§ 4.01                   

PSLRA -- Stay of Discovery

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On the one hand, the PSLRA imposes specificity requirements relating to the defendant’s state of mind in private fraud actions brought under the Exchange Act (see § 3.02) and, on the other hand, severely limits plaintiff’s ability to discover facts relating to the defendant’s state of mind, facts often peculiarly within the control of the defendant. The impact of this limitation is considerably greater in the case of claims arising under the fraud provisions of the Exchange Act than claims asserted under Section 11 or 12(a)(2) of the Securities Act, since the opportunity to dismiss claims under the Securities Act is significantly less. The enhanced pleading requirements of the PSLRA are applicable to pleading of securities fraud claims under the Exchange Act and are not applicable to Section 11 or 12(a)(2) claims.[1] See § 3.15[1]. The Securities Act does not include a similar pleading requirement and the courts are divided as to the application of Rule 9(b). See § 3.15[2]. The PSLRA has an identical stay of discovery provision with respect to a motion to dismiss in a private action arising under the Securities Act.[2] Although the PSLRA specifically provides that failure to comply with the enhanced pleading requirements relating to actions under the Exchange Act is grounds for dismissal,[3] a motion to dismiss on any grounds affords the basis for stay of discovery. The Securities Act does not include a similar pleading requirement; hence, except for the limited extent to which the pleading requirements of Rule 9(b) of the Federal Rules of Procedure may be applicable (see § 3.15[2]), presumably, the motion to dismiss that stays discovery usually will be pursuant to Rule 12(b)(6) for failure to state a claim. The principal area in which a motion to dismiss may be a potent weapon under Section 11 is likely to be with respect to allegations based on forward-looking statements.

The PSLRA does not preclude a court in its discretion permitting plaintiff to amend the complaint after a motion to dismiss has been granted.[4] If, however, discovery has been stayed, plaintiff is not likely to have additional information needed to cure the pleading deficiencies.

The stay of discovery provision is not absolute; the court may allow “particularized discovery” on motion of the plaintiff if it finds that “it is necessary to preserve evidence or to prevent undue prejudice to that party.”[5] The Managers’ Statement put their own gloss on this provision by recasting it to require that “exceptional circumstances exist” to invoke this clause.[6] The “necessary to preserve evidence route” does not appear to be an encouraging avenue as the PSLRA explicitly provides that during the stay a party with actual notice of the allegations is to treat all discoverable evidence within the party’s possession or control “as if they were the subject of a continuing request for production of documents from an opposing party under the Federal Rules of Civil Procedure.”[7] Willful failure to comply with this provision is grounds for the court imposing sanctions.[8] Nonetheless, there may be occasions when plaintiff can convince the court that defendant has a propensity to flaunt the law and that discovery of documents is appropriate. There also may be situations where a prospective witness’s health or potential absence may justify taking his/her deposition to preserve the testimony. The Statement of Managers notes in this regard that “the terminal illness of an important witness might require the deposition of the witness prior to the ruling on the motion to dismiss.”[9]

.The “necessary to preserve evidence route” does not appear to be an encouraging avenue as the PSLRA explicitly provides that during the stay a party with actual notice of the allegations is to treat all discoverable evidence within the party’s possession or control “as if they were the subject of a continuing request for production of documents from an opposing party under the Federal Rules of Civil Procedure.”[10] Willful failure to comply with this provision is grounds for the court imposing sanctions.[11] Nonetheless, there may be occasions when plaintiff can convince the court that defendant has a propensity to flaunt the law and that discovery of documents is appropriate. There also may be situations where a prospective witness’s health or potential absence may justify taking his/her deposition to preserve the testimony. The Statement of Managers notes in this regard that “the terminal illness of an important witness might require the deposition of the witness prior to the ruling on the motion to dismiss.”[12]

The principal hope for plaintiff to obtain discovery during the stay will be on the grounds of “undue prejudice.” Conceivably, some courts will find persuasive the fact that the evidence relating to the persons responsible for making particular misrepresentations and the state of mind of the defendants is exclusively within the control of the defendants, provided the discovery sought is particularized rather than general and vague in scope. If coupled with specific allegations that tend to establish the egregious nature of the misrepresentations and raise the probability that defendants because of their position, role, or otherwise, were likely to know the representations were false, if not enough to satisfy the particularity requirements, may suffice to justify particularized discovery. Although the PSLRA evidences a strong predilection of Congress to limit discovery absent particularized pleadings, the “undue prejudice” provision is an escape valve to keep the stay from being a shield for fraud.[13] The fact remains that what is regarded as “undue prejudice” is likely to be judge specific. Judges have always had the authority to restrict discovery so as to avoid abuse of the process; the difference is now that in a securities fraud action they must approach it from a different perspective.

