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.

The history of securities and corporate governance litigation is full of wishes about the law that we later regret (or will), or are happy were not granted.  Many of these are not obvious—and some will surprise people.  From certain case-by-case tactical decisions such as establishment of special litigation committees, to the (failed) attempt to abolish the fraud-on-the-market doctrine, to the very high standard for director liability for oversight failures, not everything that seems helpful to companies really is.

I will publish a series of blog posts on this topic over the coming months.  This month’s post discusses the Private Securities Litigation Reform Act, with a focus on two provisions: the safe harbor for forward-looking statements (“Safe Harbor”), and lead plaintiff procedures.

Overview of the Reform Act

The Reform Act was passed by the Contract-with-America Congress to address its perception that securities class actions were reflexive, lawyer-driven litigation that often asserted weak claims based on little more than a stock drop, and relied on post-litigation discovery, rather than pre-litigation investigation, to sort out the validity of the claims.  The Reform Act, among other things:

  • Imposed strict pleading standards for showing both falsity and scienter, to curtail frivolous claims by increasing the likelihood that they would be dismissed.
  • Created the Safe Harbor, to encourage companies to make forecasts and other predictions without undue fear of liability.
  • Imposed a stay of discovery until the motion-to-dismiss process is resolved, to prevent discovery fishing expeditions and to eliminate the burden of discovery for claims that do not meet the enhanced pleading standards.
  • Created procedures for selecting a lead plaintiff with a substantial financial stake in the litigation, to discourage lawyer-driven actions and the “race to the courthouse.”

Over my career as a securities litigator, I’ve seen both sides of the securities-litigation divide that the Reform Act created.  In the first part of my career, I witnessed the figurative skid marks in front of courthouses, as lawyers raced to the courthouse to file claims before knowing if there really was a claim to be filed—the emblem of the problems Congress sought to correct.  And in the 21 years since, I’ve seen the Reform Act both succeed and fail to achieve the results Congress intended.

Having lived the before and after, I would not argue that the Reform Act has not helped companies and their directors and officers.  It certainly has.  But it is a mixed bag.  Indeed, I can argue that even the heightened falsity and scienter pleading standards have caused harm.  For example, the pleading standards lead even the most prominent defense lawyers to rely heavily on the lack of words in a complaint—the securities litigation equivalent of “neener neener neener”—instead of using the complaint and judicially noticeable facts to cogently explain why the defendants didn’t say anything false, much less on purpose.

Over-reliance on the pleading standards is a strategic mistake.  The Reform Act’s standards give judges enormous discretion; they can dismiss most complaints, or not, with little room to challenge their decisions upon appeal.  Winning motions recognize the human element to this discretion.  Even if a complaint is technically deficient, judges are less likely to dismiss it (certainly less likely to dismiss it with prejudice) if they nevertheless get the feeling that the defendants committed fraud.  Effective motions use the leeway given to defendants by the Reform Act, and now the Supreme Court’s decisions in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318 (2015), and Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), to build a robust factual record that gives judges a sense of comfort that they are not only following the law, but that by strictly applying the Reform Act’s protections, they are also serving justice.  And even if the judge doesn’t dismiss the case, he or she will leave the motion to dismiss process with a better feeling about the case going forward.  But the pleading standards can be an attractive nuisance, distracting defense lawyers from the best way to defend their clients.

The pleading standards have also spawned a sideshow of “confidential witnesses,” primarily former employees who provide plaintiffs’ lawyers with internal corporate information to help them meet the pleading standards.  In addition to raising whistleblower issues, causing fights over misuse of confidential information, and airing dirty laundry, the use of confidential witnesses has resulted in fights between plaintiffs’ lawyers and recanting witnesses requiring judicial intervention.

In one especially contentious dispute, Judge Rakoff spent a day taking testimony from recanting witnesses and a plaintiffs’ investigator, and took additional time to write an opinion commenting on this issue after the parties had settled the litigation.  He concluded his nine-page opinion as follows:

The sole purpose of this Memorandum … is to focus attention on the way in which the PSLRA and decisions like Tellabs have led plaintiffs’ counsel to rely heavily on private inquiries of confidential witnesses, and the problems this approach tends to generate for both plaintiffs and defendants.   It seems highly unlikely that Congress or the Supreme Court, in demanding a fair amount of evidentiary detail in securities class action complaints, intended to turn plaintiffs’ counsel into corporate “private eyes” who would entice naïve or disgruntled employees into gossip sessions that might support a federal lawsuit.  Nor did they likely intend to place such employees in the unenviable position of having to account to their employers for such indiscretions, whether or not their statements were accurate.  But, as it is, the combined effect of the PSLRA and cases like Tellabs are likely to make such problems endemic.

