Holding Claims, Slusa And Other Issues Arising From Enron And Worldcom Litigation

Alan R. Perry, Jr.
J. Steven Parker

I. Introduction

Predictably, the collapses of Enron and WorldCom, which resulted in something like a combined $250 billion in losses to shareholders, have spawned a substantial number of lawsuits by those shareholders. This litigation has yielded a number of judicial opinions of interest to any bankruptcy, class action, securities or ERISA practitioner.

At the Sixth Annual Georgia ICLE Corporate Litigation Seminar in 2002, Thomas S. Richey of Powell, Goldstein, Frazer & Murphy LLP presented a paper entitled Corporate litigation Issues Under the Sarbanes-Oxley Act and After Enron and WorldCom, which, in part, discussed significant developments in Enron- and WorldCom-related litigation through November, 2002. A copy of that 2002 paper is republished immediately following this paper. The purpose of the present paper is to discuss some of the interesting or novel issues addressed by the courts during the past year, or expected to be addressed in the near future.

A. Overview of Enron Litigation

Enron’s precipitous decline resulted in numerous lawsuits during the last quarter of 2001.¹ On December 12, 2001, in an unpublished order, the U.S. District Court for the Southern District of Texas found that the many Enron-related proceedings that had been filed in that district arose from a common core of operative facts and implicated similar legal issues. As a result, those actions were ordered consolidated into one of three lead cases pertaining to (1) securities actions, (2) ERISA actions, or (3) actions filed derivatively on behalf of Enron against its present or former directors.

On April, 2002, the Federal Judicial Panel on Multidistrict Litigation (“MDL”) designated the Southern District of Texas as the MDL venue for Enron-related civil litigation, and transferred other pending cases to that district. The MDL Transfer Order also consolidated the securities, derivative, and ERISA cases and assigned the consolidated case to Judge Melinda Harmon of the Southern District of Texas. Thus, the Southern District of Texas is currently the clearinghouse for most Enron-related civil actions. In re Enron Com. Securities, Derivative & ERISA Litigation, 196 F. Supp.2d 1375 (J.P.M.L. 2002).

The consolidated class action complaint asserts securities law claims, including claims under Sections 10 and 11 of the Securities Act of 1933 (“Securities Act”), against officers, directors, and employees of Enron, seven distinct Arthur Andersen entities, individual Andersen accountants, two law firms, and nine investment banks and lenders. The complaint also asserts claims under the Racketeer Influence and Corrupt Organizations (RICO) Act and state law claims for negligent misrepresentation and conspiracy against many of these same defendants. Finally, the complaint asserts claims for breach of fiduciary duty under ERISA against various officers, directors, and employees of Enron, as well as trustees and administrators of various qualified benefit plans.

The Court has ruled on various motions to dismiss. Generally speaking, the Court has denied or denied in part the motions of all defendants except one bank, one law firm, several individuals associated with Arthur Andersen, and two Enron officers. The automatic stay of discovery under the Private Securities Litigation Reform Act (PSLRA) has been lifted. There is a proposed settlement between lead plaintiffs and Andersen Worldwide SC, but Judge Harmon has taken the proposed settlement under advisement after a fairness hearing held on October 23, 2003.

Various individuals or small groups of plaintiffs also filed actions in state court against Enron or its officers, directors, underwriters, or other related entities. Many of those cases were removed to federal court and dismissed as preempted by the Securities litigation Uniform Standards Act (”SLUSA”), while others, including the group action cases described in section III C, infra, were removed and later remanded as not preempted by SLUSA.

B. Overview of WorldCom Litigation

On April 30, 2002, the first class action asserting federal securities law claims was filed in the Southern District of New York against WorldCom and certain of its officers, directors, employees and third parties such as accountants and underwriters. ²

By August, more than twenty (20) such actions had been filed in that district. On August 15, 2002, the Court ordered those cases consolidated into In re WorldCom. Inc. Securities Litigation, Case No. 02 Civ. 3288 (DLC) (S.D.N.Y.).

Two other class actions had been filed in the same court under ERISA by investors who had acquired shares of WorldCom stock through qualified retirement plans. On September 18, 2002, the Court ordered those cases consolidated, with the resulting consolidated case to be known as In re WorldCom, Inc. ERISA Litigation. In re WorldCom Securities Litigation, 2002 WL 31095170 (S.D.N.Y. September 18, 2002).

¹ Enron filed for bankruptcy on December 3, 2001. At the time of filing, it was the largest corporation ever to file for bankruptcy, listing assets of $63-4 billion.

² A lawsuit filed by WorldCom shareholders in June, 2001 contained allegations similar to those contained in the current litigation, i.e., that WorldCom had deliberately understated costs, hid bad debts, and booked orders early to pad its financial statements. In March, 2002, the district court dismissed the complaint on the grounds that fraud had not been adequately pled. In re MCI WorldCom, Inc. Securities Litigation, 191 F. Supp. 2d 778 (S.D. Miss. 2002).