Ironically, the first case raising the stay of discovery issue did not involve a class action for damages but an action seeking an injunction in connection with a contest for control of a public company.[14] The company sought to enjoin a special meeting of shareholders called by dissident shareholders to replace the existing board and elect their slate of directors. The plaintiff company alleged that the defendant had violated Section 13(d) by failing to disclose in the Schedule 13D its true intentions as to the purpose of its investment and the amount of securities it had acquired, seeking to take defendant’s deposition on these issues. The defendant made a motion to dismiss for failure to state an actionable basis for an injunction and a motion to stay discovery pending resolution of its motion to dismiss. The defendant and the SEC as amicus argued that the stay of discovery provision was intended to apply to class action strike suits and not to a proxy contest and an action seeking an injunction. Judge Rita Brewster noted that the language of the PSLRA relating to a stay of discovery was not so limited and was applicable to any private action brought under the Securities Act.

The SEC appeared as amicus because of concern that the initial ruling by the magistrate judge denying plaintiff discovery appeared to apply an “irreparable harm” standard rather than the “undue prejudice” standard of the PSLRA. Judge Brewster reviewing the magistrate’s ruling de novo, agreed that “the correct standard for granting an exception to the statutorily mandated stay of discovery is ‘undue prejudice’ for the moving party. This ‘undue prejudice’ standard is, as Appellant in this case has correctly stated, something less than ‘irreparable harm.’ In contrast to ‘irreparable harm,’ ‘undue prejudice’ means improper or unfair detriment.”[15]

Judge Brewster also accepted that the exigencies of a proxy contest may be taken into account “as part of the totality of the circumstances” in determining whether a stay of discovery would result in “undue prejudice.”[16] This notwithstanding, when she concluded her analysis she found that the stay would not result in “undue prejudice” as that term is used in the PSLRA. The analysis began with the Conference Report statement that adoption of the Act was “prompted by significant evidence of abuse in private securities lawsuits,” which included, “the abuse of the discovery process to impose costs so burdensome that it is often economical for the victimized party to settle.”[17] At the same time, the Conference Report noted that the purpose of the federal securities laws was “to protect investors and to maintain confidence in the securities markets.”[18] The role of the court in applying the “undue prejudice” standard is to “to balance the competing concerns of maintaining truth and integrity in the marketplace while curbing meritless litigation.”[19] Judge Brewster attempted to answer the question, would plaintiff be unduly prejudiced if discovery was delayed until the motion to dismiss was resolved if the motion to dismiss is resolved in the plaintiffs favor?[20] Plaintiff would not have been because notwithstanding the time frame plaintiff either would have had an opportunity to obtain discovery in time for it to be considered in connection with the motion to enjoin the meeting,[21] or, if there was not sufficient time, plaintiff would have less satisfactory but still available remedies after the shareholder meeting.[22] “Thus, this Court concludes that the magistrate Judge, considering the facts presented here, correctly applied the ‘undue prejudice’ standard and found that Appellant had failed to meet that standard.”[23] There is also something of a dichotomy between the particularized pleading requirements and stay of discovery provisions on the one hand and the provisions of Rule 11(b) of the Federal Rules of Civil procedure relating to sanctions for frivolous pleadings. Rule 11(b) permits a pleading to identify “allegations and other factual contentions . . . likely to have evidentiary support after a reasonable opportunity for further investigation or discovery.” If allegations are so identified, does that per se constitute a lack of particularized pleading or is it appropriate for laying the foundation for the assertion that a stay of discovery will result in undue prejudice?

