In March 2018, the U.S. Supreme Court unanimously held in Cyan that state courts retain concurrent jurisdiction for liability actions under the Securities Act of 1933. As a result, defendants could face the prospect of parallel litigation in both federal and state court, with no means of consolidating the proceedings. In the following guest post, Bruce G. Vanyo, Richard H. Zelichov, Michael J. Lohnes, and Jonathan Rotenberg, all of the Katten law firm, take a look at Cyan’s impact and review some recent positive developments that address some of the concerns Cyan has led to. I would like to thank the authors for allowing me to publish their article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is the authors’ article.
In its March 2018 decision in Cyan v. Beaver County Employees’ Retirement Fund, the U.S. Supreme Court held that neither the Private Securities Litigation Reform Act of 1995 (“Reform Act”) nor the Securities Litigation Uniform Standards Act of 1997 modified the Securities Act of 1933 (“Securities Act”) in a way that limited concurrent jurisdiction over Securities Act claims in state court or allowed removal to federal court of Securities Act cases filed in state court. As a result, unlike claims for securities fraud under the Securities Exchange Act of 1934, which can only be filed in federal court, Securities Act claims can still be filed in state court and there is nothing defendants can do about it. The more plaintiff-friendly pleading standard applied by most state courts and questions about the applicability of certain protections for defendants in the Reform Act, including the automatic discovery stay, in state court, made state court a far more attractive forum than federal court for plaintiff and their lawyers. Indeed, a low pleading hurdle and early discovery is every securities plaintiffs’ lawyer’s dream.
In the two years since Cyan, filings of Securities Act cases in state court have spiked. After averaging 19 such filings per year between 2015 and 2017, 35 Securities Act claims were filed in state court in 2018 and 49 in 2019.
With any hope of legislative reform years away, it looked like the trend would continue unabated. Several recent decisions from around the country, however, offer some initial signs that the tide is beginning to turn.
California Issues the First Published State Appellate Decision Affirming Dismissal of Securities Act Claims on the Pleadings
While the dismissal rate of Securities Act cases filed in state court has been historically dismal, especially in comparison to those filed in federal court, the California Court of Appeal, First District’s recent decision in City of Warren Police and Fire Retirement System v. Natera Inc. is a significant countercurrent. Plaintiff sued Natera and its officers and directors in San Mateo County, California, alleging claims under Sections 11, 12 and 15 of the Securities Act in connection with Natera’s IPO, claiming that Natera failed to disclose interim financial results of a quarter ending two days before the IPO in which Natera suffered the largest loss in its history. Defendants filed a demurrer (the California-state equivalent of a motion to dismiss) and moved to stay discovery. The Court initially sustained the demurrer with leave to amend the Section 11 claim only and granted the motion to stay discovery.
Rather than repeat the demurrer process, the Court ordered Defendants to answer the amended complaint and file a motion for judgment on the pleadings. The Court then granted the motion on the pleadings, holding that Natera disclosed the increased losses and revenue decline in its Registration Statement, and Plaintiff failed to plead “actual knowledge” under Item 303 of Regulation S-K.
Plaintiff appealed the decision to the California Court of Appeal which subsequently affirmed dismissal in the first-ever published state appellate decision in a Section 11 case on the pleadings, concluding that Natera’s Registration Statement itself refutes any argument that defendants failed to disclose the negative trend of declining reimbursements and revenues with increasing costs and losses.”
It is too early to tell whether Natera is a sign of a shift among state courts in their attitudes toward Securities Act claims. At the very least, the decision provides issuers with a new and important piece of ammunition in arguing for pleading-stage dismissal.
Some Headway on Imposing a Discovery Stay
The Reform Act discovery stay is an important protection for defendants in securities cases. It acts as a roadblock against lawsuits that are filed just to obtain discovery that the plaintiff can then use to bolster the claims asserted such that the claims can survive pleading dismissal motions. Several state courts in California, Michigan, and New York have refused to stay discovery based on the Reform Act, holding that “[t]he PSLRA’s provision for a discovery stay is of a procedural nature, and therefore only applies to actions filed in federal court.” Switzer v. Hambrecht & Co., 2018 WL 4704776 at *1 (Cal. Super. Ct. Sept. 19, 2018); see also Matter of PPDAI Grp. Sec. Litig., 2019 WL 2751278 at *7 (Sup. Ct. N.Y. Cty. July 1, 2019); In re Ally Financial Inc., et. al., No. 16-013616-CB, at *3–4 (Mich. Cir. Ct. Wayne Cty. Aug. 1, 2018).
