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Responding to a False Alarm: Federal Preemption of State Securities Fraud Causes of Action Richard W

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Cornell Law Review Volume 84 Article 1 Issue 1 November 1998 Responding to a False Alarm: Federal Preemption of State Securities Fraud Causes of Action Richard W. Painter Follow this and additional works at: http://scholarship.law.cornell.edu/clr Part of the Law Commons Recommended Citation Richard W. Painter, Responding to a False Alarm: Federal Preemption of State Securities Fraud Causes of Action , 84 Cornell L. Rev. 1 (1998) Available at: http://scholarship.law.cornell.edu/clr/vol84/iss1/1 This Article is brought to you for free and open access by the Journals at Scholarship@Cornell Law: A Digital Repository. It has been accepted for inclusion in Cornell Law Review by an authorized administrator of Scholarship@Cornell Law: A Digital Repository. For more information, please contact [email protected]. RESPONDING TO A FALSE ALARM: FEDERAL PREEMPTION OF STATE SECURITIES FRAUD CAUSES OF ACTION Richard W. Painte4t INTRODUCTION ................................................. 2 I. THE FEDERALISM DEBATE IN CORPORATE LAW ............ 13 II. FEDERALISM IN SECURITIES LAW .......................... 20 A. Sales of Securities Under Common Law and State Blue Sky Laws ...................................... 20 B. The Federal Securities Laws ........................ 23 1. The Legislation of 1933 and 1934 ................. 23 2. Why Not Preemption?.... 25 3. The FederalismDebate Revisited .................... 29 III. THE BATTLE OVER SECURITIs LITIGATION ............... 31 A. The 1995 Securities Litigation Reform Act .......... 32 B. The Battle in California ............................ 36 1. Propositions201 and 211 ......................... 38 2. Diamond Multimedia and StorMedia ............ 39 IV. THE PREEMPTION DEBATE ............................... 41 A. Migration of Litigation to State Court .............. 42 B. State Court Litigation and the Federal Safe Harbor. 46 C. The Preemption Legislation ........................ 47 V. SHOULD CONGRESS HAVE PREEMPTED STATE CLASS ACTION SECURITIES LITIGATION? ......................... 60 A. The "Economic" Equation: Is a Dual-Forum Class Action Framework Cost Effective? ................... 60 1. Costs of a Dual-Forum Class Action Framework...... 60 2. Benefits of a Dual-Forum Class Action Framework ... 65 B. The Political Equation: Will a Dual-Forum Class Action Framework Achieve the Right Balance Between Issuers and Investors? ...................... 68 t A.B. Harvard 1984;J.D. Yale 1987; Associate Professor, University of Illinois College of Law; Visiting Associate Professor, Cornell Law School 1997-98. The author is grateful to Kevin ClermontJim Cox, Bob Hillman,Jon Macey, William Painter, Roberta Romano, and Lynn Stout for very helpful comments on earlier drafts of this Article. Portions of this Article were incorporated into the author's prepared statement and testimony before the United States Senate Committee on Banking, Housing, and Urban Affairs Subcommittee on Securities on February 23, 1998 and before the House of Representatives Committee on Commerce Subcommittee on Finance and Hazardous Materials on May 19, 1998. CORNELL LAW REVIEW [Vol. 84:1 1. Type I Error: Will the States Be Biased in Favor of Plaintiffs? ....................................... 71 2. Type II Error: Will the Federal System Be Biased in Favor of Defendants? ............................. 75 a. Type II Error in the Legislative Branch ......... 75 b. The Supreme Court's Scaling Back of Private Rights of Action .............................. 78 c. Proposals To Scale Back PrivateRights of Action Even Further................................. 84 C. Federalism Concerns ............................... 86 VI. How SHOULD CONGRESS HAVE PREEMPTED STATE SECURITIES LITIGATION? .................................... 89 A. Tailored Preemption ............................... 89 B. Preempting Settlement of Federal Claims in State C ourt ............................................... 94 1. Matsushita and Unified Settlements ................ 95 2. The Uniform StandardsAct's Impact on Unified Settlements ....................................... 98 CONCLUSION ....................................................... 99 APPENDIX A: THE PRICE WATERHOUSE STUDY .................... 101 APPENDIX B: SELECTED PROVISIONS OF THE UNIFORM STANDARDS ACT As ENACTED ON NOVEMBER 3, 1998 ................. 105 INTRODUCTION Congress has passed the Securities Litigation Uniform Standards Act of 1998 ("Uniform Standards Act"),' preempting securities fraud class actions under the common law and statutes of all fifty states.2 As a result, defrauded investors, with the exception of state and local gov- ernments and their pension funds,3 will be barred from bringing class 1 Pub. L. No. 105-353, 112 Stat. 3227 (to be codified in scattered sections of 15 U.S.C.). 