Forty-two other actions “arising out of alleged misrepresentations or omissions concerning WorldCom’s financial condition and accounting practices,” had been filed and identified as pending in federal district courts by October, 2002. On October 8, 2002, the Judicial Panel on Multi-District litigation (“MDL”) ordered these and all such future cases centralized in the Southern District of New York, pursuant to 28 U.S.C. § 1407, before Judge Denise Cote.

Meanwhile, many individuals or small groups of plaintiffs filed lawsuits against WorldCom and related defendants in state courts.

On July 21, 2002, WorldCom filed for bankruptcy under Chapter 11 in the Southern District of New York. WorldCom surpassed Enron as the largest bankruptcy on record, declaring assets of approximately $107 billion. Many of the actions that had been filed in state courts were removed as related to bankruptcy proceedings pursuant to 28 U.S.C. § 1452(a), and were transferred to the Southern District of New York pursuant to the order of the MDL panel. By unpublished Order dated December 23, 2002, the Southern District of New York consolidated the individual cases into In re WorldCom Securities Litigation for pretrial purposes.

On October 24,2003, Judge Cote entered an order certifying a class as “all persons and entities who purchased or otherwise acquired publicly traded securities of WorldCom during the period beginning April 29,1999 through and including June 25, 2002 … and who were injured thereby.” In re WorldCom Securities Litigation, 2003 WL 22420467 (S.D.N.Y. October 24, 2003). The judge also recently set a “firm trial date” of January 10, 2005. Counsel for at least one defendant has publicly indicated it will make application to the Second Circuit seeking a review of the decision to certify the class.

II. Procedural Issues

1. Removal of Cases Related to Bankruptcy

In one of the WorldCom actions filed in state court, the New York City Employees’ Retirement System (”NYCERS”) and eight other New York City pension funds are plaintiffs. The case asserts claims under Section 11 of the Securities Act and common law fraud claims. One of the defendants removed the case on the ground, among others, that it related to the WorldCom bankruptcy and therefore was removable under 28 U.S.C. §§ 1452(a) and 1334(b).

After removal, NYCERS filed a motion to remand. The Court allowed numerous other plaintiffs that had filed individual actions that had been removed, among them the California Public Employees Retirement Systems (“CALPERS”), to intervene in support of NYCERS’motion to remand. The Court also permitted the Securities Industry Association (”SIA”) to file an amicus curiae brief in opposition to the motion to remand.

In ruling on the motion, the Court considered whether the claimed statutory and common law rights of indemnification and contribution possessed by the individual defendants against WorldCom rendered the cases related to bankruptcy for purposes of the removal statute. ³ The Court then resolved the issue before it primarily by reference to decisions of Third Circuit Court of Appeals, the court that had developed the “dominant standard” for determining whether related-to-bankruptcy jurisdiction is present. In re WorldCom, Inc. Securities Litigation, 293 B.R. 308, 317-320 (S.D.N.Y. 2003)(hereinafter “WorldCom Securities (Removal)”).

In In re Federal-Mogul Global, Inc., 300 F.3d 368,382 (3rd Cir 2002), the Third Circuit addressed a situation involving tens of thousands of legal actions filed across the country against the defendant and other manufacturers and distributors of friction products containing asbestos. After the defendant filed for bankruptcy, the co defendants removed the actions to federal court on the ground that their claims against the debtor for indemnification and contribution made the claims against them related to the bankruptcy. The Third Circuit Court of Appeals disagreed. In reliance upon its prior opinion in In re Pacor. Inc., 743 F.2d 984 (3rd Cir. 1984), the Court held that because there was no automatic right against the debtor for contribution or indemnification, the litigation was not related to the bankruptcy. According to the Third Circuit Court in Federal-Mogul, a case is related to bankruptcy for purposes of § 1452(a) only when the claims asserted would affect the bankruptcy proceeding “without the intervention of yet another lawsuit.” Federal-Mogul, 300 F.3d at 382.

WorldCom Securities (Removal) rejected the Third Circuit’s interpretation of its own precedent in favor of what it characterized as a broader reading of Pacor developed in other jurisdictions and approved by the U. S. Supreme Court in Celotex Corp. v. Edwards, 514 U.S. 300 (1995). According to the Court, the true test is whether the claims asserted in the removed action could have any “conceivable effect” on the bankruptcy proceeding. The Court held that because this test was met the motion to remand must be denied. ⁴ WorldCom Securities (Removal), 293 B.R at 322.

