I am grateful for the enthusiastic feedback I’ve received on my three-part blog post “Who is Winning the Securities Class Action War—Plaintiffs or Defendants?”  I especially appreciate the time Kevin LaCroix took to write a post addressing my post in his leading blog, The D&O Diary.

With the benefit of 25 years’ experience defending directors and officers in securities class actions, shareholder derivative actions, and SEC investigations, I’ve had a front-row seat to the dynamics I described in my three-part post.  Directors and officers expect that their D&O insurance will protect them when they are sued.  They expect a high-quality defense at a cost that allows them to defend the litigation on the merits and to settle when it’s strategically smart, at a price that doesn’t bespeak guilt.

But I’m deeply concerned that directors and officers are getting far less than they expect—and it’s a double-whammy: while the cost of securities litigation defense has dramatically increased, the quality of this expensive defense has dramatically decreased.  To be sure, a handful of defense firms provide a quality defense at a price that’s appropriate for the size of the litigation, especially in the so-called “mega cases.”  However, in smaller cases, and overall, directors and officers face far greater reputational and financial risk than they appreciate.  They expect better—and deserve better—from their lawyers and D&O insurance.

So my main message is simple: for defendants, the securities class action system is broken.  The defense bar is highly splintered, comprising many dozens of firms, with multiple possible litigators within each firm.  Far too many non-specialists are hired to defend cases simply because their law firm is well-known or handles the company’s corporate work.  Although these lawyers know or can learn the basics of the law, they can never possess the things that set specialists apart, such as the years of investment necessary to build the trust of plaintiffs’ lawyers, mediators, and D&O insurers.  The quality of defense, overall, is far lower than it should be.  And, to add insult to injury, defendants typically pay a fortune for their defense, whether led by a specialist or generalist.

Securities class actions are manageable if they are defended correctly by the right lawyers for the particular case.  But securities class action defendants can’t be reasonably expected to select the right lawyers for their unique case.  The vast majority of director and officer defendants have never been through a securities class action before, and no one spends time researching whom they’d hire if they were to face a securities case someday.

Defendants are put in an awful position when a case is filed:

  • From one side, dozens of defense firms descend on them and bombard them with bold boasts.
  • From the other side, the company’s regular outside firm assures them that this is just a straightforward legal problem that their litigation department can easily handle just fine—and never mind that the law firm may have provided the legal advice on the very disclosures challenged in the litigation.

The result is near-anarchy—as I explained in Part II.

In contrast, as I explained in Part I, the plaintiffs’ bar comprises a relatively small number of full-time nationwide securities class action specialists.  Within this small group, there is nevertheless a diversity of types of firms that allows them to efficiently cover all types of cases, large and small.  The tailoring of plaintiffs’ firms to types of cases happens through self-selection inherent in firms picking particular cases to file, and through the lead plaintiff competition.  The contingent-fee nature of their cases creates further efficiency.

Defendants can’t win the securities class action war unless the defense bar can match the plaintiffs’ bar’s effectiveness and efficiency.  But to create the right defense bar, the defendants need help.  The best sources of help—indeed the only practical sources—are D&O insurers, as I explained in Part III.

Defendants are entitled to a defense that allows them to get through securities litigation safely and comfortably, and without any real financial risk.  Indeed, they already expect that their D&O insurers will take care of them.  Giving insurers a greater role in defending securities class actions will allow insurers to do exactly that.

I feel strongly about these issues and am encouraged by the agreement and enthusiasm I’ve heard from readers.  But I’ve heard a bit of skepticism too, and would like to briefly address it.

How can defendants be losing the war given the high dismissal rate and various legislative and Supreme Court successes?

The big picture.  Before evaluating individual battles, it’s useful to look at the big picture—and it’s bleak.  Securities litigation defense, as a practical matter, doesn’t even involve defending securities litigation anymore.  Settlement values as a percentage of damages are increasing.  Defense costs are skyrocketing. Cases can’t be defended through summary judgment without risking that there won’t be enough insurance limits to cover both defense costs and a settlement.  In my experience, most of the defense bar doesn’t actually defend cases past the motion to dismiss stage anymore.  If defendants lose the motion to dismiss and defense counsel aren’t prepared to press a defense through summary judgment and toward trial (because of stage fright, fear of an economic catastrophe, or both), the only rational economic approach is to settle the case—and the plaintiffs’ bar is keenly aware of that dynamic.

Indeed, the words “litigation” and “defense” in the phrase “securities litigation defense” are misnomers.  It’s hard to say that defendants are winning the war when they don’t actually fight.

Dismissal rate.  As I wrote in Part II, the relatively high dismissal rate masks the defense side’s dysfunction.  The right question to ask is how much higher the dismissal rate would be if securities class action defense bar comprised specialists, not generalists.  While there can be no accurate answer to this hypothetical, I firmly believe defendants would win more than they do now.  And I would guess it would be a lot more—maybe even 50% more.

U.S. Supreme Court.  Although defendants have technically prevailed in most of the U.S. Supreme Court securities cases over the last decade, most of the decisions haven’t been very helpful to defendants in the big picture, outside of clarifying the standards for pleading falsity (Omnicare) and scienter (Tellabs).  For example, Janus and Dura basically just restated the law; Amgen and Halliburton I were virtually meaningless; Halliburton II may well have had the lowest impact-to-fanfare ratio of any Supreme Court decision, ever; and Morrison backfired.

Legislative.  Although it has had some unintended consequences, the Private Securities Litigation Reform Act of 1995 was indeed a victory for the defense bar (as was the Securities Litigation Uniform Standards Act of 1998).

The Reform Act illustrates the benefits of a specialized defense bar.  With support from Silicon Valley securities litigators—the primary firms for oft-sued technology companies—defendants literally changed the rules of engagement.  Indeed, my ideal securities class action defense bar would be very similar to the experience and economics of the Silicon Valley defense bar as it existed in 1995—as I discussed in Part II.

Isn’t the plaintiffs’ bar splintered too, given the diversity in types of firms and target defendants?

Over the past several years, I have written extensively about the evolution of the securities class action plaintiffs’ bar—which I summarized in Part I.  The plaintiffs’ bar is indeed diverse, and the leaders of the dozen or so firms that bring cases certainly aren’t best friends.

But my point isn’t that the plaintiffs’ firms are homogeneous or friendly.  It’s that the plaintiffs’ bar is specialized and small enough that they can be cohesive.  They know who’s who, and they know who’s doing what.  And they have the capacity to appreciate what is, and isn’t, in the interests of the plaintiffs’ bar as a whole.

That type of cohesion is non-existent in the defense bar.  It is simply too splintered—as I explained in Part II.  Despite having defended securities litigation for 25 years and full time for the past 20 years, I don’t even recognize the names of many of the defense lawyers listed on the dockets.

How can insurers create better cohesion in the defense bar, given the highly competitive business of D&O insurance?

To be sure, the D&O insurance community is large and competitive, with more than 50 markets writing primary and excess policies.  Despite these issues the D&O insurance community is structurally unified.

  • The community of D&O insurers comprises a relatively small, strong, and specialized group of companies and people.  There is a small number of repeat-player primary insurers.  At the less frequent primary and excess insurers, the underwriting and claims leadership is knowledgeable and strong—some of the most prominent professionals work there.  These insurers are represented by a small and highly specialized bar of outside lawyers, who drive thought leadership across all carriers.  The leading D&O insurance brokers also drive thought leadership. Professional organizations such as Advisen and PLUS further bring people and ideas together.  This community of shared interests creates a common analytic framework, lexicon, and culture.
  • D&O insurers’ strongest structural bond is their economic incentive to win both individual securities class action battles and the securities class action war.  Indeed, they are the only group that cares both about individual cases and the big picture.  Defendants themselves only care about winning the individual cases against them.  D&O insurers share this goal, but they also care about all of the other cases as well—not just the ones they insure, but the other cases too, because they shape the legal and economic landscape and thus the risks they insure.

D&O insurers have substantial securities litigation expertise.  The leading D&O insurance professionals have multiples more experience evaluating defense and resolution strategies than even the most prominent securities defense lawyers, and can provide significant strategic insights.  Indeed, if I were sued in a securities class action and could assemble a dream defense team, I would hire a prominent D&O insurance lawyer on the team as a strategic quarterback—on securities class action issues.

Defendants’ success or failure in the securities class action war has significant implications for D&O insurance professionals.  The lack of actual litigation defense in securities class actions will eliminate the need for any real claims management.  That, in turn, will result in the death of any meaningful role by D&O insurers in the defense of securities litigation.  The role of D&O insurance claims professionals will be merely to determine when defense costs have exhausted the policy limits.  What a tragedy that would be not just for them, but also for defendants and specialized defense counsel who value their input, insight, and collegiality.

Do public companies really want their D&O insurers involved in the defense of claims?

If I had one wish concerning D&O insurance, it would be to dispel the myth that public companies distrust D&O insurers and don’t want them to stick their noses into the defense of a claim.

This myth is perpetuated by frequently contentious claims experiences, in which insureds’ representatives argue for coverage of defense costs and settlements that insurers are reluctant to pay.  But these disagreements are just a symptom of a problem—they don’t identify the underlying problem.  In my experience, the problem is most often defense lawyers, who set up their clients to have a strained relationship with their insurers, so that the lawyers have maximum freedom to do whatever tasks they want, at whatever cost they want to charge.  Most public companies have never been through a securities class action before and have no idea what tasks are required and what they should cost.  But D&O insurers do.  And that’s the root of the problem.

So, defense lawyers condition their clients to believe D&O insurers are an adversary.  But pre-claim, directors and officers don’t think that way.  As I look back on the clients I’ve defended or advised on D&O insurance procurement, I can’t think of any who believed the insurer was an adversary.  Just the opposite is true: they’ve often expressly regarded the D&O insurer as a teammate in the defense of the case.

This has been true even in my most difficult securities fraud cases.  I’ve never had an insurer even seriously threaten to deny coverage on the basis of the fraud exclusion.  An actual fraud-exclusion coverage denial is almost unthinkable under current policies, which exclude coverage only for finally adjudicated fraud in the case at hand.  Nearly all cases settle, so the fraud exclusion isn’t even in play.  And even a finally adjudicated securities fraud judgment would not often trigger the fraud exclusion, since the scienter standard under Section 10(b) is “recklessness,” not intentional fraud.  For these reasons, any concern about the need for “regular” Cumis counsel in duty-to-defend cases is misplaced; far from regular, it would be rare.

Would public companies buy a policy giving D&O insurers greater control of the defense?

I strongly believe that there would be high demand for D&O insurance that placed greater control of the defense of claims in the hands of insurers—including an optional duty to defend feature.

