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Omnicare Court Ponders Two Middle Paths: One Rocky, One Smooth

Posted in 6th Circuit, Falsity Analysis, Securities Class Action, Statements of Opinion, Supreme Court

Monday’s oral argument before the Supreme Court in Laborers District Counsel Construction Industry Pension Fund v. Omnicare, Inc. (“Omnicare”) was remarkable in that, as Omnicare attorney Kannon Shanmugam noted, it was the “rare case in which none of the parties is defending the reasoning of the court of appeals below.”

As we explained in last week’s blog post previewing the argument, the Sixth Circuit held in the decision under review that a showing of so-called “objective falsity” alone was sufficient to demonstrate falsity in a claim filed under Section 11 of the Securities Act – in other words, that an opinion could be false even if was genuinely believed, if it was later concluded that the opinion was somehow “incorrect.”  On appeal, Omnicare contended, as did we in our amicus brief on behalf of the Washington Legal Foundation (“WLF”), that this ruling was contrary to the U.S. Supreme Court’s decision in Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083, 1095 (1991).  Virginia Bankshares held that a statement of opinion is a factual statement as to what the speaker believes – meaning a statement of opinion is “true” as long as the speaker honestly believes the opinion expressed, i.e., if it is “subjectively” true.

Other than a passing and unenthusiastic nod made by plaintiffs’ counsel in defense of the Sixth Circuit’s reasoning, Monday’s discussion assumed that some showing other than so-called “objective falsity” would be required to establish the falsity of an opinion.  Most of the argument by Omnicare, the plaintiffs, and the Solicitor General revolved around what this additional showing should be, as did the extensive and pointed questions from Justices Breyer, Kagan, and Alito.

It thus seems unlikely from the tone of the argument that the Court will affirm the Sixth Circuit’s holding that an opinion is false if it is “objectively” untrue.  If the pointed opening question from Chief Justice Roberts is any indication, the Court also may not fully accept Omnicare’s position, which is that an opinion can only be false or misleading if it was not actually believed by the speaker.  It seems more probable that the Supreme Court will take one of two middle paths – one that was advocated by the Solicitor General in Monday’s argument, or one that was advanced in our brief for the WLF.

In a position embraced by the plaintiffs, the Solicitor General contended that a statement of opinion should be considered “false,” even if it was genuinely believed, if plaintiffs can show that there was no “reasonable basis” for the speaker to hold that opinion.  As we have observed, however, this test breaks down quickly.  Any reasonableness inquiry is, in and of itself, entirely subjective, meaning that whether an opinion was true or false would hinge on someone else’s later opinion as to its “reasonableness.”  Although Justice Breyer seemed to be leaning toward such a “reasonableness” test in much of his questioning, both he and Justice Alito expressed concern over how this reasonableness would be determined, and in particular, how to decide what sort of inquiry is “reasonable” for a company or individual to conduct before voicing a particular opinion.

A far better middle path, advocated by our WLF brief (see pp. 23-29), is to subject statements of opinion to the same sort of inquiry about whether they were “misleading” as for any other statement.  In other words, a statement of opinion can be honestly believed (and thus “true”), but nonetheless rendered misleading by the omission of certain facts.  Justice Kagan urged such a standard in her questioning of the parties, although none took advantage of the opening that she provided.  If framed correctly, this standard would avoid the pitfalls of the Solicitor General’s reasonableness standard, because liability would not hinge upon a later opinion about the validity of a speaker’s original expressed opinion.  Rather, by this standard, plaintiffs would be required to demonstrate either that an opinion was false because it was not actually believed, or that omitted facts caused the opinion – when considered in the full context of the company’s other disclosures – to be misleading because it “affirmatively create[d] an impression of a state of affairs that differs in a material way from the one that actually exists.”  Brody v. Transitional Hosps. Corp., 280 F.3d 997, 1006 (9th Cir. 2002).

Such a standard would be faithful to the text of the most frequently litigated provisions of the federal securities laws – Section 11, at issue in Omnicare, and Section 10(b) of the Securities Exchange Act – which allow liability for statements that are either false or that omit material facts “required to be stated therein or necessary to make the statements therein not misleading . . . .”  At the same time, this standard would preserve the commonsense holding of Virginia Bankshares – that an opinion is “true” if it is genuinely believed – and prevent speakers from being held liable for truthfully expressed opinions simply because someone else later disagrees with them.

Sixth Circuit again Demonstrates the Need for the Supreme Court to Clarify the Standard for Judging the Falsity of Opinions

Posted in 6th Circuit, Falsity Analysis, Scienter Analysis, Securities Class Action, Statements of Opinion, Supreme Court

On November 3, 2014, the U.S. Supreme Court will hear oral argument in Laborers District Counsel Construction Industry Pension Fund v. Omnicare, Inc., which concerns the standard for judging the falsity of an opinion challenged in an action under Section 11 of the Securities Act of 1933.  In the Sixth Circuit decision under review (“2013 Omnicare decision”), the court held that a statement of opinion can be “false” even if the speaker genuinely believed the stated opinion. This holding is contrary to the U.S. Supreme Court’s decision in Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083, 1095 (1991), which held that a statement of opinion is a factual statement as to what the speaker believes – meaning a statement of opinion is “true” as long as the speaker genuinely believes the opinion expressed, i.e., if it is “subjectively” true.

On behalf of Washington Legal Foundation (“WLF”), my partner Claire Davis and I filed an amicus brief in Omnicare to emphasize the importance of clarifying the standard for challenging “false” statements of opinion under all the federal securities laws, not just Section 11.  WLF’s view that such clarification is needed was reinforced by an October 10, 2014 decision in a subsequently filed securities class action against Omnicare under Section 10(b) of the Securities Exchange Act of 1934.  In re Omnicare, Inc. Sec. Litig., — F. 3d —-, 2014 WL 5066826 (6th Cir. Oct. 10, 2014) (“2014 Omnicare decision”).  In the 2014 Omnicare decision, the Sixth Circuit appeared to embrace the proposition that a statement of opinion is not actionable if it is subjectively true – at least under Section 10(b) – but then held that the subjective falsity inquiry should be analyzed within the element of scienter.  The opinion shows the continued confusion that pervades analysis of this issue, jumbling subjective falsity with other concepts, and conflating the separate elements of falsity and scienter.

As part of its scienter analysis, the Sixth Circuit also grappled with another important question: whose state of mind counts for purposes of determining a corporation’s scienter?  Although the Sixth Circuit believes the standard it enunciated constitutes a “middle ground” between restrictive and liberal tests among the federal circuit courts, its ruling misunderstands the nature of the scienter inquiry and conflicts with the Supreme Court’s ruling in Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011), and thus risks expanding corporate liability beyond the proper reach of Section 10(b).

Today, Claire and I posted an analysis of the 2013 and 2014 Omnicare decisions on WLF’s blog, The WLF Legal Pulse.  We invite our readers to read our post there.

Please stay tuned to D&O Discourse for more on the November 3, 2014 Supreme Court argument and the Court’s opinion.

The Root Cause of Skyrocketing Securities Class Action Defense Costs

Posted in D&O Insurance, Defense Costs, Defense Counsel, Litigation Strategy, Securities Class Action, Settlement

Why do the costs of defending securities class actions continue to increase?  Because of my writing on the subject (e.g. here and here), I’m asked about the issue a lot.  My answer has evolved from blaming biglaw economics – a combination of rates and staffing practices – to something more fundamental.  Biglaw economics is a consequence of the problem, not its cause.  I believe the root cause is the convergence of two related factors:

  • The prevailing view, fueled by defense lawyers, that securities class actions are “bet the company” cases and threaten the personal financial security of director and officer defendants; and
  • As a result of these perceived threats, the reflexive hiring of biglaw firms, which companies and their directors and officers feel are uniquely equipped to defend them – in other words, they go to what they perceive to be the “Mayo Clinic” of defense firms.

But it simply isn’t necessary, and is often even strategically unwise, to turn to a biglaw firm for most securities class actions.

To be sure, securities class actions are serious matters that assert large theoretical damages.  But the vast majority of cases, if defended effectively and efficiently by securities litigation specialists, are easily managed and settled within D&O insurance limits, with no real risk of any out-of-pocket payment by a company’s directors and officers.

The Vast Majority of Securities Litigation Is Manageable

Companies and their directors and officers understandably feel threatened by securities class actions.  Plaintiffs asserting 10b-5 claims allege that the defendants lied on purpose, and claim theoretical damages in the hundreds of millions or billions of dollars in the lion’s share of cases.  Plaintiffs asserting Section 11 claims have relaxed standards of pleading and proof – the company’s liability is strict, and individuals have the burden of showing their due diligence.  Section 11 damages are typically lower than 10b-5 damages, but they are still substantial.  In the world of complex corporate litigation, securities lawsuits certainly are among the most threatening.