The Court also rejected the argument, made by NYCERS and supported by the intervenors, that Section 22(a) of the Securities Act bars any removal of Section 11 and 12 claims to federal court. Section 22(a) provides:

Except as provided in section 77p(c), no case arising under this subchapter and brought in any State court of competent jurisdiction shall be removed to any court of the United States.

Employing rules of statutory construction, the WorldCom Securities (Removal) Court first noted that 28 U.S.C. § 1441, the statute that allows removal of any civil action “of which the courts of the United States have original jurisdiction,” contains a provision that prevents removal of any cases which Congress expressly excepts. The Court then held that Section 22 (a) of the Securities Act was an implementation of Congressional authority to except certain federal causes of action from Section 1441. Unlike Section 1441, however, Section 1452(a) does not contain a general exception for cases in which Congress “provides otherwise,” but contains only specific limited exceptions not applicable to the present case. Id. at 328-30. The Court thus held that a case arising under the Securities Act may be removed if it is related to a bankruptcy proceeding. Id.

The WorldCom Securities (Removal) Court found support for its holding in Gonsalves v. Amoco Shipping Co., 733 F.2d 1020 (2d Cir. 1984), in which the Second Circuit held that a case involving a Jones Act claim was removable because of the existence of diversity jurisdiction, notwithstanding that the Jones Act contains a bar to removal similar to that in Section 22(a) of the Securities Act. Id. at 1022. While the case could not have been removed if the complaint had asserted only the Jones Act claim, the entire case could be removed under 28 U.S.C. § 1441(c) because the non-Jones Act claims were removable due to the existence of diversity jurisdiction. Id.

On October 1, 2003, the Southern District of Texas reached the same result in In re Enron Securities. Derivative & Erisa Litigation, Case No. H-01-3624 (S.D.Tex. September 15, 2003)(available on PACER). In an unpublished opinion, the Court held that certain state court actions were properly removed because they were related to Enron’s bankruptcy proceeding. The courts differ, however, on whether a case can be removed based upon related-to-bankruptcy jurisdiction by fewer than all defendants. Compare In re WorldCom Securities Litigation, 2003 WL 22383090 (S.D.N.Y. October 20, 2003)(fewer than all defendants may remove) with In re Enron Corporation Securities, Derivative & Erisa Litigation, (S.D.Tex. September 15, 2003)(available on PACER), p. 14 (fewer than all defendants may not remove).

³ The individual defendants argued that a statutory right of indemnification or contribution arises by virtue of 15 U.S.C. § 77(f)(1), the joint and several liability provision of the Private

⁴ The Court also rejected a similar argument made by NYCERS that a claim for contribution or indemnification must be reduced to judgment, that is, not contingent upon a judgment being entered against the contribution or indemnity claimant, before the claim against the claimant could be considered related to the bankruptcy. 293 B.R at 322. In rejecting that argument, the Court stated that if a judgment were entered against the remaining WorldCom defendants “the effect of their contribution claims on the bankruptcy proceeding would not simply be ‘conceivable,’ it would be certain and quantifiable.” Id.

B. The Automatic Discovery Stay of the PSLRA

In 1995,Congress passed the Private Securities Litigation Reform Act (”PSLRA”), the ostensible purpose of which was to limit the potential for so-called “strike suits” — meritless securities class actions filed for the purpose of extracting settlements. The PSLRA, among other things, imposes heightened pleadings standards and limits joint and several liability. It also stays discovery during the pendency of any motion to dismiss, unless such discovery is necessary to preserve evidence or to prevent undue prejudice to the party seeking discovery. 15 U.S.C. § 78u-4(b)(3)(B). The discovery stay was designed to minimize the incentive for plaintiffs to file frivolous class action complaints in the hope that corporate defendants would settle those actions rather than bear the high cost of discovery, or for plaintiffs to use discovery as a fishing expedition to uncover evidence supporting a claim not asserted in the complaint. See H. R Conf. Rep. No. 104-369, p. 37 (1995); S. Rep. No. 104-98, p. 14 (1995).

The lead plaintiff in In re WorldCom Securities, Derivative & Erisa Litigation sought relief from the discovery stay for the purpose of obtaining documents and other materials that WorldCom had produced to the U.S. Department of Justice and the Securities and Exchange Commission. The plaintiff also sought to obtain documents previously obtained by the law firm of Wilmer, Cutler & Pickering in connection with that firm’s representation of a special investigative committee established by WorldCom’s board of directors.

