The fifth of my “5 Wishes for Securities Litigation Defense” (April 30, 2016 post) is to move securities class action damages expert reports and discovery ahead of fact discovery.  This simple change would allow the defendants and their D&O insurers to understand the real economics of cases that survive a motion to dismiss, and allow the parties to make more informed litigation and settlement decisions.

Securities class actions are often labeled “bet the company” cases because they assert large theoretical damages and name the company’s senior management and sometimes the board as defendants.  In reality, however, very few securities class actions pose a real threat to the company or its directors and officers.  Most securities class actions follow a predictable course of litigation and resolution.  Nearly all cases settle before trial.  And, with the help of economists, experienced defense lawyers and D&O insurance professionals can predict with reasonable accuracy the settlement “value” of a case based on historical settlement information and their judgment.

Historically, settlement amounts were driven by an accurate understanding of the merits of the litigation and damages exposure.  Cases that weren’t dismissed on a motion to dismiss were often defended through at least the filing of a summary judgment motion and the completion of damages discovery.  This kind of vigorous defense is no longer economically rational in the lion’s share of cases, because of the high billing rates and profit-focused staffing of the typical defense firms—primarily firms with marquee names.  Those firms’ skyrocketing defense costs threaten to exhaust most or all of the D&O insurance towers in cases that are not dismissed on a motion to dismiss.  Rarely can such firms defend cases vigorously through fact and expert discovery and summary judgment anymore.

The reality of these economics is increasingly leading to mediations and settlements very early in the litigation, if a case isn’t dismissed.  But, though rational, this comes at a high price.  Early settlements are, by definition, less informed than later settlements.  Plaintiffs’ lawyers must push for a higher settlement payment to compensate for the risk that they are settling a meritorious case for too little, and to increase the baseline for a smaller percentage fee due to a lower lodestar.  Defendants and their insurers tend to be willing to overpay because they are saving on defense costs by not litigating further, and because there may be some downward pressure on the settlement amount since the plaintiffs’ lawyers will be doing less work too.

Damages considerations also loom large.  At an early mediation, before damages expert discovery, the parties typically come to the mediation only with a preliminary damages estimate that neither side has thoroughly analyzed, much less tested through intensive work with the experts and expert discovery.  Rigorous expert work often significantly reduces realistic damages exposure.  For example, stock drops that lead to a securities class action are often the result of multiple negative news items.  A rigorous damages analysis parses each item from the total stock drop to isolate the portion caused by the revelation of the allegedly hidden truth that made the challenged statements false or misleading.  A defense firm that is motivated to settle the litigation sometimes does not want to do this work, so that it can use the large bet-the-company damages figure to pressure the insurer into settling for an amount that the plaintiffs will take.  A defense lawyer might say, “Our economist says that damages are $1 billion, so the $30 million the plaintiffs are demanding is a reasonable settlement.”  But expert analysis and discovery may well push the $1 billion number down to a much lower number, which in turn would dramatically reduce a reasonable settlement amount.  Worsening this problem is the increasing unwillingness of mediators and plaintiffs’ lawyers to base settlement amounts on historical data—which places the preliminary damages analysis at the center of the negotiations.

This problem leads to my fifth wish: expert damages analysis and discovery should be the first thing we do after a motion to dismiss is denied.  This will help us know if the case is really a big case, or is a small case that just seems big.  Everyone would benefit.  Plaintiffs and defendants would be able to reach a settlement more easily, based on true risk and reward.  Insurers would know that they are funding a settlement that reflects the real risk, in terms of damages exposure.  And courts would feel more comfortable that they are approving (or rejecting) settlements based on a litigated assessment of damages.  Indeed, placing damages expert work first would help serve the core policy of our system of litigation: “to secure the just, speedy, and inexpensive determination of every action and proceeding.”  Federal Rule of Civil Procedure 1.

Although the logic of my wish would lead to full fact discovery before mediation as well, so that settlements can be fully informed, I favor a continued stay of fact discovery during early expert discovery.  Early expert discovery can be accomplished relatively quickly and efficiently, whereas fact discovery can be immediately and wildly expensive—which is primarily what drives very early settlements.  And although plaintiffs and defendants often disagree about the relevance of fact discovery on damages, the absence of fact discovery for consideration in damages analysis is a factor the parties can weigh in evaluating the damages experts’ opinions.  Unless and until the cost of discovery becomes more manageable, continuing the fact-discovery stay while expert damages discovery proceeds would strike the right balance.

