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The number of companies that have been sued for securities fraud in recent years is staggering. Many of these suits were baseless “strike suits” designed to extort money from companies based solely on the fact that their share prices had dropped. Most, if not all, of these suits were victimless. Recognizing that something had to be done, in 1995 Congress passed the Private Securities Litigation Reform Act (PSLRA). This statute was designed to reduce the volume of abusive federal securities litigation by erecting procedural barriers to prevent the assertion of baseless claims. According to H.R. Conf. Rep. No. 104-369, Congress was “prompted by significant evidence of abuse in private securities lawsuits to enact reforms to protect investors and maintain confidence in our capital markets.” It is still unclear whether the PSLRA will have its intended consequence. According to Joseph A. Grundfest of Stanford Securities Class Action Clearinghouse, between 1996 and 1999 more than 729 companies were sued under the federal securities fraud laws; post-PSLRA cases only began to reach the courts in 1998, and that year saw the largest number of securities suits in decades — 244 in 1998, versus 181 and 114 in 1997 and 1996, respectively. Although there was a slight drop in the number of securities fraud suits filed in 1999 (only 214). That number is still substantially higher than in pre-PSLRA years, Grundfest says. There is no secret formula for avoiding a securities fraud suit. Because of the large amounts at stake (these suits seldom involve less than $25 million in claimed damages) and the public’s tendency to treat federal securities laws as investor insurance rather than a means to ensure fair market practices, almost any public company could become a target. Any time a company’s stock drops by more than 25 percent in a relatively short period of time, that company could be faced with a securities fraud suit, even if the decline in stock value was solely due to market factors. Given the circumstances, perhaps the best way to avoid a suit is to try to manage investor expectations on the front end. Where large sums of money are involved, no one — analysts, employees, investors or even the Securities and Exchange Commission (SEC) — likes surprises. By actively managing the investing community’s expectations with respect to company performance, a company may be able to reduce significantly its risk of being sued. The surest way for a company to manage expectations is to keep the investing world informed of the company’s performance. There is much disagreement, however, on the best way to do this. To ensure that the market is properly informed, a company should also include risk factors in most documents filed with the SEC, including 10Ks and MD&A sections. The financial community is capable of recognizing why these factors are included, and potential investors may benefit from receiving more frequent reminders of the risks inherent in investing. A company might also reduce the risk of becoming a securities fraud defendant by sticking to a “just the facts” policy of disclosure. For example, a company should release information only, not self-congratulatory hype. This means providing concrete facts and historical data, rather than “spinning” the facts. This may be especially important in public statements after a company’s stock has suffered a decline in value. Second, a company should limit the projections it makes public. Analysts are sophisticated enough to make their own projections when given the concrete data. As reported in the NASDAQ Financial Executive Journal, one expert has gone so far as to suggest that companies refrain from using adjectives to describe performance in corporate communications of any kind, including press releases, SEC disclosure statements and annual reports. Whether such a step is necessary is debatable, but it is clear that a company takes a risk if it attempts to say, or spin, too much. Another way companies can make themselves less attractive as securities suit targets is to be especially attuned to what their officers and directors are doing with their shares. Companies that are aware that disappointing operating results are forthcoming should close the trading window — where one exists — for all those with such inside information, particularly officers and directors. Given the readily available information on insider trading patterns on the Internet — insider trading was alleged in roughly 60 percent of the complaints filed under the PSLRA — increasing management control over all selling and buying activity could sharply reduce the likelihood of a company being sued. Despite a company’s best efforts, however, with the wild gyrations in today’s market, a significant price swing over a short period is commonplace. Such a shift in value is bound to attract scrutiny (and in many cases, action) from entrepreneurial plaintiffs’ lawyers. Thus, defendants should be ready to respond. SAFE HARBOR Defendants in securities class actions may be faced with a wide variety of federal and state law causes of action, including claims under �� 11, 12(1), 12(2) and 15 of the Securities Act of 1993, �� 10(b) and 20(a) of the Securities Exchange Act of 1934, state “blue sky” statutes, and common law fraud, breach of fiduciary duty, negligent misrepresentation and professional malpractice allegations. While defense strategies are intensely case-specific, client and defense counsel should meet face-to-face as soon as possible to gather the facts, evaluate the