A panel of the Ninth Circuit has held that the PSLRA stay of discovery provision has virtually zero tolerance.[24] The case involved alleged selective disclosure by the company (Rational Software) to a brokerage firm (Cowen) analyst that the company would be announcing lower than expected third quarter earnings. Cowen allegedly before the public announcement advised its customers to sell Rational stock and Cowen’s customers allegedly did so. The complaint was dismissed because of the failure to allege facts creating a strong inference that the tipper (the company) had received a personal benefit as required by Dirks[25] or that the analyst who received the information was aware that it had been disclosed in breach of a fiduciary duty. The dismissal was with leave to amend and the district court after dismissal allowed plaintiffs limited discovery based on the “undue prejudice” exception to the stay of discovery provision of the PSLRA.[26] The discovery was limited to interrogatories relating to the relationship between Cowen and the company and subpoenas to the NASD and broker-dealers for information as to the broker-dealers who traded in the security and who traded on the relevant date. The district court reasoned that although the allegations were not sufficient as to the personal benefit alleged or knowledge of the analyst “at a minimum [they] give rise to an appearance of impropriety.” on their part. The facts needed to establish plaintiffs’ claim “are of a type likely to be solely within Defendants’ possession. Under these circumstances, . . . there is a reasonable probability that Defendants will be shielded from liability unless Plaintiffs are permitted to take limited discovery regarding the relationship between Cowen and Rational.”[27]

The Ninth Circuit reversed granting defendants’ request for a writ of mandamus, stating: “Distilled to its essence, the district court granted plaintiffs leave to conduct discovery so that they might uncover facts sufficient to satisfy the Act’s pleading requirements. This is not a permissible reason for lifting the discovery stay under the Act.”[28] Quoting from its decision in Medhekar: “Congress clearly intended that complaints in these securities actions should stand or fall based on the actual knowledge of the plaintiffs rather than information produced by the defendants after the action has been filed.”[29] One may ask, if not under the circumstances of this case, when, if ever, is their “undue prejudice” to the plaintiff?

Judge Cote in the District Court for the District of Southern New York has allowed limited discovery to avoid “undue prejudice.”[30] Plaintiff alleged that defendants had manipulated the price of it stock downward, permitting defendants to acquire a substantial block of stock preliminary to waging a proxy contest to elect a new board of directors. Plaintiff argued that unless it could obtain the information it sought it would be unduly prejudiced as defendants could take action (presumably elect a new board) that plaintiffs would be unable to undo. Plaintiffs sought the following discovery: (1) compliance by third-party market makers with subpoenas requiring identification of trading records and customer identities with respect to the Thomson Defendants’ trades, (2) from the Thomson Defendants, trading in Global common stock, or derivatives thereof, by Thomson Defendants or their affiliated entities, (3) from the Thomson Defendants, relationships and affiliations among the Thomson Defendants, Canadian Advantage Limited Partnerships (“Canadian”) and any other Global shareholders or entities that have traded in Global common stock, and (4) also from the Thomson Defendants, communications, agreements or understandings among the Thomson Defendants, their affiliates, and any other Global shareholders. The court allowed particularized discovery on the first three items, but denied it as to the fourth item.

