Private Securities Litigation Reform Act - Putting The PSLRA in Context: The Procedural Course of A Modern Securities Fraud Action

Putting The PSLRA in Context: The Procedural Course of A Modern Securities Fraud Action

In a the typical Rule 10b-5 claim, the plaintiff will commence the action by filing a complaint in federal court. The defendant will then file a motion to dismiss under Rule 12(b)(6) of the Federal Rules of Civil Procedure. A motion to dismiss under Rule 12(b)(6) is essentially an argument by the defendant that, even if all of the facts alleged in the complaint were assumed to be true, those facts would not be sufficient to give rise to liability under Rule 10b-5. If the court determines that the facts alleged in the complaint are sufficient to state a Rule 10b-5 claim, the plaintiff then becomes entitled to obtain "discovery" from the defendant—which typically means the right to demand documentary evidence in the defendant's possession concerning the facts at issue, and the right to require the defendant (and other witnesses) to sit for depositions.

In a modern litigation context, the discovery process is protracted and very expensive, often involving production of millions of pages of documents and depositions of dozens of witnesses, costing the defendant as much as millions of dollars in legal fees. Thus, it is extremely important to the litigants whether a motion to dismiss is granted, as the costs of litigation increase substantially when the motion to dismiss is denied.

If the plaintiff's complaint survives the defendant's Rule 12(b)(6) motion to dismiss, the next step is usually for the plaintiff to seek class certification under Rule 23 of the Federal Rules of Civil Procedure. If the court grants the plaintiff's motion for class certification, the case becomes a securities fraud class action. At this point, the defendant usually faces enormous liability if the case goes to trial and the jury renders a verdict against the defendant.

For example, if the plaintiff class is composed of 50,000 shareholders, each shareholder owns an average of 1000 shares, and each shareholder claims to have sustained losses of $10 per share, the potential compensatory damages are $500 million. Therefore, as a practical matter, if a Rule 10b-5 case is not dismissed on a motion to dismiss, and if the case is certified as a class action, the defendant will face a lot of pressure to settle the case. Even if the plaintiff has a relatively weak case, the expected value of going to trial will put the defendant under pressure to settle. That is, the cost of significantly high damages, even when multiplied by the small chance of losing a jury verdict, may still be very high.

Thus, the outcome of a motion to dismiss in a Rule 10b-5 case essentially determines whether the case gets dismissed or whether it proceeds to discovery and, very often, results in class certification and a very large settlement. Because the motion to dismiss is a pivotal stage in the course of a Rule 10b-5 case, the attorneys for plaintiffs and defendants argue fiercely over the rules that govern such motion to dismiss. Plaintiff lawyers advocate less demanding standards, as such standards would result in a larger number of cases to proceed to discovery and higher amounts of settlements. Defense lawyers and the corporations they represent, on the other hand, advocate more demanding standards, for opposite reasons.

Both sides in this debate use rhetoric that claims the mantle of "justice". The defense bar generally contends that lower pleading standards will allow more frivolous lawsuits and extorted settlements that primarily benefit plaintiff lawyers, not shareholders. On the other hand, the plaintiffs' bar claims that higher pleading standards will enable corporate executives to loot their companies and defraud innocent shareholders with impunity.

The importance of the ratification of the PSLRA in 1995 can be fully appreciated only when one notes such long-running debate between the plaintiff bar and the defense bar over the applicable standards governing Rule 12(b)(6) motions to dismiss in Rule 10b-5 claims.