Monday, April 15, 2002
Halting Discovery in Securities Cases
Rulings Explore Potential Exceptions to Mandatory Stays Under the Reform Act
BY ALAN R. FRIEDMAN
AND MICHAEL TREMONTE
HE MANDATORY STAY OF
discovery during the pendency
of a motion to dismiss is a key
feature of the Private Securities
Litigation Reform Act of 1995 (PSLRA).1
Enacted in identical form in both
the Securities Act of 1933 and the
Securities Exchange Act of 1934, the stay
provision states:
In any private action arising under this
chapter, all discovery and other proceedings shall be stayed during the pendency
of any motion to dismiss, unless the court
finds upon the motion of any party that
particularized discovery is necessary to
preserve evidence or to prevent undue
prejudice to that party.2
This statutorily mandated stay of discovery
is a powerful weapon for the defense,
eliminating the manifold burdens of discovery
while a motion to dismiss is pending. Not
surprisingly, plaintiffs have attempted to limit
the stay’s effect. This article examines several
recent decisions interpreting the PSLRA’s stay
provision, with particular attention to three
issues that recent cases have presented:
whether the stay provision applies to state
law claims over which the federal court
has independent diversity jurisdiction;
whether the mandatory disclosures of Rule
26(a) are “discovery” stayed by the Act; and
what special circumstances plaintiffs must
demonstrate to obtain “particularized
discovery … to prevent undue prejudice.”
State Law Claims
The PSLRA does not explicitly state
whether the discovery stay extends to state
claims when subject matter jurisdiction over
those claims is premised on diversity and not
Alan R. Friedman is a partner, and
Michael Tremonte is an associate, with
Kramer Levin Naftalis & Frankel LLP.
merely the presence of federal claims.3
Plaintiffs have argued — until recently
without success — that application of the stay
to state law claims in such cases effectively
penalizes plaintiffs for also bringing federal
securities law claims, in the absence of which
discovery would proceed notwithstanding the
pendency of a motion to dismiss.
Most courts initially rejected this argument,
primarily on the ground that nothing in the
—————————
This
statutorily
mandated stay of
discovery is a powerful
weapon for the defense,
eliminating the manifold
burdens of discovery
while a motion to dismiss
is pending.
------------------------------------------------
PSLRA’s text or legislative history indicates
Congress’ intent to treat such cases differently
from cases in which diversity is lacking.4
Others have noted that the policy rationale
for enacting the stay provision — namely,
preventing abuse of the discovery process —
would be undermined if the presence of
state law claims were sufficient to defeat
its operation.5
Two recent decisions call into question
previous refusals to recognize an exception to
the mandatory stay where jurisdiction is
premised upon both federal question and
diversity jurisdiction. In Tobias Holdings, Inc.
v. Bank United Corp., an action alleging both
federal and state claims for relief arising from
the same set of facts, a court in the Southern
District of New York held that where
jurisdiction is based on diversity, non-fraud
common law claims are excepted from the
PSLRA’s stay of discovery.6 This exception was
again recognized, but distinguished, in a
decision by a Northern District of Illinois
court in Angell Investments, L.L.C. v.
Purizer Corp.7
In Purizer, plaintiffs sought an exception to
the mandatory stay to take discovery on their
state-law negligent misrepresentation claim.
Citing Tobias Holdings, plaintiffs argued
that the PSLRA does not apply if diversity
jurisdiction provides an alternative basis for
hearing state law claims, even when the state
claims are closely tied to the federal claims.
Judge George W. Lindberg denied plaintiffs’
motion, however, and read Tobias Holdings
narrowly as permitting an exception only
where discovery on the state law claims would
not amount to an impermissible “end run”
around the PSLRA’s stay provision.