We may well see this problem as one of the underpinnings of a legislative attempt to reform the Reform Act one day.

In any event, and regardless of one’s views of the pleading standards’ overall benefits, two other Reform Act provisions certainly have grown to be problematic for public companies: the Safe Harbor, and the lead plaintiff provisions.

The Safe Harbor for Forward-Looking Statements

The Safe Harbor was a centerpiece of the Reform Act.  Lawsuits prompted by announcements of missed earnings forecasts deterred companies from giving valuable earnings guidance.  Congress sought to encourage guidance and other forward-looking statements by precluding liability if the statements were accompanied by “meaningful cautionary statements” or made without “actual knowledge” that they were false.  15 U.S.C. § 77z-2(c)(1); 15 U.S.C. § 78u-5(c)(1).

Yet the Safe Harbor is anything but safe.  In the 21 years of the Reform Act, surprisingly few dismissals are based solely the Safe Harbor; instead, courts either use it as  fallback grounds for dismissal, or just sidestep it—which has resulted in some significant legal errors.  The most notorious erroneous Safe Harbor decision was written by one of the country’s most renowned judges, Judge Frank Easterbrook, in Asher v. Baxter, 377 F.3d 727 (7th Cir. 2004).  Judge Easterbrook read into the Safe Harbor the word “the” before “important” in the phrase “identifying important factors,” to then hold that discovery was required to determine whether the company’s cautionary language contained “the (or any of the) ‘important sources of variance’” between the forecast and the actual results.  Id. at 734.

The reason for this judicial antipathy was best articulated by Bill Lerach, who famously said that the Safe Harbor would give executives a “license to lie.”  Judges have tended to agree with his conclusion.  Some have been quite explicit about it.  For example, in In re Stone & Webster, Inc. Securities Litigation, the First Circuit called the Safe Harbor a “curious statute, which grants (within limits) a license to defraud.”  414 F.3d 187, 212 (1st Cir. 2005).  And the Second Circuit, in its first decision analyzing the Safe Harbor—15 years after the Reform Act was enacted, illustrating the degree of judicial avoidance—correctly interpreted “or” to mean “or,” but stated that “Congress may wish to give further direction on …. the reference point by which we should judge whether an issuer has identified the factors that realistically could cause results to differ from projections.  May an issuer be protected by the meaningful cautionary language prong of the Safe Harbor even where his cautionary statement omitted a major risk that he knew about at the time he made the statement?”  Slayton v. American Express Co., 604 F.3d 758, 772 (2d Cir. 2010).  Probably for this reason, the Safe Harbor has not deterred plaintiffs’ counsel from continuing to bring false forecast cases.  Twenty-one years later, a great many securities class actions still focus on earnings forecasts and other forward-looking statements.

Much of this problem is self-inflicted.  We defense lawyers have worsened the judicial antipathy and reluctance to issue rulings on Safe Harbor grounds by making hyper-technical arguments that are detached from any notion that the challenged forward-looking statements aren’t false in the first place.  Most challenged forward-looking statements are true statements of opinion—an especially strong argument under the Supreme Court’s Omnicare decision—and don’t even need the Safe Harbor’s protection.  But by bypassing the falsity argument, and falling back on the Safe Harbor, defense counsel plays right into plaintiffs’ hands.  Many defense lawyers try to overcome this problem by emphasizing that Congress intended to immunize even unfair forward-looking statements, if they are accompanied by appropriate warnings.  But judges don’t like caveat emptor, and they don’t like liars—regardless of Congressional intent.  A much better way to defend forward-looking statements is to show that they were true statements of opinion and then use the Safe Harbor as a fallback argument.  It makes the judge feel comfortable dismissing the claim in either or both ways.  But few defense lawyers take that approach.

Finally, companies and their outside corporate counsel have contributed to the Safe Harbor’s lack of safety by failing to describe their risks in a fresh and detailed way each quarter.  When I evaluate a securities class action complaint that challenges forward-looking statements and other statements of opinion (which comprise nearly all securities cases), one of the first things I look for is the progression of the risk factors each quarter.  Using a chart, I read them from start to finish, just as the judge will when we create the context for our arguments against falsity and to support the application of the Safe Harbor.  Are the risk factors specific or generic?  Do they change over time or are they static?  Do the changes in the risk factors track disclosed changes in business conditions?  Etc.  But companies and their outside corporate counsel frequently devolve to boilerplate, and fail to draft careful disclosures that make a judge feel comfortable that they were trying to disclose their real risks each quarter.