In exchange for a reduction in premium or the self-insured retention, such a policy would be highly attractive to public companies, especially smaller companies, for which even five- or six-figure savings can mean the difference between profit and loss, and success and failure.

I appreciate that the idea of greater insurer control of the defense of public company D&O claims is novel.  But I strongly believe it’s time for D&O insurers and brokers to re-think the structure of defense of D&O claims.

Currently, the line between indemnity and duty-to-defend is drawn at public versus private companies.  A much more commercially logical line would be smaller public companies versus larger public companies.  Just as many private companies would prefer the flexibility of indemnity insurance, many smaller public companies would prefer the certainty and efficiency of a duty-to-defend option.

Smaller public companies—say those with market capitalization of $1 billion or less—often lack larger-company infrastructure.  They need and would welcome more insurer control and less financial risk.  And with the increasing number of claims by smaller plaintiffs’ firms against smaller public companies now a permanent part of the securities class action landscape, now is a good time for insurers to make this type of change.

But even many larger companies would welcome more insurer control of claims, including a duty-to-defend option, in exchange for some reduction in the premium or self-insured retention.  I’ve never met a CFO who didn’t want to save money on insurance.  And, unfortunately for us lawyers, very few individual defendants are beholden to any particular lawyer or law firm—that type of connection typically happens at the level of in-house counsel, who unlike directors and officers, are not named as individual defendants in securities class actions.

The key for the success of a D&O policy with greater insurer control would be the quality of the defense.  As the party with the biggest financial stake in the individual case and overall, D&O insurers certainly would ensure that the quality of the defense is high, and as repeat players, they know who’s who and are better situated than defendants to pick the right lawyers.

So I strongly disagree with any assertion that public companies wouldn’t buy such a product and brokers wouldn’t sell it.  If the quality of the defense is high, and the price is lower through lower premiums and/or retentions, companies will buy it.  And if they will buy it, brokers will sell it.  It’s just basic economics.

This is the third of a three-part post that analyzes why plaintiffs are winning the securities class action war and what defendants can do about it.

At stake is a system of securities litigation that sets up one side or the other to win more cases in the long term.  It has real-world consequences for directors and officers—they expect companies, D&O insurers and brokers, and the securities defense bar to fight for a system of securities litigation defense that will allow them to get through a securities case comfortably and safely.

But despite winning many battles, defendants are losing the war.

Part I of this three-part post explained that the plaintiffs’ bar is back, and better than ever.  It comprises a small group of about a dozen firms with lead partners who are full-time national securities litigators.  Given the size and focus, the plaintiffs’ bar is specialized and has the capacity to coordinate.

Part II explained that, in contrast, the defense bar is splintered, relatively inexperienced, and highly inefficient.

This third and final part discusses how defendants can overcome these disadvantages and close the gap between the plaintiffs’ bar and defense bar.

The Potential Paths Forward

Because the current path is leading to a strategic and economic cliff—as I’ve mapped out in Part I and Part II—we need to backtrack, examine the landscape, and pick the right path forward.  What are the possible paths?

Elimination or Further Reform of Securities Class Actions

One alternative path is to try to kill securities class actions, or further undermine them.  Over the years, various constituents have sought to eliminate or reform securities cases.  Most recently, in Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014), the U.S. Chamber of Commerce and others supported Halliburton in trying to abolish the fraud-on-the-market presumption established in Basic Inc. v. Levinson, 485 U.S. 224 (1988)—the legal mechanism that allows securities cases to proceed as class actions.  And, of course, industry groups achieved a significant legislative victory in 1995, through the Private Securities Litigation Reform Act.

Continuing to try to kill securities class actions would be an enormous error.  Securities class actions are far superior for defendants than the alternatives.  If securities class actions didn’t exist, the plaintiffs’ bar would adjust, not perish.  In place of class actions, they would file non-class securities actions that would be vastly less manageable than class actions.  For evidence of what would happen without a class action mechanism, we need look no further than the global securities class action landscape in the wake of Morrison v. National Australia Bank, 561 U.S. 247 (2010).  And without securities class actions as an enforcement safety net, the SEC would doubtless increase enforcement.  Companies are better off with one of a handful of plaintiffs’ lawyers as an adversary than an often-unknown and aggressive SEC enforcement lawyer.  (I examined this question in depth, in my post “Be Careful What You Wish For, Part II: Would Companies Be Better Off Without the Fraud-on-the-Market Doctrine?”)

Further legislative reform could be helpful.  The Reform Act mostly has helped defendants—though it has come with a steep price tag, as I mentioned in Part I.  Although I could come up with some additional defendant-friendly reforms, they would mostly be about correcting problems the Reform Act has caused (see, for example, my post ”Be Careful What You Wish For, Part I: Does the Reform Act Need Reforming?”) or improving litigation procedures (see, for example, my post “5 Wishes for Securities Litigation Defense: Early Damages Analysis and Discovery”).

Most defense lawyers would probably suggest further raising the pleading standards.  I don’t think that would help much.  I’ve always believed that the top of the plaintiffs’ bar isn’t really bothered by higher pleading burdens—at core, pleading a fraud claim involves convincing a judge that the defendants are bad-guys, and a good motion to dismiss involves convincing a judge that the defendants are good-guys.  The pleading standards are just a way to convey those arguments.  Plaintiffs’ lawyers are still able to get past motions to dismiss in a high percentage of cases and certainly in the lion’s share of difficult cases.  Even with even higher pleading standards, the plaintiffs would still file cases they think are the right ones, and I’d predict they’d defeat motions to dismiss at roughly the same rate.

Formation of Industry Groups to Oversee Securities Class Actions

Another alternative path is to form industry groups to create cohesion among groups of defendants—for example, technology companies, biotechs, retailers, etc.  Many years ago, this type of securities-litigation cohesion worked for accounting firms who, as a group, were a formidable foe.  They were represented by a small group of lawyers—there were just a few key lawyers.  Although the accounting firms were fierce competitors in the business of auditing, they took a big-picture approach to the industry’s litigation risk.  Together, they basically chased off the plaintiffs’ securities bar.  Indeed, today accounting firms are typically joined as a securities class action defendant along with its audit client only in the very largest cases.

Part of accounting firms’ success, and the reason they aren’t sued much anymore, is the Supreme Court’s abolition of aiding-and-abetting liability, in Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994).  But it’s more than that.  Auditors make statements that can still yield primary liability—most typically, by opining that a company’s financial statements conform with GAAP and the audit was performed in accordance with GAAS.  But accounting firms, with their small bar of specialized lawyers, helped to largely insulate those statements from attack under the securities laws.  And when accounting firms were sued along with their audit clients, the accounting firms’ specialized and experienced lawyers brought significant firepower to the defense group—making the claim against the main defendants, the company and their officers and directors, more difficult.  As a result, plaintiffs’ firms have sued accounting firms less and less.

Can public companies adopt this type of cohesive approach as a path forward?  Unfortunately, a number of factors suggest it wouldn’t work.  The types of companies sued in securities class actions are far more numerous and diverse than the Big-X accounting firms.  I watch the cases come over the transom, and the companies sued are a real mishmash, even if the types of cases seem to align in a dozen or so buckets.  Even the technology industry—historically the most frequently sued type of company, and the industry that primarily spurred the adoption of the Reform Act—isn’t sued with the consistency it once was.  Biotech companies are probably the best candidate for a cohesive approach, but most of those companies have their heads down working on their drug candidates, without the time or resources necessary to coordinate.

But most fundamentally, it’s hard to imagine that any group of potential-defendant companies could come together and agree on a small, focused set of securities defense specialists to defend cases against them—or to engage in enough repeat hiring that such a set would naturally develop.  Once again, one of the core problems with securities litigation defense is the hordes of lawyers who comprise the so-called “securities defense bar.”  Until that fundamental problem is fixed, the quality of defense will continue to suffer, and the cost of even the current low-quality defense will remain ridiculously high.

Greater Control by D&O Insurers Is the Only Clear Path

While there is no group of defendants that can replicate the accounting-firm model, D&O insurers can play a similar unifying role across all categories of defendants.

In nearly every securities class action, there is a group of D&O insurer representatives associated with the defense of the litigation.  D&O insurers are the only repeat players on the defense side and as a group, they see the big picture in a way no defense firm ever could.  They have the greatest economic interest in the outcome—both overall and in individual cases.  A victory for the defendants is a victory for them.  They employ highly experienced claims professionals, many of whom have been involved in exponentially more securities class actions than even the most experienced defense lawyers.  I have achieved superior results for many clients by working collegially with insurers—from helping shape motion-to-dismiss arguments, to learning insights about particular plaintiffs’ lawyers and their latest tricks, to selecting the right mediator for a particular case, to achieving favorable settlements that don’t leave the impression of guilt.

Given this expertise and alignment of interests, defense counsel should involve insurers in the defense of the case as part of their responsibility to their clients.  Defense counsel should involve insurers in key strategic decisions—working with them to help find the right defense counsel for the particular case, to help shape the overall defense strategy at the inception of the case, and to help make good decisions about the use of policy proceeds.  And defense counsel who involve insurers undoubtedly help their clients make it through securities cases more successfully, efficiently, and comfortably than those who don’t.

Yet insurers usually are shut out of meaningful involvement in the defense, with most defense lawyers treating them almost like adverse parties and other defense lawyers merely humoring them as they would a rich relative.  Although this dysfunction is rooted in a complex set of factors, it could easily be fixed.

When the general public thinks about insurance, they usually think of auto insurance or other duty-to-defend insurance, under which the insurer assumes the defense of the claim for the insureds.  But public-company D&O insurance is indemnity insurance:  The insurer is obligated to reimburse the company and its directors and officers for reasonable and necessary defense costs and settlement payments, up to the policy’s liability limit.

Indemnity insurance gives the defendants control over the litigation, including counsel selection and strategic approach, with the insurer retaining limited rights to participate in key decisions.  Although those rights give insurers a foot in the door, the rights are not robust or frequently exercised.

Insurers often take a relatively hands-off approach to D&O claims because they assume that their customers want them to stay out of the defense of the claim.  But in my experience, this is a misconception.  The priority for most companies and their directors and officers is simply the greatest protection possible, including assurances that they will not be left to pay any uncovered legal fees or settlement payments.  In fact, not only do most insureds not want to be stuck paying their lawyers for short-pays, they don’t even want to write any checks at all after satisfying the deductible.  Instead, they prefer that the insurer take charge of the bills and pay the lawyers and vendors directly.

In other words, most public companies actually want their D&O insurance to respond more like duty-to-defend insurance, particularly if it were offered at a slightly lower price or with lower self-insured retentions.  This is especially so for smaller public companies, for which the cost of D&O insurance and the self-insured retention can be real hardships and who often lack the resources of larger companies, such as in-house counsel.  Significantly, these are the types of companies against which the plaintiffs’ bar is bringing more and more securities class actions.  Outside directors also lack intense allegiance to any particular defense firm.  Loyalty to particular law firms is typically rooted at the level of in-house counsel, who are often beholden to particular law firms for personal reasons.  In contrast, smaller public companies and outside directors typically just want to be defended well, at no cost to them.

