Federal laws/regulations;

OLR Research Report

August 16, 2002





By: George Coppolo, Chief Attorney

You asked for a summary of the 1995 Private Securities Reform Act. You also asked whether it preempts state laws dealing with the same subject.


On December 22, 1995, Congress enacted, over President Clinton's veto, the Private Securities Litigation Reform Act of 1995 (P.L.104-67; 109 Stat.737 et seq.) It focuses primarily on civil liability under the 1933 and 1934 federal securities laws. Supporters claimed the law was needed to put a stop to frivolous complaints and to curb abusive securities litigation.

The act established rules relating to class action lawsuits apparently designed to discourage frivolous and abusive lawsuits. The rules deal with such areas as the selection of the lead plaintiff; limitations on damages, attorneys' fees, discovery, and sealed settlements; and notification of proposed settlements. Also, the act establishes immunity from liability for financial projections and other forward-looking statements, and eliminates joint and several liability under certain circumstances. The act authorizes the Securities and Exchange Commission (SEC) to take action against those who aid and abet those who violate the federal laws. Finally, it imposes certain duties on auditors to disclose fraudulent conduct.

The act does not expressly preempt state law. Thus, if someone challenged on preemption grounds our current state regulatory scheme or legislation proposed to amend it, the challenge would likely be based on the doctrine of implied preemption. Under this doctrine, a court could find implied pre-emption if it determines that Congress has “occupied the field” in which the state is attempting to regulate, a state law directly conflicts with federal law, or enforcement of the state law might frustrate federal purposes. Federal “occupation of the field” occurs when there is no room left for state regulation (Pennsylvania v. Nelson, 350 U.S. 497 (1956)).


At least partially in response to the 1929 stock market crash, Congress enacted the Securities Act of 1933 (15 U.S.C. 77a et seq.) and the Securities Exchange Act of 1934 (48 Stat. 881, 15 U.S.C. 78a-et. seq.). The 1933 act primarily regulates initial distributions of securities, while the 1934 act regulates the purchase and sale of securities after the initial distributions. These acts create an extensive scheme of civil and criminal liability. They authorize the SEC to bring administrative actions and injunctive proceedings to enforce a variety of statutory prohibitions. In addition, private plaintiffs may sue under both express private rights of actions and under implied private rights of action contained in 10 (b) and 14 (a) of the 1934 act.

Section10 (b) is the general anti-fraud provision. This section provides “It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange to use or employ in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the (SEC) may prescribe ...” (15 U.S.C. 78j).

In 1942, the SEC adopted a similar anti-fraud provision, Rule 10(b)-5. Rule 10(b)-5 states “it shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange, (a) to employ any device, scheme, or artifice, to defraud; (b) to make any untrue statement of a material fact or to omit to state a material necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or (c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.”

Supreme Court Decisions Dealing with Securities Fraud

The U.S. Supreme Court decided two cases that limited the power of plaintiffs to bring suits based on securities fraud. In 1991, the Supreme Court determined that because there was no explicit statute of limitations for fraud cases under Rule 10(b)-5, it would apply a uniform federal statute of limitations to such actions. The court noted that other sections of federal law contained a statute of limitations of one year after the discovery of the fraud or three years after its occurrence. The court determined the one-year statute of limitations combined with the three-year statute of repose would be the most appropriate to private actions brought under 10(b) (Lampf v. Gilbertson, 501 U.S. 350 (1991)).

In the second case, the Supreme Court held there is no private cause of action for aiding and abetting those who defraud under 10(b). The court rejected the argument that the phrase “directly or indirectly” imposes liability on those who aid or abet, reasoning that aiding and abetting liability extends beyond people who engage, even indirectly, in prohibited activities. The Court noted the statute prohibits only the making of a material misstatement or omission or the commission of a manipulative act, and the act of aiding and abetting itself involves neither of those things (Central Bank v. First Interstate Bank, 114 S.Ct. 1439 (1994)).


The 1995 act does not explicitly preempt state law. Primarily, it amends federal securities laws in the area of civil lawsuits filed under federal law. Generally, courts have held that federal securities laws do not impliedly preempt state laws that also regulate the sale of securities and the protection of the public from fraud and deceit.