Lead Plaintiff Procedures

The symbol of the pre-Reform Act era is the race to the courthouse among plaintiffs’ lawyers to file a complaint first and thus win the lead counsel role.  Congress intended the heightened pleading standards and the Safe Harbor to play a role in fixing that problem, because they are meant to incentivize plaintiffs to do more pre-filing investigation.  However, the Reform Act’s lead plaintiff provisions—which require the court to choose a lead plaintiff and lead plaintiff’s counsel after a beauty contest—undermine that goal, since only the lead plaintiff has an economic incentive to invest much time and money in an investigation.  So although the initial filer no longer has a competitive advantage by being the first plaintiff to file, the initial complaint is still routinely filed without any real investigation or worry about satisfying the pleading standards.

The lead plaintiff procedures were also designed to prevent lawyer-driven litigation, by providing that the lead plaintiff is presumptively the plaintiff with the largest financial loss—i.e., a plaintiff with “skin in the game.”  While that goal is salutary, it has spawned complex and mixed results.  The Reform Act’s lead plaintiff process incentivized plaintiffs’ firms to recruit institutional investors to serve as plaintiffs.  For the most part, institutional investors, whether smaller unions or large funds, retained the more prominent plaintiffs’ firms, and smaller plaintiffs’ firms were left with individual retail investor clients who usually can’t beat out institutions for the lead plaintiff role.  At the same time, securities class action economics tightened in all but the largest cases.  Dismissal rates under the Reform Act are pretty high, and defeating a motion to dismiss often requires significant investigative costs and intensive legal work.  And the median settlement amount of cases that survive dismissal motions is fairly low.  These dynamics placed a premium on experience, efficiency, and scale.  Larger firms filed the lion’s share of the cases, and smaller plaintiffs’ firms were unable to compete effectively for the lead plaintiff role, or make much money on their litigation investments.

But nature abhors a vacuum—here, a securities litigation system that leaves out retail investors and smaller plaintiffs’ firms.  So, it was inevitable that these alienated groups would find a way to bring securities class actions. As I’ve chronicled previously, this void started to be filled with the wave of cases against Chinese issuers in 2010.  Smaller plaintiffs’ firms initiated the lion’s share of these cases, primarily on behalf of retail investors, as the larger firms were swamped with credit-crisis cases and likely were deterred by the relatively small damages, potentially high discovery costs, and uncertain insurance and company financial resources.  Moreover, these cases fit smaller firms’ capabilities well; nearly all of the cases had “lawsuit blueprints” such as auditor resignations and/or short-seller reports, thereby reducing the smaller firms’ investigative costs and increasing their likelihood of surviving a motion to dismiss.  The dismissal rate has indeed been low, and limited insurance and company resources have prompted early settlements in amounts that, while on the low side, appear to have yielded good outcomes for the smaller plaintiffs’ firms.

With these gains in efficiency, market share, and money, these smaller plaintiffs’ firms have continued to file a large number of securities class actions on behalf of retail investors.  Like the China cases, these tend to be against smaller companies.  Thus, smaller plaintiffs’ firms have discovered a class of cases—cases against smaller companies that have suffered well-publicized problems that reduce the plaintiffs’ firms’ investigative costs—for which they can win the lead plaintiff role and that they can prosecute at a sufficient profit margin.

We now have two classes of prominent plaintiffs and plaintiffs’ firms:  larger firms with institutional investor clients, as Congress intended, and smaller plaintiffs’ firms with smaller individual clients, which Congress sought to displace.   In a sense, we’re back to where we started, but now with more aggressive institutional investors to boot.

Smaller plaintiffs’ firms’ permanent arrival on the scene has led to two sets of additional problems.