Not surprisingly, many biglaw lawyers exaggerate this threat – so that the obvious and necessary recourse seems to be to hire their firm.  In turn, in-house lawyers often reflexively turn to biglaw because “no one ever got fired for hiring _______ [fill in your favorite biglaw firm].”  This is especially so if such a “safe” biglaw firm is their regular outside firm.  Busy CEOs and CFOs, the typical individual defendants, rely on their in-house lawyers’ recommendation of which firm to hire, or firms to interview.  Boards often defer to management’s hiring process and recommendation or decision, even though board members often will become defendants themselves in a related shareholder derivative action shortly after the securities class action is filed.

In reality, however, very few securities class actions pose a real threat to the company or its directors and officers.  Most securities class actions are brought by a small group of plaintiffs’ firms, who have a playbook that experienced defense counsel know well.  There are few surprises in the vast majority of cases.  Indeed, at the outset of a securities class action, most good securities defense lawyers and D&O insurance professionals can accurately estimate the odds of prevailing on a motion to dismiss and, if the case is not dismissed, the settlement value.

Securities class actions follow a highly predictable course.  The first step, of course, is a motion to dismiss.  Because of the high pleading standards imposed by the Private Securities Litigation Reform Act, the rate of dismissal of 10b-5 cases is high.  According to NERA Economic Consulting, approximately 50% of securities class actions filed and resolved from 2000 through 2013 were dismissed on a motion to dismiss.

Of cases that are not dismissed, nearly all are settled short of a trial verdict.  According to NERA, of the 4,226 securities class actions filed since the Reform Act, only 20 have gone to trial and only 14 have reached a verdict.  Settlements, moreover, are generally relatively modest.  For the past five years, the median settlement amount was, in millions (again according to NERA), $8.5, $11.0, $7.5, $12.3, and $9.1 respectively – well within the limits of a typical public company D&O insurance program.

Shareholder derivative litigation and shareholder challenges to M&A transactions likewise pose little real threat to companies and individual defendants as a general rule.  Corporate law imposes high hurdles for plaintiffs in the typical shareholder derivative case, which is often dismissed on motions to dismiss.  If not dismissed, the vast majority of such cases are settled through corporate governance changes and a six-figure payment to the plaintiffs’ lawyers.  Likewise, the vast majority of shareholder challenges to M&A transactions are resolved early in the litigation through proxy statement changes, and sometimes changes to the transaction, and a six-figure payment to the plaintiffs’ lawyers.

These settlements are covered by D&O insurance, with limited exceptions.  Major D&O insurers typically handle D&O claims in an insured-friendly and responsive manner, owing in part to the fact that they are insuring the company’s directors and officers.  Actual D&O coverage litigation is uncommon.  Insurers’ in-house and outside claims professionals are experts in D&O liability litigation, and many of them have handled vastly more D&O claims than even the most experienced securities defense lawyers.  Good defense counsel are able to work cooperatively with D&O claims professionals through the litigation, utilize their experience to assist with strategic decisions to improve the defense of the litigation, and if the litigation isn’t dismissed, obtain funding of a reasonable settlement, typically within policy limits and without a contribution from the company – provided defense costs are in line with the settlement value of the litigation.

Biglaw Securities Defense Tends to Over-Litigate or Under-Litigate

To illustrate the way that biglaw firms tend to over-litigate or under-litigate securities actions, let’s use a hypothetical case.  Acme and its CEO and CFO are sued in a securities class action.  Acme has $25 million in D&O insurance, which is an appropriate amount based on Acme’s market capitalization, risk profile, and other company and industry considerations.  Acme hires a biglaw firm to defend the litigation.  Defense counsel’s billing rates range from $1,200 for the senior partner to $600 for a new associate.  There are 2 partners and 6 associates at various levels assigned to the case.*

At the outset of the case, Acme’s economist conducts a preliminary “plaintiffs’-style” damages analysis, and estimates that plaintiffs will assert damages of around $500 million.  Based on this estimate of asserted damages and analysis of various other factors, Acme’s economist, D&O insurer, and defense counsel suggest that the case should settle in the range of $10–15 million.

Acme makes a motion to dismiss the securities class action, and loses.  Acme’s defense counsel’s fees through the motion to dismiss total $1.5 million.  Acme’s D&O insurer asks defense counsel for a budget through completion of discovery and summary judgment – i.e., the budget does not include trial.  Defense counsel gives the insurer an estimate of $10 million (and, in most matters, the defense budget understates what the actual defense costs will be).  Around the same time, an Acme shareholder files a tag-along shareholder derivative action against Acme’s directors and officers.  Acme intends to move to dismiss the shareholder derivative action.  Depending on the outcome of the motion, defense counsel gives a budget estimate of $1–5 million up to, but not including, trial.

Let’s pause here.  At this point, at least $12.5 million of Acme’s $25 million of D&O insurance will be depleted for work up to, but not including, trials in the two matters:  $1.5 million incurred, plus $11 million estimated.  That amount could grow to $16.5 million if the derivative action survives a motion to dismiss.  And the actual cost could be even higher if the biglaw defense firm’s estimates are indeed low.  So let’s say a better estimate of total defense costs for the securities and derivative actions, not including trials, would be $20 million.  Based on that estimate, Acme would have as much as $12.5 million and as little as $5 million with which to settle the litigation if it were to litigate through summary judgment – which is normal in complex commercial cases, because litigation through summary judgment helps the parties reach a settlement that reflects the actual merits of the litigation.  And if the case did not settle at that point, there would not be enough insurance proceeds left to take the case to trial.

What are Acme’s options?

First, it could proceed to defend the litigation through summary judgment.  However, absent a denial of plaintiffs’ motion for class certification or dismissal on summary judgment, at most there would remain just enough to settle within insurance limits, and if in fact the defense firm has underestimated defense costs, there probably would not be sufficient proceeds left for settlement – which means that Acme itself would need to write a check to pay for the settlement.

Second, Acme could try to settle the case at this point, before incurring further defense costs.  This would allow for a settlement within policy limits.  However, early settlements tend to be more expensive than later settlements – i.e., they overpay the plaintiffs.  And Acme and its directors and officers feel they did nothing wrong, and would prefer to litigate the case further and try to obtain dismissal at class certification or summary judgment – and perhaps even consider taking the case to trial.  (Acme has tried several large commercial and IP cases over the years, and likes to take cases to trial if they can’t be settled reasonably.)

Thus, Acme has two options: (1) it can defend the case past its insurance limits, or (2) it can settle early and probably pay more than the merits say it should.  To avoid this dilemma, biglaw firms sometimes employ a third alternative: they under-litigate cases, cutting corners to make their economics fit matters that don’t justify the billing they would generate based on their “normal” rates and staffing practices.  The result, of course, is a diminished defense.  I suppose with client and insurer permission, deliberate under-litigation and corner-cutting would be a legitimate strategy.  But who would knowingly want a diminished defense?

The Solution is Non-Biglaw Alternatives

Some securities cases are well-suited for biglaw securities defense practices, primarily large cases that are relatively cost-insensitive and require large teams.  And some biglaw firms and partners do a better job than others defending securities matters within the biglaw system.  But, as the Acme hypothetical illustrates, there are many cases for which biglaw economics just don’t work.  Public companies and their directors and officers need an alternative to biglaw defense practices in such cases.

Let’s briefly re-analyze the Acme hypothetical assuming incurred fees of $500,000 and a capped defense-cost budget of $5 million for the securities class action and $500,000–$2.5 million for the derivative action.   If Acme were to litigate up to trial, it would have $17 to $19 million left with which to settle the litigation – leaving plenty of room under the policy for settlement, as well as potentially for trial.

There are a handful of firms (including mine) that can handle the hypothetical case with those economics while providing the same, or better, quality of defense, and can litigate nationwide.  D&O brokers and insurers can help companies find them.  But there need to be more.  The ideal profile of a biglaw alternative is a team comprising former biglaw lawyers, who can offer the best of both worlds: the sophistication and quality of defense biglaw offers, without the economic difficulties that biglaw can present.  I hope that other biglaw partners will consider doing what I did, and move their practice to a strong non-biglaw firm, and build a team that is a good alternative to biglaw in the right cases.

Public companies, their directors and officers, and their D&O insurers would be better served with more of us providing an attractive alternative to the standard defense practice.

* As we have written previously (e.g., here and here), the associate-heavy structure of the team is, in large part, simply a function of biglaw firms’ economic model – high associate-to-partner ratios designed to increase profits-per-partner.  That system invites over-litigation and economic inefficiency, including make-work, over-delegation, and inadequate supervision.  Even partners acting with the utmost good faith often can’t overcome the pressures biglaw’s economic system imposes.