So why do insurers mistakenly think that the insureds would rather have them stay out of the defense of the claim?  To be sure, after a claim is filed, the insurer often gets an earful from the insureds’ lawyers and broker about the insureds’ indemnity-insurance freedoms.  But these aggressive positions are typically not the positions of the insureds themselves. Instead, these positions are driven by defense counsel, usually for self-interested reasons:  to get hired, to justify excessive billing, or to settle a case for a bloated amount because the defense is compromised by mounting costs or the defense lawyer’s inability to take the case to trial.

Frequently, defense lawyers will set the stage for their clients to have a strained relationship with their insurers by feeding them a number of stock lines:

  • “This is a bet-the-company case that requires us to go all-out to defend you, so we have to pull out all the stops and do whatever is necessary, no matter what the insurer has to say.”
  • “The insurer may ask you to interview several defense firms before choosing your lawyers.  Don’t do that. They’ll just want to get some inferior, cut-rate firm that will save them money.  But you’ll get what you pay for—we’re expensive for a reason!  And don’t forget that we’ve stood by you through thick and thin since before your IPO, back when you were a partner here.  Plus, we gave you advice on your disclosures and stock sales, so we’re in this thing together.”
  • “The business of any insurance company is to try to avoid paying on claims, so the insurer may try to curtail our level of effort and even refuse to pay for some of our work.  But trust us to do what we need to do for you.  You might need to make up the difference between our bills and what the insurer pays, but we can go after the insurer later to try to get them to pay you back for those amounts.”
  • “We’ll need you to support us in these insurance disputes.  You don’t have to get involved directly—we can work with the insurer and broker directly if you agree.  Agree?  Good.”

That’s how defense lawyers set the insurer up as an adversary, but these self-serving talking points get several key things wrong:

  1. Most importantly, D&O insurers are not the insured’s adversaries in the defense of a securities class action. To the contrary, insurers’ economic interests are aligned with those of the insureds. Insurers want to help minimize the risk of liability through good strategic decisions. Although keeping defense costs to a reasonable level certainly benefits the insurer, it also benefits the insureds by preserving policy proceeds for related or additional claims on the policy, so that the insureds will not need to pay any defense or settlement costs out-of-pocket, and will avoid a significant premium increase upon renewal.
  2. Insurers want their insureds to have superior lawyers—inferior lawyers would increase their exposure. Their interest in counsel selection is to help their insureds choose the defense counsel that is right for the particular case. The key to defense counsel selection in securities class actions, for insureds and insurers alike, is to find the right combination of expertise and economics for the particular case—in other words, to find good value.
  3. A D&O insurer’s business is not to avoid paying claims. D&O insurance is decidedly insured-friendly, which isn’t surprising given its importance to a company’s directors and officers. D&O insurers pay billions of dollars in claims each year, and there is very little D&O insurance coverage litigation. Although D&O insurance excludes coverage for fraud, the fraud exclusion typically requires a final adjudication—it does not even come into play when the claim is settled, and even if the case went to trial and there was a verdict for the plaintiffs, it would only be triggered under limited circumstances.
  4. If utilized correctly, D&O insurers can be highly valuable colleagues in securities class action defense.  Because they are repeat players in securities class actions, they are able to offer valuable insights in defense-counsel selection, motion-to-dismiss strategy, and overall defense strategy.  They have the most experience with securities class action mediators and plaintiffs’ counsel, and they often have key strategic thoughts about how to approach settlement.  The top outside lawyers and senior claims professionals for the major insurers have collectively handled many thousands of securities class actions.  Although their role is different from that of defense counsel, these professionals are more sophisticated about securities litigation practice than the vast majority of defense lawyers.

D&O insurers most definitely have the practical ability to effect these changes.  Although the number of insurers may seem large to many, from my perspective it is a relatively small and close-knit group.  Every major D&O insurer has highly experienced internal or external claims personnel who track securities litigation developments very closely, in individual cases and the big picture.  There is a relatively small number of primary insurers who write the lion’s share of primary D&O policies.  And there is a handful of professionals who drive thought leadership.  Without question, the D&O insurance community is well-suited to be the glue that fixes the fractured defense bar.

All that would be necessary are a few simple D&O insurance contract modifications.  A duty to defend structure for a “Securities Claim” would work best, and I am certain it would be highly attractive to smaller companies, if offered at a lower premium or with a lower self-insured retention.  Since very few cases actually involve exclusion of coverage under the fraud exclusion, the lurking problem of conflicts of interest is often not present, and in any event can be cured by Cumis counsel (i.e., an attorney employed by a defendant in a lawsuit when there is a liability insurance policy covering the claim and there is a conflict between the defendant and the insurer arising from a coverage issue).

But even within the current indemnity structure, D&O insurers could easily tweak terms to give insurers a stronger voice in three areas:

>  Select the right defense counsel for the particular case—which would tend to create a defense bar that rivals the specialization of the plaintiffs’ bar.  Insurers don’t need to choose counsel for defendants to make sure that they have the right counsel in place.  They can require insureds to conduct an interview process that includes firms that they believe would be right for the case for strategic and/or economic reasons.  Currently, insurers can’t unreasonably refuse to consent to the insureds’ choice of counsel.  Although stronger counsel-selection language could easily be added—for example, that the insurer can propose a range of firms, and the insureds can’t unreasonably refuse to consent to the insurers’ options—even the current formulation allows insurers to reasonably refuse to consent to counsel who aren’t sufficiently experienced or are too expensive for the particular case.

>  Make defendant-focused strategic and settlement decisions—which would approximate the strategic coherence of the plaintiffs’ bar.  Insurers don’t need to have an attorney-client relationship with defense counsel to have a meaningful say in strategic decisions.  The current cooperation clause already gives them this right, and it could be slightly enhanced to make clear that insurers can and should provide strategic input about the full range of decisions.  In this way, insurers could not only make a difference in individual cases, but in the big picture, similar to a portfolio manager’s investment decision-making.

>  Use policy proceeds only for defense costs that further the defendants’ interests—which would allow defendants to approach the efficiency the plaintiffs’ bar achieves through their contingent- fee structure.  Insurers should be allowed to refuse to pay defense expenses that are not in the interests of the defendants—including billing rates and staffing practices that exceed what is reasonable and necessary.  Insurers simply need the contractual right to require a defense firm to live with the insurers’ decisions and prevent a defense firm from seeking reimbursement of unpaid amounts from the defendants.  In my experience, defendants actually believe that insurers are better able to judge what is reasonable than they are and are perfectly willing to defer to the insurer.  The rancor typically comes from defense counsel, not the insureds.

Again, a duty-to-defend option would be the very best way to accomplish necessary change.  But even these types of modest changes within the current indemnity-contract framework would enable D&O insurers to greatly improve securities class action defense.

A key consideration, of course, is whether brokers would be motivated to sell policies with these modifications.  I’m absolutely certain that directors and officers would want to buy them.

And I’m confident that client-focused brokers would want to give their clients the option to purchase a policy that would help the particular client and the broader public-company community to defend securities class actions better.

Conclusion

The only way for defendants to win the securities class action war is to make the defense bar more effective and efficient.  And the only way to do so is for D&O insurers to have greater control of claims.  Defendants are entitled to a defense that allows them to get through securities litigation safely and comfortably, and without any real financial risk.  Indeed, they already expect that their D&O insurers will take care of them.  Giving insurers a greater role in defending securities class actions will allow insurers to do exactly that.

The villain in the fight against securities class actions is the fraud-on-the-market presumption of reliance established by the U.S. Supreme Court in 1988 in Basic Inc. v. Levinson, 485 U.S. 224 (1988).  Without Basic, the thinking goes, a plaintiff could not maintain a securities class action, and without securities class actions, executives could speak their minds without worrying so much about securities law liability.  In the current environment, the risk of further attacks on Basic seems high.  (A general class action reform bill, the “Fairness in Class Action Litigation Act of 2017,”  has already been introduced in the House—analyzed by Alison Frankel here, and by Kevin LaCroix here.)

But Basic ballasts the system of securities-law enforcement by protecting investors, while providing companies with predictable procedures and finality upon settlement.  We have a lead plaintiff and class representative who prosecutes a claim that defendants can settle with a broad class-wide release.  Because the private plaintiffs’ bar is doing its job, the SEC stays away in most cases. Honest executives have nothing to fear with the current system—they routinely get through securities litigation without any real reputational or personal financial risk.

On the other hand, without Basic, plaintiffs’ lawyers would still file securities litigation.  In place of class actions, each plaintiffs’ firm would file an individual or multi-plaintiff collective action, resulting in multiple separate actions in courts around the country.  These would be difficult to manage, expensive to defend, and impossible to settle with finality until the statute of limitations expires.  SEC enforcement would become more frequent.  Companies and their D&O insurers and brokers would be unable to predict and properly insure against the risk of a disclosure problem.

Moreover, I have never understood the supposed benefits of abolishing Basic.  Although it is possible that the frequency of securities litigation would decline, I doubt it would.  A disclosure problem that would trigger a securities class action today would result in at least several non-class securities actions in a post-Basic system.

And any decrease in frequency would come at a high cost—in addition to the increased cost of defending and resolving those cases that are filed, investors and the economy would suffer from more securities fraud resulting from the diminished deterrence that class actions provide. Even an executive who detests securities class actions pictures prominent plaintiffs’ lawyers when he or she decides whether to omit an important fact.

So, to those who bash Basic, be careful what you wish for.

A Brief History of the Fraud-on-the-Market Doctrine

The fraud-on-the-market doctrine concerns the reliance 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 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., 563 U.S. 804 (2011), the Supreme Court unanimously rejected the latter argument, finding that loss causation is not a condition of the presumption of reliance.  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. Conn. Ret. Plans and Trust Funds, 133 S. Ct. 1184 (2013), 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.”

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 Halliburton case ended up before the Supreme Court once again, this time with the viability of Basic squarely presented.  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.  Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014).  Thus, Basic survived the Halliburton battle.

What Would Securities Litigation Look Like without Basic?

Our current securities class action system is straightforward and predictable.  Like any other action, a securities class action starts with the filing of a complaint by a plaintiff.  But after that, the procedure for these actions is unique.  The Reform Act mandates that the first plaintiff to file a securities class action publish a press release giving notice of the lawsuit and advising class members that they can attempt to be the “lead plaintiff” by filing a motion with the court within 60 days of the press release.  Additional plaintiffs will often file their own complaints in advance of the deadline, or they may simply file a motion to become lead plaintiff at the deadline.