First, smaller plaintiffs’ firms have ratcheted up the number of press releases by plaintiffs’ firms seeking plaintiffs to file a securities class action.  There have always been plaintiff law firm “investigations” to try to find plaintiffs to file lawsuits, but there has been nothing short of an avalanche in recent years.  This is so for a number of reasons. Unlike larger plaintiffs’ firms that have spent 21 years cultivating institutional investor clients as the Reform Act envisioned, smaller plaintiffs’ firms generally don’t have existing attorney-client relationships with potential plaintiffs who own a wide range of securities—so they need to recruit plaintiffs for particular cases. Smaller plaintiffs’ firm successes are drawing more smaller firms into the securities class action business.  This competition is resulting in an “investigation” following nearly every negative corporate announcement.  Increasingly, this is so even if the stock price drop is relatively small—indeed, I’ve seen more investigations and subsequent securities class actions follow single-digit stock drops than ever before, likely because the of the number of smaller-firm players and the reality that a small case is better than none.  The press release process is repeated after a lawsuit is filed.  As the Reform Act requires, the first filer publishes a press release announcing the filing. Other smaller plaintiffs’ firms then publish their own announcements that a lawsuit has been filed in order to find a good lead plaintiff contestant.  Each firm publishes their own notice, and the firms then publish reminders leading up to the lead plaintiff filing deadline 60 days later.

To put it mildly, this process is a real nuisance, especially for smaller companies. Investors, employees, and other stakeholders who don’t understand this process sometimes perceive that the company is falling apart.  Dealing with their concerns can cause officers and directors to become distracted.  The result can be further deterioration of the company’s business and financial condition, and an unwarranted sell-off of the company’s stock.  This can be about more than money—for example, development of life-saving drugs can be slowed or even derailed. Obviously, none of that is good.  I doubt the plaintiffs’ lawyers themselves would disagree, but instead would say that they’re simply working under the Reform Act’s lead plaintiff procedures.

Second, the fervent competition among smaller plaintiffs’ firms is affecting the types of cases filed and settlement dynamics.  Although the smaller plaintiffs’ firms’ bread-and-butter are “lawsuit blueprint” cases that often have difficult facts, they are also filing many low-merit cases, such as challenges to earnings guidance.  At the same time, the intense competition sometimes results in more difficult and protracted litigation, meritorious or not.  There are usually other smaller plaintiffs’ firms on the scene through tag-along derivative suits or as co-lead securities class action counsel, and none of the firms wants the others to see it as a pushover for wanting to settle for an amount they’d otherwise gladly take.  That said, it’s also true that smaller plaintiffs’ firms are defeating an increasing number of motions to dismiss and can be formidable adversaries—which of course gives them greater leverage and leads to more difficult litigation to defend and resolve.

Conclusion

Although these issues won’t make the legislative agenda anytime soon, we defense lawyers can make a difference.  We can:

  • Emphasize the truth of the challenged statements through the tools the Reform Act and Supreme Court have provided, and avoid over-reliance on the Safe Harbor and pleading standards.
  • Ask courts to impose clear leadership and coordination between and among securities class action and derivative plaintiffs’ counsel.
  • Educate companies about the reasons for the frustrating flurry of press releases.

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

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

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

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

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

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

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

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

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

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

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

In combination with the Delaware Court of Chancery’s decision in In re Trulia, Inc. Stockholder Litigation, 129 A.3d 884 (Del. Ch. 2016), Judge Posner’s blistering opinion In re Walgreen Company Stockholder Litigation, 2016 WL 4207962 (7th Cir. Aug. 10, 2016), may well close the door on disclosure-only settlements in shareholder challenges to mergers.  That certainly feels just.  And it may well go a long way toward discouraging meritless merger litigation.  But, as I’ve cautioned, I am concerned that we will regret it.  Lost in the cheering over Trulia and Walgreen is a simple and practical reality: the availability of disclosure-only settlements is in the interests of merging companies as much as it is in the interests of shareholder plaintiffs’ lawyers, because disclosure-only settlements are often the most timely and efficient way to resolve shareholder challenges to mergers, even legitimate ones.

I am offended by meritless merger litigation, and have long advocated reforms to fix the system that not only allows it, but encourages and incentivizes it.  Certainly, strict scrutiny of disclosure-only settlements will reduce the number of merger claims—it already has.  Let’s say shareholder challenges mergers are permanently reduced from 90% to 60% of transactions.  That would be great.  But how do we then resolve the cases that remain?  Unfortunately, there aren’t efficient and generally agreeable alternatives to disclosure-only settlements to dispose of a merger lawsuit before the closing of the challenged transaction.  Of course, the parties can increase the merger price, though that is a difficult proposition.  The parties can also adjust other deal terms, but few merger partners want to alter the deal unless and until the alteration doesn’t actually matter, and settlements based on meaningless deal-structure changes won’t fare better with courts than meaningless disclosure-only settlements.

