best Securities Litigation, 864 F. Supp. 960 (C.D. Cal. 1994), said that plaintiffs must allege and eventually prove that the defendant's own acts were manipulative or its statements deceitful. The court nevertheless found enough in the complaint to deny the defendant's motion for summary judgment.

To overcome the statute of limitations in Lampf, one might consider filing a claim in state court, or at the very least, alleging a violation of the state securities laws. Its fraud section, M.G.L. c. 110A, Sec. 410(a)(2), is similar to Rule 10b-5, but has a longer statute of limitations -- four years from the date when the plaintiff was or should have been aware of the fraud. See M.G.L. c. 110A, § 410(e). Use of such statute by an individual or group of plaintiffs might overcome some of the above limitations, although Rule 9(b) has its companion state rule, and normally materiality must be proven.

While use of misstatements in a written document accompanying or preceding the sale of a security can be prosecuted under 10b-5, if not a public offering, plaintiffs might also consider filing a state securities claim under the Massachusetts Consumer and Business Protection Act, M.G.L. c. 93A. This has a four year statute of limitations. While individuals can file a claim under Section 9, unlike non-securities claims under that section, the remedy explicitly forbids recouping multiple damages and attorney fees.

Nonetheless, for the class action plaintiff, prospects look bleak, particularly if discovery is needed before bringing a case. Most of the above limitations were designed to make it difficult to bring a class action in the absence of very specific evidence of fraud. Witness the difficulties of the plaintiffs in Lucia v. Prospect Street High Income Fund, 36 F.3d 170 (1st Cir. 1994), where there was clearly monetary damage, but plaintiffs could allege only generally that the defendants and the infamous Michael Milliken had entered into illegal repurchase agreements; they could not get beyond the procedural hurdle of Rule 9, and much of their claim was dismissed.

There are also problems with state lawsuits if they concern class actions. Class action law in Massachusetts is poorly developed. If securities claims are brought, the issue of settlement is complicated by whether a state court judgment can preclude further claims from being brought by other plaintiffs. Contrast Nottingham Partners v. Trans-Lux Corp., 925 F.2d 29 (1st Cir. 1991) (gave preclusive effect to Delaware state court judgment since claims arose out of same transaction) with Epstein v. MCA Inc., 50 F.3d 644, 663-666 (9th Cir. 1995), cert. granted, 63 U.S.L.W. 3883, No. 48, (June 20, 1995) (distinguished Nottingham, and held a claim under Section 14d-10 of the Exchange Act to be different from state class action alleged in a Delaware state case).

Also, state courts are split over whether they have the power to certify and bind a multi-state or national class. See Newberg on Class Actions (3ded.1994), §§13.25-13.51. The crux of the issue is whether multi-state class suits are limited by state court territorial limitations for exercising personal jurisdiction. Bound up in this matter is the issue of personal jurisdiction rights of absent class members and whether non-residents of the forum who are in the multi-state class preclude such a class action because of state sovereignty and interstate federalism principles. Since the Supreme Court has yet to settle these matters, state courts that have addressed the issue have been free to reject or permit multi-state class actions.

Collateral to a decision permitting a multi-state class action suit is the need to make a choice of law determination. See Newberg on Class Actions at §§ 13.29-13.30. This necessarily implicates the constitutional principles of the full faith and credit clause and the due process provision of the Fourteenth Amendment. In Allstate Ins. Co. v. Hauge, 449 U.S. 302 (1981), the Supreme Court held that "for a state's substantive law to be selected in a constitutionally permissible manner, that state must have a significant contact or significant aggregation of contacts, creating state interests such that choice of its laws is neither arbitrary not fundamentally unfair." Id. at 312-313.

The Massachusetts courts have not yet addressed the legal propriety of multi-state class action suits. It may not be much longer before the courts are prompted to do so by plaintiffs' attorneys who must adapt to the narrowed possibilities for bringing a securities claim in federal court.