D&O Discourse Schedule, News, and Events

Posted in D&O Discourse News

Following our post on the Supreme Court’s decision in Halliburton II, we decided to take the summer off from further blogging.  We will resume our regular postings in September.

In addition to reading the blog, I hope that you can attend conferences at which I’m speaking this fall:

  • I am co-chairing a panel discussion on board oversight of cybersecurity at a meeting of the Northwest Chapter of the National Association of Corporate Directors in Seattle on September 23.
  • I am co-chairing and speaking at ACI’s D&O Liability Forum in New York City on September 30 – October 1.  Readers of D&O Discourse can receive a discount off the current price by registering using the code DWG200.
  • I am speaking at the PLUS Conference in Las Vegas on November 5 – 7.

We also want to remind you about our Twitter feature.  We tweet current securities and corporate governance litigation news and links.  Our goal is to help turn the fire hose of securities litigation news into a drinking fountain, by tweeting the current developments that we find most important.  You can follow us by reading our Twitter feed on the left-hand side of the D&O Discourse blog, or on Twitter, @DandODiscourse.

We hope you enjoy the remainder of your summer.

First Take on Halliburton II: The Price-Impact Rule May Not Have Much Practical Impact

Posted in 2nd Circuit, 3rd Circuit, 5th Circuit, Class Certification, Plaintiffs' Bar, Securities Class Action, Supreme Court

Yesterday’s Supreme Court decision in Halliburton Co. v. Erica P. John Fund, Inc. (Halliburton II) may well have the lowest impact-to-fanfare ratio of any Supreme Court securities decision.  Despite the social-media-fueled frenzy within the securities bar leading up to the decision, the Court’s decision will effect little change in class certification law and practice in most securities class actions.

Most of the fanfare concerned whether the Court would overrule the fraud-on-the-market presumption of reliance established in its 1988 decision in Basic v. Levinson.  But the Court refused to overrule Basic.  Instead, the core of the Halliburton II decision focused on defendants’ fallback argument that plaintiffs must show that the alleged misrepresentations had impact on the market price of the stock, as prerequisite for the presumption of reliance.  The Court refused to place on plaintiffs the burden of proving price impact, but agreed that a defendant may rebut the presumption of reliance at the class certification stage, with evidence of lack of price impact.

The Court’s ruling, which in the lead-up to the decision has been called the “middle ground” between overruling Basic or affirming the Fifth Circuit, is a well-reasoned decision, and reaches a good practical result.  Overruling Basic would have led to a securities-litigation train wreck.  Affirming the Fifth Circuit would have been legally dubious.   But the legal middle ground of allowing a defendant to demonstrate a lack of price impact captures class-certification arguments that defendants have been making for many years, although they have often been framed as arguments about materiality or loss causation.   Thus, the Court’s ruling allows defense attorneys to contest the right issue on class certification, by demonstrating that the market just didn’t care about the challenged information.  Although I believe the ruling will not have an impact on the merits of most cases, it sets up an analytically sound framework for addressing arguments that did not fit well in other doctrinal buckets.

And, for those of us who litigate securities class actions full time, the Court’s decision to revisit Basic set up the Super Bowl of securities litigation.  The road to Halliburton II was long.  I trace it below, before discussing and analyzing Halliburton II.  (Kevin LaCroix’s post on Halliburton II in The D&O Diary contains a good discussion of the background and issues as well.)

The Fraud-on-the-Market Presumption: From Basic to Halliburton I to Amgen to Halliburton II

All of the Halliburton hubbub is about reliance, which is an essential element of a Section 10(b) claim.  Absent some way to harmonize individual issues of reliance, class treatment of a securities class action is not possible; individual issues would overwhelm common ones, precluding certification under Federal Rule of Civil Procedure 23(b)(3).  In Basic, the Supreme Court provided a solution: a rebuttable presumption of reliance based on the fraud-on-the-market theory, which provides that a security traded on an efficient market reflects all public material information. Purchasers (or sellers) rely on the integrity of the market price, and thus on a material misrepresentation.  Decisions following Basic have established three conditions to its application: market efficiency, a public misrepresentation, and a purchase (or sale) between the misrepresentation and the disclosure of the “truth.”

Over the years, defendants have argued that, absent a showing by plaintiffs that the challenged statements were material, or upon a showing by defendants that they were not, the presumption is not applicable or has been rebutted.  And, in a twist on such arguments, defendants sometimes argued that the absence of loss causation rebutted the presumption. In Erica P. John Fund, Inc. v. Halliburton Co. (Halliburton I), the Supreme Court unanimously rejected loss causation as a condition of the presumption of reliance.

In Halliburton I, the defendants did not dispute that proof of loss causation is not required for the fraud-on-the-market presumption to apply.  Instead, they argued to the Supreme Court that, although the Fifth Circuit ruled on loss-causation grounds, it really ruled that the absence of loss causation means that the challenged statements were not material because the challenged statements did not impact the price of Halliburton’s stock, and a lack of materiality defeats the application of the presumption.  The Supreme Court disagreed: “Whatever Halliburton thinks the Court of Appeals meant to say, what it said was loss causation: ‘[EPJ Fund] was required to prove loss causation, i.e., that the corrected truth of the former falsehoods actually caused the stock price to fall and resulted in the losses.’ . . . . We take the Court of Appeals at its word. Based on those words, the decision below cannot stand.”

But the Court explicitly left the door open for the argument that plaintiffs must prove materiality for the presumption of reliance to apply.  Later, the Court granted certiorari in Amgen Inc. v. Connecticut Retirement Plans to review the Ninth Circuit’s decision that plaintiffs are not required to prove materiality for the presumption to apply, and that the district court is not required to allow defendants to present evidence rebutting the applicability of the presumption before certifying a class.

In a majority opinion authored by Justice Ginsburg, and joined by Chief Justice John Roberts and Justices Breyer, Alito, Sotomayor, and Kagan, the Amgen Court concluded that proof of materiality was not necessary to demonstrate, as Rule 23(b)(3) requires, that questions of law or fact common to the class will “predominate over any questions affecting only individual members.”  The Court reasoned that this was because: 1) materiality was judged according to an objective standard that could be proven through evidence common to the class, and 2) a failure to prove materiality would not just defeat an attempt to certify a class, it would also defeat all of individual claims, because it is an essential element to a claim under Section 10(b).

The majority’s conclusion was dubious.  Its chief flaw was its avoidance of the central question through circular reasoning.  The materiality of a statement is an essential prerequisite for the application of the fraud-on-the market presumption that the Court developed in Basic, as a device to overcome the need to prove actual, individual reliance.  In Basic, the Court used then-emerging economic theory to create a rebuttable presumption of reliance, based on the assumption that a security traded in an efficient market reflects all public material information, and that traders in that market rely on the market price, and thus on any material misrepresentations that are reflected in the price.  The Amgen Court did not dispute that the materiality of a misrepresentation is necessary to create the fraud-on-the-market presumption, nor that the fraud-on-the-market presumption is essential to show under Rule 23 that common questions predominate for the class.

Instead, to avoid the logical conclusion that a showing of materiality was thus necessary to certify the class, the Court reasoned backwards: because plaintiffs must also show the materiality of the alleged misstatements in order to prove the underlying merits of a Section 10(b) claim, a finding that there was no materiality would defeat claims for all plaintiffs, whether brought as a class or individually.  Therefore, the Court concluded, materiality (or the lack of it) was a “common question,” that should not be decided until summary judgment, or theoretically, trial.

The holding was properly subject to wide criticism, but the criticism was quickly displaced by intrigue.  The Court’s opinions signaled a willingness to re-evaluate Basic, with four votes already supporting the view that the decision was “questionable,” and the other five failing to come to its defense.  In addition, as I wrote following the Amgen argument, the justices seemed intrigued by Amgen’s argument that market efficiency depends on the type of specific information at issue.

The Holding in Halliburton II

That leads us back to Halliburton II.  As Amgen was being litigated in the Supreme Court, the parties in Halliburton were briefing the plaintiffs’ class certification motion on remand.  The district court certified a class, prior to the Supreme Court’s decision in Amgen.  Halliburton sought and obtained Rule 23(f) certification from the Fifth Circuit, which affirmed, after the Supreme Court decided Amgen.

The Fifth Circuit held that a price-impact inquiry is more analogous to materiality than it is to the permissible prerequisites to the fraud-on-the-market presumption (market efficiency and a public misrepresentation).  Based upon that view, the Fifth Circuit reasoned that while price impact is not an element, as is materiality, “a plaintiff must nevertheless prevail on this fact in order to establish loss causation.”  Thus, “if Halliburton were to successfully rebut the fraud-on-the-market presumption by proving no price impact, the claims of all individual plaintiffs would fail because they could not establish an essential element of the action.”  Because the Fifth Circuit believed that the absence of price impact would doom all individual claims, it concluded that price impact is not relevant to common-issue predominance and is therefore not relevant at class certification.