If the disclosure-only door to resolving merger cases is shut, then more cases will need to be litigated post-close.  That will make settlement more expensive.  Plaintiffs lawyers are not going to start to settle for less money, especially when they are forced to litigate for longer and invest more in their cases.   And in contrast to adjustments to the merger transaction or disclosures, in which 100% of the cash goes to lawyers for the “benefit” they provided, settlements based on the payment of cash to the class of plaintiffs require a much larger sum to yield the same amount of money to the plaintiffs’ lawyers.  For example, a $500,000 fee payment to plaintiffs’ under a disclosure-only settlement would require around $2 million in a settlement payment to the class to yield the same fee for the plaintiffs’ attorneys, assuming a 25% contingent-fee award.

The increase in the cash outlay required for companies and their insurers to deal with post-close merger litigation will actually be much higher than my example indicates.  Plaintiffs’ lawyers will spend more time on each case, and demand a higher settlement amount to yield a higher plaintiffs’ fee.  Defense costs will skyrocket.  And discovery in post-close cases will inevitably unearth problems that the disclosure-only settlement landscape camouflaged, significantly increasing the severity of many cases.  It is not hard to imagine that merger cases that could have settled for disclosures and a six-figure plaintiffs’ fee will often become an eight-figure mess.  And, beyond these unfortunate economic consequences, the inability to resolve merger litigation quickly and efficiently will increase the burden upon directors and officers by requiring continued service to companies they have sold, as they are forced to produce documents, sit for depositions, and consult with their defense lawyers, while the merger case careens toward trial.

Again, it’s hard to disagree with the logic and sentiment of these decisions, and the result may very well be more just.  But this justice will come with a high practical price tag.

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

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

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

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

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

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

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

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

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

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

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

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

In 2015, the Private Securities Litigation Reform Act* turned twenty years old.

Over my career as a securities litigator, I’ve seen both sides of the securities-litigation divide that the Reform Act created.  In the first part of my career, I witnessed the figurative skid marks in front of courthouses, as lawyers raced to the courthouse to file claims before knowing if there really was a claim to be filed – the emblem of the problems Congress sought to correct.  And in the 20 years since, I’ve seen the Reform Act both succeed and fail to achieve the results Congress intended.

In this blog post, I assign grades to each of the Reform Act’s key provisions, and an overall grade.  The Reform Act’s successes and failures derive from an amalgam of factors, ranging from Congressional insight and oversight, to good and bad lawyering by plaintiffs’ and defense lawyers alike, to good and bad judging.  The grades I assign are necessarily based on a defense perspective, and mine at that – but I do try to be fair.

Grading the Reform Act’s Key Provisions

The Reform Act was passed by the Contract-with-America Congress to address its perception that securities class actions were reflexive, lawyer-driven litigation that often asserted weak claims based on little more than a stock drop, and relied on post-litigation discovery, rather than pre-litigation investigation, to sort out the validity of the claims.  The Reform Act, among other things:

  • Imposed strict pleading standards for showing both falsity and scienter, to curtail frivolous claims by increasing the likelihood that they would be dismissed;
  • Created a Safe Harbor for forward-looking statements, to encourage companies to make forecasts and other predictions without undue fear of liability;
  • Imposed a stay of discovery until the motion-to-dismiss process is resolved, to prevent discovery fishing expeditions and to eliminate the burden of discovery for claims that do not meet the enhanced pleading standards; and
  • Created procedures for selecting a lead plaintiff with a substantial financial stake in the litigation, to discourage lawyer-driven actions and the “race to the courthouse.”

Following are my grades for each of these provisions:

Falsity Pleading Standard – Grade: D

The Reform Act requires a plaintiff to plead the element of a false or misleading statement with particularity.  Indeed, the statute says that “if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.” 15 U.S.C. § 78u-4(b)(1) (emphasis added).

Yet this powerful tool is now almost a museum piece.  I don’t just mean the “all facts” part – an issue plaintiffs and defendants heavily litigated for years,  before courts converged around the proposition that plaintiffs only need to include enough detail to adequately plead the claim.  Rather, I mean that most defense firms now merely go through the motions of attacking and analyzing plaintiffs’ falsity allegations.

How could that have happened?  To be blunt, it’s mostly through bad lawyering by defense lawyers, who got sidetracked by the Safe Harbor and the scienter pleading standard (see below), and by self-indulgent statutory analysis, such as what Congress meant by the term “all facts.”  In doing so, they overlooked the more basic but powerful point: the Reform Act’s falsity standard must be a higher and different hurdle than Rule 9(b), requiring a robust analysis of the falsity allegations.  And when they got distracted, defense counsel took their eye off their main job: to stick up for their clients’ honesty.