Judge Schwartz, however, in the Southern District of New York, has allowed particularized discovery to avoid undue prejudice in a case that he deemed warranted such discovery.[31] Further, he held in abeyance ruling on the defendants’ motion to dismiss until discovery has been completed. A Corp., the plaintiff, and B Corp., the defendant, jointly formed C Corp. each owning half of the stock, to jointly develop a virtual lymph node technology, assigning their respective patents to C Corp. B Corp. on behalf of C Corp. investigated the possibility of obtaining financing from pharmaceutical companies, including Johnson and Johnson (J & J) and allegedly reported to A Corp. on August 31, 1998 a lack of interest on the part of pharmaceutical companies, including J & J. A Corp. in October of 1998 advised B Corp. it was in danger of running out of money. On December 16, 1998, B Corp. offered to purchase A Corp.’s shares for $1 million and a percentage of future royalties. On April 6, 1999, they entered into a preliminary agreement incorporating those and other terms, pursuant to which subject to obtaining financing B Corp. agreed to purchase A Corp.’s shares. On April 22, 1999 B Corp. advised it had the available financing and the deal was closed on June 1, 1999, the parties signing a new stock purchase agreement embodying the terms. Plaintiff subsequently determined that J & J had provided B Corp. $3 million to finance the activities of C Corp., but was unable to determine precisely when such amounts were advanced. A Corp. contended that B Corp. had failed to disclose the availability of financing from J & J, which may have occurred prior to the April preliminary agreement and in any event A Corp. alleged had occurred prior to the final agreement of June 1. A Corp. argued that it was not bound until the execution of the June 1, 1999 agreement. Without resolving that issue, Judge Schwartz allowed expedited and particularized discovery for the purpose of determining when J & J agreed to provide financing. The court in allowing particularized discovery stated: “The record reflects that plaintiffs have requested particularized discovery solely related to the nature and timing of J & J’s interest in AVT [C Corp.] and VLN [successor to C Corp.], and its agreement to invest in those companies. This request does not implicate a concern that plaintiffs are seeking discovery to coerce a settlement or to support a claim not alleged in the Complaint. H.R. Conf. Rep. No. 104-369 at 37 (1995); S. Rep. No. 104-98, at 14 (1995). Rather, the removal of the PSLRA’s discovery stay is warranted on grounds of undue prejudice, because the failure to allow discovery on the limited issue of the nature and timing of J & J’s interest and investment in AVT and VLN may unfairly insulate defendants from liability for securities fraud as alleged by plaintiffs in the Complaint. Moreover, defendants’ failure to specify the timing of their negotiations with J & J concerning the latter’s investment further suggests the possibility that plaintiffs would suffer improper or unfair treatment in the absence of the requested discovery. Accordingly, the Court orders that the stay be lifted in order to allow plaintiffs to conduct discovery on this limited issue.”[32]

Judge Kimball in the District Court for the District of Utah also held a final motion to dismiss in abeyance pending completion of particularized discovery.[33] The case is also significant because the court embraced the liberal Second Circuit Novak view of pleading based on information and belief and is discussed in that context and the facts outlined in greater detail at § 3.13[5]. The case involved allegations that First Security Bank and three of its principal officers engaged in financial irregularities that inflated the price of its stock preliminary to a proposed merger with Zion Bancorporation. Specifically, the complaint alleged that the financial statements for the third and fourth quarter of 1999 were false and misleading because of the failure to take appropriate write-offs with respect to its loan portfolios in a number of significant categories (delinquent installment loans, repossessed automobiles, unsecured loans of debtors in bankruptcy). The stockholders of Zion Bancorporation turned down the proposed merger after First Security disclosed disappointing first quarter 2000 results that plaintiffs alleged reflected charges that should have been taken during the third and fourth quarter of 1999.

Judge Kimball concluded that the complaint failed to allege facts that created a strong inference of scienter. The court not only allowed plaintiffs to replead, but granted plaintiffs’ motion for particularized discovery based on the claim that employees and former employees of Zion who conducted a due diligence investigation of First Security in connection with the merger were willing to furnish information, but could not because of the “confidentiality agreement” included as part of the merger agreement. Plaintiffs sought “to serve a deposition subpoena and accompanying document requests on Zions’ CEO, CFO, and perhaps one other current or former Zions’ employee, as may be appropriate in the wake of these two depositions.” The court granted this request based on the assumption that plaintiffs would have been able to obtain this information except for the confidentiality agreement. “Because Plaintiffs have articulated their alleged bases of liability, such discovery will not result in a fishing expedition. At this stage, Plaintiffs may not seek any information on issues or claims that are not already alleged in their Complaint. Rather, they may seek additional information regarding Plaintiffs’ previously alleged financial manipulations and information concerning the Defendants’ knowledge regarding the same.”[34]