The court in Purizer highlighted Judge
Shira A. Scheindlin’s insistence that the state
law claims in Tobias Holdings were entirely
“separate and distinct” from the federal
securities claims, and refused to apply the
exception to plaintiffs’ state law claim
because, unlike the “separate and distinct”
claims in Tobias Holdings, the negligent
misrepresentation claim is related closely
enough to the federal securities law claims
that it appears that the discovery sought on
the negligent misrepresentation claim would
be precisely the same as what plaintiffs would
seek on the securities violations claims absent
the discovery stay.8
Judge Lindberg’s reasoning in Purizer is
sound. Where discovery on the state claims
overlaps with discovery on the federal claims,
as in Purizer, any discovery on the state law
claims necessarily amounts to an “end run”
around the discovery stay. Moreover, the
distinction between diversity and pendent
jurisdiction is not a convincing basis for
determining whether to apply the stay to state
law claims. As the court in Tobias Holdings
recognized, if diversity is the key to invoking
an exception to the PSLRA’s discovery stay,
plaintiffs could bring state law claims for
the sole purpose of evading the PSLRA’s
limitation on discovery, thereby frustrating
Congress’ prohibition against using discovery
NEW YORK LAW JOURNAL
LITIGATION
to extort settlement.9
Rule 26 Initial Disclosures
Application of the PSLRA’s discovery stay
to the initial disclosures mandated by Fed. R.
Civ. P. 26(a) has also proved controversial. In
a rare U.S. Circuit Court of Appeals decision
interpreting the stay provision, the Ninth
Circuit required application of the discovery
stay to mandatory initial disclosures in
Medhekar v. U.S. Dist. Court.10 However, the
Medhekar panel’s reasoning was recently called
into question. In In re Comdisco Sec. Litig.,11 a
court in the Northern District of Illinois held
that plaintiffs’ motion to compel the
production of insurance policies pursuant to
Rule 26(a)(1)(D) fell within the statute’s
exception granting relief from the stay “to
prevent undue prejudice.” In dicta, Judge
Milton I. Shadur explained his disagreement
with the Ninth Circuit’s reasoning. The
Medhekar panel had given little weight to the
distinction between “discovery” and
“disclosure” under the Federal Rules, and held
that even if Congress had intended a
meaningful distinction, initial disclosures
would be prohibited under the stay provision’s
ban on “other proceedings.”12
Judge Shadur, in contrast, found textual
support for treating automatic disclosure
separately from discovery, noting that “Rule
26 … is meticulous in distinguishing between
‘disclosure’ and ‘discovery.’ ”13 He also
reasoned that because a legislative title is not
part of the enactment itself, the heading
“Depositions and Discovery,” applied to Rules
26 through 37, should not be taken literally.
He further emphasized that:
when the provisions for initial disclosure
were newly inserted into Rule 26, the title
of Rule 26 itself was changed from
“General
Provisions
Governing
Discovery” to “General Provisions
Governing
Discovery;
Duty
of
Disclosure,” thus highlighting the differentiation between the two concepts. That
discrete two-category treatment, rather
than “disclosures” being merely “a subset
of discovery” seems to this Court to
invalidate the Ninth Circuit’s reliance on
the purely convenient placement of the
new discovery provisions in Rule 26,
which has retained its original placement
under the generic heading [“Depositions
and Discovery”].14
Judge Shadur did not, however, address
Medhekar’s point that the PSLRA’s discovery
stay was intended to eliminate precisely the
practical burdens associated with the initial
disclosures mandated by Rule 26.
Judge Shadur’s reliance on the text of Rule
26 and the canons of statutory construction is
ultimately less persuasive than the Medhekar
panel’s vindication of Congress’ clear purpose
to minimize abuse of the discovery process.
From the perspective of Medhekar, this
purpose is not diminished simply because the
cost of producing insurance policies is
minimal; and initial disclosure under Rule 26
is not limited to insurance policies. Nor does
the Comdisco decision address the Medhekar
panel’s conclusion that the PSLRA’s
legislative history warrants interpreting “other
proceedings” to include initial disclosures.15
Interpreting the Language
Under the PSLRA, a court may lift the stay
where “necessary to preserve evidence or to
prevent undue prejudice.” Although
numerous courts have interpreted this
language, a standard for deciding when to
apply the statutory exception has yet
to emerge.