The Supreme Court vacated the Fifth Circuit’s decision and remanded with the decision issued yesterday.  The Court’s opinion is remarkably straightforward.  First, the Court refused to overrule Basic.  The Court rejected Halliburton’s argument that Basic is inconsistent with modern economic theory, under which market efficiency is not a binary “yes or no” issue, finding that “Halliburton’s criticisms fail to take Basic on its own terms.”  Halliburton II at 9.    According to the Halliburton II Court, the Basic Court expressly refused to enter into such economic debate and instead “based the presumption on the fairly modest premise that market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices.”  Basic “thus does not rest on a “binary’ view of market efficiency.”  Indeed, in “making the presumption rebuttable, Basic recognized that market efficiency is a matter of degree and accordingly made it a matter of proof.”  Id. at 10.

Second, the Court rejected Halliburton’s argument that trading that is based on factors other than price undermines Basic’s premise that purchasers and sellers invest in reliance on the integrity of the market price.  The Court held that “Basic never denied the existence” of investors that believe that the market price does not fully reflect public information, and,  in any event, surmised that such investors do indeed “implicitly” rely on the integrity of the market price.

Third, the Court found that the presumption of reliance does not conflict with Rule 23 or the Court’s recent decisions ratcheting up the degree of proof at class certification:  “Basic does not, in other words, allow plaintiffs simply to plead that common questions of reliance predominate over individual ones, but rather sets forth what they must prove to demonstrate such predominance.”  Id. at 14.

Finally, the Court found that Halliburton’s concerns about the “serious and harmful consequences” that the Basic presumption produces are more appropriately addressed by Congress, which has already addressed them in part through the Private Securities Litigation Reform Act of 1995 and the Securities Litigation Uniform Standards Act of 1998.

Having refused to overrule Basic, the Court turned to Halliburton’s alternative arguments that (1) plaintiffs should be required to prove that a misrepresentation impacted the stock price as a condition to invoking the presumption of reliance; and (2) if plaintiffs do not bear the burden of proving price impact, defendants should be allowed to introduce evidence of lack of price impact to rebut the presumption.  The Court refused to place the burden of proof on the plaintiffs:  “By requiring plaintiffs to prove price impact directly, Halliburton’s proposal would take away the first constituent presumption,” i.e., that the misrepresentation was public and material and that the stock traded in a generally efficient market.  In response to Halliburton’s concern that a misrepresentation might not impact the price of a stock even in an efficient market, the Court held that “Basic never suggested otherwise; that is why it affords defendants an opportunity to rebut the presumption by showing, among other things, that the particular misrepresentation at issue did not affect the stock’s market price.”  Id. at 18.

But the Court did hold that defendants could rebut the presumption by proving at the class-certification stage that the misrepresentations did not impact the market price of the stock.  The Court based its holding in part on the fact that price impact evidence is part of the market-efficiency determination.  Given this, it found that plaintiffs’ argument that defendants may not introduce such evidence at class certification “makes no sense, and can readily lead to bizarre results.”  The presumption is an “indirect proxy” of showing price impact, and “an indirect proxy should not preclude direct evidence when such evidence is available.”  Id. at 20.  In so holding, the Court distinguished Amgen:  price impact “is ‘Basic’s fundamental premise.’  It thus has everything to do with the issue of predominance at the class certification stage.”  Id. at 22 (quoting Halliburton I).   In contrast, “materiality is a discrete issue that can be resolved in isolation from the other prerequisites.”  Id.

The Court summarized its price-impact holding as follows:

Our choice in this case, then, is not between allowing price impact evidence at the class certification stage or relegating it to the merits.  Evidence of price impact will be before the court at the certification stage in any event.  The choice, rather, is between limiting the price impact inquiry before class certification to indirect evidence, or allowing consideration of direct evidence as well.  As explained, we see no reason to artificially limit the inquiry at the certification stage to indirect evidence of price impact.  Defendants may seek to defeat the Basic pre­sumption at that stage through direct as well as indirect price impact evidence.

Id. at 22-23

Halliburton II is Important, but Will Not Impact the Merits of Many Cases

Halliburton II presented two very important issues: the viability of Basic, and the need to prove price impact.  After the Court granted cert in Halliburton II, most defense lawyers seemed to actively hope that the Court would put an end to securities class actions.  But after some time, most defense lawyers seemed to come around to the view that the end of Basic would result in a securities litigation train wreck, with plaintiffs’ firms filing individual and large collective actions that would be quite difficult and expensive to manage, while the government would also step up enforcement, since the federal and state governments wouldn’t allow under-regulation of the securities markets, at least for long.  And those who still hoped for the end of Basic had their hopes dashed by the Halliburton II oral argument, in which the justices did not seem interested in overruling Basic, and instead seemed focused on the price-impact argument.  Since that argument, most of the discussion has been about the potential price-impact ruling.

What impact will the price-impact ruling have?  For starters, it’s important to remember that the ruling will only affect securities class actions that have survived a motion to dismiss – class certification is premature before then.  It wouldn’t be economical to adjudicate class certification while parties moved to dismiss under Rule 12(b)(6) and the Reform Act, and adjudicating class certification before rulings on motions to dismiss could result in defendants waiving their right to a discovery stay under the Reform Act.

It’s also important to remember that most securities class actions challenge many statements during the class period.  Although there could be strategic benefit to a ruling that a subset of the challenged statements did not impact the stock price – for example, shortening the class period or dismissing especially awkward statements – a finding that some statements had an impact would support certification of some class, and thus would allow the case to proceed.

It is impossible to say what percentage of the cases that survive motions to dismiss would be good candidates for price-impact disputes at class certification.  To be sure, defendants will make price-impact arguments in most cases in which there is some basis to make the argument.  But the number of cases in which there is a real issue, much less a knock-out blow, is likely relatively small.  Some types of cases, such as biotech cases and cases involving companies with a low volume of public statements, tend to present fewer economic problems.  More generally, the experience in the Second and Third Circuits before Amgen is cause for some skepticism.  Despite standards for class certification that allowed defendants to contest materiality and price impact, defendants seldom defeated class certification.

It also is debatable whether a price-impact rule will weed out many more bad cases on a net basis.  For example, cases that suffer from a price-impact problem typically also suffer from some other fatal flaw, such as the absence of loss causation or materiality.  Indeed, the price-impact issue in Halliburton was based on evidence about the absence of loss causation.  (Nevertheless, it may be helpful to have a cleaner legal argument to make about the underlying lack of logic to the claims.)

Defendants will lose an important feature of the pre-Halliburton II world: the ability to make no-price-impact arguments in settlement discussions in the absence of a ruling about them.  Now, defendants will make and obtain rulings on class certification arguments that they previously could have asserted would be resolved in their favor at summary judgment or trial, if necessary. Plaintiffs will press harder for higher settlements in cases with certified classes.  Prominent plaintiffs’ lawyers make this point in Alison Frankel’s blog about Halliburton II.  The more sophisticated firms already think through price impact and related issues as they evaluate which cases to pursue, and I expect plaintiffs’ lawyers to make that point in the wake of Halliburton II as well.

Yet plaintiffs certainly would have preferred to have the Court eliminate any fight over price impact at class certification.  They will face another hurdle and greater costs, and will have to adapt.  Plaintiffs’ lawyers likely will attempt to bring more Section 11 claims, where reliance is not an element.  However, Section 11 claims aren’t possible without a registered offering, and the damages are limited.  Plaintiffs’ lawyers also will try to re-cast their misrepresentations as omissions claims, and thus invoke Affiliated Ute’s presumption of reliance for claims of omission.  But plaintiffs face an uphill legal battle on this issue, as we wrote last winter.  And they likely will not file cases in which it is clear that they face a difficult and expensive class-certification battle – or they will try to settle them before class certification.

One thing that is certain is that Halliburton II will increase defense costs.  Whether the increased defense costs will be worth it will be the subject of much debate in individual cases, and in the big picture over time.  In the coming months, I will write about post-Halliburton II issues, including the shape of the price-impact dispute, and the cost-benefit of the new world of class-certification.

Cybersecurity Securities Class Actions are Coming: Predictions, Analysis, and Practical Guidance

Posted in Board Oversight, Cyber Security, Falsity Analysis, Scienter Analysis, Securities Class Action, Shareholder Derivative Action

Last fall, I wrote about board oversight of cybersecurity and derivative litigation in the wake of cybersecurity breaches.  I plan to update my thoughts later this year, after we see developments in the recently filed Target and Wyndham derivative actions, and learn the results of the 2014 installment of Carnegie Mellon’s bi-annual CyLab Governance of Enterprise Security Survey, which explores oversight of cybersecurity by boards of directors and senior management.