The Reform Act provides that the “presumptively most adequate lead plaintiff” is the one who “has the largest financial interest in the relief sought by the class” and otherwise meets the requirements of Rule 23 of the Federal Rules of Civil Procedure, which governs class actions.  The Reform Act’s standards for lead plaintiff selection have caused plaintiffs’ firms to pursue institutional investors and pension funds as plaintiffs, since they are more likely to be able to show the financial interest necessary to be designated as lead plaintiffs.  But as I have chronicled, in recent years, smaller plaintiffs’ firms have won lead-plaintiff contests with retail investors as lead plaintiffs, primarily in securities class actions against smaller companies.  About half of all securities class actions are filed against smaller companies by these smaller plaintiffs’ firms.

This deeper and more diverse new roster of plaintiffs’ firms means that securities litigation won’t just go away if they can’t file securities class actions.  The larger plaintiffs’ firms have strong client relationships with the institutional investors the Reform Act incentivized them to develop.  Claims by the retail investors that the Reform Act sought to replace have made a resurgence through relationships with smaller plaintiffs’ firms.  Together, these plaintiffs and plaintiffs’ firms fully cover the securities litigation landscape.  These firms are competitive with one another. One will rush to file a case, and if one files, others will too.  They are specialized securities lawyers, and they aren’t going to become baristas or bartenders if Basic is abolished.  They will seek out cases to file.

So the plaintiffs’ bar would adjust, just as they have adjusted to limited federal-court jurisdiction under Morrison v. National Australia Bank, 561 U.S. 247 (2010).  And if the post-Morrison framework is any indication of what we would face post-Basic, look out—Morrison has caused the proliferation of unbelievably expensive litigation around the world, without the ability to effectively coordinate or settle it for a reasonable amount with certain releases.

In a post-Basic world, the plaintiffs’ firms with institutional investor clients would likely file large individual and non-class collective actions.  Smaller plaintiffs’ firms would also file individual and non-class collective actions.  The damages in cases filed by smaller firms would tend to be smaller, but the litigation burdens would be similar.

Non-class securities actions would be no less expensive to defend than today’s class actions, since they would involve litigation of the same core merits issues.  In fact, non-class litigation would be even more expensive in certain respects because, for example, there would be multiple damages analyses and vastly more complex case management.  And if securities class action opt-out litigation experience is indicative of the settlement value of such cases, they would tend to settle for a larger percentage of damages than today’s securities class actions.

In a new non-class era of securities litigation, the settlement logistics would be vastly more difficult.  It’s hard enough to mediate with one plaintiffs’ firm and one lead plaintiff.  Imagine mediation with a dozen or more plaintiffs’ firms and even more plaintiffs.  We often object to lead-plaintiff groups because of the difficulty of dealing with a group of plaintiffs instead of just one.  In a world without securities class actions, the adversary would be far, far worse—a collection of plaintiffs and plaintiffs’ firms with no set of rules for getting along.

Even when settlement could be achieved, it wouldn’t preclude suits by other purchasers during the period of inflation, because there would be no due process procedure to bind them, as there is when there’s a certified class with notice and an opportunity to object or opt out.  Indeed, there likely would develop a trend of random follow-up suits by even smaller plaintiffs’ firms after the larger cases have settled.  There would be no peace absent the expiration of the statute of limitations.

These unmanageable and unpredictable economics would disrupt D&O insurance purchasing decisions and cost. Under the current system, D&O insurers and brokers can reliably predict the risk a particular company faces based on its size and other characteristics.  A company can thus purchase a D&O insurance program that fits its risk profile.

Compounding the uncertainty of all of this would be the role of SEC and other government enforcement.  Even with the current U.S. administration’s relatively hands-off regulatory approach, the job of the human beings who work at the SEC is to investigate and enforce the securities laws.  They aren’t going to not do their jobs just because government regulation has been eased in the bigger picture.  And they will step in to fill the void left by the inability of plaintiffs to bring securities class actions.  Experienced defense counsel can predict how plaintiffs’ firms will litigate and resolve a case, but they have much less ability to predict how an enforcement person with whom he or she may never have dealt will approach a case.

Conclusion

Executives who do their best to tell the truth really have nothing to fear under the securities laws.  The law gives them plenty of protection, and the predictability of the current system allows them to understand their risk and resolve litigation with certainty.  It would be a mistake to try to abolish securities class actions.  Abandoning Basic would backfire—badly.

Earlier this month, I spent a week in the birthplace of D&O insurance, London.  In addition to moderating a panel at Advisen’s European Executive Risks Insights Conference, I met with many energetic and talented D&O insurance professionals, both veterans and rising stars, to discuss U.S. securities litigation and regulatory risks.  Themes emerged on some key issues.  What follows is a collection of my impressions and opinions about three of them—not quotes from any particular company or person.

1.  Greater frequency of securities class actions against smaller public companies gives D&O insurers an opportunity to innovate.

As I’ve observed over the past several years, a significant risk to companies is that ever-increasing securities defense fees no longer match the economics of most cases, and are quickly outpacing D&O policy limits.  In the past, securities class actions were initiated by an oligopoly of larger plaintiffs’ firms with significant resources and mostly institutional clients that tended to bring larger cases against larger companies.  But in recent years, smaller plaintiffs’ firms with retail-investor clients have been initiating more cases, primarily against smaller companies. Indeed, in recent years, approximately half of all securities class actions were filed against companies with $750 million or less in market capitalization.  As a result, securities class actions have shrunken in size to a level last seen in 1997.

Yet at the same time, the litigation costs of the typical defense firms (mainly firms with marquee names) have increased exponentially.  This two-decade mismatch—between 1997 securities-litigation economics and present-day law-firm economics—creates the danger that a company’s D&O policy will be insufficient to cover the fees for a vigorous defense and the price to resolve the case.  Indeed, in my view, inadequate policy proceeds due to skyrocketing defense costs is the biggest risk directors and officers face from securities litigation—by far.

D&O insurers face a double-whammy: They are paying defense costs on smaller claims that are out of proportion to the actual risk because the lion’s share of cases against all companies, both large and small, are defended by the typical defense firms.  At the same time, insurers are unable to charge a sufficient premium for this risk, due to the softness of the market.

I strongly believe the solution lies in a more tailored D&O insurance option for smaller public companies.  Today, every public company buys some form of D&O indemnity insurance, which allows the company to choose their own lawyers and control their defense strategy.  Under this approach, securities litigation defense lawyers effectively control the D&O insurance claims process; even the most veteran in-house lawyers are almost always securities litigation rookies.  Is that in the insureds’ interest?  Is the one-size-fits-all D&O insurance model right for smaller public companies, whose insurance proceeds are being disproportionately being spent on defense costs?  Is there demand for an optional product that gives insurers greater control, up to and including an optional duty to defend D&O product for smaller companies?

London insurers and brokers are working through these issues. I’m extremely hopeful that there will be innovation for smaller public companies and their directors and officers—insureds who most need the guidance and protection of their insurance professionals.

2.  In the wake of Morrison, greater strategic control is needed to deal with the risk of separate actions around the world.

In Morrison v. National Australia Bank, 561 U.S. 247 (2010), the U.S. Supreme Court held that the U.S. securities laws only apply to “transactions in securities listed on domestic exchanges, and domestic transactions in other securities.”  In the aftermath of the decision, it was widely assumed that the frequency of U.S. securities class actions against foreign issuers would decline.  Yet it has not.  For more background, I refer you to Kevin LaCroix’s September 26, 2016 post in his blog, The D&O Diary.

Despite Morrison, foreign issuers whose securities are traded in the U.S. are still subject to a securities class action with respect to those securities.  To add insult to injury, plaintiffs’ lawyers are also bringing separate actions around the world to recover for losses suffered from securities purchased outside of the U.S.  The result is vastly more expensive claim resolution due to multiple actions around the world, with many lawyers madly working in each jurisdiction, and a greater practical settlement value due to the “let’s just get this over with” dynamic—but with uncertainty about the ability to obtain a worldwide release.  So insurers now face a world in which claims are more severe, and in which the anticipated decline in the number of claims has not materialized.

London insurers and brokers are grappling with how to bring some order to this chaos.  I don’t see an easy fix.  As long as U.S. courts can’t accommodate all claims, worldwide litigation can’t be “won”—it can only be managed and settled as efficiently as possible.  This requires strong strategic control of the overall litigation, both to orchestrate settlements in the most efficient fashion and to avoid lawyers in every jurisdiction doing duplicative and unproductive legal work.

Critically, strong strategic control must be imposed by an independent lawyer—someone who would obviously be paid for his or her time, but who otherwise has no financial interest in the worldwide work.  Independence would give the strategic lawyer freedom from law-firm economics when making decisions about which lawyers should be doing what—and which lawyers should be doing nothing—as well as about when to settle.  In other words, if Dewey Cheatham & Howe is worldwide defense counsel, with multiple offices and dozens of lawyers working on the case, the strategic leader should not be a Dewey Cheatham & Howe lawyer.

But who would play such a role?  Although many companies of course have excellent in-house lawyers, very few have in-house lawyers who formerly were prominent securities litigators.  So should the strategic quarterback be a securities litigator from a firm other than the worldwide defense firm?  Should it be the broker?  Should it be a lawyer for the primary or a low excess carrier?  These are all good possibilities.  And how can this arrangement be put in place before the litigation defense is already beyond control?  Having the discussion is an important first step, and London insurers and brokers are working hard to figure this out.

3.  The danger of a wave of D&O claims relating to cyber security remains real.

One of the foremost uncertainties in securities and corporate governance litigation is the extent to which cyber security will become a significant D&O liability issue.  Although many practitioners and D&O insurers and brokers have been bracing for a wave of cyber security D&O matters, to date there has been only a trickle.  Yet among D&O insurers and brokers in London and elsewhere, there remains a concern that a wave is coming.

I share that concern.  To date, plaintiffs generally haven’t filed cyber security securities class actions because stock prices have not significantly dropped when companies have disclosed breaches.  That is bound to change as the market begins to distinguish companies on the basis of cyber security.  There have been a number of shareholder derivative actions asserting that boards failed to properly oversee their companies’ cyber security.  Those actions will continue, and likely increase, whether or not plaintiffs file cyber security securities class actions, but they will increase exponentially if securities class action filings pick up.