Although “wholly speculative assertions as
to the risk of losing evidence are not sufficient
to establish undue prejudice,”16 courts have
applied the exception when, absent court
intervention, evidence is likely to be lost. In
In re Pacific Gateway Exchange, Inc.,17 for
example, the Northern District of California
court permitted discovery and the issuance
of document preservation notices where
potentially relevant data was stored on
computers that had been reprogrammed or
sold to third parties.
Even in the absence of a threat of imminent
loss of evidence, issuance of a document
preservation order was permitted in Neibert v.
Monarch Dental Corp.,18 where the Northern
District of Texas court concluded that “[a]
subpoena which does not demand compliance
by a date certain is not inimical to the policy
reasons for the [PSLRA’s] discovery bar.” The
broader implications of Pacific Gateway and
Neibert are limited, however, because neither
articulates a standard for assessing when the
threat of lost evidence is sufficient to trigger
the exception.
Unlike Pacific Gateway and Neibert, most
recent cases interpreting the statutory
exception focus on the meaning of the phrase
“undue prejudice.” In general, courts have
been reluctant to find “undue prejudice” when
it appears that the main purpose for seeking
relief from the stay is to uncover facts to
support the allegations in the complaint.
This trend is illustrated by a number of
recent cases. In Faulkner v. Verizon
MONDAY, APRIL 15, 2002
Communications, Inc.,19 plaintiffs alleged
violations of the federal securities laws by
corporate insiders prior to a contemplated (but
ultimately failed) merger between defendant
Verizon and NorthPoint. Before defendants’
motion to dismiss had been filed, plaintiffs
sought relief from the stay to conduct
discovery of NorthPoint’s attorneys. Plaintiffs
requested, inter alia, documents produced by
Verizon in litigation brought against it by
NorthPoint in another forum.
The Southern District of New York court
denied plaintiffs’ motion on the ground that
“plaintiffs seek to lift the stay for the sole
purpose of uncovering facts to support the
fraud allegations in the Complaint.”20 It was of
no consequence that the discovery request had
been propounded to a third party, because
“the PSLRA does not distinguish between
discovery of non-parties and parties.” The
court also held that plaintiffs’ broadly phrased
requests did not satisfy the “particularized
discovery” requirement. Finally, the court
rejected plaintiffs’ argument based on the the
fact that a third party, rather than defendants,
would incur the cost of responding to the
discovery request.21
The decisions recognize a distinction,
however, between seeking relief in order to
effect an “end run” around the discovery stay,
as in Faulkner, and seeking to escape a
situation where imposition of the stay would
effectively end the suit by forever depriving
plaintiffs of relevant, but otherwise unobtainable, evidence. In In re Baan Co. Secs. Litig.,22
the court confronted the question whether the
PSLRA’s stay provision conflicts with the
District of Columbia Circuit’s case law
permitting limited jurisdictional discovery.
The court found no conflict, on the grounds
that permitting jurisdictional discovery would
“prevent the unfairness of a party’s being
denied access to information which his
opponent possesses and which, if produced,
would establish the legitimacy of his being
before the court.” Imposing the stay would
have the opposite effect: “[t]here is no reason
to read the statute or its legislative history to
abolish the case law permitting limited
jurisdictional discovery and to create the very
unfairness that case law prevents.”23
In some recent cases, courts have focused
on whether the discovery at issue seeks to
expand the allegations beyond those already
in the complaint or to support matters already
pleaded. In Anderson v. First Security Corp.,24
purchasers of a corporation’s common stock
brought a federal class action alleging that
officers of the corporation caused it to engage
in financial manipulations, thereby artificially
NEW YORK LAW JOURNAL
LITIGATION
inflating its stock price during the period
immediately prior to a merger. A Utah district
court dismissed the plaintiffs’ claims without
prejudice for failure to meet the Reform Act’s
heightened pleading standards and for failure
to comply with Fed. R. Civ. P. 9(b), and
simultaneously granted plaintiffs leave to file
an amended complaint.