strengths and weaknesses of the case, the likelihood of success on the merits, and marshal the resources available to defend the suit. Significant procedural mechanisms to dispose of the case do exist, and some of these are outlined below. � The PSLRA’s Heightened Pleading Standard. The PSLRA requires a securities fraud plaintiff to plead with particularity each statement alleged to be misleading and set forth in detail the “reasons why the statement is misleading.” To the extent that the plaintiff is required to prove that a defendant acted with a “particular state of mind,” the plaintiff must also “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” The federal courts of appeal have taken different approaches in deciding what satisfies the “strong inference” requirement. For example, the 2nd U.S. Circuit Court of Appeals, in Press v. Chemical Investment Services Corp., No. 98-7123 (2d Cir. 1999), allowed plaintiffs to plead mere motive and opportunity or recklessness. In In re Advanta Corp. Sec. Litig., No. 98-1846 (3d Cir. 1999), the 3rd Circuit did the same, but required more stringent proof of motive and opportunity than the 2nd Circuit. The 9th and 6th Circuits have rejected motive and opportunity, requiring, as the 6th Circuit noted in Hoffman v. Comshare Inc.( In re Comshare Inc. Sec. Litig.), No. 97-2098 (6th Cir. 1999), that the plaintiff instead “plead, in great detail, facts that constitute strong circumstantial evidence of deliberately reckless or conscious misconduct.” Considering the significant number of cases brought in the 9th Circuit, the high bar in that circuit should definitely reduce the number of successful cases brought there. Clearly, the 9th Circuit’s practice is in keeping with Congress’ objectives in passing the PSLRA. � The PSLRA’s Safe Harbor. The so-called “bespeaks caution” doctrine was effectively codified as a safe harbor provision in the PSLRA. Under this doctrine, a company may not be held liable under federal securities laws for projections and other forward-looking statements, either written or oral, that later prove to be inaccurate, if the statements are identified as forward-looking and are accompanied by meaningful cautionary statements. Even if the statements are not accompanied by cautionary language, liability is still precluded if the plaintiff fails to show that the statements were made with actual knowledge of falsity. These provisions are plainly designed to encourage full disclosure by companies. Although there are important limits to the safe harbor’s reach, its existence reinforces the argument that sufficient warnings and disclaimers should protect defendants from liability. It also highlights the importance of including risk factors affecting the company in most publicly filed documents. � The PSLRA’s Effect on Class Actions. The size and definition of a class is an area ripe for early discovery and attack by a securities fraud defendant. The PSLRA requires that the plaintiff seeking to serve as class representative file a sworn certificate providing the court and defendants with information concerning the putative class representative’s prior experience as a class representative, the size of the plaintiff’s investment and trading history with the defendant company. Defendants should scrutinize this information and then engage in substantial discovery to test the plaintiff’s class certification allegations. A defendant should object to the inclusion of any class representatives who purchased only a small number of shares in the defendant company. Because one of the principal purposes of the PSLRA was to prevent lawyer-driven litigation, defendants should challenge class certification in conjunction with the filing of dispositive motions. � Insider Trading. Because plaintiffs have alleged insider trading violations in almost 60 percent of the post-PSLRA complaints, a securities fraud defendant must be ready to address this allegation. To state a claim, a plaintiff must plead with specificity that he or she traded contemporaneously with the defendants who are alleged to have traded on inside information. Although the exact contours of this requirement have not been defined, the 9th Circuit has held in Neubronner v. Miliken, 6 F.3d 666 (9th Cir. 1993) that trades occurring about a month apart were not contemporaneous. Defendants should examine each plaintiff’s situation carefully, and object to any alleged trades that occurred outside this period. As for any remaining trades, the plaintiff must show that the alleged insider trade was out of line with past trading practices at times calculated to maximize personal benefit from undisclosed inside information. Given this standard, a defendant’s prior trading history, and any restrictions on sales of stock on prior periods, are of critical importance and should be raised in dispositive motions. In sum, plaintiffs’ attorneys have become quite creative in attempting to hit corporate defendants with high-dollar securities fraud judgments. To survive in this environment, defendants must be aggressive in using the defensive tools at their disposal. If applied aggressively, the PSLRA can be a powerful weapon. If a company is cautious in its disclosures, vigilant in monitoring trades by officers and directors, and aggressive in holding plaintiffs to their newly heightened burdens of pleading and proof, it may come through a securities fraud suit unscathed. Jeffery A. Smisek is executive vice president, general counsel and secretary of Continental Airlinesin Houston.

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