Investors in the stock market should know the purpose of a securities class action based upon fraud allegations, the underlying purpose for filing this type of litigation, and the rules governing such litigation.  Typical securities fraud class actions involve “alleged” misrepresentation during a specific period of time regarding a company’s operations, financial performance or future prospects that inflate the price of the company’s stock in secondary trading markets.  In these “fraud on the market” class actions, plaintiffs’ attorneys sue the corporation and its officers under Rule 10b-5 of the Securities Exchange Act of 1934, which was a huge, sweeping piece of legislation, but basically states:  “The rule prohibits any action or omission resulting in fraud or deceit in connection with the purchase or sale of any security.”  In order for plaintiffs to establish a Rule 10b-5 claim when bringing a securities fraud class action, they must show (i) a material misrepresentation, deception or omission on the part of the defendant ; (ii) a connection between the misrepresentation or omission and the purchase or sale of a security; (iii) scienter, which is the intent to deceive or engage in reckless conduct; (iv) loss causation; and ( for private investors only) (v) standing; (vi) reliance upon the misrepresentation or omission; and (vii) damages/economic loss that can be connected to the misrepresentation or omission.

Plaintiffs are classes of private or institutional investors who paid too much for their shares during the “class period” because of price distortion caused by the company’s misstatements or omissions during this relevant period.  Fraud-on-the-market lawsuits allow investors to recover their losses from the company based on the misstatements or omissions made during the relevant period.  Given the volume of trading in secondary trading markets, the potential damages recoverable in such suits can reach hundreds of millions of dollars.  Thus, securities fraud class actions impose a punitive sanction that can substantially harm a company’s stock price, which does make sense when a corporation has truly engaged in some type of fraud.

The Private Securities Litigation Reform Act of 1995 (“Reform Act”) was enacted by Congress to adopt procedural rules regulating securities fraud class actions by requiring plaintiffs to specify in their complaint which statements they allege to be misleading, and more specifically, why the statements are misleading.  By requiring plaintiffs to include facts supporting their allegations, defendants have a clear understanding of which company statements are considered to be vague, ambiguous or misleading.  And, unless plaintiffs can plead their facts with particularity and provide information that a corporation, and its officers and directors, acted with a particular state of mind to perpetrate “fraud on the market”, the courts are likely to dismiss such actions.

The Reform Act was enacted to distinguish the meritorious from non-meritorious lawsuits, which has caused law firms representing plaintiffs to be specific about the fraud allegations being brought in every lawsuit.  This also allows judges overseeing these lawsuits to have more information up front in order to rule on any motion to dismiss brought by the defendants.  The “motion to dismiss” is considered the pivotal point in securities fraud litigation, because the judge’s decision is often construed as a judicial assessment of the likelihood that the corporation did engage in some type of intentional fraud.