At oral argument on the motion to dismiss,
plaintiffs sought a partial lifting of the
automatic stay, arguing that although they
had already gained access to and pleaded
“significant information” concerning how,
during due diligence, the proposed merger
partner became aware of the defendant
corporation’s alleged financial manipulations,
a confidentiality order prevented employees of
the merger partner from disclosing more
detailed information. Having been informed
by counsel for the merger partner that it
would not object to a subpoena seeking
documents and testimony, plaintiffs requested
permission to do so.
The court granted plaintiffs’ request,
crediting their argument that but for the
confidentiality
agreement,
additional
information would have been available from
the proposed merger partner’s employees to
support the allegations in the complaint, and
held that plaintiffs would suffer “undue
prejudice” absent limited discovery of the
otherwise unavailable third-party merger
partner’s employees. The court noted that the
discovery would not amount to an impermissible “fishing expedition,” because plaintiffs had
already stated the alleged bases of liability.
Using similar arguments, plaintiffs obtained
a partial lifting of the discovery stay in Vacold
LLC v. Cerami.25 The parties in Vacold had
been joint venturers in a company developing
virtual lymph node technology. Shortly after
defendants bought out plaintiffs’ investment,
the venture received a substantial investment
from a pharmaceutical giant. Plaintiffs
complained that defendants knew of but failed
to disclose the imminent investment.
Defendants moved to dismiss, and plaintiffs
cross-moved for expedited discovery on the
limited question of when defendants first
became aware that the pharmaceutical company was willing to invest in the company.
Holding the motion to dismiss in abeyance,
the court allowed expedited discovery.
Southern District of New York Judge Allen G.
Schwartz agreed with prior rulings that the
discovery stay should be lifted on “undue
prejudice” grounds “where defendants might
be shielded from liability in the absence of the
requested discovery.”26 He concluded that
plaintiffs’ motion satisfied this criteria:
because the failure to allow discovery on
the limited issue of the nature and timing
of J&J’s interest and investment in
AVT and VLN may unfairly insulate
defendants from liability for securities
fraud as alleged by plaintiffs.27
As in Anderson, the court in Vacold
concluded that Congress’ purpose in enacting
the stay provision was not undermined when
the discovery sought both related directly
to claims already in the complaint and
could readily be obtained through limited
—————————
Two recent
decisions call
into question previous
refusals to recognize an
exception to the
mandatory stay where
jurisdiction is premised
upon both federal
question and diversity
jurisdiction.
------------------------------------------------
depositions or document requests.
In contrast, the Ninth Circuit in Medhekar
underscored Congress’ intent “that complaints
… should stand or fall based on the actual
knowledge of the plaintiffs rather than
information produced by the defendants after
the action has been filed.”28 A claim of “undue
prejudice” should be strictly and narrowly
construed to conform to that intent.29 And
nothing in either the statute itself or the
PSLRA’s legislative history suggests that
Congress’ ban on “all discovery” was intended
to prohibit discovery only on claims not
made in the complaint. Ultimately, the
Medhekar court’s analysis is the more natural
interpretation of the stay provision’s
categorical language and entails fewer
inconsistencies than the permissive holdings
in cases such as Anderson and Vacold.
••••••••••••••
•••••••••••••••••
(1) Pub. L. No. 104-67, 109 Stat. 737 (1995).
(2) The PSLRA’s stay provision amendments are codified at 15 U.S.C. §77z-1(b) and §78u-4(b)(3)(B).
(3) See Tobias Holdings, Inc. v. Bank United Corp., No.
MONDAY, APRIL 15, 2002
01 Civ. 1343 (SAS), 2001 WL 921168, at *1 (S.D.N.Y.
Aug. 14, 2001) (“It is not clear from the face of the statute
whether Congress contemplated the situation where both
federal question and diversity jurisdiction are invoked in a
single action.”).
