Securities litigation has a culture defined by multiple elements: the types of cases filed, the plaintiffs’ lawyers who file them, the defense counsel who defend them, the characteristics of the insurance that covers them, the way insurance representatives approach coverage, the government’s investigative policies – and, of course, the attitude of public companies and their directors and officers toward disclosure and governance.
This culture has been largely stable over the nearly 20 years I’ve defended securities litigation matters full time. The array of private securities litigation matters (in the way I define securities litigation) remains the same – in order of virulence: securities class actions, shareholder derivative litigation matters (derivative actions, board demands, and books-and-records inspections), and shareholder challenges to mergers. The world of disclosure-related SEC enforcement and internal corporate investigations is basically unchanged as well. And the art of managing a disclosure crisis, involving the convergence of shareholder litigation, SEC enforcement, and an internal investigation, involves the same basic skills and instincts.
But I’ve noted significant changes to other characteristics of securities-litigation culture recently, which portend a paradigm shift. Over the past few years, smaller plaintiffs’ firms have initiated more securities class actions on behalf of individual, retail investors, largely against smaller companies that have suffered what I call “lawsuit blueprint” problems such as auditor resignations and short-seller reports. This trend – which has now become ingrained into the securities-litigation culture – will significantly influence the way securities cases are defended and by whom, and change the way that D&O insurance coverage and claims need to be handled.
Changes in the Plaintiffs’ Bar
Discussion of the history of securities plaintiffs’ counsel usually focuses on the impact of the departures of former giants Bill Lerach and Mel Weiss. But although the two of them did indeed cut a wide swath, the plaintiffs’ bar survived their departures just fine. Lerach’s former firm is thriving, and there are strong leaders there and at other prominent plaintiffs’ firms.
The more fundamental shifts in the plaintiffs’ bar concern changes to filing trends. Securities class action filings are down significantly over the past several years, but as I have written, I’m confident they will remain the mainstay of securities litigation, and won’t be replaced by merger cases or derivative actions. There is a large group of plaintiffs’ lawyers who specialize in securities class actions, and there are plenty of stock drops that give them good opportunities to file cases. Securities class action filings tend to come in waves, both in the number of cases and type. Filings have been down over the last several years for multiple reasons, including the lack of plaintiff-firm resources to file new cases as they continue to litigate stubborn and labor-intensive credit-crisis cases, the rising stock market, and the lack of significant financial-statement restatements.
While I don’t think the downturn in filings is, in and of itself, very meaningful, it has created the opportunity for smaller plaintiffs’ firms to file more securities class actions. As D&O Discourse readers know, the Reform Act’s lead plaintiff process incentivized plaintiffs’ firms to recruit institutional investors to serve as plaintiffs. For the most part, institutional investors, whether smaller unions or large funds, have retained the more prominent plaintiffs’ firms, and smaller plaintiffs’ firms have been left with individual investor clients who usually can’t beat out institutions for the lead-plaintiff role. At the same time, securities class action economics tightened in all but the largest cases. Dismissal rates under the Reform Act are pretty high, and defeating a motion to dismiss often requires significant investigative costs and intensive legal work. And the median settlement amount of cases that survive dismissal motions is fairly low. These dynamics placed a premium on experience, efficiency, and scale. Larger firms filed the lion’s share of the cases, and smaller plaintiffs’ firms were unable to compete effectively for the lead plaintiff role, or make much money on their litigation investments.
This started to change with the wave of cases against Chinese issuers in 2010. Smaller plaintiffs’ firms initiated the lion’s share of them, as the larger firms were swamped with credit-crisis cases and likely were deterred by the relatively small damages, potentially high discovery costs, and uncertain insurance and company financial resources. Moreover, these cases fit smaller firms’ capabilities well; nearly all of the cases had “lawsuit blueprints” such as auditor resignations and/or short-seller reports, thereby reducing the smaller firms’ investigative costs and increasing their likelihood of surviving a motion to dismiss. The dismissal rate has indeed been low, and limited insurance and company resources have prompted early settlements in amounts that, while on the low side, appear to have yielded good outcomes for the smaller plaintiffs’ firms.
The smaller plaintiffs’ firms thus built up a head of steam that has kept them going, even after the wave of China cases subsided. For the last year or two, following almost every “lawsuit blueprint” announcement, a smaller firm has launched an “investigation” of the company, and they have initiated an increasing number of cases. Like the China cases, these cases tend to be against smaller companies. Thus, smaller plaintiffs’ firms have discovered a class of cases – cases against smaller companies that have suffered well-publicized problems that reduce the plaintiffs’ firms’ investigative costs – for which they can win the lead plaintiff role and that they can prosecute at a sufficient profit margin.
To be sure, the larger firms still mostly can and will beat out the smaller firms for the cases they want. But it increasingly seems clear that the larger firms don’t want to take the lead in initiating many of the cases against smaller companies, and are content to focus on larger cases on behalf of their institutional investor clients.