In an unpublished opinion dated November 21, 2002, Judge Cote granted lead plaintiffs motion based upon “the unique circumstances of this case.” Relying primarily upon the fact that settlement discussions had been ordered to proceed between the lead plaintiff and the WorldCom defendants, as well as between the lead plaintiff in In re WorldCom ERISA Litigation and defendants in that case, the Court held that to refuse to allow access to the documents sought would place the plaintiffs at a disadvantage vis a vis the other parties to the settlement discussions. According to the Court, if plaintiff was required to “wait until the resolution of a motion to dismiss to obtain discovery and formulate its settlement or litigation strategy, it faces the very real risk that it will be left to pursue its action against defendants who no longer have anything or at least as much to offer.” In re WorldCom Securities Litigation, Nov. 21, 2002 Order (available on PACER), p. 11. According to recent news reports, however, the judge has indicated that she will restrict discovery of information relating directly to the government’s ongoing investigation of wrongdoing by defendants who have been charged criminally. Hamblett, WorldCom Defendants Barred from Seeking Information in Criminal Probe, N.Y.L.J. (October 31, 2003).

III. Securities Law Issues

A. Liability of Secondary Actors

In 1994, the U.S. Supreme Court held that there is no private right of action under Section 10(b) of the Securities Act against those who aid and abet the commission of fraud in connection with the sale of securities. Central Bank of Denver. N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). Nevertheless, the Court held that “secondary actors in securities markets” may be liable as primary violators if any such actor “employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies.” Id. at 191.

The lower courts are still debating what level of participation in a fraudulent act or scheme will render a secondary actor liable as a primary violator. In ruling on a motion to dismiss filed by secondary actor defendants, the Southern District of Texas in In re Enron Securities Litigation evaluated the two principal tests that have emerged — the ”bright line” test of the Second and Eleventh Circuits and the “substantial participation” test of the Ninth Circuit. In re Enron Securities Litigation, 235 F.Supp.2d 549 (2002)(hereinafter “Enron (Secondary Actors)”). The bright line test requires that the actor must sign or otherwise publicly acknowledge the misrepresentation in order to be liable. See Wright v. Ernst & Young LLP, 152 F.3d 169, 175 (2d Cir. 1998). The substantial participation test, on the other hand, would hold liable any person who is “intricately involved” in making or preparing a fraudulent statement, even though that participation may not have included actually making the statement. See Howard v. Everex Systems. Inc., 228 F.3d 1057, 1061, n. 5 (9th Cir. 2000).

Enron (Secondary Actors) rejected both tests. According deference to the Securities and Exchange Commission as the body to which Congress delegated rulemaking authority under Section 10(b) of the Securities Act, the Court adopted a test proposed by the S.E.C. in an amicus curiae brief. Under the test adopted by the Court, anyone who “creates” a statement disseminated to the public, regardless of whether that person signs or otherwise acknowledges it, may be liable.” Enron (Secondary Actors), 235 F. Supp. 2d at 588-590. In rejecting the “substantial participation”test, the Court agreed with critics that without a “narrowing of the kind of conduct and circumstances required to constitute substantial participation,” the distinction between primary violators and aiders and abettors under Central Bank is not preserved. Id. at 37. ⁵

Given the division of authority among the circuits, this issue is one that is quite likely to be addressed by the Supreme Court. Alternatively, Congress may restore aiding and abetting liability or more clearly define what conduct gives rise to primary liability. Section 703 of the Sarbanes-Oxley Act of 2002 requires the SEC to report to Congress the number of securities professionals found to have aided and abetted violations of the securities laws between 1998 and 2001. Although that report has been filed, no action has yet been taken by Congress based upon it.

B. Loss Causation

Under federal securities laws plaintiffs must allege and prove both “transaction causation,” i.e., that but for the fraudulent statement or omission the plaintiff would not have entered into the transaction; and “loss causation,” i.e., that the subject of the fraudulent statement or omission was the cause of the actual loss. In ruling on a motion to dismiss, the Southern District of New York considered whether both these elements were adequately pled in the context of plaintiffs’ claims against Salomon Smith Barney and its telecommunications analyst, Jack Grubman. In re WorldCom Securities Litigation, 2003 WL 21219049 (S.D.N.Y. May 19, 2003) (hereafter “WorldCom Dismissal Order”). Plaintiffs alleged that Grubman issued analyst reports that contained materially false financial information and failed to disclose certain allegedly conflicted relationships between SSB and WorldCom.

The Court found both transactional causation and loss causation sufficiently pled. In so doing, it relied upon Marbury Management, Inc. v. Kohn, 629 F.2d 705 (2d Cir. 1980), in which the Second Circuit found loss causation existed when a sales trainee at a brokerage falsely claimed he was a stockbroker and recommended that the plaintiff purchase a certain stock. The Court held that the misrepresentation by the trainee inherently infected any representation he made regarding the investment quality of a stock, even though the misrepresentation did not directly relate to the stock’s intrinsic investment characteristics. Id. at 708-09. Under Marbury Management, the misrepresentations of the recommender’s qualifications therefore related to the stock’s value. Finding Marbury Management to bear a “striking resemblance” to the plaintiffs theory that the failure of SSE to reveal its conflicted status caused the loss in the value of WorldCom stock, the Court found the existence of loss causation sufficiently pled. WorldCom Dismissal Order, 2003 WL 21219049 at p. 33.