Accelerating the timing of damages expert discovery would align it with the work required by damages experts to analyze price-impact issues under the Supreme Court’s 2014 decision in Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014) (“Halliburton II“).  In Halliburton II, the Supreme Court held that defendants may seek to rebut the fraud-on-the-market presumption of reliance, and thus defeat class certification, through evidence that the alleged false and misleading statements did not impact the market price of the stock.   Unifying these two overlapping economic expert projects would create efficiencies for the lawyers and economists.  Completing both of them before fact discovery starts would avoid unnecessary discovery costs if the Halliburton II opposition defeated or limited class certification, or if the damages analysis facilitated early settlement.

I’m sure it is not lost on readers that I just argued for a fundamental reform in the procedure for securities class action litigation to fix a problem that is primarily caused by the inability of typical defense firms to efficiently and effectively defend a securities class action even through summary judgment.  To say the least, a system of litigation that can’t accommodate actual litigation is broken.  Significant change in securities litigation defense is inevitable.

I hope that this series has provoked thought and discussion about ways to re-focus our system of securities litigation defense on its mission: to help directors and officers through litigation safely and efficiently, without losing their serenity or dignity, and without facing any real risk of paying any personal funds.  Here, again, are my five wishes:

  1. Require an interview process for the selection of defense counsel, to allow the defendants to understand their options; to evaluate conflicts of interest and the advantages and disadvantages of using their corporate firm to defend the litigation; and to achieve cost concessions that only a competitive interview process can yield.  (5 Wishes for Securities Litigation Defense: A Defense-Counsel Interview Process in All Cases)
  2. Increase the involvement of D&O insurers in defense-counsel selection and in other strategic defense decisions, to put those who have the greatest overall experience and economic stake in securities class action defense in a position to provide meaningful input.  (5 Wishes for Securities Litigation Defense: Greater Insurer Involvement in Defense-Counsel Selection and Strategy)
  3. Make the Supreme Court’s Omnicare decision a primary tool in the defense of securities class actions.  Obviously, Omnicare should be used to defend against challenges to all forms of opinions, including statements regarded as “puffery” and forward-looking statements protected by the Reform Act’s Safe Harbor for forward-looking statements.  But defense counsel should also take advantage of the Supreme Court’s direction in Omnicare that courts evaluate challenged statements in their full factual context.  Omnicare supplements the Court’s previous direction in Tellabs that courts evaluate scienter by considering not just the complaint’s allegations, but also documents incorporated by reference and documents subject to judicial notice.  Together, Omnicare and Tellabs allow defense counsel to defend their clients’ honesty with a robust factual record at the motion to dismiss stage.  (5 Wishes for Securities Litigation Defense: Effective Use of the Supreme Court’s Omnicare Decision)
  4. Increase the involvement of boards of directors in decisions concerning D&O insurance and the defense of securities litigation, including counsel selection, to ensure their personal protection and good oversight of the defense of the company and themselves.  (5 Wishes for Securities Litigation Defense: Greater Director Involvement in Securities Litigation Defense and D&O Insurance)
  5. Move damages expert reports and discovery ahead of fact discovery, to allow the defendants and their D&O insurers to understand the real economics of cases that survive a motion to dismiss, and to make more informed litigation and settlement decisions.

I am committed to helping shape a system for securities litigation defense that helps directors and officers get through securities litigation safely and efficiently, without losing their serenity or dignity, and without facing any real risk of paying any personal funds.

But we are actually moving in the opposite direction of this goal, and unless some changes are made, securities litigation will pose greater and greater risk to individual directors and officers.  It is time for the “repeat players” in securities litigation defense – D&O insurers and brokers, defense lawyers, and economists – to make some fundamental changes to how we do things.  Although most cases still seem to turn out fine for the individual defendants, resolved by a dismissal or a settlement that is fully funded by D&O insurance, the bigger picture is not pretty.  The law firms that have defended the lion’s share of cases since securities class actions gained footing through Basic v. Levinson – primarily “biglaw” firms based in the country’s several largest cities – are no longer suitable for many, or even most, securities class actions.  Fueled by high billing rates and profit-focused staffing, those firms’ skyrocketing defense costs threaten to exhaust most or all of the D&O insurance towers in cases that are not dismissed on a motion to dismiss.  Rarely can such firms defend cases vigorously through summary judgment and toward trial anymore.