I also worry about SEC enforcement actions concerning cyber security.  The SEC has been struggling to refine its guidance to companies on cyber security disclosure, trying to balance the concern of disclosing too much and thus providing hackers with a roadmap, with the need to disclose enough to allow investors to evaluate companies’ cyber security risk.  But directors and officers should not assume that the SEC will announce new guidance or issue new rules before it begins new enforcement activity in this area.  All it takes to trigger an investigation of a particular company is some information that the company’s disclosures were rendered false or misleading by inadequate cyber security.  And all it takes to trigger broader enforcement activity is a perception that companies are not taking cyber security disclosure seriously.  As in all areas of legal compliance, companies need to be concerned about whistleblowers, including overworked and underpaid IT personnel, lured by the SEC’s whistleblower bounty program, and about auditors, who will soon be asking more frequent and difficult questions about cyber security.

In addition to an increase in frequency, I worry about severity because of the notorious statistics concerning a lack of attention by companies and boards to cyber security oversight and disclosure.  Indeed, the shareholder litigation may well be ugly:  The more directors and officers are on notice about the severity of cyber security problems, and the less action they take while on notice, the easier it will be for plaintiffs to prove their claims.

Cyber security has improved, albeit not enough, in part because of the thought leadership and product development by insurers and brokers. So even if there is never a wave of D&O cyber security matters, the excellent work by insurers and brokers in London and around the world will have been worthwhile.

The Roots of D&O Insurance

London insurers and brokers are also focused on finding the right coverages for entities and individuals in the Yates-memo regulatory environment.  This of course can create tension between entities, who would like their investigations costs covered, and individuals, for whom D&O insurance was created.

I am a D&O insurance fundamentalist—director and officer protection should always be our North Star.  But a company can find the right path to protection of both individuals and the company with good communication between and among the company, its directors and officers, broker, and insurers—both at policy inception and when a claim arises.

It was a privilege to discuss this fundamental D&O insurance question, and many others, with thoughtful D&O insurance professionals who work just down the street from Edward Lloyd’s coffee house.

One of my “5 Wishes for Securities Litigation Defense” (April 30, 2016 post) is greater involvement by boards of directors in decisions concerning D&O insurance and the defense of securities litigation, including defense-counsel selection. Far too often, directors cede these critical strategic decisions to management.

For most directors, securities litigation is a mysterious world ruled by sinister plaintiffs’ lawyers, powerful judges, and a unique legal framework that must be navigated by fancy defense lawyers who charge exorbitant fees. Directors react to this litigation with everything from unnecessary panic to an unjustified feeling of invincibility. The right approach is somewhere in the middle: “attentive concern.” Securities litigation can pose personal risk to directors as well as to their companies, but if directors educate themselves and pay attention, this risk is almost always manageable.

Of course, part of what makes the risk manageable is D&O insurance. But in the event of a claim, independent directors share their D&O insurance with the company and its management. Despite this competition for policy proceeds, directors typically leave management to handle D&O insurance decisions. Directors need to protect their own interests by having a greater role in deciding the features of their D&O insurance program and how the company uses the policy proceeds in the event of a claim.

Greater Involvement by Directors in Securities Litigation Defense

Why Should Directors Care?

Although much of the recent discussion about securities litigation has revolved around meritless merger litigation, securities class actions and associated shareholder derivative actions have always posed greater risk than merger actions. A securities class action alleges that a company and its representatives made false or misleading statements that artificially inflated the stock price. Directors are virtually always included in Section 11 cases, which challenge statements in registered offerings, and increasingly are also named in Section 10(b) actions, which can challenge any public corporate statement. Directors are often named in “tag-along” shareholder derivative actions as well, which allege that the directors failed to properly oversee the company’s public disclosures.

Often, it is difficult to know from the initial complaint whether a securities case will pose a personal risk to directors because it is merely a placeholder. Only after the court selects the lead plaintiff and lead counsel will the plaintiffs’ attorneys draft more substantial allegations and add defendants through an amended complaint. But regardless of any personal risk, directors have a duty to oversee the significant potential liability the company faces. For these reasons, directors should treat each one of these cases as if they are personally named.

The Economics of Securities Litigation Matter

One emerging risk to companies is that ever-increasing securities defense fees no longer match the economics of most cases, and are quickly outpacing D&O policy limits. In the past, securities class actions were initiated by an oligopoly of larger plaintiffs’ firms with significant resources and mostly institutional clients that tended to bring larger cases against larger companies. But recently, smaller plaintiffs’ firms with retail-investor clients have been initiating more cases, primarily against smaller companies. Indeed, in recent years, approximately half of all securities class actions were filed against companies with $750 million or less in market capitalization. As a result, securities class actions have shrunk in size to a level last seen in 1997.

Yet at the same time, the litigation costs of most defense firms have increased exponentially. This two-decade mismatch—between 1997 securities-litigation economics and 2016 law-firm economics—creates the danger that a company’s D&O policy will be insufficient to cover the fees for a vigorous defense and the price to resolve the case. Indeed, inadequate policy proceeds due to skyrocketing defense costs is directors’ biggest risk from securities litigation—by far.

Historically, most securities defense firms have marquee names with high billing rates. Especially in cases against small-cap companies—now the lion’s share—it is more difficult for these firms to vigorously defend an action without risking that there will be too little D&O insurance left for settlement. To avoid this result, firms either cut corners or settle early for bloated amounts that make the defendants look like they did something wrong.

Quite obviously, directors should not be subjected to these hazards—which are created not by the securities class action itself, but by law-firm economics. The vast majority of securities class actions—if handled in the right way by the right defense counsel—can be defended and either won or settled, within D&O insurance policy limits, leaving no residual liability for either the company or its directors. With just a little time and effort at the beginning of the litigation, directors can put these cases on the right track.

The Importance of Directors’ Involvement in Defense-Counsel Selection

First and foremost, directors must ensure their company selects the right counsel. Securities litigation is a specialty field, and it can be nearly impossible to differentiate between the claims of expertise and experience made by the herd of lawyers that descends upon a company after a suit is filed. And it is a serious error—especially for mid-size and smaller companies—to use a law firm brand name as a proxy for quality and fit. Fortunately, many pitfalls of counsel selection can be avoided if directors keep in mind a few key principles:

  • Select a securities litigation specialist, and not a multi-discipline commercial litigator, even one who is highly regarded and/or from a marquee firm.
  • Educate yourself about the strategic differences between firms.
  • Avoid defaulting to your regular corporate firm.
  • Conduct an interview process.

An interview process is essential, in all cases. Directors should use the interview process to insist on a better alternative than the rote decision by most companies to simply retain their regular outside counsel, or a firm with a marquee name. To state the obvious, the most effective securities defense lawyers do not all work at marquee firms. Directors should insist that management interview a range of firms, including those that emphasize a combination of superior quality and reasonable cost—in other words, firms that offer good value. And directors should insist that management push for price concessions from all defense firms that management interviews.

The key is for directors to pay attention and to use the leverage of a competitive hiring process to find counsel to help them through the litigation safely, strategically, and economically.

Directors’ Oversight of D&O Insurance

As a refresher, a D&O insurance policy has three categories of coverage.

  • Side A coverage reimburses directors and officers for losses not indemnified by the company.
  • Side B coverage reimburses the company for indemnification of its directors and officers.
  • Side C coverage insures the company for its own liability.

Directors’ exposure to securities litigation has changed. Due in part to the changes in the plaintiffs’ bar noted above, directors are now much more frequent targets in securities class actions and related shareholder derivative claims—and the trend is very likely to continue. Even as directors’ involvement in securities and derivative suits is increasing, their share of the D&O insurance is effectively decreasing, due to more competition for policy proceeds.

For example, companies frequently seek D&O insurance coverage for various types of investigations, which may help the company, but can significantly erode the policy limits. Companies also deplete limits by, among other things, requesting coverage for employees beyond directors and officers, and seeking ways to avoid triggering the fraud exclusion, which can result in large defense-costs payments to rogue officers. These types of decisions might make sense in certain circumstances, but they should be subject to director oversight.

Perhaps the biggest threat to the sufficiency of directors’ D&O insurance policy is from their own lawyers, due to skyrocketing defense costs. Some insurers have a pre-set list of lawyers from which defendants are encouraged or required to choose. This means that some of the counsel-selection process is done before a claim is filed—which is another reason directors should be involved in the D&O insurance purchasing decision.

Some companies try to eliminate the competition between the company and individuals for policy proceeds by purchasing separate Side A policies that cover only individuals, but these policies do not address erosion from other individuals or by attorneys’ fees, and they only apply if the company cannot indemnify the directors. There are Side A products available specifically for outside directors, but those are infrequently purchased, probably because directors are usually not involved in D&O insurance purchasing decisions.

Independent directors don’t need to take over the process of handling the company’s D&O insurance, or spend an inordinate amount of time on these issues, in order to adequately protect themselves. Rather, they need to become more involved and understand their D&O insurance options and the realities of the claim process. They can do this simply by asking for direct access to the D&O broker and insurer, and by spending some time on D&O insurance decisions at board meetings.

Conclusion

At the same time directors’ securities litigation risk is increasing, they share an increasing percentage of their D&O insurance with the company, officers, and even their own lawyers. Directors can mitigate the risks of these trends by simply becoming more involved in purchasing their D&O insurance and overseeing the defense of securities litigation, including defense-counsel selection. In doing so, they will not only protect their own interests, but will also better oversee and manage the company’s risks as well.

One of my “5 Wishes for Securities Litigation Defense” (April 30, 2016 post) is to require an interview process for the selection of defense counsel in all cases.

When a public company purchases a significant good or service, it typically seeks competitive proposals.  From coffee machines to architects, companies invite multiple vendors to bid, evaluate their proposals, and choose one based on a combination of quality and cost.  Yet companies named in a securities class action frequently fail to engage in a competitive interview process for their defense counsel, and instead simply retain litigation lawyers at the firm they use for their corporate work.

To be sure, it is difficult for company management to tell their outside corporate lawyers that they are going to consider hiring another firm to defend a significant litigation matter.  The corporate lawyers are trusted advisors, often former colleagues of the in-house counsel, and have usually made sacrifices for the client that make the corporate lawyers expect to be repaid through engagement to defend whatever litigation might arise.  A big litigation matter is what makes all of the miscellaneous loss-leader work worth it.  “You owe me,” is the unspoken, and sometimes spoken, message.

Corporate lawyers also make the pitch that it will be more efficient for their litigation colleagues to defend the litigation since the corporate lawyers know the facts and can more efficiently work with the firm’s litigators.  Meanwhile, they tell the client that there is no conflict—even if their work on the company’s disclosures is at issue, they assure the company that they will all be on the same side in defending the disclosures, and if they have to be witnesses, the lawyer-as-witness rules will allow them to work around the issue.

All of these assertions are flawed.  It is always—without exception—in the interests of the defendants to take a day to interview several defense firms of different types and perspectives.  And it is never—without exception—in the interests of the defendants to simply hand the case off to the litigators of the company’s corporate firm.  Even if the defendants hire the company’s corporate firm at the end of the interview process, they will have gained highly valuable strategic insights from multiple perspectives; cost concessions that only a competitive interview process will yield; better relationships with their insurers, who will be more comfortable with more thoughtful counsel selection; greater comfort with the corporate firm’s litigators, whom the defendants sometimes have never even met; and better service from the corporate firm.