The Court also rejected the defendants’ argument that the complaint should be dismissed because the market “ignored or rejected[their]bullish valuations of WorldCom shares” and therefore the alleged fraud did not cause plaintiffs’ losses. Id. at 32. Taking plaintiffs’ allegations to be true for purposes of a motion to dismiss, the Court held that argument to be a matter to be decided at a later stage of the litigation, when the parties present their competing evidence on the issue of causation. Id. at 32. ⁶

⁵ The SEC’s position was first advanced in an amicus brief filed in 1998 in connection with a rehearing en banc ordered by the Third Circuit in Klein v. Boyd, Fed Sec. L. Rep. (CCH) 90136, Fed. Sec. L. Rep. (CCH) ‘1190165 (3d Cir. 1998), and was first accepted by the Northern District of Georgia in Carley Capital Group v. Deloitte & Touche. LLP, 27 F.Supp.2d 1324 (N.D.Ga. 1998), which has been overruled as to this issue by Ziemba v. Cascade Int’l. Inc., 256 F.3d 1194 (11th Cir. 2001).

⁶ Judge Cote’s ruling on loss causation provides interesting contrast to those of Judge Milton Pollack in other cases involving allegations of analyst conflicts of interest. In In re Merrill Lynch & Co.. Inc. Research Report Securities Litigation, 273 F.Supp. 2d 351 (S.D.N.Y. 2003), Judge Pollack held that losses in the values of the stocks at issue were not a foreseeable result of the failure to disclose such conflicts. Id. at 364. In doing so, he distinguished the WorldCom Dismissal Order on the basis of the undisclosed insider information possessed by Grubman at the time of his recommendation. Id. at 364, n. 25. In other cases, Judge Pollack has been more receptive than Judge Cote to the argument that a decline in share price may be an intervening cause that negates loss causation as a matter of law, thereby necessitating dismissal at the pleadings stage. In re Global Technology Fund, 272 F.Supp.2d 243, 253-256 (S.D.N.Y. 2003); In re Merrill Lynch & Co., Inc. Research Reports Securities Litigation, 2003 WL 22451060 (S.D.N.Y. October 29, 2003) at p. 5.

C. Group Actions

SLUSA makes federal court the exclusive venue for “covered class actions” alleging fraud in connection with the purchase or sale of “covered securities.” 15 U.S.C. § 77p. A covered class action is a single lawsuit in which damages are sought on behalf of more than 50 persons. 15 U.S.C. § 77p(f)(2). In an effort to avoid SLUSA’s reach, a law firm located in Houston filed several state court lawsuits against Enron defendants, naming fewer than 50 plaintiffs in each suit. Plaintiffs concurrently filed motions for temporary restraining orders seeking to restrain certain Enron-related defendants from destroying, deleting, or altering certain documents. After three of these actions were filed and ex parte restraining orders obtained, the defendants moved in the district court for an injunction preventing the law firm from filing any new Enron-related actions without leave of court. The district court granted the requested injunction. Thereafter, the district court denied the law firm’s request for leave to file a state court action, and the law firm and the prospective plaintiffs appealed to the Fifth Circuit.

On appeal, the defendants contended that the law firm was abusing SLUSA by breaking a large group of plaintiffs up into groups smaller than 50. There was undisputed evidence that the law firm planned to file numerous lawsuits on behalf of over 750 clients. The Fifth Circuit held that breaking up plaintiffs into groups of less than 50 was not of itself an abuse of the courts that would warrant such an injunction. Newby v. Enron Corp., 303 F. 3d 295, 302 (5th Cir. 2002). Furthermore, the Court declined to recognize an implied federal preemption of the cases filed by the law firm. Id. at 303. Nevertheless, the Court affirmed the injunction because of the law firm’s practice of filing motions for temporary restraining orders against the defendants in state court. The court reasoned that the law firm’s practice of seeking ex parte TROs was abusive in light of the fact that the firm represented certain other plaintiffs in the consolidated action and therefore could have easily served counsel for the Enron defendants with notices of intention to seek the TROs. Id. Thus the district court did not abuse its discretion in granting the injunction. Id. Because the law firm did not attach a copy of the complaint to the motion for leave to file, the district court likewise did not abuse its discretion in denying leave to file the complaint. Id.

D. SLUSA Preemption

In In re Enron ERISA Litigation, plaintiffs asserted state common law claims for negligent misrepresentation and conspiracy in addition to claims under ERISA. The defendants contended in a motion to dismiss that these claims were preempted by SLUSA. SLUSA preempts certain defined securities-related class actions and provides a removal vehicle to assure that the cases so defined can be removed and, if appropriate, dismissed.

