The PwC securities litigation study had a number of interesting statistics. In the past six years the number of securities class-action lawsuits filed averaged approximately 200 per year, after a peak of 258 class-action suits in 1998. The percentage of securities class-action lawsuits alleging accounting fraud was 74 percent in 2002, 66 percent in 2003, and 59 percent in 2004. The average settlement amount for cases with accounting allegations were almost three times higher than those without such allegations in 2004. There were 78 accounting cases with an average settlement value of $33.6 million. There were 26 non-accounting cases which had an average settlement by a $9.6 million.
 
In enforcement actions the trend has been for the Securities and Exchange Commission and the Department of Justice to receive larger amounts for fines, penalties and disgorgement. PwC believes that the international financial reporting standards conversion in 2005 for many foreign private issuers, combined with Sarbanes-Oxley section 404 reporting on internal control standards and the proposed new PCAOB " fraud auditing" standards, will increase the risks to outside auditors. The corollary will be an increase in securities class-action suits with accounting fraud allegations.
 
As practitioners in this area are well aware, the SEC and DOJ cooperate closely, notwithstanding the SEC's protestations that they are not a stalking horse for the DOJ. Many SEC enforcement actions are referred over to the DOJ before they are filed by the SEC or shortly after the SEC has instituted some type of enforcement action.

According to the PwC study, between 1996 and 2004 there were 153 securities class actions that involved both SEC and DOJ investigations, of which 90 percent, involved accounting issues. CFOs were named as defendants in 83 percent of all class actions filed in 2004. The SEC noted that for all enforcement actions during the five-year period through July 2002 either CEOs, CFOs, COOs or chief accounting officers were implicated in over 70 percent of the SEC enforcement actions. The trend to include individuals as defendants in both securities class actions and governmental enforcement actions is likely to continue to increase.
 
Two industries accounted for approximately 50 percent of the securities class actions filed in 2004. High-tech companies accounted for approximately 30 percent, up from 15 percent in 2003. And health services and pharmaceuticals accounted for 20 percent in 2004.

There is also an increasing trend over the last five years for including foreign companies as targets in securities class-action cases.
 
Loss causation

Loss causation continues to be a hot topic, and there appears to be a trend construing this more favorably to defendants in 10b-5 cases. There are two types of causation that must be pleaded and proven. The first is transaction causation; e.g., the investors would not have purchased the securities but for the fraudulent statement or omission. The second type of causation is loss causation; e.g., the investor's loss must be proximately caused by the alleged wrongful conduct.

In Dura Pharmaceuticals, Inc. v. Broudo (2005) the Supreme Court held that at least in fraud-on-the-market class-action securities cases, "an inflated purchase price will not itself constitute or proximately cause the relevant loss." Now the focus is on showing that the loss was sustained when the fraud was revealed or the true facts became generally known. Just prior to the Dura Supreme Court decision, the Second Circuit in Lentil v. Merrill Lynch & Co. stated that in order to establish loss causation a plaintiff must allege that the subject of a fraudulent statement or omission was the cause of the actual loss suffered. 
 
It is important to note that in deciding Dura the Supreme Court assumed, without deciding, that only Rule 8 of the Federal Rules of Civil Procedure apply to pleading loss causation, rather than the fraud particularity requirements of Rule 9(b), which requires the circumstances constituting the fraud be plead with particularity. In deciding which is the appropriate standard for pleading loss causation, the district courts are divided, with the majority appearing to require a plaintiff to plead loss causation with particularity. 
 
Class-action status

Class-action certification is becoming much more difficult for plaintiffs. Traditionally, the granting of class-action status was not appealable because it was not deemed a final resolution. In almost all instances, once a class is certified the cases settle. As a result, there were very few decisions of appellate courts analyzing whether or not the district courts had properly certified the class. As a result of a 2001 decision by the Seven Circuit sitting in Chicago, Illinois in Szabo v. Bridgeport Machines, Inc., which was not a securities case, this view started to change, as Szabo encouraged securities defendants to challenge class certification. In 2003, Federal Rule of Civil Procedure 23 was modified to give judges greater flexibility.

More courts are now looking at the merits of the claim when ruling on class-action certification. In fraud-on-the-market cases this has some unusual twists and turns. Normally, class-action certification is resolved before there is extensive discovery on the merits. But the plaintiff, without the benefit of discovery, is required to use expert testimony to show why the market for that particular stock is efficient and that the decline in the market is directly attributable to the revelation of the fraud alleged in the complaint. Even if the plaintiff has a viable economic theory, this is difficult to show without the benefit of discovery.
 
PSLRA holders

Another hot area is whether plaintiffs counsel can continue to circumvent the stringent pleading requirements of the Private Securities Litigation Reform Act in the federal courts and PSLRA's automatic stay of discovery until the motion to dismiss is decided by bringing state law class actions. To do this, plaintiffs are filing so-called "holders" cases in state court that do not involve the purchase or sale of the security. In this type of case, the plaintiff is saying that if I had known of the fraudulent misstatement or omission I would have sold my securities. The defendants then remove the case to federal court.

Generally, these holders suits have been remanded back to the state courts by the federal courts. For example in Dabit v. Merrill Lynch, the Second Circuit, in one of the securities analysts class actions, permitted the suit to go forward in state court. The Eighth and Eleventh Circuits agreed with the Second Circuit that the scope of SLUSA (Securities Litigation Uniform Standards Act) tracks the coverage of § 10(b). The Ninth Circuit rule is that there is a direct correlation when the plaintiff is a governmental agency. The Third Circuit has reserved decision on this issue. The Supreme Court granted certiorari to a Seventh Circuit case, Kircher v. Putnam Funds Trust, which held that these "holders" claims are preempted by federal law and should not be remanded to the state courts, holding that if the complaint does not satisfy PSLRA, it should be dismissed no matter who instituted the suit.

Interestingly, at the Seventh Circuit, both the SEC and the U.S. Solicitor General submitted amicus curia ("friend of the court") briefs in support of the position that these types of holders suits are preempted by federal law, whether or not instituted by a governmental agency.

Update, May 2006: Supreme Court Resolves 'Holders' Conflict Among Circuits

CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC. Contact him at 212.490.3232 or visit www.securitiescounselors.com

*Public Company Accounting Oversight Board