Indeed, the core argument of virtually every motion to dismiss should be that the defendants told the truth and said nothing false.  The Reform Act, and now the Supreme Court’s decision in Omnicare, Inc. v. Laborers Dist. Council Const. Industry Pension Fund, 135 S. Ct. 1318 (2015), leave securities defense lawyers with broad latitude to attack falsity.  A proper falsity analysis always starts by examining each challenged statement individually, and matching it up with the facts that plaintiffs allege illustrate its falsity.  From there, the truth of what the defendants said can be supported in numerous ways that are still within the proper scope of the motion-to-dismiss standard:  showing that the facts alleged do not actually undermine the challenged statements, because of mismatch of timing or substance; pointing out gaps, inconsistencies, and contradictions in plaintiffs’ allegations; demonstrating that the facts that plaintiffs assert are insufficiently detailed under the Reform Act; attacking allegations that plaintiffs claim to be facts, but which are really opinions, speculation, and unsupported conclusions; putting defendants’ allegedly false or misleading statements in their full context to show that they were not misleading; and pointing to judicially noticeable facts that contradict plaintiffs’ theory.

These arguments must be supplemented by a robust understanding of the relevant factual background, which defines and frames the direction of any argument based on the complaint and judicially noticeable facts.  Yet most motions to dismiss do not make a forceful argument against falsity that is supported with a specific challenge to the facts alleged by the plaintiffs.  Some motions superficially assert that the allegations are too vague to satisfy the pleading standard, but do not engage in a detailed defense of the challenged statements.  Others simply attack the credibility of “confidential witnesses” without addressing in sufficient detail the content of the information the complaint attributes to them.  And others fall back on the doctrine of “puffery,” essentially conceding that the statements may have been lies, but contending that they were not specific or important enough to be taken seriously.  By focusing on these and similar approaches, a brief may leave the judge with the impression that defendants concede falsity, and that the real defense is that the false statements were not made with scienter.  Not only is this an argument not available for Section 11 and 12 claims, but defense counsel’s failure to attack falsity allegations in detail actually undermines the argument that defendants did not have scienter.

The Reform Act’s falsity pleading standard was an enormous gift for defense attorneys, which enables them to mount a strong and vibrant defense on a motion to dismiss if it is used correctly.  But because it has not been used to its potential, I give it a D.

Scienter Pleading Standard – Grade: C

The Reform Act says that “with respect to each act or omission alleged to violate this chapter, [plaintiffs must] state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind,” i.e., scienter. 15 U.S.C. § 78u-4(b)(2).

Defense lawyers have billed billions of dollars analyzing and briefing what these simple words mean.  We argued for years about the meaning of “the required state of mind” – did it mean actual intent, recklessness, or a hybrid?  We litigated how courts must consider whether plaintiffs have pleaded a “strong inference” of that state of mind, an issue ultimately decided by the Supreme Court in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), which held that courts must weigh inferences of scienter to decide whether the alleged inference of fraud is stronger than opposing innocent inferences.  We then argued over whether Tellabs did away with the various “rules” courts had established, such as the amount or percentage of stock holdings a defendant had to sell before his or her sales suggested scienter, and whether looking at stock sales, or any other type of scienter allegation, in isolation was even allowed.  And we have argued over the degree of particularity Congress intended to require, and engaged in thousands of “did so, did not” spats over whether the allegations met the standard for which we were arguing.

For defendants, the overall outcome of all of this is decent.  The dismissal rate is pretty good, and the vast majority of dismissals are based on plaintiffs’ failure to plead scienter.  But the defense counsel community’s intense focus on improving the defendant-friendly scienter standard contributed to the distraction that sidetracked good falsity analysis.  And to what end?  I would bet a great deal that the difference between plain old “recklessness” and a slightly higher degree of recklessness has made no real difference in the dismissal rate.  A judge who believes that a defendant didn’t mean to say something false would not deny a motion to dismiss simply over a slightly different formulation of the legal standard.

But defendants have achieved this decent dismissal rate without their defense counsel making the best possible arguments for them.  As with falsity, the primary flaw in most defense arguments against scienter is with defense counsel’s failure to engage in a fact-specific analysis of the complaint’s allegations about what the defendants knew in regard to each specific challenged statement.  All too often, defendants allow themselves to be sidetracked by technicalities, or even worse, drawn to the plaintiffs’ preferred ground of battle, focusing on arguing about the sufficiency of the circumstantial evidence that plaintiffs use to create the impression that the defendants must have done something wrong.