Nevertheless, a growing chorus of decisions, primarily in New York, have reached the opposite conclusion, reasoning that the automatic discovery stay applies ‘[i]n any private action,’” and “[n]owhere in [the PSLRA] does the statute indicate that it applies only to actions brought in federal court.” In re Everquote, Inc. Sec. Litig.,106 N.Y.S.3d 828 (N.Y. Sup. Ct. 2019); see also City of Livonia Retiree Health and Disability Benefits Plan v. Pitney Bowes Inc., 2019 WL 2293924 (Conn. Super. May 15, 2019). In fact, half of the New York courts that have decided contested motions to stay discovery have granted those requests.
Furthermore, a number of courts have avoided the complex substance versus procedure argument entirely and instead decided to implement a discovery stay based on their inherent discretion to order discovery as they deem appropriate. See Natera, supra; Greensky, Inc. Securities Litigation, 2019 WL 6310525, at *2 (N.Y. Sup. Ct. Nov. 25, 2019) (“The important purpose underlying enactment of the automatic stay–ensuring that cases have merit at the outset–should not be disregarded merely because a federal cause of action is being prosecuted in state court”).
The increasing willingness of state courts to impose a discovery stay, regardless of the reason, is significant because, as the number of decisions grow, it will deter at least some of the forum shopping that resulted from Cyan and will prevent plaintiffs from quickly getting their hands on discovery that they can use in an amended complaint. The fact that courts in New York are pushing back on early discovery is also significant as New York courts are seeing a plurality of the Securities Act filings. Eighteen out of the forty-nine Securities Act cases filed in state court in 2019 (or 36.7%) were filed in New York – more than in any other individual state. This means that New York courts will have a major role in shaping the standards applied in Securities Act litigation going forward.
Delaware Supreme Court Holds Federal Forum Provisions Covering Securities Act Claims Facially Valid
In perhaps the most significant recent development, the Delaware Supreme Court recently held that articles of incorporation designating federal courts as the exclusive forum for Securities Act claims of 1933 (the “Securities Act”) are facially valid under Delaware law. Salzberg v. Sciabacucchi, 2020 WL 1280785 (Del. 2020).
In order to counteract the impact of Cyan, IPO companies began adopting exclusive Federal Forum Provisions (“FFPs”) expressly covering Securities Act claims as a way to steer the claims into federal court or provide for a means of dismissal if a plaintiff files such claims in state court. Seeing the potential impact such FFPs could have on their ability to file Securities Act claims in their preferred forum, the plaintiffs’ bar set to work to undermine them. In December 2017, serial plaintiff Matthew Sciabacucchi filed a derivative action in Delaware Chancery Court against the individuals who signed the registration statements for Blue Apron, Stich Fix and Roku, three recent IPO companies which had adopted FFPs covering Securities Act claims. Sciabacucchi sought a declaration that the companies’ FFPs are invalid. The parties filed cross-motions for summary judgment.
In a December 19, 2018 opinion, Vice Chancellor Laster granted Sciabacucchi’s motion for summary judgment, holding that such FFPs are ineffective and invalid under Delaware law. He reasoned that the mandate in Delaware General Corporation Law (“DGCL”) § 102(b)(1) that certificates of incorporation may include “[a]ny provision for the management of the business and for the conduct of the affairs of the corporation” is limited to the internal affairs of the corporation. Federal law defines Securities Act claims, and those claims do not, therefore, “involve rights or relationships that were established by or under Delaware’s law.” On that basis, Vice Chancellor Laster held that the claims were external to the corporation and invalid under Delaware law. The companies appealed.