In this post, I’d like to focus on cybersecurity disclosure and the inevitable advent of securities class actions following cybersecurity breaches.  In all but one instance (Heartland Payment Systems), cybersecurity breaches, even the largest, have not caused a stock drop big enough to trigger a securities class action.  But there appears to be a growing consensus that stock drops are inevitable when the market better understands cybersecurity threats, the cost of breaches, and the impact of threats and breaches on companies’ business models.  When the market is better able to analyze these matters, there will be stock drops.  When there are stock drops, the plaintiffs’ bar will be there.

And when plaintiffs’ lawyers arrive, what will they find?  They will find companies grappling with cybersecurity disclosure.  Understandably, most of the discussion about cybersecurity disclosure focuses on the SEC’s October 13, 2011 “CF Disclosure Guidance: Topic No. 2” (“Guidance”) and the notorious failure of companies to disclose much about cybersecurity, which has resulted in a call for further SEC action by Senator Rockefeller and follow-up by the SEC, including an SEC Cybersecurity Roundtable on March 24, 2014.  But, as the SEC noted in the Guidance, and Chair White reiterated in October 2013, the Guidance does not define companies’ disclosure obligations.  Instead, disclosure is governed by the general duty not to mislead, along with more specific disclosure obligations that apply to specific types of required disclosures.

Indeed, plaintiffs’ lawyers will not even need to mention the Guidance to challenge statements allegedly made false or misleading by cybersecurity problems.  Various types of statements – from statements about the company’s business operations (which could be imperiled by inadequate cybersecurity), to statements about the company’s financial metrics (which could be rendered false or misleading by lower revenues and higher costs associated with cybersecurity problems), to internal controls and related CEO and CFO certifications, to risk factors themselves (which could warn against risks that have already materialized) – could be subject to challenge in the wake of a cybersecurity breach.

Plaintiffs will allege that the challenged statements were misleading because they omitted facts about cybersecurity (whether or not subject to disclosure under the Guidance).  In some cases, this allegation will require little more than coupling a statement with the omitted facts.  In cybersecurity cases, plaintiffs will have greater ability to learn the omitted facts than in other cases, as a result of breach notification requirements, privacy litigation, and government scrutiny, to name a few avenues.  The law, of course, requires more than simply coupling the statement and omitted facts; plaintiffs must explain in detail why the challenged statement was misleading, not just incomplete, and companies can defend the statement in the context of all of their disclosures.  But in cybersecurity cases, plaintiffs will have more to work with than in many other types of cases.

Pleading scienter likely will be easier for plaintiffs as well.  With increased emphasis on cybersecurity oversight at the senior officer (and board) level, a CEO or CFO will have difficulty (factually and in terms of good governance) suggesting that she or he didn’t know, at some level, about the omitted facts that made the challenged statements misleading.  That doesn’t mean that companies won’t be able to contest scienter.  Knowledge of omitted facts isn’t the test for scienter; the test is intent to mislead purchasers of securities.  However, this important distinction is often overlooked in practice.  Companies will also be able to argue that they didn’t disclose certain cybersecurity matters because, as the Guidance contemplates, some cybersecurity disclosures can compromise cybersecurity.  This is a proper argument for a motion to dismiss, as an innocent inference under Tellabs, but it may feel too “factual” for some judges to credit at the motion to dismiss stage.

As this analytic overview shows, cybersecurity securities class actions, on the whole, likely will be virulent.  Companies, of course, are talking about cybersecurity risks in their boardrooms – and they should also think about how to discuss those risks with their investors.  The best way for companies to lower their risk profile is to start to address this issue now, by thinking about cybersecurity in connection with all of their key disclosures, and enhancing their disclosures as appropriate.

Perfection and prescience are not required.  Effort matters most.  Companies that don’t even try will stand out.  As I’ve written in the context of the Reform Act’s Safe Harbor for forward-looking statements, judges are skeptical of companies whose risk factors remain static over time, and look favorably on companies who appear to try to draft meaningful risk factors.  I thus construct a defense of forward-looking statements by emphasizing, to the extent I can, ways in which the company’s risk disclosures evolved, and were tailored and focused.  I predict that the same approach will prove effective in cybersecurity cases.


D&O Discourse Authors Davis and Greene to File Amicus Brief in Omnicare Case

Posted in Falsity Analysis, Securities Class Action, Statements of Opinion, Supreme Court

My partner Claire Loebs Davis and I are honored to be working with Washington Legal Foundation on a U.S. Supreme Court amicus brief in the Omnicare securities class action.  Omnicare concerns what makes a statement of opinion false.

As many of our readers know, Claire and I feel that improvement in the law on statements of opinion is of great importance for companies, their directors and officers, and their D&O insurers.  Although Omnicare arises in the context of Section 11, the issues raised are fundamental to the question of what makes a statement of opinion false, and it thus is important for Section 10(b) cases as well.  We are thrilled to have a chance to influence how this area of law develops.

Update: Here is a link to the brief Claire and I filed on June 12, 2014.

You can find the docket and all of the briefs on the SCOTUSblog page for Omnicare.

Here is a link to Claire’s D&O Discourse blog post on the Sixth Circuit’s (incorrect) decision in Omnicare.  Here is a link to the Law360 version of Claire’s post, which Omnicare cited in its cert petition.

Here are links to other helpful articles about the Omnicare case:

Securities Defense Bar Has High Hopes Riding On Omnicare

Important Conflict Being Overlooked In Omnicare Case

We will update this post with further links as the matter progresses.


Ineffective Motions to Dismiss Erode the Power of the Reform Act

Posted in Defense Counsel, Falsity Analysis, Litigation Strategy, Motions to Dismiss, Safe Harbor, Scienter Analysis, Securities Class Action, Statements of Opinion, Supreme Court

In 1995, public companies and their directors and officers received one of the greatest statutory gifts in the history of American corporate law:  the Private Securities Litigation Reform Act.  The Reform Act established heightened standards for pleading falsity and scienter, among other protections, to allow for dismissal before discovery in a fair percentage of cases.  That was a tremendous change from the pre-Reform Act world, in which dismissals were infrequent and expensive discovery was the norm.

The provisions of the Reform Act make motions to dismiss in securities cases different from those in any other area of law, and guide our strategy in every case that we litigate.  As a full-time securities litigation defense lawyer, I feel a responsibility to understand the Reform Act and the cases applying it with as much sophistication as possible.  I have a sense of pride in my Reform Act analysis.  It may sound hokey, but I consider myself a craftsman, and I know that some of the most effective full-time securities litigators tend to feel the same.

I was recently asked about the biggest threats to the Reform Act’s protections, and have since been giving that question a lot of thought.  To be blunt, the biggest threat is the failure by many defense firms to make rigorous arguments on motions to dismiss that hold plaintiffs to the strict pleading standards of the Reform Act, allowing for court decisions that likewise lack rigor and fail to enforce the Act’s high pleading burdens.

This lack of technical rigor has many causes.  One factor is the dwindling number of securities litigation defense specialists, caused by the downturn in classic securities litigation cases calling for straightforward Reform Act motions to dismiss.  Beginning in 2006, securities litigation defense has mostly consisted of stock-option backdating derivative cases, large credit-crisis cases, and merger objection cases.  Through these waves, very few securities litigators remained dedicated to studying Reform Act developments and devising better arguments that take advantage of its provisions.  As a result, today there are relatively few practitioners whose practices are devoted to securities litigation defense – defense lawyers who sweat over subtleties in the law that in isolation may seem trivial, but which collectively make a big difference in the development of the law.

Another factor is the biglaw approach to writing motions to dismiss “by committee.”  Biglaw firms tend to write motions with large teams composed of new associates, mid-level associates, senior associates, and partners.  Writing by committee doesn’t work.  It is not only expensive, it is ultimately far less effective.  If the first draft of a motion is written without sufficient intellectual rigor and sophisticated understanding of the law and practice of securities litigation, it is difficult to reach an end result that will compensate for these deficiencies.  To draft the best motion to dismiss possible, Reform Act “craftsmen” should be involved in the process from the beginning, the entire drafting team needs to coordinate closely on the strategic objectives of the motion, and all the attorneys need to be well trained to appreciate the subtleties of the law.

Whatever the cause, the declining quality of many motions to dismiss is leading to a deterioration of the law that is eroding the Reform Act’s protections.  The rate of dismissals remains relatively high, but I predict that the dismissal rate will decrease, perhaps dramatically, over time as the law becomes more lax.

Below, I discuss the building blocks of a strong motion to dismiss and then address flaws found in many that I have seen filed lately – both by practitioners who do not specialize in the field, and by some “go to” biglaw firms with departments that specialize in securities litigation.