The first laws to regulate securities transactions were enacted on the state level. Kansas may have been the first in 1911. By 1933, 48 states had passed such laws. An early description of the legislative purpose of such laws asserted they were aimed at “speculative schemes which have no more bases than so many feet of blue sky”. This description apparently had a lasting influence because state securities laws are commonly called “blue sky laws”(Securities Laws-State, 69A Am Jur 2d, Section 1).

The prime purpose of blue-sky laws is protecting the public from deceit and fraud in securities transactions. Other purposes include protecting the public from 1`) dishonest or overzealous promoters, 2) insubstantial or speculative schemes, and 3) its own gullibility and greed. Another purpose is to give the public access to truthful information upon which to make informed investment decisions. Unlike federal securities that focus primarily on the national markets, the blue-sky laws are aimed primarily at new and unproven concerns and speculative ventures that often have local or regional impact. And unlike federal securities laws, these laws are not intended to be directed primarily at disclosure (69A Am Jur 2d Section 1).

Generally speaking, in enacting the various federal securities laws, including the 1933 and 1934 acts, Congress did not preempt the field and the blue-sky laws remain valid as long as they do not conflict with such federal laws. (There are a few exceptions to this general rule, such as the Commodity Exchange Act, 7 USCA Section 1 et. seq., where Congress has explicitly preempted state legislation).

For example, courts have held that blue sky laws requiring (1) registration of broker-dealers do not conflict with and are not preempted by the 1934 Act, (2) registration in order to sell securities within or from it also does not conflict with and is not preempted by the 1933 Act, and (3) registration for federally exempt offerings is not in conflict with but in harmony with the federal securities laws. Likewise, courts have concluded rules and regulations of the SEC adopted pursuant to the federal securities laws, have no authority to preempt blue sky laws (69A Am Jur 2d Section 13).


The act requires that each plaintiff seeking to serve as a representative party in a class action suit file a sworn certificate: (1) that he did not purchase subject matter securities at the direction of counsel or to participate in a private action; (2) or that identifies any other action filed during the preceding three year period in which he sought to serve as a representative party on behalf of a class; and (3) that he will not accept payment for serving as a representative party on behalf of a class beyond his pro rata share of any recovery, except as approved by the court.

Method for Determining the Representative Plaintiff in a Class-Action Suit

The act requires that a plaintiff filing a securities class action lawsuit must, within 20 days of filing the complaint, provide notice to members of the purported class in a widely circulated business publication. The notice must identify the claims alleged in the lawsuit and the purported class period and inform potential class members that within 60 days they may move to serve as the lead plaintiff. Publication includes a variety of media, including wire, electronic, or computer services.

Within 90 days of the published notice, the court must consider motions made under the act and appoint the lead plaintiff.

The act establishes a presumption that the most adequate plaintiff in any private class action lawsuit is the person or group of people that (1) has either filed a complaint or made a motion in response to the notice; (2) has the largest financial interest in the relief sought by the class; and (3) otherwise satisfies the requirements of the federal rules of civil procedure. A member of the purported plaintiff class may rebut the presumption by proving that the presumptively most adequate plaintiff (1) will not fairly and adequately protect the class' interests or (2) is subject to unique defenses that render him incapable of adequately representing the class. The act allows the most adequate plaintiff to select and retain counsel to represent the class, subject to court approval.

The act prohibits a person from being a lead plaintiff, or an officer, director, or fiduciary of a lead plaintiff, in more than five securities class actions brought as plaintiff class actions during any three-year period. It allows the court to waive this prohibition if it does so in a manner that is consistent with the purposes of the act.

Limitation on Lead Plaintiff's Recovery

The act removes the financial incentive for becoming a lead plaintiff by limiting the recovery to his or her pro rata share of the settlement or final judgment. Thus, the lead plaintiff's share of the final judgment or settlement will be calculated in the same manner as the share of the other class members. But the act allows courts to award lead plaintiffs reasonable costs and expenses associated with service as lead plaintiff, including lost wages.

Prohibition on Secret Settlements

The act generally bars the filing of settlements or portions of settlements that are sealed if a party shows good cause such as that publication of a portion or portions of a settlement agreement would result in direct and substantial harm to any person or entity, whether or not a party to that lawsuit.