Worse, these high prices too often do not yield strategic benefits.  A strong motion to dismiss focuses on the truth of what the defendants said, with support from the context of the statements, as directed by the U.S. Supreme Court in Tellabs and Omnicare.  Yet far too often, the motion-to-dismiss briefs that come out of these large firms are little more than cookie-cutter arguments based on the structure of the Reform Act.  And if a motion is lost, settlements are higher than necessary because the defendants often have no option but to settle in order to avoid an avalanche of defense costs that would exhaust their D&O insurance limits.  On the other hand, if settlement occurs later, it can be difficult to keep settlement within D&O insurance limits – and defense counsel’s analysis of a “reasonable” settlement can be influenced by a desire to justify the amount they have billed.

At the same time that defense costs are continuing to rise exponentially, securities class actions are becoming smaller and smaller, with two-thirds of cases brought against companies with market caps less than $2 billion, and almost half under $750 million.  Although catawampus securities litigation economics is a systemic problem, impacting cases of all sizes, the problem is especially acute in the smallest half of cases.  Some of those cases simply cannot be defended both well and economically by typical defense firms.  Either defense costs become ridiculously large for the size of the case and the amount of the D&O insurance limits, or firms try to reduce costs by cutting corners on staffing and projects – or both.  We see large law firms routinely chase smaller and smaller cases.  From a market perspective, it makes no sense at all.

So how do we achieve a better securities litigation system?  Five changes would have a profound impact:

  1. Require an interview process for the selection of defense counsel, to allow the defendants to understand their options; to evaluate conflicts of interest and the advantages and disadvantages of using their corporate firm to defend the litigation; and to achieve cost concessions that only a competitive interview process can yield.
  2. Increase the involvement of D&O insurers in defense-counsel selection and in other strategic defense decisions, to put those who have the greatest overall experience and economic stake in securities class action defense in a position to provide meaningful input.
  3. Make the Supreme Court’s Omnicare decision a primary tool in the defense of securities class actions.  Obviously, Omnicare should be used to defend against challenges to all forms of opinions, including statements regarded as “puffery” and forward-looking statements protected by the Reform Act’s Safe Harbor for forward-looking statements.  But defense counsel should also take advantage of the Supreme Court’s direction in Omnicare that courts evaluate challenged statements in their full factual context.  Omnicare supplements the Court’s previous direction in Tellabs that courts evaluate scienter by considering not just the complaint’s allegations, but also documents incorporated by reference and documents subject to judicial notice.  Together, Omnicare and Tellabs allow defense counsel to defend their clients’ honesty with a robust factual record at the motion to dismiss stage.
  4. Increase the involvement of boards of directors in decisions concerning D&O insurance and the defense of securities litigation, including counsel selection, to ensure their personal protection and good oversight of the defense of the company and themselves.
  5. Move damages expert reports and discovery ahead of fact discovery, to allow the defendants and their D&O insurers to understand the real economics of cases that survive a motion to dismiss, and to make more informed litigation and settlement decisions.

These five changes are among the top wishes I have to improve securities litigation defense, and to preserve the protections of directors and officers who face securities litigation.  Over the next several months, I will post about each one.  Here are links to the posts in the series so far:

Wish #1:  5 Wishes for Securities Litigation Defense: A Defense-Counsel Interview Process in All Cases

Wish #2:  5 Wishes for Securities Litigation Defense: Greater Insurer Involvement in Defense-Counsel Selection and Strategy

Wish #3:  5 Wishes for Securities Litigation Defense: Effective Use of the Supreme Court’s Omnicare Decision

Wish #4:  5 Wishes for Securities Litigation Defense: Greater Director Involvement in Securities Litigation Defense and D&O Insurance

Wish #5:  5 Wishes for Securities Litigation Defense: Early Damages Analysis and Discovery