Constructing a Strong Motion to Dismiss

The Reform Act erected high hurdles for plaintiffs to clear before requiring a company to be put through the burdens of discovery:

  • To plead the falsity of a challenged statement of fact, plaintiffs must plead inconsistent contemporaneous facts.
  • To plead a false statement of opinion, in most circuits plaintiffs must plead that the statement was both objectively false and subjectively false, meaning they must show the speaker did not genuinely believe the opinion expressed.
  • To plead that the defendant made a false statement with intent to defraud, plaintiffs must plead facts demonstrating a strong inference that the defendant either knew the statement was false or was extremely and deliberately reckless in choosing not to find out whether it was true or false.
  • Even if plaintiffs plead facts demonstrating it was false, a forward-looking statement is not actionable under the Safe Harbor provisions of the Reform Act if either: (1) the statement was accompanied by meaningful cautionary statements, or (2) plaintiffs fail to plead that the speaker had actual knowledge of the statement’s falsity.

A rigorous motion to dismiss uses the Reform Act’s pleading tools in the most advantageous way possible, by really understanding them and maximizing their usefulness.  These tools give defense lawyers the opportunity to delve into factual issues in a manner that is unusual in motion -to-dismiss practice, and which may feel unnatural to attorneys who are not securities litigation specialists or who didn’t become securities litigation specialists during the Reform Act era.  An effective motion to dismiss not only dismantles the complaint with these tools, but capitalizes upon them to tell the judge a compelling story of an honest company that did its best to make straightforward disclosures to the market.

The Reform Act’s standards give judges enormous discretion; they can dismiss most complaints, or not, with very little room to challenge their decisions upon appeal.  Winning motions recognize the human element to  this discretion.  Even if a complaint is technically deficient, judges are less likely to dismiss it (certainly less likely to dismiss it with prejudice) if they nevertheless get the feeling that the defendants committed fraud.  Effective motions use the leeway given to defendants by the Reform Act to give judges a sense of comfort that they are not only following the law, but that by strictly applying the Reform Act’s protections, they are also serving justice.  On the other hand, one of the most common flaws in ineffective motions to dismiss is the use of formulaic and hyper-technical arguments, which fail to take advantage of the Reform Act to dig into the facts of the individual case, expose the flaws of each complaint in detail, and tell the judge a compelling story of the case that negates the inference of scienter.

Flaws Found in Many Motions to Dismiss

Flaws in Arguments against Falsity

The first element of a claim under Rule 10b-5(b) – the classic securities claim – is a false or misleading statement.  As we recently wrote, it is an incorrect statement of law to characterize this element as requiring a “materially false statement or omission.”  An omission is only actionable if it made what the defendant said materially misleading (or he or she otherwise had a duty to disclose it, which is a rare assertion as the main claim in a securities class action).

Yet if I had a dollar for every motion to dismiss that contained this misstatement of law, I would be writing this blog from a vacation home in Hawaii.  This is not a semantic issue; the difference between an “omission” and a “misleading statement” is enormous.  Every disclosure problem involves dozens or even hundreds of omitted facts that seem “material” in the sense that an investor would want to know them, but far fewer involve statements that were materially misleading (it is the statement that must be material, not the omitted fact) as a result of the omission.  I realize that many courts, including the U.S. Supreme Court, use this incorrect terminology.  But that doesn’t mean we need to parrot it – and every time that we do, we weaken the standard that is an explicit part of the Reform Act statute.

Defense lawyers’ loose language is a symptom of a bigger problem:  a lack of focus on falsity.  The allegedly false statements frame the entire case; other defense arguments are derived from the attack on plaintiffs’ falsity claims.  Foremost among the arguments derived from a strong falsity argument is the argument against scienter.  Scienter requires plaintiffs to show that a speaker knew what he or she said was false.  Falsity thus sets the stage for the scienter analysis – if there was no false statement to begin with, there can be no knowledge of that falsity.  On the other hand, the more egregiously false plaintiffs can make a statement appear, the easier it will be for them to show knowledge of falsity.  A strong scienter argument has as its North Star, “scienter as to what?”  That “what” must be a false statement, and a good motion to dismiss will enforce that structure from the beginning.  I cringe when I read a motion to dismiss that addresses scienter before falsity.  That is simply backwards.

The lack of focus on falsity infects the way defense firms tend to argue against falsity.  The Reform Act falsity standard generally requires the plaintiffs to allege contemporaneous facts that are inconsistent with each challenged statement.  That is a high hurdle.

To be sure, it isn’t easy to make a fact-specific argument against falsity; it requires a great command of the complaint and judicially noticeable documents, which isn’t the forte of most litigators.  And it can seem “too factual” to general litigators, or to many senior securities litigators who became securities litigation specialists under the pre-Reform Act regime, where motions to dismiss had to be simple and safe to have any chance of success under lenient pleading standards.  Perhaps for these reasons, in addition to those discussed above, a large number of motions to dismiss bypass this advantageous and fundamental argument, or fail to emphasize it, and instead opt for arguments that lump statements together by type and argue against them as a group in a boilerplate fashion.  In my view, one of the worst arguments of this type is the “puffery” defense – which basically concedes that a statement was false, but contends it was too immaterial to be actionable.  The subtext is cavalier, and unlikely to reassure a dubious judge: “sure the defendant lied, but it doesn’t matter because no one cared.”  Although courts do sometimes accept this argument, whether to do so or not amounts to an unprincipled coin-flip, and it is often made at the expense of better and more definite arguments.  For example, statements constituting “puffery” also generally qualify as statements of opinion, which have a standard for falsity that is protective and can be analyzed specifically.

The Reform Act called out forward-looking statements for special analysis and protection.  As we have previously written, the Safe Harbor is not as safe as Congress intended.  Because they think it goes too far, and can give companies a “license to lie,” many judges go to great lengths to avoid the statute’s plain language.  Many defense lawyers’ arguments not only fail to address this judicial skepticism, but actually reinforce it.  They do this by relying solely on the Safe Harbor’s technical elements, while failing to simultaneously contend that the forward-looking statements in question also had a reasonable basis, and the company’s cautionary language was a good-faith effort to describe specific risks the company faced.  Such arguments based only on the letter of the Safe Harbor ring of “caveat emptor,” which the law has been trying to shake for centuries.

Flaws in Arguments against Scienter

Scienter allegations are of two types:  allegations pleading facts about what the defendant knew, to attempt to plead that he or she knew the challenged statements were false; and, far more prevalent, allegations that the defendant “must have” meant to lie, based on circumstantial considerations such as a defendants’ stock sales, corporate transactions, the temporal proximity of the challenged statement to the disclosure of the “truth,” and the relationship of the subject of the challenged statements to the company’s “core operations.”  As with falsity, the primary flaw in most defense arguments against scienter is with their failure to engage in a fact-specific analysis of the complaint’s allegations about what the defendants knew in regard to each specific challenged statement. All too often, defendants allow themselves to be drawn to the plaintiffs’ preferred ground of battle, focusing just on arguing about the sufficiency of the circumstantial evidence that plaintiffs use to create the impression that the defendants must have done something wrong.

Circumstantial scienter allegations are only ways to try to make an educated guess about what the speaker knew or intended.  But the Reform Act’s scienter standard requires particularized pleading yielding a “strong inference” that the defendant lied on purpose – a very high standard.  So it makes no sense for defense counsel not to approach the issue directly, by making it clear that the speaker did not lie, and holding plaintiffs to the strict standard of showing specific scienter as to each challenged statement.

For this reason, all effective motions to dismiss start by testing the complaint’s allegations that the defendants actually knew, or were intentionally reckless about not knowing, the facts establishing falsity.  This means that, for each statement and each defendant, the motion to dismiss needs to isolate the statement and the reasons that the complaint alleges it was false, and analyze what the complaint alleges each defendant knew about those facts at the time he or she made each challenged statement. Without this focus on each specific challenged statement, the scienter inquiry is vague, and becomes more about whether the defendant seems bad, or had generally bad motives, than whether he lied on purpose.  A good motion to dismiss does not let plaintiffs get away with these kinds of generalized allegations.

The problem is made worse if defense counsel approaches falsity categorically, without careful scrutiny of the reasons the complaint alleges the challenged statements were false.  Without this focus, defense counsel can’t meaningfully answer the central question in the Reform Act analysis – “scienter as to what?” – because there isn’t a sufficient nexus between the challenged statements and contemporaneous facts that made the statements false.  The scienter inquiry thus becomes unmoored from knowledge that specific statements were false.  The result is a lower burden for plaintiffs:  if they are able to plead falsity, and the defendants seemed to know something about the general subject matter, scienter is almost a foregone conclusion.