Problems with Using Corporate Counsel

A Section 10(b) claim involves litigation of whether the defendants:  (1) made a false statement, or failed to disclose a fact that made what they said misleading in context; and (2) made any such false or misleading statements with intent to defraud (i.e. scienter).

Corporate counsel is very often an important fact witness for the defendants on both of these issues.  For example, in a great many cases, corporate counsel has:

  • Drafted the disclosures that plaintiffs challenge, so that the answer to the question “why did you say that?” is “our lawyers wrote it for us.”
  • Advised that omitted information wasn’t required to be disclosed, so that the answer to the question “why didn’t you disclose that” is “our lawyers told us we didn’t have to.”
  • Reviewed disclosures without questioning anything, or not questioning the challenged portion.
  • Drafted the risk factors that are the potential basis of the protection of the Reform Act’s Safe Harbor for forward-looking statements.
  • Not revised the risk factors that are the potential basis of Safe Harbor protection.
  • Advised on the ability of directors and officers to enter into 10b5-1 plans and when to do so, and on the ability of directors and officers to sell stock at certain times, given the presence or absence of material nonpublic information.
  • Advised on individual stock purchases.

The fact that the lawyer has given such advice, or not given such advice, can win the case for the defendants.  For example, for any case turning on a statement of opinion, the lawyer’s advice that the opinion had a reasonable basis virtually guarantees that the defendants won’t be liable.  Likewise, a lawyer’s drafting, revising, or advising on disclosures virtually guarantees that the defendants didn’t make the misrepresentation with scienter, and a lawyer’s advice on the timing of entering into 10b5-1 plans or selling stock makes the sales benign for scienter purposes.

To the defendants, it doesn’t matter if the lawyer was right or wrong.  As long as the advice wasn’t so obviously wrong that the client could not have followed it in good faith, the lawyer’s advice protects the defendants.  But to the lawyer, it matters a great deal for purposes of professional reputation and liability.  Deepening the conflict is the specter of the law firm defending its advice on the basis that the client didn’t tell them everything.  The interests of the lawyer and defendant client thus can diverge significantly.

That this information may be privileged doesn’t change this analysis.  Of course, the privilege belongs to the client, who can decide whether to use the information in his or her defense, or not.  But with corporate counsel’s litigation colleagues guiding the development of the facts, privileged information is rarely analyzed, much less discussed with the client.  The reality is that most privileged information isn’t truly sensitive to the client, but instead reflects a client seeking advice—and seeking the liability protection the lawyer’s advice provides.  But from the lawyer’s perspective, there can be much to protect.  Privileged communications may reflect poor legal advice, and internal files may contain candid discussions about the client and the client’s issues that would result in embarrassment to the firm, and possible termination, if produced.

Perhaps even more importantly, regular corporate counsel’s litigation colleagues may often fail to assess the case objectively, in part because it implicates the work of their corporate colleagues, and in part because of a desire not to ask hard questions that could strain the law firm’s relationship with the client.  Sometimes the problem arises from a deliberate attempt by the lawyers to protect a particular person who may have made an error leading to the litigation, such as the General Counsel (often is a former colleague), the CFO, or the CEO—all of whom are important to the client relationship.  Sometimes, though, the failure to thoughtfully analyze a case is due to a more generalized alliance with the people with whom the law firm works regularly.  It’s hard for a lawyer to scrutinize someone who will be in the firm’s luxury box at the baseball game that night, much less report a serious problem with him or her to the board.

Yet the defendants, including the board of the corporate client, need candid advice about the litigation to protect their interests.  For example, some problematic cases should be settled early, before the insurance limits are significantly eroded by defense costs and documents are produced that that will make the case even more difficult, and could even spawn other litigation or government investigations.  Defendants and corporate boards need to know this.

Corporate firms might counter that their litigation colleagues will give sound and independent advice, because they are a separate department and will face no economic or other pressure from the corporate department.  But that undermines one of the main reasons corporate lawyers urge that their litigation colleagues be hired: that it is more efficient to use the firm’s litigators since they work closely with the corporate lawyers, if not the company itself.  The corporate firm can’t have it both ways: either the litigators are close to the corporate lawyers and the company, and suffer from the problems outlined above, or they are independent, and their involvement yields little or no benefit in efficiency.  Indeed, it is most likely that the corporate firm’s litigators will be hindered by conflict, while nevertheless failing to create greater efficiency.  Just because lawyers are in a same firm doesn’t mean that they can read each other’s minds.  They still have to talk to one another, just as litigators from an outside firm would have to do.

So Why is Corporate Counsel Used So Often?

I doubt many directors or officers would disagree with the analysis above.  So why do so many companies turn to their corporate counsel without conducting an audition process?  Several practical factors impede the proper analysis of counsel selection in the initial days of a securities class action.

The single most important factor is probably that the corporate firm is first on the scene. Many companies reflexively hire their corporate firm immediately after the initial complaint is filed, or even after the stock drop, before a complaint is even filed.  By the time the defendants start to hear from other securities defense practices, they often have retained counsel.  And then it’s very difficult from a personal and practical perspective to walk the decision back.

This decision, moreover, is often made by the legal department, sometimes in consultation with the CEO and CFO.  The board is often not involved.  Instead, the board is merely presented with the decision, which can seem natural because the firm hired is familiar to them.  The directors often aren’t personally named in the initial complaint, so they might not pay as much attention as they would if they understood if they were likely to become defendants later – either in the main securities action, especially if the case involves a potential Section 11 claim, or in a tag-along shareholder derivative action.

Initial complaints can also mislead the company as to the real issues at stake.  Regular corporate counsel and the defendants may review the first complaint and incorrectly conclude that the allegations don’t implicate the lawyer’s work.  But these initial complaints are merely placeholders, because the Reform Act specifies that the lead plaintiff appointed by the court can later file an amended complaint.  Initial filers have little incentive to invest the time or effort into making detailed allegations in the initial complaint, because they may be beaten out for the lead plaintiff role.  The lead plaintiff’s amended complaint thus typically greatly expands the case to include new alleged false and misleading statements, more specific reasons why the challenged statements were false or misleading, and more detailed scienter allegations, including stock-sale and confidential-witness allegations that most initial complaints lack.  If a conflict becomes apparent at that point, however, it can be very difficult and even prejudicial to the defendants for corporate counsel to bow out.

Regular corporate counsel will often advise their clients that there is no issue with them defending the litigation, or even that doing so makes sense because they advised on the underlying disclosures.  But even if the corporate firm is trying to be candid and look out for its client’s interests, it may have blind spots in seeing its potential conflicts—especially when the corporate lawyers are facing pressure from their firm management to “hold the client.”

The pressures that lead a company to hire its corporate firm to defend the securities litigation are very real, and sometimes this decision is ultimately fine.  But I strongly believe that it is never in a client’s interest to take its corporate counsel’s advice on these issues without obtaining analysis from other securities practices as part of a competitive interview process.

The Benefits of a Competitive Process

In addition to obtaining important perspectives about potential problems with corporate counsel’s defense of the securities class action, an interview process involves myriad benefits – including tens of thousands of dollars of free legal advice.  The only cost to the company is a few hours to select the 3-5 firms that it wants to interview, and a day spent hearing presentations from those firms and discussing their analysis and approach with them.

An interview process gives defendants the opportunity to hear from several experienced securities litigators, who will offer a range of analyses and strategies on how best to defend the case.  It also allows defendants to evaluate professional credentials and personal compatibility, which are both important criteria.  It is difficult, if not impossible, for a company to evaluate how their corporate counsel’s litigators stack up against other litigators in this specialized and national practice area, without first hearing from some other firms.  Sometimes, a company will not even meet its corporate firm’s securities litigators in person before engaging them, which obviously makes it impossible for them to make judgments about personal compatibility and trust.

An interview process, if properly structured, is highly substantive.  The firms that fare best in a new-case interview typically prepare thorough discussions of the issues, and come prepared to analyze the case in great detail.  And the best ones look beyond the issues in the initial complaint to the issues that might emerge in the amended complaint, analyzing the full range of the company’s disclosures, to forecast future disclosure and scienter allegations, and evaluating the defenses that will remain even after allegations are added.

An interview process also helps the company to achieve a better deal on billing rates, staffing, and alternative fee arrangements.  Without an interview process, a law firm is much more likely to charge rack rates and do its work in the way it sees fit—which defendants are rarely in a position to challenge without having done some comparison shopping.  Even though securities class action defense costs are covered by D&O insurance, price matters in defense-counsel selection.  It is a mistake to treat D&O insurance proceeds as “free money.”  Without appropriate cost control, defendants run the risk of not having enough insurance proceeds to defend and resolve the case.  Appropriate cost control can help the litigation from resulting in a difficult or expensive D&O insurance renewal, and can allow the company to save money if the fees are less than the deductible.

An interview process also helps get the defendants off to a better start with its D&O insurers.  In addition to appreciating the cost control that an interview process yields, insurers also appreciate the defendants making a thoughtful decision on defense counsel, including vetting the potential problems with use of the company’s corporate firm.  D&O insurers and brokers are “repeat players” in securities litigation, and know the qualifications of defense counsel better than anyone else—a seasoned D&O insurance claims professional has overseen hundreds of securities class actions.  Asking insurers and brokers to help identify defense counsel to interview may therefore not only yield helpful suggestions, but may also make it easier to develop a relationship of strategic trust with the insurers—which will make it easier to obtain consent to settle early if appropriate, and if not, to defend the case through summary judgment or to trial.

Perhaps most importantly, an interview process results in a closer relationship between the defendants and their lawyers, whoever they end up being.  Most securities class action defendants are troubled by being sued, and need lawyers that they can trust to walk them through the process.  An interview process is the best way to find the lawyers who have the right combination of relevant characteristics—including skills, strategy, and bedside manner—that will best fit the needs of the defendants.

When a public company purchases a significant good or service, it typically seeks competitive proposals.  From coffee machines to architects, companies invite multiple vendors to bid, evaluate their proposals, and choose one based on a combination of quality and cost.  Yet companies named in a securities class action frequently fail to engage in a competitive interview process for their defense counsel, and instead simply retain litigation lawyers at the firm they use for their corporate work.

To be sure, it is difficult for company management to tell their outside corporate lawyers that they are going to consider hiring another firm to defend a significant litigation matter.  The corporate lawyers are trusted advisors, often former colleagues of the in-house counsel, and have usually made sacrifices for the client that make the corporate lawyers expect to be repaid through engagement to defend whatever litigation might arise.  A big litigation matter is what makes all of the miscellaneous loss-leader work worth it.  “You owe me,” is the unspoken, and sometimes spoken, message.

