As the adage goes, the best defense is a good offense. With the proliferation of state court securities class actions following the United States Supreme Court’s ruling in Cyan, Inc. v. Beaver County Employees Retirement Fund, public companies, or those planning to go public, should consider proactive measures to stay out of state court. True, the issue may be less prevalent following the Supreme Court’s July 2, 2021 decision to address whether the Private Securities Litigation Reform Act’s (“PSLRA”) mandatory discovery stay applies to Section 11 claims filed in state court. But prudent companies should not wait for the Court to resolve the issue for them when a potentially viable solution is already available: Federal Forum Provisions (“FFPs”). Small sample size notwithstanding, recent trends suggest FFPs are effective at stopping state court Section 11 claims and the associated costs and uncertainty. While more time is needed to determine the full impact of FFPs, adopting such a provision is a small risk with a potentially huge reward.
In fact, since writing this article, the Supreme Court has removed from its docket the case involving the PSLRA’s mandatory discovery stay in state court based on a potential settlement between the parties. If anything, this further emphasizes the need for public companies or companies planning to go public to be proactive in preventing federal securities claims in state court. Litigating the issue to a conclusion before the Supreme Court may not be realistic given the stakes involved. Likewise, waiting for Congressional action in the current political climate may be unrealistic (though, one can hope).
Congress has attempted to control securities class actions for decades
Class actions came on the American legal scene way back in 1820 courtesy of the esteemed Justice Story, then a judge on the First Circuit Court of Appeals.His opinion in West v. Randall set out the framework for modern class litigation contained in Federal Rule of Civil Procedure 23. Securities class actions, however, did not get the thumbs up from the Supreme Court until 1988 when it decided Basic v. Levinson and approved the fraud-on-the-market theory. Notably, Justice Byron White dissented in Basic, expressing concern that the Court’s decision may change significantly the future of securities litigation, and whether the Court would be able to control it.
Not long after Basic, in 1995, Congress passed the PSLRA to rein in frivolous suits and extortionate settlements while, at the same time, ensuring legitimate claims were able to proceed. Reforms under the PSLRA included, among others, creating a safe harbor for forward looking statements (subject to certain requirements and exceptions), weighing in on selection of lead plaintiffs, imposing heightened pleading standards, and, relevant for this discussion, staying all discovery while a motion to dismiss is pending.
The PSLRA, though, quickly ran into trouble. Plaintiffs fled to state courts beyond the statute’s reach. It became apparent that the PLSRA’s objectives were in jeopardy. In response, Congress passed the Securities Litigation Uniform Standards Act (“SLUSA”) in 1998, trying to keep securities claims in federal court and subject to the PSLRA. SLUSA, however, left holes for plaintiffs’ lawyers to exploit. Fast forward twenty years to the Supreme Court’s ruling in Cyan, which addressed SLUSA’s impact on claims brought in state court under the Securities Act of 1933 (“the ‘33 Act”), most commonly Section 11 claims related to the public offering of securities. As the Court set forth, SLUSA “does nothing to deprive state courts of their jurisdiction to decide class actions brought under the 1933 Act.” Plaintiffs had a viable escape from the PSLRA for claims arising from public offerings. And corporate defendants faced ongoing risk and uncertainty.
State court class actions continue to bring risk and costs
As expected, following Cyan, plaintiffs again flocked to state courts with Section 11 claims. For companies, particularly concerning was the increase in parallel litigation and the need to defend identical claims in multiple forums at significant cost. Compounding the problem, questions persisted as to whether the PSLRA’s discovery stay during motion practice applied in state court with no consensus among courts. Perhaps waiting for an opportune caption to take up this potentially pivotal issue, the Supreme Court recently granted certiorari in In re Pivotal Securities Litigation, in which California state trial and appellate courts refused to stay discovery while Pivotal Software, Inc’s (“Pivotal”) motion to dismiss was pending.
As set forth in Pivotal’s Certiorari Petition, Pivotal was named in a securities class action in the Northern District of California related to alleged misrepresentations made in connection with its IPO. The federal suit was dismissed for failure to state a claim. No amended complaint was filed. Contemporaneously, another group of plaintiffs filed a near identical suit in California Superior Court. Not uncommon. While the federal motion to dismiss was pending, the state court plaintiffs agreed to stay the state court litigation. Once the federal case was dismissed, however, the state court plaintiffs immediately sought discovery from Pivotal and both the Superior Court and the Appellate Court rejected Pivotal’s argument that the PSLRA’s discovery stay applied. The result: Pivotal found itself in the undesirable position of spending millions on discovery related to claims another judge already found meritless.
More than just unnecessary defense costs, litigating federal securities claims in state court brings increased uncertainty into play. Judges generally have less experience with securities claims, especially outside of California and New York. This is no slight to these judges. It is simply a byproduct of the comparably fewer securities class actions filed in state court versus federal court, as well as the nature of state court judgeships, which see more turnover than the federal bench due to judges often being elected rather than appointed for life. Dockets may also be more crowded without the support of law clerks and magistrate judges. The result is likely more cases making it through dismissal, leading to more expensive settlements. The Institute for Legal Reform recently published a paper presenting some of this data. These risks could be avoided if discovery was stayed until after the court rules on a motion to dismiss, or if plaintiffs were barred from state court.