In its March 18, 2020 opinion, the Delaware Supreme Court unanimously reversed the Chancery Court’s ruling and held that FFPs covering Securities Act claims are facially valid.
The Delaware Supreme Court rejected the binary internal affairs versus external affairs manner in which the Chancery Court analyzed DGCL 102. Rather than this division, there is a “continuum” between “internal affairs” and purely “external” claims. While Securities Act claims are not strictly ‘internal affairs’ claims nor are they ‘external’ claims. Rather, they are on the continuum in what might be called Section 102(b)(1)’s “Outer Band.”
According to the Delaware Supreme Court, a Delaware corporation’s creation of registration statements is “an important aspect of a corporation’s management of its business affairs and of its relationship with its stockholders.” A provision in a corporate charter “that seeks to regulate the forum in which such ‘intra-corporate’ litigation can occur addresses the ‘management of the business’s and the ‘conduct of the affairs of the corporation.’” The Court observed that, here, “by directing 1933 Act claims to federal courts when coordination and consolidation are possible, FFPs classically fit the definition of a provision “for the management of the business and conduct of the affairs of the corporation” within the meaning of Section 102. They are thus facially valid under Delaware law.
In reaching this conclusion, the Court also emphasized that one of the primary goals of Delaware law is “to achieve judicial economy and avoid duplicative efforts among courts in resolving disputes.” The FFPs covering Securities Act claims “advance these goals” and maintain a “sense of balance” between stakeholders rights and the need for consistency “as they allow for litigation of federal Securities Act claims in a federal court of plaintiff’s choosing, but [also] allow for consolidation and coordination of such claims to avoid inefficiencies and unnecessary costs.” In contrast, the Court said that the same logic could not be applied to a mandatory arbitration provision, which would be invalid under Delaware law if it precluded litigating such claims in Delaware courts.
While the Delaware Supreme Court’s decision considerably undercuts plaintiffs’ efforts to exploit Cyan, this is the first battle in a struggle that will likely play out over the next several years. Significantly, the decision only addressed the facial validity of FFP covering Securities Act claims generally. It does not address whether and when such an FFP is valid “as applied.” Enforceability of specific FFPs will need to be addressed on a case-by-case basis.
The decision was also limited to FFPs stating that Securities Act claims have to be filed in federal court generally. It does not address FFPs that have to be filed in a specific federal court. FFPs that require such claims be brought in a federal jurisdiction outside of Delaware will almost certainly violate DGCL § 115. FFPs that require such claims be brought in Delaware may also run into problems. Part of the Delaware Supreme Court’s reasoning in ruling that the FFPs under review were facially valid is that they balanced a plaintiff’s right to choose the federal court while also easing consolidation and coordination of cases filed in disparate federal jurisdictions. As opposed to internal affairs claims, requiring that all “outer band” Securities Act cases be filed in the District of Delaware may undercut the balance the Court made central to its analysis.
Lastly, the Delaware Supreme Court’s decision applies only to FFPs found in a corporate charter, which are subject to a shareholder vote. It is an open question whether FFPs covering Securities Act claims in by-laws, which a board can generally amend at its discretion, would be facially valid.
Now that the Delaware Supreme Court has given its blessing to FFPs covering Securities Act claims, companies looking to IPO, access the public markets, or issue new shares in a stock-for-stock merger, should seriously consider amending their articles of Incorporation to include such an FFP prior to doing so. Companies that have had offerings at any point during the past three years (the relevant statute of limitations) should also consider taking such steps. While the Delaware Supreme Court has not addressed the question of whether such newly adopted FFPs would apply retroactively to cover claims related to a prior offering, Delaware case law concerning other types of forum selection provisions strongly suggests that the Court would apply the FFPs in such a scenario.
In its two-year existence, Cyan has undoubtedly worked in plaintiffs’ favor. Nevertheless, there is a real possibility that the growing willingness of state courts to grant motions to dismiss and stay discovery in Securities Act cases combined with the facial legality of federal forum provisions covering Securities Act claims under Delaware law will have an impact on both how many Securities Act cases are filed in state court and in the number of those causes that are dismissed at the pleading without discovery.