Saying So Long to State Court Securities Litigation

When Congress enacted the Securities Exchange Act of 1934, providing for federal regulation of securities traded on the public markets, it took the opportunity to consider conforming amendments to the sister statute regulating initial public offerings it had enacted the year before, the Securities Act of 1933. One such amendment would have done away with the ’33 Act’s concurrent jurisdiction and removal bar provisions, instead providing for exclusive federal jurisdiction like the new ’34 Act did. An ABA Special Committee had advocated for the change, which was included in the original Senate bill, out of concern that concurrent jurisdiction “will inevitably result in varied interpretations of the Act.” The Special Committee warned that “in view of the [‘33 Act’s] heavy liabilities,” “the resulting uncertainty” of “varied [and inconsistent] interpretations” by state and federal courts “will almost certainly operate as a detriment to legitimate business.” Unfortunately, the amendments were not adopted and the prophecy has proved prescient.

As senior SEC officials, the Treasury Department, and stock exchange leaders have recognized, the threat of protracted and often frivolous securities class action litigation has contributed to a decades-long decline in IPOs. Rather than risk becoming the target of vexatious securities litigation, companies increasingly choose private capital transactions or strategic combinations in lieu of going public, a phenomenon that has had significant detrimental effects on both the economy in general and small investors in particular. Congress attempted to stem the tide when it adopted the Private Securities Litigation Reform Act (“PSLRA”) in 1995. However, since that time, the number of public companies has been halved and the number of IPOs has declined from 949 in 1996 to an average of less than 150 per year.

In part, this is because the PSLRA was primarily focused on claims under the ’34 Act and thus did not squarely address the “heavy liabilities” and more lenient pleading standards under the ’33 Act, a combination that makes newly public companies uniquely vulnerable to securities claims. Typical securities fraud claims under Section 10(b) of the ’34 Act require proof of intentional or extremely reckless wrongdoing and must be brought in federal court where the PSLRA imposes stringent pleading requirements and a stay of discovery until plaintiffs’ claims are sustained. In contrast, IPO-related claims under Sections 11 and 12 of the ‘33 Act impose liability for innocent or merely negligent misstatements. Moreover, because the jurisdictional amendments to the ‘33 Act were not adopted, these IPO-related claims can be filed in either federal or state courts, the latter of which often lack familiarity with the complex federal securities laws and do not always adhere to the heightened scrutiny and protective procedures required by the PSLRA.

Plaintiffs’ lawyers took full advantage of the significant discrepancy between state and federal courts in adjudicating IPO-related claims. After the PSLRA was passed, they flocked to the state courts in an attempt to avoid the new law’s reforms, filing claims under state law challenging disclosures dictated by the federal securities laws for nationally traded securities. Three years later, Congress was forced to close that loophole by effectively pre-empting state law securities class actions in the Securities Litigation Uniform Standards Act (“SLUSA”).

However, in closing that loophole, Congress left another. In 2011, a California appeals court held that while SLUSA effectively pre-empted securities claims under state law, it did not divest the state courts of concurrent jurisdiction to hear IPO-related claims under federal law. With the floodgates once again opened, an increasing number of plaintiffs filed stand-alone federal IPO claims in state courts. This tactic has had its desired effect: Securities class action plaintiffs have achieved a much higher rate of success in surviving threshold motions in IPO-related federal securities class actions litigated in state courts, extracting significant settlements out of proportion to results typically achieved in federal fora.

Several newly-public companies have tried different legal approaches meant to stem the tide of state court IPO-related securities litigation. Unfortunately, two decisions in 2018 have thwarted these efforts, not on policy grounds but because of the courts’ narrow construction of existing law.

First, in Cyan v. Beaver County Employees Retirement Fund, 138 S. Ct. 1061 (2018), the U.S. Supreme Court narrowly construed SLUSA, agreeing with the California appeals court that while SLUSA’s less-than-clear language prevented plaintiffs from bringing securities class actions under state law, it did not strip state courts of jurisdiction to entertain federal IPO-related claims. The Cyan Court also rejected the argument—made by the government—that SLUSA overrode the “unusual” removal bar included in the ‘33 Act, thereby also closing that avenue to the federal courts for IPO-related claims.