This problem is even worse under the “core operations” inference of scienter, and the “corporate scienter” doctrine.  Each of these theories allows a plaintiff to avoid pleading specific facts establishing the speaker’s scienter.  For example, the core operations inference posits that scienter can be inferred where it would be “absurd to suggest” that a senior executive doesn’t know facts about the company’s “core operations.”  Many motions to dismiss set up some formulation of this statement as a legal rule and make a simplistic syllogistic argument from it.  Such arguments devolve into “did not, did so” debates, and thus play into plaintiffs’ hands because they are detached from knowledge of falsity.

Instead, the right approach to the core operations inference is to understand that it requires a falsity so blatant that we can strongly infer that the executive had knowledge of the exact facts that made the statement false – not just the subject matter of the facts.  The most effective defense against the core operations inference thus focuses on falsity first, to show that even if a statement is false, it is at least a close call – making it hard for plaintiffs to contend that defendants must have known of this falsity.  This can’t be done effectively, of course, if the argument against falsity is categorical (i.e., embraces arguments such as “puffery,” rather than discussing the specific statements), or otherwise fails to address the falsity allegations in detail.  Of course, it is impossible to make this argument effectively if the scienter section precedes the falsity section of the brief.


We plan to address in greater depth some of the technical Reform Act issues in later posts, in hopes that we can improve the craftsmanship of motions to dismiss.  These are important issues to discuss as a defense bar, because each motion to dismiss that fails to maximize the Reform Act’s protections runs the risk of weakening the law for the rest of us.



Derivative Litigation Representation: Strategic and Ethical Issues

Posted in Board Oversight, Corporate Governance, Cyber Security, D&O Insurance, Defense Costs, Defense Counsel, Delaware Courts, Securities Class Action, Shareholder Derivative Action

Shareholder litigation comes in waves.  There is a widespread belief that the next big wave will be shareholder derivative litigation – a shareholder’s assertion of a claim belonging to the corporation, typically brought against directors and officers, alleging corporate harm for a board’s failure to prevent corporate problems.

Derivative cases filed as tag-alongs to securities class actions have long been commonplace, and frequently are little more than a nuisance.  Over the years, there have been sporadic large derivative actions concerning other areas of legal compliance – typically over a very large corporate problem.   Non-disclosure derivative litigation filings recently have seemed more frequent, and there have been some large settlements that have come as a result.  And the specter of cyber liability derivative suits looms large – not surprisingly, Target shareholders just filed derivative litigation related to the recent customer data breach.  Whether the forecasted non-disclosure derivative-litigation wave materializes, or remains a sporadic occurrence in the larger world of D&O litigation, is one of the issues I’m watching closely in 2014 and beyond.

This potential wave raises issues that are unique to derivative litigation.  One key issue that has not been analyzed enough is representation: which lawyers can and should represent the company and the individual defendants in derivative litigation?

Because a derivative litigation claim belongs to the corporation, it puts the corporation in an odd spot.  A shareholder, as one of the corporation’s “owners” (usually a really, really small owner – but an owner nevertheless), is trying to force the company to bring a claim against the people who run the company.  The law says, however, that those people, the directors, get to decide whether the company should sue someone – including themselves – unless a shareholder can show that they couldn’t make a disinterested and independent decision.   Thus, to bring a derivative action, a shareholder must allege that it would have been futile to demand that the board take action, and defendants will typically challenge the lawsuit with a motion to dismiss for failure to make a demand (“demand motion”) on the basis that the demand-futility allegations aren’t sufficiently probative or particularized.

It is often said that the interests of the company and defendants are aligned through the demand motion, because they all have an interest in making sure that the shareholder follows proper governance procedures – namely, making a pre-suit demand on the board.  But this sort of statement prejudges the demand-futility allegations; it assumes that the allegations of futility are insufficient.  In Delaware and states that follow its demand law, proper corporate governance procedures require a shareholder either to make a demand or to plead demand-futility.  Only if and when the court rules that demand was required can we truly say that the interests of the company and defendants on the demand issue were aligned.  However, I don’t think this means that legal ethics require the company to be separately represented from the inception of a derivative action in all cases; the shared-interest view is arguable.   So if there are good practical reasons for joint representation from inception, and it causes no harm, so be it.  (That the primary lawyers are expensive relative to the D&O insurance limits isn’t a good reason for joint representation – it’s a good reason why those lawyers were the wrong lawyers for the matter.  But I digress.)

There’s also a compelling strategic reason to separate the representation from the beginning of the case.  A demand motion asks the court to allow the defendants to be the judge – to require the plaintiff to ask the directors to evaluate and bring claims against themselves and senior officers.  Thus, the company must overcome a judge’s skepticism that such an evaluation presents a “fox-guarding-the-chicken-coop” problem.  This is far easier to do if the company is separately represented and makes the demand motion.  It is true that courts frequently grant demand motions made during joint representation of the company and defendants.  But it is also true that joint representation always carries strategic risk, and the more serious the derivative litigation, the more unwise it is to take the risk.  Rather than make judgments in advance about which derivative litigation is serious, warranting a split, and which isn’t, allowing joint representation, I advocate splitting the representation from the outset – since the representation must be split up if demand is excused, splitting it from the outset imposes relatively little additional cost burden, if there’s appropriate coordination.

Representation between and among the defendants has strategic components, in addition to ethical considerations.  It can be strategically advantageous for individuals who aren’t accused of active wrongdoing to be separately represented from those who are.  That typically means officers and outside directors are represented separately in groups.  With this division, the court can see that the directors who would evaluate a demand don’t have the same lawyers as the people who allegedly engaged in active wrongdoing.  However, I don’t think that’s as strategically important for purposes of the demand motion as splitting up the company and defendants.  In evaluating a demand, the directors, acting as directors and not director-defendants, should be represented by counsel other than their litigation defense counsel.  Moreover, demand futility is judged at the time the suit is filed, not when the court decides the demand motion.  Thus, it isn’t technically necessary or legally accurate to send a “signal” of independence to the court through splitting up the representation further.  That said, in a very significant derivative case, and/or one in which the judge is new to derivative litigation, such an approach could be strategically advantageous.

It can sometimes be appropriate to consider even more divisions – for example, splitting the outside directors into audit-committee and non-audit-committee groups where audit-committee oversight is the main oversight allegation.  Such divisions may be ethically prudent or necessary later, but for purposes of the demand motion, they often don’t add much, if anything, since the demand motion is about the ability of a majority of the full board to consider a demand.

So, a typical case needs at least two lawyers from the outset – one for the company, and another for the individual defendants.  The type of derivative litigation we’re discussing often arises in the context of an underlying legal problem for which the company has lawyers – in a disclosure-related matter for a related securities class action, and in non-disclosure matters for other types of underlying matters (FCPA, antitrust, privacy, etc.).   To what extent should the lawyers defending the underlying matters be involved in the derivative action?

In general, I believe that the lawyers defending the underlying proceedings that created the corporate liability or harm (actual or potential) at issue in the derivative case should not defend the derivative case.  The reasons are similar to those I have written about in the context of using corporate counsel to defend a securities class action that may involve corporate counsel’s advice – there are tricky and hidden conflict issues, and the lawyers can be of better service to their clients as witnesses.

In derivative litigation, the problem can be even worse.  Corporate counsel typically advises on relevant corporate governance issues, such as compliance programs, the severity of legal risks that ultimately trigger the derivative litigation, board review of various risks, and preparation or review of board minutes.  Some companies are heavily guided in these areas by their corporate counsel, either directly in the boardroom or indirectly through advice to in-house counsel.   It is in the interests of the company and the board to be able to testify that they took a course of action, or didn’t do so, because of their lawyers’ advice.  The problem is greater than that of lawyer-as-witness – defense counsel should not be in the position of making judgments or recommendations that might be influenced by the law firm’s concerns about the public airing of its corporate work.

In derivative cases based on a disclosure problem, another representation issue arises:  whom should the securities class action defense counsel represent – the company or the defendants?   Securities class action defense counsel take different approaches to dividing derivative litigation representation.  Some will represent the company only, and have their securities class action individual defendant clients be represented by a different firm.  Others represent the individual defendants in the derivative action, and have the company represented by a different firm.   The right approach is a judgment call, but I prefer to have the securities class action defense counsel represent the individual defendants in the derivative action and have another firm represent the company.  That approach allows the lawyers in defense mode to fully remain in defense mode – they can defend the lack of merit to the charges of wrongdoing in all proceedings.   It also allows the defending lawyers to avoid the tension involved in simultaneously defending individuals in the securities class action and representing the potentially adverse company in the related derivative action.  This approach is possible with the right waivers, but I prefer the pure-defense approach.