The plaintiffs argued that they asserted “holding”claims that were not preempted by SLUSA. A holding claim is one in which the plaintiff has suffered damages as a result of holding, rather than purchasing or selling, securities. These claims do not fall within the scope of the federal securities laws, which pertain only to certain conduct in connection with the purchase or sale of securities. See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975). Because SLUSA likewise only expressly preempts claims involving the purchase or sale of securities, holding claims are not preempted. Riley v. Merrill Lynch, Pierce, Fenner & Smith. Inc., 292 F.3d 1334, 1342 (11th Cir. 2002).

The Court held that the Plaintiffs did not solely state holding claims, but rather alleged that they were defrauded into adding to their holdings in Enron stock through their participation in the plan and retaining the stock so added. In re Enron Corporation Securities, Derivative & ERISA Litigation, 2003 WL 22245394 (S.D. Tex. September 30, 2003) at p. 83 (hereinafter “Enron ERISA”). Because the claims involved both purchasing and holding, they are preempted by SLUSA. Id. ⁷

A similar result was reached in In re WorldCom ERISA Litigation, 263 F.Supp.2d 745 (2003)(hereinafter “WorldCom ERISA”). The plaintiffs in that case asserted a Mississippi state law claim for negligent misrepresentation against Arthur Andersen, the accounting firm that served as auditor both for WorldCom and the plan. Under plaintiffs’ theory, Anderson was negligent for failing to recognize, in connection with its audits of plan assets, that WorldCom securities should not have been valued according to their market price. Because Andersen consented to the inclusion of the audits in communications with plan members, plaintiffs alleged that it knew or reasonably should have known that the participants would rely on the audits in making investment decisions. Id. at 768.

Plaintiffs sought to avoid preemption of this claim by, inter alia, alleging that their injuries arose from the retention of WorldCom stock, rather than the purchase or sale of stock. The Court noted, however, that the complaint alleges that plaintiffs were injured because of both the purchase and the retention of WorldCom stock. Because the complaint made no effort to differentiate between purchasers and holders, the claim “sweeps within its ambit actual purchases or sales of stock”and therefore is preempted. Id. at 771. The Court held it was unnecessary to decide whether SLUSA would apply to claims dealing solely with retention of securities. Id.

E. Development of State Law Holding Claims

Although there are only a handful of reported state cases recognizing a claim of fraud brought by one who held securities, there is little reason to expect that courts confronted with the issue would create a “significant exception” to the common law of fraud by failing to recognize such claims. See, Gutman v. Howard Savings Bank, 748 F. Supp. 254 (D.N.J. 1990)(recognizing claim under New Jersey law). Indeed, the arguments against the existence of such claims are usually based not on state law, but on “policy considerations,” “implied preemption” under SLUSA,or some other such theory. Courts considering these arguments thus far have been reluctant to accept them.

Indeed, in one important recent decision, the Supreme Court of California recognized that the tide has turned against those who would argue for restrictions that go beyond the letter of the recent Congressional reforms. Citing the “daily dose of scandal, from Adelphia to Enron and beyond,”as having “changed the perspective”that prevailed when Congress enacted legislation designed to prevent nonmeritorious securities class action suits, the California high court refused to recognize a public policy exception to a fraud claim by a holder in California. Small v. Fritz Companies, 30 Cal.4th 167, 181, 132 Cal. Rptr.2d 490 (Cal. 2003). Recent events demonstrate, according to the Court, “that many charges of corporate fraud were neither speculative nor attempts to extort settlement money, but were based on actual misconduct.” Id.

⁷ Nevertheless, the Enron ERISA Court held that certain claims asserted by participants in the ERISA plan did not fall within the scope of SLUSA and therefore are not preempted. For example, the Court held that interests in the Employee Stock Option Plan (ESOP) were not securities since participation was mandatory and represented partial compensation for employment. Therefore, plaintiffs’ state law claims for negligent misrepresentation and conspiracy were not preempted as they related to participation in the ESOP. 2003 WL 22245394 at p. 88.

1. Causes of Action

Holding claims presented as claims for fraud or negligent misrepresentation have been recognized under the laws of California, Massachusetts, New York, New Hampshire, New Jersey, and Wisconsin. ⁸ A claim based upon negligent misrepresentation has been rejected based upon an interpretation of Connecticut law. ⁹

Although there are slight differences from state to state, a typical cause of action for common law fraud is described by the Restatement (Second) of Torts, § 525:

One who fraudulently makes a misrepresentation of fact, opinion, intention or law for the purpose of inducing another to act or to refrain from action in reliance upon it, is subject to liability to the other in deceit for pecuniary loss caused to him by his justifiable reliance upon the misrepresentation.