Corporate lawyers also make the pitch that it will be more efficient for their litigation colleagues to defend the litigation since the corporate lawyers know the facts and can more efficiently work with the firm’s litigators.  Meanwhile, they tell the client that there is no conflict – even if their work on the company’s disclosures is at issue, they assure the company that they will all be on the same side in defending the disclosures, and if they have to be witnesses, the lawyer-as-witness rules will allow them to work around the issue.

All of these assertions are flawed.  It is always – without exception – in the interests of the defendants to take a day to interview several defense firms of different types and perspectives.  And it is never – without exception – in the interests of the defendants to simply hand the case off to the litigators of the company’s corporate firm.  Even if the defendants hire the company’s corporate firm at the end of the interview process, they will have gained highly valuable strategic insights from multiple perspectives; cost concessions that only a competitive interview process will yield; better relationships with their insurers, who will be more comfortable with more thoughtful counsel selection; greater comfort with the corporate firm’s litigators, whom the defendants sometimes have never even met; and better service from the corporate firm.

Problems with Using Corporate Counsel

A Section 10(b) claim involves litigation of whether the defendants:  (1) made a false statement, or failed to disclose a fact that made what they said misleading in context; and (2) made any such false or misleading statements with intent to defraud (i.e. scienter).

Corporate counsel is very often an important fact witness for the defendants on both of these issues.  For example, in a great many cases, corporate counsel has:

  • Drafted the disclosures that plaintiffs challenge, so that the answer to the question “why did you say that?” is “our lawyers wrote it for us.”
  • Advised that omitted information wasn’t required to be disclosed, so that the answer to the question “why didn’t you disclose that” is “our lawyers told us we didn’t have to.”
  • Reviewed disclosures without questioning anything, or not questioning the challenged portion.
  • Drafted the risk factors that are the potential basis of the protection of the Reform Act’s Safe Harbor for forward-looking statements.
  • Not revised the risk factors that are the potential basis of Safe Harbor protection.
  • Advised on the ability of directors and officers to enter into 10b5-1 plans and when to do so, and on the ability of directors and officers to sell stock at certain times, given the presence or absence of material nonpublic information.
  • Advised on individual stock purchases.

The fact that the lawyer has given such advice, or not given such advice, can win the case for the defendants.  For example, for any case turning on a statement of opinion, the lawyer’s advice that the opinion had a reasonable basis virtually guarantees that the defendants won’t be liable.  Likewise, a lawyer’s drafting, revising, or advising on disclosures virtually guarantees that the defendants didn’t make the misrepresentation with scienter, and a lawyer’s advice on the timing of entering into 10b5-1 plans or selling stock makes the sales benign for scienter purposes.

To the defendants, it doesn’t matter if the lawyer was right or wrong.  As long as the advice wasn’t so obviously wrong that the client could not have followed it in good faith, the lawyer’s advice protects the defendants.  But to the lawyer, it matters a great deal for purposes of professional reputation and liability.  Deepening the conflict is the specter of the law firm defending its advice on the basis that the client didn’t tell them everything.  The interests of the lawyer and defendant client thus can diverge significantly.

That this information may be privileged doesn’t change this analysis.  Of course, the privilege belongs to the client, who can decide whether to use the information in his or her defense, or not.  But with corporate counsel’s litigation colleagues guiding the development of the facts, privileged information is rarely analyzed, much less discussed with the client.  The reality is that most privileged information isn’t truly sensitive to the client, but instead reflects a client seeking advice – and seeking the liability protection the lawyer’s advice provides.  But from the lawyer’s perspective, there can be much to protect.  Privileged communications may reflect poor legal advice, and internal files may contain candid discussions about the client and the client’s issues that would result in embarrassment to the firm, and possible termination, if produced.

Perhaps even more importantly, regular corporate counsel’s litigation colleagues may often fail to assess the case objectively, in part because it implicates the work of their corporate colleagues, and in part because of a desire not to ask hard questions that could strain the law firm’s relationship with the client.  Sometimes the problem arises from a deliberate attempt by the lawyers to protect a particular person who may have made an error leading to the litigation, such as the General Counsel (often is a former colleague), the CFO, or the CEO – all of whom are important to the client relationship.  Sometimes, though, the failure to thoughtfully analyze a case is due to a more generalized alliance with the people with whom the law firm works regularly.  It’s hard for a lawyer to scrutinize someone who will be in the firm’s luxury box at the baseball game that night, much less report a serious problem with him or her to the board.

Yet the defendants, including the board of the corporate client, need candid advice about the litigation to protect their interests.  For example, some problematic cases should be settled early, before the insurance limits are significantly eroded by defense costs and documents are produced that that will make the case even more difficult, and could even spawn other litigation or government investigations.  Defendants and corporate boards need to know this.

Corporate firms might counter that their litigation colleagues will give sound and independent advice, because they are a separate department and will face no economic or other pressure from the corporate department.  But that undermines one of the main reasons corporate lawyers urge that their litigation colleagues be hired: that it is more efficient to use the firm’s litigators since they work closely with the corporate lawyers, if not the company itself.  The corporate firm can’t have it both ways: either the litigators are close to the corporate lawyers and the company, and suffer from the problems outlined above, or they are independent, and their involvement yields little or no benefit in efficiency.  Indeed, it is most likely that the corporate firm’s litigators will be hindered by conflict, while nevertheless failing to create greater efficiency.  Just because lawyers are in a same firm doesn’t mean that they can read each other’s minds.  They still have to talk to one another, just as litigators from an outside firm would have to do.

So Why is Corporate Counsel Used So Often?

I doubt many directors or officers would disagree with the analysis above.  So why do so many companies turn to their corporate counsel without conducting an audition process?  Several practical factors impede the proper analysis of counsel selection in the initial days of a securities class action.

The single most important factor is probably that the corporate firm is first on the scene. Many companies reflexively hire their corporate firm immediately after the initial complaint is filed, or even after the stock drop, before a complaint is even filed.  By the time the defendants start to hear from other securities defense practices, they often have retained counsel.  And then it’s very difficult from a personal and practical perspective to walk the decision back.

This decision, moreover, is often made by the legal department, sometimes in consultation with the CEO and CFO.  The board is often not involved.  Instead, the board is merely presented with the decision, which can seem natural because the firm hired is familiar to them.  The directors often aren’t personally named in the initial complaint, so they might not pay as much attention as they would if they understood if they were likely to become defendants later – either in the main securities action, especially if the case involves a potential Section 11 claim, or in a tag-along shareholder derivative action.

Initial complaints can also mislead the company as to the real issues at stake.  Regular corporate counsel and the defendants may review the first complaint and incorrectly conclude that the allegations don’t implicate the lawyer’s work.  But these initial complaints are merely placeholders, because the Reform Act specifies that the lead plaintiff appointed by the court can later file an amended complaint.  Initial filers have little incentive to invest the time or effort into making detailed allegations in the initial complaint, because they may be beaten out for the lead plaintiff role.  The lead plaintiff’s amended complaint thus typically greatly expands the case to include new alleged false and misleading statements, more specific reasons why the challenged statements were false or misleading, and more detailed scienter allegations, including stock-sale and confidential-witness allegations that most initial complaints lack.  If a conflict becomes apparent at that point, however, it can be very difficult and even prejudicial to the defendants for corporate counsel to bow out.

Regular corporate counsel will often advise their clients that there is no issue with them defending the litigation, or even that doing so makes sense because they advised on the underlying disclosures.  But even if the corporate firm is trying to be candid and look out for its client’s interests, it may have blind spots in seeing its potential conflicts – especially when the corporate lawyers are facing pressure from their firm management to “hold the client.”

The pressures that lead a company to hire its corporate firm to defend the securities litigation are very real, and sometimes this decision is ultimately fine.  But I strongly believe that it is never in a client’s interest to take its corporate counsel’s advice on these issues without obtaining analysis from other securities practices as part of a competitive interview process.

The Benefits of a Competitive Process

In addition to obtaining important perspectives about potential problems with corporate counsel’s defense of the securities class action, an interview process involves myriad benefits – including tens of thousands of dollars of free legal advice.  The only cost to the company is a few hours to select the 3-5 firms that it wants to interview, and a day spent hearing presentations from those firms and discussing their analysis and approach with them.

An interview process gives defendants the opportunity to hear from several experienced securities litigators, who will offer a range of analyses and strategies on how best to defend the case.  It also allows defendants to evaluate professional credentials and personal compatibility, which are both important criteria.  It is difficult, if not impossible, for a company to evaluate how their corporate counsel’s litigators stack up against other litigators in this specialized and national practice area, without first hearing from some other firms.  Sometimes, a company will not even meet its corporate firm’s securities litigators in person before engaging them, which obviously makes it impossible for them to make judgments about personal compatibility and trust.

An interview process, if properly structured, is highly substantive.  The firms that fare best in a new-case interview typically prepare thorough discussions of the issues, and come prepared to analyze the case in great detail.  And the best ones look beyond the issues in the initial complaint to the issues that might emerge in the amended complaint, analyzing the full range of the company’s disclosures, to forecast future disclosure and scienter allegations, and evaluating the defenses that will remain even after allegations are added.

An interview process also helps the company to achieve a better deal on billing rates, staffing, and alternative fee arrangements.  Without an interview process, a law firm is much more likely to charge rack rates and do its work in the way it sees fit – which defendants are rarely in a position to challenge without having done some comparison shopping.  Even though securities class action defense costs are covered by D&O insurance, price matters in defense-counsel selection.  It is a mistake to treat D&O insurance proceeds as “free money.”  Without appropriate cost control, defendants run the risk of not having enough insurance proceeds to defend and resolve the case.  Appropriate cost control can help the litigation from resulting in a difficult or expensive D&O insurance renewal, and can allow the company to save money if the fees are less than the deductible.

An interview process also helps get the defendants off to a better start with its D&O insurers.  In addition to appreciating the cost control that an interview process yields, insurers also appreciate the defendants making a thoughtful decision on defense counsel, including vetting the potential problems with use of the company’s corporate firm.  D&O insurers and brokers are “repeat players” in securities litigation, and know the qualifications of defense counsel better than anyone else – a seasoned D&O insurance claims professional has overseen hundreds of securities class actions.  Asking insurers and brokers to help identify defense counsel to interview may therefore not only yield helpful suggestions, but may also make it easier to develop a relationship of strategic trust with the insurers – which will make it easier to obtain consent to settle early if appropriate, and if not, to defend the case through summary judgment or to trial.