Once the right lawyers are in place, how can and should the lawyers interact to prepare motions to dismiss and conduct other preliminary projects effectively – and cost-effectively?  The gating question is who should make the demand motion – the company or the defendants?  The company is really the right movant.  The demand motion is about the company’s corporate governance procedures, and the directors are involved not as directors but as individual defendants, so the purest approach is for the company to make the demand motion.

The same result makes sense from a strategic perspective.  The defendants have 12(b)(6) motions to make, and having them make both motions is awkward.   Although both motions say that the allegations (not the claims) aren’t good enough – the demand motion asserts that the allegations don’t raise a substantial likelihood of liability or other disabling interest sufficient to excuse demand, and the 12(b)(6) motion asserts they are not sufficient to state a claim – having the directors simultaneously assert that they could impartially consider a demand, but that the claims should be dismissed, is slicing the issues pretty finely.   If the defendants don’t make a 12(b)(6) motion, that problem is alleviated.  Many defense lawyers – including me from time to time – opine that the 12(b)(6) motions will fail if the demand motion fails, so defendants should just forego the 12(b)(6) motion entirely and make a 12(c) motion later, if necessary.  However, that foregoes the initial line of defense for the individuals.

It will be interesting to see if there is indeed a wave of more serious derivative litigation coming.  I will be on the look-out, and will write about other derivative-litigation issues that I think are of interest.

Halliburton: Is the Fix as Basic as Alleging Omissions under Affiliated Ute? Or Is That Too Cute?

Posted in Class Certification, Fraud-on-the-Market Doctrine, Litigation Reforms, Litigation Strategy, Securities Class Action, Supreme Court

Even the most experienced securities defense attorneys regularly summarize Rule 10b-5(b) as creating a cause of action for “false or misleading statements and omissions of material fact.”  Courts –including the Supreme Court – routinely use the same shorthand.   When I was a new securities litigation defense attorney, one of the first things that I learned was the importance of adding the rest of the sentence: “false or misleading statements and omissions of material fact necessary to make statements made not misleading.”

One of the most common misconceptions about the federal securities laws is that Rule 10b-5(b) creates a cause of action for omissions as well as for false or misleading statements.  But by the express terms of the rule, and Supreme Court precedent, omissions are only actionable if they cause an affirmative statement to be false or misleading because of the information that was omitted.  In other words, when a claim is based upon an alleged omission, it is not enough for a plaintiff to demonstrate that something was omitted, or even that the omitted fact was material.  Rather, in order to state a cause of action, the omitted information must have made an affirmative statement materially misleading by creating “an impression of a state of affairs that differs in a material way from the one that actually exists.” See Brody v. Transitional Hosps. Corp., 280 F.3d 997, 1006 (9th Cir. 2002).

It is understandable that plaintiffs’ attorneys would try to obscure this standard.  If all they needed to establish was that material information was omitted, it would be relatively easy to bring a successful claim.  No matter how much is disclosed, you can always find something that was omitted, and the squishy standard for materiality leaves plenty of room to make a case that the omission was material.  But the key to many successful motions to dismiss is to hold plaintiffs to the text of the rule:  whether they are alleging an affirmative lie, or a lie by omission, they must point to a statement that was false or misleading.

In the building frenzy among securities attorneys over the possible consequences of the Supreme Court’s upcoming ruling in Halliburton Co. v. Erica P. John Fund, this key distinction has been widely forgotten.  As attorneys contemplate the possible demise of the fraud-on-the-market presumption laid down in Basic v. Levinson, there is wide speculation about how, in the face of such a ruling, securities class actions might continue. (See Doug Greene’s discussion of the possible impact of Halliburton.)  One theory that has been repeatedly put forward by defense attorneys and legal commentators is that plaintiffs’ attorneys could cast their claims as alleging only material omissions, rather than false or misleading statements.  The theory is that this approach would allow plaintiffs to sidestep the formidable obstacle of proving class-wide reliance in the absence of the fraud-on-the-market presumption, by taking advantage of a Supreme Court ruling that indicated that proof of reliance was not necessary to support a claim based on omissions. See Affiliated Ute Citizens v. United States, 406 U.S. 128 (1972).

Wrote one securities litigation defense firm: if the Halliburton court rejects the fraud-on-the-market presumption, “plaintiffs could turn to the Affiliated Ute presumption, in which a plaintiff can avoid pleading actual reliance in a case framed as a material omission . . .The Affiliated Ute presumption will allow plaintiffs’ lawyers to recast their affirmative misrepresentation claims as pure omission claims, which do not need to rely on the fraud-on-the-market presumption to proceed.. . .Parties will vigorously litigate whether the crux of a case concerns affirmative misstatements, pure omissions, or both.”

But Affiliated Ute does not offer a quick fix to the potential elimination of Basic’s fraud-on-the-market presumption.  Affiliated Ute did not involve public statements or the securities markets, much less a securities class action under Rule 10b-5(b).  Rather, it involved face-to-face transactions among a relatively small group of individuals related to the allocation of Native American mineral rights.  The Affiliated Ute Court found that the defendants had failed to disclose material information to Native Americans as part of a fraudulent scheme to induce them to sell their mineral rights below market value.  The Court found that this created liability under Rule 10b-5(a) and (c), the subsections of the rule that create liability for a fraudulent “device, scheme, or artifice” or “practice or course of business.”  In these circumstances, the Court held that causation was established, and the plaintiffs did not need to prove “reliance” on the material omissions.

The Affiliated Ute ruling is thus based on the existence of a material omission as part of a fraudulent scheme.  But as the Supreme Court pointed out in Basic, and recently reaffirmed in Matrixx: “Silence, absent a duty to disclose, is not misleading under Rule 10b-5.”  Basic, Inc. v. Levinson, 485 U.S. 224, 239 n.17 (1988); Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1322 (2011).  No matter how material it might be, an omission is not actionable unless there is a duty to disclose.  See, e.g., In re Time Warner, Inc. Sec. Litig., 9 F.3d 259, 267 (2d Cir. 1993) (“[A] corporation is not required to disclose a fact merely because a reasonable investor would very much like to know that fact.”).  There are specific circumstances under which such a duty to disclose might arise – for example, when there is a fiduciary relationship between the parties, if an insider is trading stock, or under Items 303 or 503 of Regulation S-K relating to public offerings.

But Rule 10b-5(b), the traditional territory of securities class actions, imposes no such requirement.  For this reason, as several courts have pointed out, the “presumption” of reliance on material omissions that developed from Affiliated Ute does not implicate core securities fraud claims.  See, e.g., Regents of the University of California v. Credit Suisse First Boston, 482 F. 3d 372, (5th Cir. 2007) (clarifying that Affiliated Ute does not apply to actions for misrepresentations under Rule 10b-5(b)). Thus, plaintiffs cannot simply recast their securities fraud allegations as “omissions,” as many commentators have suggested, and cause the parties to have to “litigate whether the crux of a case concerns affirmative misstatements, pure omissions, or both.”  Plaintiffs may only state a claim under 10b-5(b) based on an affirmative misstatement – whether that affirmative statement was misleading because of what it said, or because of what it did not say.

Under Affiliated Ute itself, the presumption of reliance on omissions is only invoked under Rule 10b-5 if there is proof of a fraudulent “course of business” or a “device, scheme or artifice that operated as a fraud” – under the Rule’s little-used subsections (a) and (c).  Do these subsections – which are not necessarily dependent upon affirmative misstatements – create a route for plaintiffs to find a way around the potential rejection of the fraud-on-the-market presumption?  Maybe in some cases, where plaintiffs are able to allege additional facts necessary to show some form of “scheme” liability under these subsections.  See Credit Suisse, 482 F.3d at 384 (“Merely pleading that defendants failed to fulfill [a duty to disclose] by means of a scheme or act, rather than by a misleading statement, does not entitled plaintiffs to employ the Affiliated Ute presumption.”). But that potential “solution” raises more questions than it answers, since the law surrounding these subsections is far less developed that the law of Rule 10b-5(b), and incorporates a number of additional complexities.*

One thing is clear.  Affiliated Ute does not offer a straightforward solution for plaintiffs’ lawyers if the Halliburton Court takes away the fraud-on-the-market presumption.   Whether they phrase their allegations as claims of affirmatively false statements or statements made false by omission, they are still claims based on statements, not omissions, and current law requires that plaintiffs find a way to show class-wide reliance.


* For example, the courts have established that Rule 10b-5 imposes a duty to disclose material nonpublic information on a defendant who sells stock.  But this “omission” claim is difficult for plaintiffs’ lawyers to bring, because a plaintiff must be a contemporaneous buyer to have standing – which generally means the plaintiff must have purchased stock in the few days surrounding when the defendant sold.  The standing requirement also restricts damages for such a claim to a class of contemporaneous purchasers – a much smaller group than the typical class in a securities class action arising out of a false or misleading statement, which can include purchasers of stock over a period of several years.