2 A bill that would have preempted all private rights of action for securities fraud under state law was introduced in the House of Representatives, but it did not proceed further. See Securities Litigation Improvement Act of 1997, H.R. 1653, 105th Cong. § 16 (1997). Congressman Tom Campbell (R-Cal.), a Stanford Law School Professor, proposed House Bill 1653 and ProfessorJoseph Grundfest of Stanford Law School had drafted it. See The Securities Litigation Uniform Standards Act of 1997: Hearing on H.R. 1689 Before the Sub- comm. on Fin. and Hazardous Materials of the House Comm. on Commerce, 105th Cong. 15-17 (1998) [hereinafter May 19, 1998, House Uniform StandardsAct Hearing] (statement of Rep. Tom Campbell). 3 See S. 1260, 105th Cong. § 3(f) (1998), reprinted in 144 CONG. REC. S4811 (May 13, 1998) (agreeing to Amendment No. 2397 exempting suits brought by "a State or political subdivision thereof or a State pension plan" on its own behalf or as a member of a class comprised solely of similar entities); H.R. 1689, 105th Cong. § 16(d) (2) (1998), reprinted in 144 CONG. REC. H6053 (July 21, 1998) (same, except providing that exempted class mem- bers must have "authorized participation[ in such action"). The Uniform Standards Act incorporated the House language. 1998] UNIORM STANDARDS ACT actions in state court or under state law. Because most plaintiffs find litigation outside of a class action impractical and uneconomical, 4 the vast majority of investors will be left with only federal remedies-the express remedies created by the Securities Act of 1933 ("1933 Act") 5 and the remedies that the federal courts have implied under the Se- curities Exchange Act of 1934 ("1934 Act"). 6 Preemption now occurs even though the 1933 and 1934 Acts expressly preserved state causes of action, 7 and the courts that subsequently interpreted federal reme- dies under these statutes assumed that alternative state remedies were available. 8 Ironically, the Congress that now preempts these state remedies has been committed to federalism in almost every other area of legislation. 9 4 For a discussion of the economics of class action litigation, see infra Part VA. 5 Securities Act of 1933, 15 U.S.C. §§ 77a-77bbbb (1994 & Supp. 111996). 6 Securities Exchange Act of 1934, 15 U.S.C. §§ 78e-78mm. The 1934 Act contains express remedies in section 9 for market manipulation, see id. § 78i (1994), and in section 18 for false statements in filings with the SEC. See id. § 78r. Section 9, however, is limited to enumerated acts of market manipulation and does not generally reach misrepresenta- tions made to purchasers of securities. See id. § 78i. Section 18 requires a showing that each plaintiff relied on the defendant's misrepresentations in its SEC filings. See id. § 78r(a). Because reliance turns on different questions of fact for each plaintiff (many of whom never read SEC filings), class actions under section 18 are virtually impossible. Most plaintiffs instead use the implied private right of action under section 10(b) of the 1934 Act, see id. § 78(j). This implied right of action is discussed more fully below. See infranote 47; infra text accompanying notes 410-27. 7 See Securities Act of 1933, ch. 38, § 16, 48 Stat. 74, 84 (codified at 15 U.S.C. § 7 7p (1994)) ("The rights and remedies provided by this [Act] shall be in addition to any and all other rights and remedies that may exist at law or in equity."); Securities Exchange Act of 1934, ch. 404, § 28(a), 48 Stat. 881, 903 (codified as amended at 15 U.S.C. § 78bb(a) (Supp. 111996)) ("The rights and remedies provided by this [Act] shall be in addition to any and all other rights and remedies that may exist at law or in equity. ... ). 8 For example, the Supreme Court stated in MarineBank v. Weaver: "[W] e are satis- fied that Congress, in enacting the securities laws, did not intend to provide a broad fed- eral remedy for all fraud." 455 U.S. 551, 556 (1982) (holding that a privately negotiated arrangement promising a share of a borrower's profits in return for a loan guarantee was not a security for purposes of section 10(b)); see also Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 738 n.9 (1975) (holding that a plaintiff has no standing to sue under section 10 (b) of the 1934 Act unless the plaintiff was an actual purchaser or seller of securi- ties, and pointing out that disadvantages imposed on investors by this seemingly arbitrary restriction are "attenuated to the extent that remedies are available to nonpurchasers and nonsellers under state law"). Blue Chip and other holdings narrowly construing federal private rights of action are discussed infra text accompanying notes 410-37. 9 Welfare reform, health care, and environmental regulation are a few examples of areas in
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