Chapter 4  PSLRA – Discovery; Sanctions, Other Class Action Provisions, Contribution and Partial Settlements

Hypothetical 4 -- Background

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     There can be no effective enforcement of the law, whether by the agency responsible for enforcement or through private actions, without the power to investigate. Those being investigated have traditionally objected to "fishing expeditions." The answer has long been clear with respect to federal agencies such as the SEC. A federal agency charged with investigating violations of an Act and enforcing the Act can investigate corporate behavior to satisfy the agency's "official curiosity" that the law is being complied with.[1] The authority of the agency is akin to that of a grand jury and does not require probable cause as the basis for its investigation or for the issuance and enforcement of subpoenas to testify or produce documents. It is sufficient if "the investigation is authorized by Congress, is for a purpose Congress can order, and the documents sought are relevant to the inquiry."[2]

     The SEC can investigate without commencing a proceeding and commonly conducts private investigations, formally or informally, before initiating a proceeding. Those investigations generally are private and information relating to the investigation does not become public unless the company being investigated chooses to make it public or the SEC has to go to court to enforce a subpoena. We knew that it was conducting an investigation in connection with Enron, as it couldn’t credibly deny it is doing so and it has been forced to go to court to enforce a subpoena being resisted by Fastow. Click HERE. A private litigant generally does not have the ability to obtain discovery before initiating a proceeding. Rule 27 does permit one to petition to take a deposition before initiating a proceeding for the purpose of preserving testimony, but is limited to situations in which the testimony might be lost if it could not be taken until after a proceeding is commenced. Once a complaint is filed in a private action in federal court, however, the Federal Rules of Civil Procedure all parties in civil actions in federal courts, including private actions created by federal law, have (had as to securities fraud class action) the capability to discover information "which is relevant to the subject matter involved in the pending action," or if "reasonably calculated to lead to the discovery of admissible evidence." Rule 26(b). Under Federal Rules of Civil Procedure Rule 26(a), as amended each party without awaiting discover are required to furnish the other with (1) the name, address, and telephone number of each individual "likely to have discoverable information that the disclosing party may use to support its claims or defenses," and (2) are to furnish the the other party with a copy or a description and the location of all documents in the party's possession or control that the disclosing party may use to support its claims or defenses. Rule 26(f) provides for a meeting of the parties at which they are to agree on when such mandatory disclosure will be made, the extent of additional discovery, whether it should be phased "or be limited to or focused upon particular issues." A written report has to be submitted by the parties to the court, and the court in connection with a scheduling conference (Rule 16(b)(4)) and/or pre-trial conference (Rule 16(c)(6)) may, among other things, determine "the extent of discovery to be permitted." None of this requires a protective order. Beyond this, the court on motion of a party for a protective order under Rule 26(c)(4) has authority to limit "the scope of discovery . . . to certain matters."

     Discovery is burdensome, time-consuming and expensive. The very expense of the discovery process, preparing for trial, and litigating a case tends to establish a minimum amount that defendants and their insurance carrier may be willing to settle for, without regard to the merits of a case. There is and has been since the liberalized discovery rules were adopted a tension between the need for discovery to get to the truth and to facilitate the trial itself and the resulting costs and opportunity for abuse of the process. The court as noted above does have the power to limit discovery. In addition, Rule 11(b)(3) provides that an attorney filing a pleading certifies "that to the best of the person's knowledge, information, and belief, formed after an inquiry reasonable under the circumstances, . . . (3) the allegations and other factual contentions have evidentiary support or, if specifically so identified, are likely to have evidentiary support after a reasonable opportunity for further investigation or discovery.” The latter clause was added by amendment in 1993. Rule 11(c) provides that the court may impose sanctions for violations of Rule 11(b). The addition of the “likely to have” qualification to Rule 11(b) in 1993 took a good deal out of the threat of sanctions for allegations lacking evidentiary support.

     The PSLRA comes down hard on the side of eliminating the abuses. The stay of discovery provision, both with respect to actions brought under the Exchange Act and the Securities Act provides as follows: “Stay of discovery.--In any private action arising under this title, all discovery and other proceedings shall be stayed during the pendency of any motion to dismiss, unless the court finds upon the motion of any party that particularized discovery is necessary to preserve evidence or to prevent undue prejudice to that party." The pleading and discovery requirements are designed to operate in tandem in this respect, at least with respect to claims asserted under the Exchange Act. Senator Hatch put it succinctly, stating:. "The conference report sensibly requires a heightened pleading standard to weed out frivolous litigation and to free parties against whom claims are made from being subject to abusive and expensive discovery."[3] 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 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. Although the Securities Act includes a similar stay of discovery provision while a motion to dismiss is pending (see § 4.01), 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(2) of the Securities Act, since the opportunity to dismiss claims under the Securities Act is significantly less.