(4) See, e.g., In re Trump Hotel S’holder Derivative Litig.,
No. 96 Civ. 7820 (DAB) (HBP), 1997 WL 442135, at *2
(S.D.N.Y. Aug. 5, 1997) (“There is simply nothing in either
the text or the legislative history of the PSLRA that suggests that Congress intended to except federal securities
actions in which there happens to be both diversity of citizenship and pendent state law claims.”).
(5) See In re Rational Software Secs. Litig., 28 F.Supp.2d
562, 565 (N.D. Cal. 1998), vacated by S.G. Cowen Secs.
Corp. v. U.S. Dist. Court, 189 F.3d 909, 913 n.1 (9th Cir.
1999) (“Congress’ attempt to address [its concern with
abuse of discovery] in federal securities actions would be
rendered meaningless if securities plaintiffs could circumvent the stay simply by asserting pendent state law
claims.”); Angell Invs., L.L.C. v. Purizer Corp., No. 01 C
6359, 2001 WL 1345996, at *2 (N.D. Ill. Oct. 31, 2001)
(same); but see Tobias Holdings, Inc. v. Bank United Corp.,
2001 WL 921168, at *4.
(6) 2001 WL 921168, at *1. Application of the Tobias
Holdings exception is limited to a narrow class of cases.
Under the Securities Litigation Uniform Standards Act
(SLUSA), most class action suits alleging fraud “in connection with the purchase or sale of a covered security” arising
under either federal or state law must be brought in federal
court and are then pre-empted whether brought in federal
or state court. As a consequence, the Tobias Holdings exception applies only to cases unaffected by SLUSA, specifically to non-class action federal securities cases where there
are pendent common law claims and complete diversity.
(7) 2001 WL 1345996 (N.D. Ill. Oct. 31, 2001).
(8) Id. at *2.
(9) See Purizer, 2001 WL 1345996, at *2 (citing SG
Cowen Sec. Corp., 189 F.3d at 913 n.1).
(10) 99 F.3d 325 (9th Cir. 1996).
(11) 166 F.Supp.2d 1260 (N.D. Ill. 2001).
(12) 99 F.3d at 328.
(13) 166 F.Supp.2d at 1261.
(14) Id.
(15) Medhekar was followed in Hilliard v. Black, 125 F.
Supp. 2d 1071, 1084 (N.D. Fla. 2000) (holding that PSLRA
stay of discovery covers initial disclosures under Rule 26).
(16) In re CFS-Related Sec. Fraud Litig., 179 F.Supp.2d
1260, 1265 (N.D. Okla. 2001).
(17) No. C 00-1211 PJH(JL), 2001 WL 1334747 (N.D.
Cal. Oct. 17, 2001).
(18) No. 3:99 CV762, 1999 WL 33290643, at *1 (N.D.
Tex. Oct. 20, 1999).
(19) 156 F.Supp.2d 384 (S.D.N.Y. 2001) (Judge
Conner).
(20) Id. at 402.
(21) Id. at 404, 405. See also In re Carnegie Int’l Corp Sec.
Litig., 107 F.Supp.2d 676, 684 (D. Md. 2000) (Magistrate
Judge Guarey) (holding that the statutory “undue prejudice” requirement had not been met where discovery was
sought to “assist [plaintiff] in establishing that it relied in
good faith upon the accounting, consulting and auditing
advice which [the subpoenaed party] provided, while
engaged by [plaintiff].”).
(22) 81 F.Supp.2d 75 (D.D.C. 2000).
(23) Id.
(24) 157 F.Supp.2d 1230 (D. Utah 2001).
(25) 2001 WL 167704 (S.D.N.Y. Feb. 16, 2001).
(26) Vacold, 2001 WL 167704, at *6. (citing cases).
(27) Id. at *7.
(28) Medhekar, 99 F.3d at 328.
(29) See Log On America v. Promethean Asset Mgmt.
L.L.C., No. 00 CIV 6218 (RMB), 2001 WL 1658223, at *1
(S.D.N.Y. Dec. 26, 2001).
This article is reprinted with permission from the Monday, April 15, 2002 edition of the NEW YORK LAW JOURNAL. © 2002 NLP IP Company. All rights reserved.
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