Unlike a claim for fraud, a claim for negligent misrepresentation in the context of securities usually arises from the conduct of a secondary actor, such as an accountant or attorney, whose professional services are compensated and who knows that shareholders will rely upon their work in making decisions regarding whether to hold or sell the stock. The Restatement (Second) of Torts, at Section 552,defines the tort of negligent misrepresentation as follows:

(1) One who, in the course of his business, profession or employment, or in any other transaction in which he has a pecuniary interest, supplies false information for the guidance of others in their business transactions, is subject to liability for pecuniary loss caused to them by their justifiable reliance upon the information, if he fails to exercise reasonable care or competence in obtaining or communicating the information.
(2) Except as stated in Subsection (3), the liability stated in Subsection (1) is limited to loss suffered
(a) by the person or one of a limited group of persons for whose benefit and guidance he intends to supply the information or knows that the recipient intends to supply it; and
(b) through reliance upon it in a transaction that he intends the information to influence or knows that the recipient so intends or in a substantially similar transaction.
(3) The liability of one who is under a public duty to give the information extends to loss suffered by any of the class of persons for whose benefit the duty is created, in any of the transactions in which it is intended to protect them.

Importantly, under neither a fraud nor a negligent misrepresentation claim is it necessary that the person relying upon the misrepresentation act upon it; rather, he may either act or refrain from acting. Therefore, as the U.S. Supreme Court correctly pointed out in Blue Chip Stamps, the transactional element of the federal securities fraud claims is typically not present under state common law fraud claims, thereby allowing holders of securities, rather than merely buyers or sellers, to bring claims under state law. 421 U.S. at 738, n. 9.

Among the Courts specifically recognizing holding claims, only the California Supreme Court has done so in the context of allegedly untrue facts contained in corporate financial statements that were distributed to the plaintiff and all other shareholders; the remaining holding cases recognize the claim in the context of a face to face or otherwise personal communication of facts directly to the plaintiff. In Small, defendants argued that holding claims should never be permitted in cases arising from generalized or public communications. Small, 132 Cal. Rptr. 2d at 499-501. These arguments were based upon the same policy considerations that lie behind the PSLRA and SLUSA, namely that a failure to reject such claims could lead to the filing of unwarranted or meritless class actions. Id. The Court reasoned that fears over meritless class actions were insufficient to reject such claims outright. Id. at 501.

2. Enhanced Pleading Requirements

Although it remains to be seen whether other courts will follow Small in allowing holding claims for generalized communications, a related question is whether other courts will consider adopting procedural safeguards designed to eliminate unmeritorious claims. The most likely safeguard is an enhanced pleading requirement such as that required by the PSLRA.

In Small, the California Supreme Court concluded that enhanced pleading requirements were necessary. In addition to the requirement that fraud be pled with specificity, which already existed under California law, the Court held that in a holding action:

a plaintiff must allege specific reliance on the defendants’ representations; for example, that if the plaintiff had read a truthful account of the corporation’s financial status the plaintiff would have sold the stock, how many shares the plaintiff would have sold, and how the sale would have taken place. The plaintiff must allege actions, as distinguished from unspoken and unrecorded thoughts and decisions, that would indicate that the plaintiff actually relied on the misrepresentations.

Small, 132 Cal. Rptr.2d at 503.

3. Derivative or Direct Claim?

One of the hurdles encountered by plaintiffs asserting holding claims is the argument that such a claim is essentially derivative in nature, that is, it seeks compensation for injury to the corporation and therefore cannot be asserted by a shareholder in his or her own right. Whether pecuniary loss from diminished value of stock is a derivative or direct claim is a matter of state law.

In Croker v. FDIC, 826 F.2d 347 (5th Cir. 1987), the Fifth Circuit, applying Mississippi law, held that because a claim for diminished value of stock is essentially a claim for injury to the corporation itself, a holding claim was derivative and could not be brought directly by individual shareholders. The Court specifically rejected plaintiffs’ argument that the lost opportunity to sell the stock as a result of the defendant’s fraud caused them to suffer lost profits that were distinct from any injury to the corporation. Id. at 350.

Under similar facts, the Delaware Supreme Court reached the opposite conclusion ten years later in Malone v. Brincat, 722 A.2d 5 (Del. 1998), in which it held that shareholders could bring holding claims directly. In the course of the Enron bankruptcy litigation, the Bankruptcy Court, after holding that the law of Oregon (the state of Enron’s incorporation) applied, referred to the Oregon courts the question of whether a holder’s claim is direct or derivative under Oregon law. In re Enron Corp., Bank. Case No. 01-B-16034 (AJG) (Bankr. S.D.N.Y. Oct 4, 2002). That issue has not yet been decided.