Limitation on Attorneys' Fee

Under prior practice, courts generally awarded attorney's fees based on the so-called “lodestar” approach. Under this approach, the court multiplied the attorneys' hours by a reasonable hourly fee, which could be increased by risk or other relevant factors. The act specifies that total attorneys' fees and expenses awarded by the court to counsel for the plaintiff class may not exceed a reasonable percentage of the amount of any damages and prejudgment interest actually paid to the class. According to the conference report, by not fixing a percentage of fees and costs counsel may receive the act in essence gives the court flexibility to determine what is reasonable on a case-by-case basis. Thus, it appears the lodestar approach as a means of calculating attorneys' fees may be still used by the court under appropriate circumstances.

Notice to Class Members about Proposed Settlements

According to the conference report, Congress heard testimony that class members frequently lacked meaningful information about the terms of a proposed settlement. To deal with this issue, the act requires that certain information be included in any proposed or final settlement agreement disseminated to class members. Such information must appear in summary form on the cover page of the notice. The notice must contain a statement of the average amount of damages per share that would be recoverable if the settling parties could agree on a figure or a statement from each settling party on why there is disagreement concerning the average amount of damage per share. It must also explain the attorneys' fees and costs sought. It must include the name, telephone number, and address of counsel for the class and a brief statement explaining the reason for the proposed settlement.

Limits on Discovery

According to the conference report, the cost of discovery often forces innocent parties to settle securities class action lawsuits that lack merit. The report indicated that a witness testified before Congress that discovery costs can account for roughly 80% of total litigation costs in security fraud cases. To deal with this issue, the act requires that courts stay all discovery pending a ruling on a motion to dismiss, unless exceptional circumstances exist where particularized discovery is necessary to preserve evidence or to prevent undue prejudice to a party.

To ensure relevant evidence will not be lost, the act makes it unlawful for anyone, upon receiving actual notice that names him as a defendant, to willfully destroy or otherwise alter relevant evidence. This prohibition expressly applies only to defendants.

Attorneys' Fees Awarded to Prevailing Parties

Under the act if a lawsuit is brought for an improper purpose, is unwarranted by existing law or legally frivolous, is not supported by the facts, or otherwise fails to satisfy the requirements set forth in Rule 11(b) of the rules of federal civil procedure, the prevailing party presumptively must be awarded its attorneys' fees and costs for the entire action. A party may rebut this presumption by proving (1) the violation was minor or (2) the imposition of fees and costs would impose an undue burden and be unjust, and it would not impose a greater a burden for the prevailing party to have to pay those same fees and costs.

Rule 11 (b) allows the court to sanction parties who abuse the court system and other litigants by doing such things as engaging in conduct to harass, cause unnecessary delay, or subject to opposing parties needless litigation costs.

Limitation on Attorneys' Conflict of Interest

The act requires a court to determine whether a lawyer who owns securities in the defendant company and seeks to represent the plaintiff class in a securities class action should be disqualified from representing the class because of conflict of interest.

Pleading Standards

The act requires plaintiffs to specify facts giving raise to a strong inference that the defendant acted with the required state of mind. In addition, there is an automatic stay of discovery pending a motion to dismiss so that plaintiffs will not have the benefit of discovery to help them to determine what facts give rise to the required state of mind. The express purpose for this heightened pleading standard is to make sure plaintiffs have a basis for their claim before it proceeds.


The act requires the plaintiff, in actions brought under the 1934 act, to plead and then prove the misstatement or omission alleged in the complaint actually caused the loss he incurred.


According to the conference report, the prior method of calculating damages in securities fraud cases was complex and uncertain. As a result, there were often substantial differences in the damages calculated by defendants and plaintiffs. Typically, in cases involving fraudulent misstatements or omissions, the investors' damages were presumed to be the difference between the price he paid for the security and the price of the security on the day the corrective information was disseminated to the market.