Judge Conner in the Southern District of New York shortly after Judge Schwartz lifted the stay on discovery in Vacold was requested to lift a discovery stay but refused to do so in a case in which he granted the motion to dismiss, but allowed plaintiff leave to amend.[35] The case arose out a proposed merger pursuant to which Verizon was to acquire NorthPoint and provide interim financing to NorthPoint. The plaintiffs had purchased publicly traded Notes of NorthPoint and brought a class action on behalf of purchasers of such notes during a narrowly defined period, from November 14, 2000 to November 29, 2000. The significance of these dates is that on November 14, 2000 Verizon filed a Form 10-Q in which it referred to the previously announced merger and stated that it expected the merger to close in 2001. On November 20, 2000, NorthPoint increased its previously announced (on October 26,2000) operating losses of $106 million to $118 million and net losses of $125 million to $136 million. On November 29, 2000, Verizon announced it was terminating the merger and related funding agreement under the materially adverse condition clause of the agreements. Plaintiffs alleged that Verizon already knew at November 14 of the higher losses at NorthPoint and already had determined to terminate the agreements with NorthPoint for unrelated reasons. NorthPoint had initiated an action in a state court in California against Verizon alleging, among other things, breach of contract and had served Verizon with document production notices and taken and were in the process of taking depositions in that action that were subject to a confidentiality order. Plaintiffs in the action before Judge Conner were seeking a lift of the stay with respect to a subpoena they had served on counsel to NorthPoint in the California action seeking in substance access to all of the documents and transcripts of all of the depositions taken in that proceeding.

Judge Conner agreed with what the Ninth Circuit had to say in Cowen, discovery should be allowed only if the complaint satisfies the heightened pleading standards of the PSLRA. Plaintiffs argued, however, that since the subpoena was served on a third party the same considerations were not applicable, citing a district court decision that attached some significance to that argument.[36] Judge Conner noted that the original decision in Flir was rendered before the Ninth Circuit had decided Cowen and, notwithstanding the court reaffirmed its decision on a petition for reconsideration after Cowen, Judge Conner thought it “questionable” whether it the court would have lifted the stay if its original decision came after Cowen. In any event, it was distinguishable, as plaintiff sought to depose only one person, a former employee of the defendant, in that case. Further, that person was willing to testify except he had been threatened with a legal action if he did so. Counsel for NorthPoint had objected to the subpoena as it would be costly and time consuming to comply with it. The information being sought was information furnished by Verizon, not information furnished by the third party and was being sought “in order to circumvent the statute.” Finally, the discovery sought was not “particularized” as it “requested all documents, testimony and transcripts that have been previously produced or will be produced in the future, amounting to more than 45,000 pages of documents.”[37]

Judge Conner also distinguished the decision of Judge Schwartz in Vacold because of defendants’ “lack of candor” in refusing to acknowledge in the course of oral argument when Johnson and Johnson had agreed to contribute financing. Judge Schwartz “concluded that narrowly limited discovery would not coerce a settlement or support a claim not alleged in the complaint.[38]” Would Judge Conner have lifted the stay if the only discovery sought was from Verizon and was limited to determining when they made the decision to abandon the NorthPoint merger? Like Vacold, that involved an issue of when certain events took place, was a critical issue, one defendants obviously would not admit if not compelled to do so, and would have supported only the complaint alleged in the complaint. On the other hand, it might have involved extensive discovery as decisions of this nature are not made by one person, and likely evolve over a substantial period of time rather than taking place at a precise moment of time. Judge Conner had his own answer as to why plaintiffs would not have been prejudiced. “Plaintiffs could have waited to determine what allegations were proven in the NorthPoint California litigation rather than filing first and using the action to discover whether they have a viable securities fraud claim.”[39] This overlooks the fact that to do so plaintiffs would have run the substantial risk that the one year after discovery statute of limitations would have been running against them. See § 1.12[[2]. Although in Judge Conner’s view of their own doing, plaintiffs clearly were prejudiced by the denial of their motion to lift the discovery stay as he gave them 20 days to file an amended complaint.[40]

Discovery, once it commences,  is a two-way street. Recall that in Theragenics Judge Thrash denied the motion to dismiss the amended complaint largely on the basis of information and belief allegations attributed to unnamed, but generically described persons in a position to have access to the alleged information. See § 3.13[2]. When defendants served interrogatories on plaintiffs for the names of the persons who furnished the basis for specific allegations of the complaint, plaintiff refused to answer most of the interrogatories, claiming the names were protected by the work product doctrine. Judge Thrash, however, held the work product doctrine inapplicable and entered an order requiring plaintiffs to answer all the interrogatories. Click HERE for his opinion.