⁸ Small v. Fritz Companies, Inc., 132 Cal. Rptr.2d 490, 65 P.3d 1255 (Cal. 2003); Fottler v. Moseley, 60 N.E. 788 (Mass. 1901); Continental Ins. Co. v. Mercadente, 225 N.Y.S. 488 (App. Div. 1st Dep’t (1927)); Brown-Wales Co. v. Barber, 184 A. 855 (N.H. 1936); Gutman v. Howard Savings Bank, 748 F. Supp. 254 (D.N.J. 1990); Seideman v. Sheboygan Loan & Trust Co., 223 N.W. 430 (Wis. 1929).

⁹ Chanoff v. U.S. Surgical Corp., 857 F.Supp. 1011 (D.Conn. 1994).

4. Class Certification

One of the factors leading to the proliferation of securities fraud class actions is the judicial acceptance of the fraud-on-the-market presumption. Under this presumption, which may be rebutted, plaintiffs need not allege that they actually read or otherwise perceived the misrepresentation, but rather are allowed to rely upon the market to have “performed a substantial part of the valuation process performed by the investor in a face to face transaction. The market is acting as the unpaid agent of the investor, informing him that given all the information available to it, the value of the stock is worth the market price.” Basic v. Levinson, 485 U.S. 224, 244 (1988). The fraud-on-the-market theory not only relieves a plaintiff of the burden of going forward with evidence of reliance upon the misrepresentation, it also constitutes a useful tool in demonstrating the commonality of reliance experienced by members of a putative class.

The fraud-on-the-market presumption may not be available in holding claims under state law. See, e.g., Small, Cal. Rptr. 2d at 503. Because each plaintiff must prove particular facts relating to reliance, it may be difficult or impossible to obtain certification in a putative class action. As the Supreme Court of Delaware has stated:

A class action may not be maintained in a purely common law or equitable fraud case since individual questions of law or fact, particularly as to the element of justifiable reliance, will inevitably predominate over common questions of law or fact.

Gaffin v. Teledyne, Inc., 611 A2d 467, 474 (Del. 1992).

5. Loss Causation

Loss causation is a creature of federal common law that was developed in the context of the interpretation of the Securities Act. See, e.g., Schlick v. Penn-Dixie Cement Corp., 507 F.2d 374, 380 (2d Cir. 1974). In state law fraud or negligent misrepresentation claims, the common law concepts of cause in fact and proximate cause will govern. Although in the view of some courts there is similarity between the concepts of loss causation and proximate cause, see, e.g., Manufacturer’s Hanover Trust Co. v. Drysdale Securities Corp., 801 F.2d 13, 20 (2d Cir. 1986), the concepts are not identical.

In a recent case involving a Massachusetts common law fraud claim, the Massachusetts Court of Appeals held that proof of loss causation is not required to be pled. Reisman v. KPMG Peat Marwick, 787 N.E.2d 1070 (Mass. App. 2003). In Reisman, plaintiffs agreed to exchange their stock for stock of another company in reliance on financial statements audited by defendant KPMG. The stock declined and plaintiffs sold their shares. Subsequently, the company whose stock plaintiffs acquired restated its financials statements for a period prior to the plaintiffs’ transaction.

Defendant sought summary judgment on the basis of failure to establish loss causation, relying on the fact that the stock price declined to the point at which plaintiffs sold before the market knew of the fraud. Defendant argued that the fraud therefore was not the cause of plaintiffs’ loss. The court characterized defendant’s argument as based on the concept of loss causation under federal securities law, which it said “would require the Reismans to prove not only that they entered the deal in reliance on Peat Marwick’s misrepresentation and were injured thereby, but also that the posttransaction decline in the value of their … shares was itself caused by Peat Marwick’s fraud.” Id. at 111.

In rejecting defendant’s contention, the Court quoted from and endorsed David v. Belmont, 291 Mass. 450,197 N.E. 83 (1935), a holding case in which the Court stated:

If the defendant fraudulently induced the plaintiff to refrain from selling his stock when he was about to sell it, he did him a wrong; and a natural consequence of the wrong, for which he was liable, was the possibility of loss from diminution in the value of the stock from any one of numerous causes. Most, if not all, of the causes which would be likely to affect the value of the stock, would be acts of third persons, or at least conditions for which neither the plaintiff nor the defendant would be primarily responsible …. The defendant, if he fraudulently induced the plaintiff to keep his stock, took the risk of all such changes [in value]…. The risk of a fall, from whatever cause, is presumed to have been contemplated by the defendant when he falsely and fraudulently induced the plaintiff to retain his stock.

Id. at 1069. The Court also relied upon Sections 546 and 548A of the Restatement (Second) of Torts as endorsing this measure of causation for common law fraud. Id. at 1068-69.