Federal forum provisions as a roadblock for state court plaintiffs
Undoubtedly, a finding that the discovery stay does not apply in state courts would seem to undermine one of the driving forces behind the PSLRA – to prevent plaintiffs from extorting outsized settlements in baseless litigation through the threat of substantial defense costs while a motion to dismiss is pending. Framed in this light, the question is one of utmost importance to securities fraud defendants. But from a purely practical perspective, the outcome, regardless of which way the Court falls, may have little significance on the future of securities class actions. The reason is simple: FFPs.
In response to Cyan, some companies began including FFPs in their governing documents. Much like other forum selection or venue clauses, FFPs require that any securities litigation, including Section 11 claims, be brought in federal court. Last year, the Delaware Supreme Court held FFPs adopted by three corporations prior to their respective IPOs to be facially valid in Salzberg v. Sciabacucchi. The benefits of FFPs were not lost on the Delaware Supreme Court, as it noted “the costs and inefficiencies of multiple cases being litigated simultaneously in both state and federal courts” and “[t]he possibility of inconsistent judgments and rulings on other matters, such as stays of discovery.” It concluded FFPs are not contrary to Delaware law, which is broadly deferential to a corporation’s right to adopt those provisions most appropriate to its governance, and do not deprive plaintiffs of the right to bring any claim.
In the relatively short time since Sciabacucchi, FFPs have been upheld in at least four other cases. The first three cases came from California and involved Delaware corporations. Notably, the California courts reviewed each FFP under California law regarding forum selection and arbitration clauses, not Delaware law. This is because the Delaware Supreme Court held FFPs do not concern internal affairs of the corporation; otherwise, the Internal Affairs Doctrine would apply and the law of the state of incorporation would govern. In reaching their respective decisions, the California courts noted various factors, such as the FFP was subject to shareholder approval, not applied retroactively, and plaintiffs could not show that it was unconscionable, unjust, or unreasonable. Conversely, the FFPs did not deprive plaintiffs of the right to bring any claim. They only limited the venue in which the claims could be brought. More recently, a New York state court upheld an FFP. Notably, the New York court held that whether the FFP was enforceable or not was a matter of internal corporate governance subject to Delaware law, which is contrary to prior rulings. For good measure, however, the court noted that deciding the matter under New York law would not change the outcome. Otherwise, the ruling largely tracked the reasoning of the prior orders on the issue, further solidifying the viability of FFPs.
Companies going public are not the only ones adopting FFPs. According to John Laide of Deal Point Data, LLC, shortly after Sciabacucchi, dozens of existing public companies filed bylaws amendments to adopt FFPs to avoid state court claims based on prior IPOs or future secondary offerings. Companies interested in adopting an FFP should look to the Delaware, California, and New York opinions for guidance to maximize the likelihood of any such provision being enforced.
Early trends support the impact of FFPs
The statistics bear out the significance of both Cyan and FFPs on state court securities litigation. Following Cyan, plaintiffs again flocked to state courts with Section 11 claims. According to Cornerstone Research, in the second half of 2017 (immediately prior to Cyan), eight cases were filed in state court. In the first half of 2018, state court claims totaled thirteen. The trend continued, reaching a peak of twenty-nine state court suits in the second half of 2019.
Immediately following Sciabacucchi, however, state court filings decreased. In the first half of 2020 (Sciabacucchi came out in March 2020), only sixteen Section 11 suits were filed in state court, almost half the number filed in the preceding six months. New filings continued to drop over each subsequent six-month period, reaching a low of five in the first half of 2021. This is the fewest state court filings in a six-month period since the second half of 2014.
The significance of this decrease, though, must be judged in context of the sample size and extenuating circumstances of 2020-21. Section 11 claims as a whole saw a steep drop-off beginning in early 2020; though, federal only filings have remained relatively steady. New securities class actions, in general, waned over 2020-21, but most of the decrease can be attributed to fewer merger suits. Also of note, no Section 11 claims were filed in California state courts in the first half of 2021; all were filed in New York, which, at the time, hadnot yet weighed in on FFPs.
Cautious optimism over the future of Section 11 litigation
Based on the above, companies can adopt an FFP with the reasonable expectation that any future Section 11 claims will be limited to federal courts, eliminating the concern over whether the PSLRA’s discovery stay applies in state courts. Yet, some uncertainty persists. FFPs have only been tested in California, Delaware, and New York. While those decisions may be persuasive, nothing prevents other courts from striking down an FFP. To that end, California and New York appellate courts have yet to weigh in on the issue. Further, as referenced above, more time may be needed to truly assess the extent to which FFPs cut down state court Section 11 claims and to rule out other contributing factors. But there is little risk to adopting a FFP. While we will have to wait to see how the Supreme Court resolves the issue regarding the PSLRA’s application in state and, more significantly, if it will resolve the issue, FFPs allow companies to take back some control over potential securities claims.
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