Both of these flaws are found in defense counsel’s typical approach to plaintiffs’ arguments under the “core operations” inference of scienter and the “corporate scienter” doctrine.  Each of these theories allows a plaintiff to avoid pleading specific facts establishing the speaker’s scienter.  For example, the core operations inference posits that scienter can be inferred where it would be “absurd to suggest” that a senior executive doesn’t know facts about the company’s “core operations.”  Many motions to dismiss set up some formulation of this statement as a legal rule and then use it to make a simplistic syllogistic argument.  Such arguments devolve into “did not, did so” debates, and thus play into plaintiffs’ hands because they are detached from knowledge of falsity.  Instead, the right approach to the core operations inference is to understand that it requires a falsity so blatant that we can strongly infer that the executive had knowledge of the exact facts that made the statement false – not just the subject matter of the facts.  The most effective defense against the core operations inference thus focuses on falsity first, to show that even if a statement is false, it is at least a close call – making it hard for plaintiffs to contend that defendants must have known of this falsity.  But this can’t be done effectively if the argument against falsity does not vigorously attack the falsity allegations.

For these reasons, I give defense counsel’s use of the scienter pleading standard an overall grade of C: a B for the results and a D for how we got there.

Safe Harbor – Grade: D

The Safe Harbor for forward-looking statements was a centerpiece of the Reform Act.  Companies were being sued following announcements of missed earnings forecasts, which deterred companies from giving valuable earnings guidance.  Congress sought to encourage companies to give guidance and make other forward-looking statements by shielding such statements from liability if they are accompanied by “meaningful cautionary statements” or made without “actual knowledge” that they were false.  15 U.S.C. § 77z-2(c)(1); 15 U.S.C. § 78u-5(c)(1).

Yet the Safe Harbor is anything but safe.  In the 20 years of the Reform Act, surprisingly few dismissals are based solely the Safe Harbor; instead, courts either use it as  fallback grounds for dismissal, or just sidestep it – which has resulted in some significant legal errors.  The most notorious erroneous Safe Harbor decision was written by one of the country’s most renowned judges, Judge Frank Easterbrook, in Asher v. Baxter, 377 F.3d 727 (7th Cir. 2004).  Judge Easterbrook read into the Safe Harbor the word “the” before “important” in the phrase “identifying important factors,” to then hold that discovery was required to determine whether the company’s cautionary language contained “the (or any of the) ‘important sources of variance’” between the forecast and the actual results.  Id. at 734.

The reason for this judicial antipathy was best articulated by Bill Lerach, who famously said that the Safe Harbor would give executives a “license to lie.”  Judges have tended to agree with this conclusion.  Some have been quite explicit about it.  For example, in In re Stone & Webster, Inc. Securities Litigation, the First Circuit called the Safe Harbor a “curious statute, which grants (within limits) a license to defraud.”  414 F.3d 187, 212 (1st Cir. 2005).  And the Second Circuit, in its first decision analyzing the Safe Harbor – 15 years after the Reform Act was enacted, illustrating the degree of judicial avoidance – correctly interpreted “or” to mean “or,” but stated that “Congress may wish to give further direction on …. the reference point by which we should judge whether an issuer has identified the factors that realistically could cause results to differ from projections.  May an issuer be protected by the meaningful cautionary language prong of the safe harbor even where his cautionary statement omitted a major risk that he knew about at the time he made the statement?”  Slayton v. American Express Co., 604 F.3d 758, 772 (2d Cir. 2010).  Probably for this reason, the Safe Harbor has not deterred plaintiffs’ counsel from continuing to bring false forecast cases.  Twenty years later, a great many securities class actions still focus on earnings forecasts and other forward-looking statements.

We as a defense community have worsened the judicial antipathy and reluctance to issue rulings on Safe Harbor grounds, by making hyper-technical arguments that are detached from any notion that the challenged forward-looking statements aren’t false in the first place.  Most challenged forward-looking statements are true statements of opinion, and don’t even need the Safe Harbor’s protection.  But by bypassing the falsity argument, and falling back on the Safe Harbor, defense counsel plays right into plaintiffs’ hands.  Many defense lawyers try to overcome this problem by emphasizing that Congress intended to immunize even unfair forward-looking statements, if they are accompanied by appropriate warnings.  But this species of the disfavored defense of caveat emptor rings hollow.  Judges don’t like caveat emptor, and they don’t like liars – regardless of Congressional intent.  A much better way to defend forward-looking statements is to show that they were true statements of opinion, and then use the Reform Act as a fallback argument.  It makes the judge feel comfortable dismissing in either or both of two ways.  But few defense lawyers take that approach.