Perhaps most importantly, an interview process results in a closer relationship between the defendants and their lawyers, whoever they end up being.  Most securities class action defendants are troubled by being sued, and need lawyers that they can trust to walk them through the process.  An interview process is the best way to find the lawyers who have the right combination of relevant characteristics – including skills, strategy, and bedside manner – that will best fit the needs of the defendants.

Securities litigation headlines are dominated by mega-cases. But the majority of securities class actions are brought against smaller companies. And it appears that plaintiffs’ lawyers are filing an increasingly large number of cases against smaller companies: in Cornerstone Research’s “Securities Class Action Filings: 2014 Year in Review,” the firm concludes, among other things, that (1) aggregate market capitalization loss of sued companies was at its lowest level since 1997, and (2) the percentage of S&P 500 companies sued in securities class actions “was the lowest on record.”

While the majority of securities class actions are against smaller companies, the predominate type of defense firm in all types of cases, big and small, is biglaw firms. Fees at such firms have skyrocketed since 1997. Billing rates have increased dramatically, with first-year associates now charging more per hour than senior partners did in 1997. Profits per partner at the most prominent securities litigation defense firms have at least tripled since 1997, with the “smallest” profits per partner at such firms now exceeding $1.5 million, and the largest totaling $3 million or more.

Biglaw firms are uniquely equipped to handle many types of matters. But they are not the only firms that can defend securities class actions effectively. And they aren’t well-equipped to defend smaller securities class actions efficiently; their fees have catapulted beyond what makes sense for a typical smaller securities class action. As I’ve written previously, catawampus economics can also cause problems with the effectiveness of the defense.

To illustrate the economic problem, consider hypothetical securities class actions against two smaller companies: 1997 Co., which carries $15 million in D&O insurance limits, and 2015 Co., which carries limits of $25 million. (Smaller company D&O insurance limits have increased some since 1997, but not markedly.) Assume settlements of $7.5 million in 1997, and $12.5 million in 2015.  Assume that defense costs through summary judgment were $5 million in 1997 (cases against smaller companies are nevertheless often as labor-intensive as cases against larger companies), and today are $15 million, or triple the 1997 figure, corresponding to the tripling (or more) of biglaw economics.

– Biglaw defense of 1997 Co. makes some economic sense: $5 million in defense costs, plus $7.5 million to settle, equals $12.5 million – or $2.5 million less than the D&O insurance limits.

– Biglaw defense of 2015 Co. does not make economic sense: $15 million in defense costs, plus $12.5 million to settle, equals $27.5 million – or $2.5 million more than the D&O insurance limits.

This is a problem without a good near-term global solution. Few firms outside of biglaw have the experience and expertise to defend cases effectively or efficiently, much less both effectively and efficiently. Perhaps what the securities defense bar needs is a new set of defense firms that have a combination of experience and economics similar to the 1997 versions of the technology and life sciences firms that historically have dominated securities class action defense. Such a development likely would require other biglaw lawyers to follow my lead and join excellent non-biglaw firms.  Until then, a company that is sued should engage in an especially thorough counsel-selection process, comprising three important steps:

  1. Ask its D&O broker and insurers to help sort through the possible candidates. Insurers and brokers are “repeat players” in securities litigation and usually have good insights on defense counsel.
  2. Choose several firms to interview, including firms of different types and with different strategies. The interview list should include firms other than regular outside counsel, which can be the wrong firm to defend the litigation. Conducting an interview process will not only ensure that the defendants end up with the right defense counsel, but also give them the advantages that come from engaging in a competitive hiring process.
  3. Involve the board in the hiring process.

 

In my last post of 2013, I thought I’d share some thoughts about how public companies can better protect themselves against securities claims – practical steps companies can take to help them avoid suits, mitigate the risk if they are sued, and to defend themselves more effectively and efficiently.  I’ll share a few thoughts in this post and expand on some of them in future posts.

How Can Companies Avoid Securities Litigation?

Companies can avoid many suits with what I’ll call “better-feeling” disclosures.  Nearly all public companies devote significant resources to accounting that conforms with GAAP, and non-accounting disclosures that comply with the labyrinth of disclosure rules.  Despite tremendous efforts in these areas, later events sometimes surprise officers and directors – and the market – and make a company’s previous accounting or non-accounting disclosures appear to have been inaccurate.

But plaintiffs’ lawyers decide to sue only a subset of such companies – a smaller percentage than most people would assume.  What makes them sue Company A, but not Company B, when both have suffered a stock price drop due to a development that relates to their earlier disclosures?  There are a number of factors, but I believe the driver is whether a company’s disclosures “feel” fair and honest.  Without the benefit of discovery, plaintiffs’ lawyers have to draw inferences about whether litigation will reveal fraud or a sufficient degree of recklessness – or show that the discrepancies between the earlier disclosures and later revelations was due to mistake or an unanticipated development.

What can companies do to make their disclosures “feel “more honest?

An easy way for companies to make their disclosures feel more honest and forthright is to improve the quality of their Safe Harbor warnings.  Although the Reform Act’s Safe Harbor was designed to protect companies from lawsuits over forward-looking statements, there are still an awful lot of such actions filed.  The best way to avoid them is by crafting risk warnings that are current and candid.  A plaintiffs’ lawyer who reads two years’ worth of risk factors can tell whether the risk factors are boilerplate, or an honest attempt to describe the company’s risks.  The latter deters suits.  The former invites them.

Another way for companies to improve their disclosures is through more precision and a greater feel of candor in the comments they make during investor conference calls.  Companies sweat over every detail in their written disclosures, but then send their CEO and CFO out to field questions on the very same subjects and improvise their responses.  What executives say, and how they say it, often determines whether plaintiffs’ lawyers sue – and, if they do, how difficult the case will be to defend.  A majority of the most difficult statements to defend in a securities class action are from investor calls, and plaintiffs’ lawyers listen to these calls and form impressions, positive and negative, about officers’ fairness and honesty.

Companies looking to minimize the risks of litigation should also take steps to prevent their officers and directors from making suspicious-looking stock sales – for obvious reasons, plaintiffs’ lawyers like to file suits that include stock sales.  If a company’s officers and directors don’t have 10b5-1 plans, companies should establish and follow an insider trading policy and, when in doubt, seek guidance from outside counsel on issues such as trading windows and the propriety of individual stock sales, both as to the legal ability to sell, and how the sales will appear to plaintiffs’ lawyers.  And even if their officers and directors have 10b5-1 plans, companies aren’t immune to the scrutiny of their stock sales – plaintiffs’ lawyers usually aren’t deterred by 10b5-1 plans, contrary to conventional wisdom. So companies should consult with their counsel about establishing and maintaining the plans, to avoid traps for the unwary.

How Can Companies Better Protect Themselves Against Securities Litigation that Does Arise?

Whether a securities class action is a difficult experience or a fairly routine corporate legal matter usually turns on the company’s decisions about directors’ and officers’ indemnification and insurance, its choice of defense counsel, and its management of the defense of the litigation.

Deciding on the right director and officer protections and defense counsel require an understanding of the seriousness of securities class actions.  Although securities class actions are a public company’s primary D&O litigation exposure,* most companies don’t understand the degree of risk they pose.  Some companies seem to take securities class actions too seriously, while others might not take them seriously enough.

The right level of concern is almost always in the middle.  A securities class action is a significant lawsuit.  It alleges large theoretical damages and wrongdoing by senior management and often the board.  But the risk presented by a securities action is usually very manageable, if the company hires experienced, non-conflicted and efficient counsel, and devotes sufficient time and energy to the litigation.  Cases can be settled for a predictable amount, and it is exceedingly rare for directors and officers to write a personal check to defend or settle the case.  On the other hand, it can be a costly mistake for a company to take a securities class action too lightly; even meritless cases can go wrong.

The right approach to securities litigation involves several practical steps that are within every company’s control.

Companies should hire the right D&O insurance broker and treat the broker as a trusted advisor.  There is a talented and highly specialized community of D&O insurance brokers.  Companies should evaluate which is the right broker for them – they should conduct an interview process to decide on the right broker, and seek guidance from knowledgeable sources, including securities litigation defense counsel.  Companies should heavily utilize the broker in deciding on the right structure for their D&O insurance program and in selecting the right insurers.  And since D&O insurance is ultimately about protecting officers and directors, companies should have the broker speak directly to the board about the D&O insurance program.

Boards should learn more about their D&O insurers.  Boards should know their D&O insurers’ financial strength and other objective characteristics.  But boards should also consider speaking with the primary insurer’s underwriting executives from time to time, especially if the relationship with the carrier is, or may be, long-term.  The quality of any insurance turns on the insurer’s response to a claim. D&O insurance is a relationship business.  Insurers want to cover D&O claims, and it is important to them to have a good reputation for doing so.  The more the insurer knows the company, the more comfortable the insurer will be about covering even a difficult claim.  And the more a board knows the insurer, the more comfortable the board will be that the insurer will cover even a difficult claim.

Boards should oversee the defense-counsel selection process, and make sure the company conducts an interview process and chooses counsel based on value.  The most important step for a company to take in defending a securities class action is to conduct an audition process through which the company selects conflict-free defense counsel who can provide a quality defense – at a cost that leaves the company enough room to defend and resolve the litigation within policy limits.  Put differently, the biggest threats to an effective defense of a securities class action are the use of either a conflicted defense counsel, defense counsel who will charge an irrational fee for the litigation, or counsel who will cut corners to make the economics appear reasonable.

Errors in counsel-selection most often occur when a company fails to conduct an interview process, or fails to consult with its D&O insurers and brokers, who are “repeat players” in D&O litigation and thus have good insights on the best counsel for a particular case.  Although the Reform Act’s 90-day lead plaintiff selection process gives companies plenty of time to evaluate, interview, and select the right defense counsel for the case, many companies quickly hire their corporate counsel’s litigation colleagues, without consulting with brokers and insurers or interviewing other firms.

The right counsel may end up being the company’s normal corporate firm, but a quick hiring decision rarely makes sense under a cost-benefit analysis.  The cost of hiring the wrong firm can substantial – the harm includes millions of dollars of unnecessary fees; hundreds of hours of wasted time by the board, officers, and employees; an outcome that is unnecessarily uncertain; and an unnecessarily high settlement – and there’s very little or no upside to the company.

On the other hand, it costs very little to interview several firms for an hour or two each, and the benefit can be substantial – free and specialized strategic advice by several of the handful of lawyers who defend securities litigation full time, and potentially substantial price and other concessions from the firm that is ultimately chosen.  The auditioning lawyers can also provide guidance to the company on whether its corporate counsel faces conflicts and, if so, the potential harm to the company and the officers and directors from hiring corporate counsel anyway.

 

* This discussion focuses on public company securities class actions. I set aside shareholder derivative litigation and shareholder challenges to mergers, which typically involve lesser risk.