These dynamics are confirmed by recent securities litigation filing statistics. Cornerstone Research’s “Securities Class Action Filings: 2014 Year in Review,” concludes that (1) aggregate market capitalization loss of sued companies was at its lowest level since 1997, and (2) the percentage of S&P 500 companies sued in securities class actions “was the lowest on record.” Cornerstone’s “Securities Class Action Filings: 2015 Midyear Assessment” reports that two key measures of the size of cases filed in the first half of 2015 were 43% and 65% lower than the 1997-2014 semiannual historical averages. NERA Economic Consulting’s “Recent Trends in Securities Class Action Litigation: 2014 Full-Year Review” reports that 2013 and 2014 “aggregate investor losses” were far lower than in any of the prior eight years. And PricewaterhouseCoopers’ “Coming into Focus: 2014 Securities Litigation Study” reflects that in 2013 and 2014, two-thirds of securities class actions were against small-cap companies (market capitalization less than $2 billion), and one-quarter were against micro-cap companies (market capitalization less than $300 million).* These numbers confirm the trend toward filing smaller cases against smaller companies, so that now, most securities class actions are relatively small cases.
Consequences for Securities Litigation Defense
Securities litigation defense must adjust to this change. Smaller securities class actions are still important and labor-intensive matters – a “small” securities class action is still a big deal for a small company and the individuals accused of fraud, and the number of hours of legal work to defend a small case is still significant. This is especially so for the “lawsuit blueprint” cases, which typically involve a difficult set of facts.
Yet most securities defense practices are in firms with high billing rates and high associate-to-partner ratios, which make it uneconomical for them to defend smaller litigation matters. It obviously makes no sense for a firm to charge $6 million to defend a case that can settle for $6 million. It is even worse for that same firm to attempt to defend the case for $3 million instead of $6 million by cutting corners – whether by under-staffing, over-delegation to junior lawyers, or avoiding important tasks. It is worse still for a firm to charge $2 million through the motion to dismiss briefing and then, if they lose, to settle for more than $6 million just because they can’t defend the case economically past that point. And it is a strategic and ethical minefield for a firm to charge $6 million and then settle for a larger amount than necessary so that the fees appear to be in line with the size of the case. .
Nor is the answer to hire general commercial litigators at lower rates. Securities class actions are specialized matters that demand expertise, consisting not just of knowledge of the law, but of relationships with plaintiffs’ counsel, defense counsel, economists, mediators, and D&O brokers and insurers.
Rather, what is necessary is genuine reform of the economics of securities litigation defense through the creation of a class of experienced securities litigators who charge lower rates and exhibit tighter economic control. Undoubtedly, that will be difficult to achieve for most securities defense lawyers, who practice at firms with supercharged economics. The lawyers who wish to remain securities litigation specialists will thus face a choice:
- Accept that the volume of their case load will be reduced, as they forego smaller matters and focus on the largest matters (which Biglaw firms are uniquely situated to handle well, on the whole);
- Reign in the economics of their practices, by lowering billing rates of all lawyers on securities litigation matters, and by reducing staffing and associate-to-partner ratios; and/or
- Move their practices to smaller, regional defense firms that naturally have more reasonable economics.
I’ve taken the third path, and I hope that a number of other securities litigation defense lawyers will also make that shift toward regional defense firms. A regional practice can handle cases around the country, because litigation matters can be effectively and efficiently handled by a firm based outside of the forum city. And they can be handled especially efficiently by regional firms outside of larger cities, which can offer a better quality of life for their associates, and a more reasonable economic model for their clients.
Consequences for D&O Insurance
D&O insurance needs to change as well. For public companies, D&O insurance is indemnity insurance, and the insurer doesn’t have the duty or right to defend the litigation. Thus, the insured selects counsel and the insurer has a right to consent to the insured’s selection, but such consent can’t be unreasonably withheld. D&O insurers are in a bad spot in a great many cases. Since most experienced securities defense lawyers are from expensive firms, most insureds select an expensive firm. But in many cases, that spells a highly uneconomical or prejudicial result, through higher than necessary defense costs and/or an early settlement that doesn’t reflect the merits, but which is necessary to avoid using most or all of the policy limits on defense costs.
Given the economics, it certainly seems reasonable for an insurer to at least require an insured to look at less expensive (but just as experienced) defense counsel before consenting to their choice of counsel – if not outright withholding consent to a choice that does not make economic sense for a particular case. If that isn’t practical from an insurance law or commercial standpoint, insurers may well need to look at enhancing their contractual right to refuse consent, or even to offer a set of experienced but lower-cost securities defense practices in exchange for a lower premium. It is my strong belief that a great many public company CFOs would choose a lower D&O insurance premium over an unfettered right to choose their own defense lawyers.
Since I’m not a D&O insurance lawyer, I obviously can’t say what is right for D&O insurers from a commercial or legal perspective. But it seems obvious to me that the economics of securities litigation must change, both in terms of defense costs and defense-counsel selection, to avoid increasingly irrational economic results.
* Median settlement values are falling as well. In 2014, the median settlement was just $6.5 million according to NERA and $6.0 million according to Cornerstone. NERA found that “[o]n an inflation-adjusted basis, 2014 median settlement was the third-lowest since the passage of the PSLRA: only in 1996 and in 2001 were median settlement amounts lower on an inflation-adjusted basis.” Cornerstone reports that 62% of settlements in 2014 were $10 million or less, compared to an average of 53% over 2005-13. Since settlements in 2014 were of cases filed in earlier years, when the size of cases was larger, it stands to reason that median settlements should remain small or decrease further in future years.