Second, just last month in the StitchFix/Roku case, the Delaware Chancery Court struck down forum selection charter provisions meant to ensure that IPO-related claims under the ‘33 Act are filed in federal courts. The Chancery Court determined that these federal forum selection provisions were not permitted because they did not seek to regulate disputes governed by Delaware law or related to the corporation’s internal affairs.

The only realistic “fix” after StitchFix/Roku and Cyan, then, would appear to be an amendment to the ’33 Act itself—a fix the Special Committee suggested eighty-five years ago and the Supreme Court itself alluded to in Cyan. There is ample reason to require all federal securities class actions to be filed in federal court and little reason not to do so.

First, as noted above, securities litigation in non-expert state courts has resulted in a flood of cases being filed in state courts, often in parallel but with results inconsistent with nearly identical federal actions. These state court IPO cases allow plaintiffs to evade the PSLRA, impose burdensome and expensive discovery before allegations are tested, and result in fewer claims being resolved at early stages of litigation and increasing settlements being extracted. This state of affairs has provided even more disincentive for companies to consider going public, perpetuating the decline in IPOs that modern lawmakers and regulators have sought to reverse.

Second, as the Supreme Court recognized in Cyan, there is ample indication in the legislative history that SLUSA’s supporters understood its purpose was “to prevent plaintiffs from seeking to evade the protections that Federal law provides against abusive litigation by filing suit in State, rather than in Federal, court.” Unfortunately, the Court found that SLUSA’s implementing language was more narrow than that purpose and prevented only state law, but not federal law, claims challenging IPO disclosures from being brought in state court.

Third, during the ’33 Act’s Congressional hearings, there was a significant emphasis on the need for expertise in interpreting and applying the Securities Act. Many felt that the D.C. Circuit Court of Appeals should have exclusive jurisdiction over disputes between securities regulators and issuers because the other federal courts lacked sufficient expertise and understanding of the markets to be trusted to adjudicate securities claims. State courts were not even considered as an option; it was universally agreed that failed state regulation had contributed to the abuses that resulted in the crash of 1929, the very cataclysm which led to the enactment of the federal Securities Act and its entirely new federal securities regulatory regime.

Finally, just one year later, the ’34 Act unequivocally provided for exclusive federal jurisdiction. Conforming amendments to the ’33 Act would have done the same for IPO claims but were not adopted. Why?

In Cyan, the Supreme Court observed: “We do not know why Congress [in enacting SLUSA] declined [explicitly] to require … that 1933 Act class actions be brought in federal court.” The same observation could be made as to why Congress provided for concurrent jurisdiction in the first place. There is nothing in the legislative history of the ‘33 Act demonstrating that Congress gave any thought whatsoever to whether state courts ought to be permitted to adjudicate federal securities claims. Back in 1933, not a single mention was made concerning the fora in which private litigants could bring their claims in all of the Congressional debates, hearings and reconciliation processes surrounding the Securities Act. Somehow, both the concurrent jurisdiction and the “unusual” removal bar provisions of the Securities Act appeared late in the process in the House bill, were removed after reconciliation, and reappeared just days before the final vote—almost as if someone realized at the last minute that the jurisdictional issue had not been addressed and just put something in.

Some have speculated that the provision for state court jurisdiction was meant to address the burdens of travel for investors back in 1933. However, as far as the legislative history shows, that argument was first raised post-hoc in 1934 and even then was rejected by the Special Committee as “not valid.” That concern is certainly not valid today. Perhaps the best explanation for the differing jurisdictional provisions in the ’33 and ’34 Acts offered by legal scholars is that they are a “myster[y]” or mere “happenstance.”

Unfortunately, almost a century later, that “happenstance” is contributing to a shrinking IPO market. Given the absence of any apparent original purpose for granting concurrent jurisdiction over adjudication of IPO-related claims and Congress’ more recent intent to prevent plaintiffs from evading the protections of the PSLRA by filing suit in state courts, it is time for Congress to finally and definitively close the remaining state-court loophole for adjudication of federal securities claims. As the Supreme Court suggested in Cyan, “If Congress … want[s] to deprive state courts of jurisdiction over [Securities] Act class actions, it ha[s] an easy way to do so: just insert … an exclusive federal jurisdiction provision (like [that included in the Securities Exchange Act]) for such suits.” 138 S. Ct. at 1070. Eighty-five years after that very amendment was first proposed, it is time for Congress to do exactly that.

The complete publication, including footnotes, is available here.