Instead, the act requires that plaintiffs' damages, in lawsuits brought under the 1934 act, be calculated based on the “mean trading price” of the security. This calculation takes into account the security's value on the date the plaintiff originally bought or sold it and the security's value during the 90-day period after dissemination of any information correcting the misleading statement or omission. If the plaintiff sells those securities or repurchases them during the 90-day period, damages may not exceed the difference between the price the plaintiff received or paid and the mean trading price from the date the corrective information was made public up to the date the plaintiff sells or repurchases the securities (109 Stat. 749).


Under prior law, a defendant who was found liable to any extent could have been forced to pay 100% of the damages in the case. The act addresses this by establishing a system of proportionate liability. According to the conference report, the prior system of joint and several liability coerced innocent parties to settle claims that lacked merit rather than risk exposing themselves to liability for a grossly disproportionate share of the damages in the case.

The act eliminates joint and several liability except when the jury (or court) determines that the defendant knowingly or intentionally violated the securities law. In addition, the act creates an exception for plaintiffs whose net worth is less than $200,000, and who have recoverable damages exceeding 10% of their net worth. Under the act, if a plaintiff who meets these criteria cannot collect from one or more defendants, the other defendants are jointly and severally liable for the uncollected share. For other plaintiffs, defendants are liable for up to 150% of their proportionate share of the damages.


The act authorizes the SEC to take action against those who knowingly provide substantial assistance to someone who violates the 1934 act or regulations adopted under it. But the act did not authorize private lawsuits for such conduct.


The act includes a statutory “safe harbor” to encourage companies to disclose forward-looking information. Forward-looking information includes (1) certain financial items, including projections of revenues, incomes and earnings, capital expenditures, dividends, and capital structure; (2) management's statement of future business plans and objectives, including those relating to its products or services; (3) certain statements made in SEC-required disclosures, including management's discussion and analysis; and (4) any statement disclosing the assumptions underlying the forward-looking statement.

The act provides a two-pronged safe harbor that gives greater flexibility to those who try to use it to protect themselves against civil liability. The first prong of the safe harbor provision protects a written or oral forward-looking statement that is (1) identified as forward-looking and (2) accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those projected in the statement. Under this first prong of the safe harbor provision, boilerplate warnings apparently are not sufficient as meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those projected in the statement. The cautionary statements must convey substantive information about factors that realistically could cause results to differ materially from those projected in the statement, such as for example, information about the issuer's business. The act apparently did not change the rule on materiality. Thus, the act specifies the safe harbor provision does not affect the rule that liability only attaches to forward-looking statements that are material.

The second or alternative prong of the safe harbor provides an alternative analysis. This also applies to both written and oral forward-looking statements. Instead of examining the statements themselves, this prong of the safe harbor focuses on the state of mind of the person making the statement. Under this approach, a person or business entity will not be liable in a private lawsuit for a forward-looking statement unless a plaintiff proves the person or entity made a false or misleading forward-looking statement with actual knowledge that it was false or misleading.

The safe harbor protection applies to written and oral forward-looking statements made by issuers of stock and certain people retained or acting on behalf of the issuer. The provision protects underwriters, but only to the extent that they provide forward-looking information that is based on or derived from information the issuer provided.

The safe harbor provision does not apply to forward-looking statements (1) included in financial statements prepared in accordance with generally accepted accounting principles; (2) contained in an initial public offering registration statement; (3) made in connection with a tender offer; (4) made in connection with partnership, limited liability company, or direct participation program offerings; or (5) made in beneficial ownership disclosure statements filed with the SEC under law.

It also does not apply to those who were convicted of securities fraud within three years of the statement or that had been the subject of a judicial or administrative action that found a violation of the anti-fraud provisions.


The act removes any conduct that would have been actionable as fraud in the purchase or sale of securities as racketeering activity under civil RICO. Thus this eliminates securities fraud as a predicate offense in a civil RICO action.


The act requires independent public accountants to adopt certain procedures in connection with their audits and to inform the SEC of illegal acts. These requirements must be carried out in accordance with generally accepted auditing standards for audits of SEC registrants on the detection of illegal acts, related party transactions and relationships, and evaluations of an issuer's ability to continue as a going concern. The act establishes notification and reporting guidelines for a public accountant who becomes aware of information indicating possible illegal

activities during the course of an audit. It specifies that an auditor may not be liable in a private action for complying with these guidelines, and imposes civil penalties for an auditor's noncompliance with the act.