     Section 4.03[1] is a case study as to how the availability of information on the Internet permits plaintiffs to put together a complaint without leaving their computers overnight after a company’s bad news announcement. The objective of the PSLRA to eliminate the race to the court house has not been realized in part because of pleading fraud by hindsight, if you want to call it that, or leaving tracks in the sand, viewed from the perspective of plaintiffs’ counsel. The latter is particularly true in the highly publicized cases, which may involve restatement of financial statements (see § 4.03[3]); resignation of the accountants (see § 4.03[2]); publicized internal investigations undertaken by new management (see § 4.03[1]). The initial complaint put together within a few days is designed to put the firm filing the complaint in play to attract the plaintiff(s) that contend for the role of lead plaintiff. The firm knows that under the PSLRA if there are several complaints filed, as is likely, a minimum of 90 days (and probably longer) will ensue before the case is consolidated and a lead plaintiff/counsel are named. Assuming its plaintiff(s) is named lead plaintiff and the firm approved as lead counsel it can then file an amended complaint. The interval between the filing of the initial complaint and the amended complaint is when the real investigation, to the extent there is one, is likely to take place.

      Milberg Weiss has been named as lead counsel in In re Enron Corp. Sec. Litig.  and brags on its home page that ‘[w]orking on behalf of its clients, Milberg Weiss has demonstrated an unparalleled commitment to the investigation, development and prosecution of this case. The firm brings to this action a securities litigation team which consists of more than two dozen attorneys, investigators, forensic accountants, analysts and corporate governance and accounting experts.” As it says, this is “an unparalled commitment” with an unparalled prospect of a huge settlement and fee, but it mimics what goes on on a much smaller scale and with fewer resources in many other cases between the filing of the initial complaint and the amended complaint after the numerous cases have been consolidated, lead plaintiff and lead counsel selected. The initial complaint filed by Milberg Weiss in Enron was filed on October 22, 2001 and the lead plaintiff was selected and lead counsel appointed on February 15, 2002. Judge Harmon, determined to achieve an “efficient resolution” contrary to the general impressions “that the judicial system grinds slowly” entered a scheduling order on February 28, 2002. That order provides plaintiff will file an amended complaint by April 1, 2002  days from the filing of the initial complaint); defendants’ motions to dismiss by May 1, 2002, opposition to motion to dismiss by June 3, 2002, replies to opposition to motion by June 17, 2002. The April 1 date was extended to April 8 (168 days from the filing of the initial complaint).

     In the typical case, the elusive facts are those that tend to establish that the representations were false at the time made and the often related issue that defendants knew the representations were false or misleading. If discovery is stayed, while the inevitable motion to dismiss is pending, and there is no fortuitous information available like a released internal investigation by new management, investigatory reporting by a reputable financial media source, and the like, where can plaintiff find information about the internal reports, meetings, conferences, etc. that provide incriminating facts that tend to establish the representations were false or misleading at the time made and know to management? One approach often followed is to allege the existence of internal reports to management, periodic review of financial information by management and the like. The existence of such internal reports and periodic review and the like is not an unreasonable assumption as to most public companies, but their content is another matter.

     Plaintiffs’ counsel in preparing the complaint must take into account that under Rule 11(b) they are certifying that the allegations “have evidentiary support” and are subject to sanctions if they do not. That was the case before the PSLRA, but there are two things different after PSLRA with respect to private actions brought pursuant to the Exchange Act or the Securities Act. First, upon final adjudication the court must make a finding “regarding compliance by each party and each attorney representing any party with each requirement of Rule 11(b).” If the court finds a violation of Rule 11(b), the court must “impose sanctions on such party or attorney.” Further, for “substantial failure of any complaint to comply with any requirement of Rule 11(b)” the PSLRA creates a presumption “that reasonable attorneys' fees and other expenses” are to be awarded to the opposing party. See § 4.04. Second, in the pre-PSLRA days allegations would be made on the basis of information and belief with the qualification that the allegation “likely to have evidentiary support after a reasonable opportunity for further investigation or discovery.” Rule 11(b) has not been changed in this respect. The catch 22, however, is that raises the issue of whether the allegations qualified in this manner create a strong inference of scienter in a private action based on Rule 10b-5..

    There is the possibility of obtaining information from former employees a la Novak, which may or may not stand up, depending on the court. See § 3.10 et. seq.. There are ethical considerations in attempting to obtain information from employees and former employees. Interestingly, those limitations were one reason Judge Irenas in Campbell Soup was willing to allow information and belief allegations based on information furnished by unnamed sources. Click HERE.  If you are a Milberg Weiss, you may even develop (but don’t count on it) information through a Report Fraud link on your website. Click HERE. Interestingly, you are not required to furnish your name, although the information may be of little value without knowing something about the informant.