Finally, companies and their outside corporate counsel have contributed to the Safe Harbor’s lack of safety by failing to describe their risks in a fresh and detailed way each quarter.  When I evaluate a securities class action that challenges forward-looking statements and other statements of opinion (which comprise nearly all securities cases), one of the first things I look for is the progression of the risk factors each quarter.  I have a chart made, and I read them start to finish, as the judge will when we create the context for our arguments against falsity and to support the application of the Safe Harbor.  Are the risk factors specific or generic?  Do they change over time or are they static?  Do the changes in the risk factors track disclosed changes in business conditions?  Etc.  But companies and their outside corporate counsel frequently devolve to boilerplate, and fail to draft careful disclosures that make a judge feel comfortable that they were trying to disclose their real risks each quarter.

So, I give the Safe Harbor a D.

Lead Plaintiff Procedures – Grade C

The symbol of the pre-Reform Act era is the race to the courthouse among plaintiffs’ lawyers to file a complaint first and thus win the lead counsel role.  Congress intended the heightened pleading standards and the Safe Harbor to play a role in fixing that problem, because they are meant to incentivize plaintiffs to do more pre-filing investigation.  However, the Reform Act’s lead plaintiff provisions – which require the court to choose a lead plaintiff and lead plaintiff’s counsel after a beauty contest – undermine that goal, since only the lead plaintiff has an economic incentive to invest much time and money in an investigation.  So although the initial filer no longer has a competitive advantage by being the first plaintiff to file, the initial complaint is still routinely filed without any real investigation or worry about satisfying the pleading standards.

The lead plaintiff procedures were also designed to prevent lawyer-driven litigation, by providing that the lead plaintiff is presumptively the plaintiff with the largest financial loss – i.e., a plaintiff with “skin in the game.”  While that goal is salutary, it has spawned complex and mixed results.  The Reform Act’s lead plaintiff process incentivized plaintiffs’ firms to recruit institutional investors to serve as plaintiffs.  For the most part, institutional investors, whether smaller unions or large funds, retained the more prominent plaintiffs’ firms, and smaller plaintiffs’ firms were left with individual investor clients who usually can’t beat out institutions for the lead plaintiff role.  At the same time, securities class action economics tightened in all but the largest cases.  Dismissal rates under the Reform Act are pretty high, and defeating a motion to dismiss often requires significant investigative costs and intensive legal work.  And the median settlement amount of cases that survive dismissal motions is fairly low.  These dynamics placed a premium on experience, efficiency, and scale.  Larger firms filed the lion’s share of the cases, and smaller plaintiffs’ firms were unable to compete effectively for the lead plaintiff role, or make much money on their litigation investments.

This started to change with the wave of cases against Chinese issuers in 2010.  Smaller plaintiffs’ firms initiated the lion’s share of these cases, as the larger firms were swamped with credit-crisis cases and likely were deterred by the relatively small damages, potentially high discovery costs, and uncertain insurance and company financial resources.  Moreover, these cases fit smaller firms’ capabilities well; nearly all of the cases had “lawsuit blueprints” such as auditor resignations and/or short-seller reports, thereby reducing the smaller firms’ investigative costs and increasing their likelihood of surviving a motion to dismiss.  The dismissal rate has indeed been low, and limited insurance and company resources have prompted early settlements in amounts that, while on the low side, appear to have yielded good outcomes for the smaller plaintiffs’ firms.

The smaller plaintiffs’ firms thus built up a head of steam that has kept them going, even after the wave of China cases subsided.  For the last year or two, following almost every “lawsuit blueprint” announcement, a smaller firm has launched an “investigation” of the company, and they have initiated an increasing number of cases.  Like the China cases, these cases tend to be against smaller companies.  Thus, smaller plaintiffs’ firms have discovered a class of cases – cases against smaller companies that have suffered well-publicized problems that reduce the plaintiffs’ firms’ investigative costs – for which they can win the lead plaintiff role and that they can prosecute at a sufficient profit margin.

To be sure, the larger firms still mostly can and will beat out the smaller firms for the cases they want.  But it increasingly seems clear that the larger firms don’t want to take the lead in initiating many of the cases against smaller companies, and are content to focus on larger cases on behalf of their institutional investor clients.  The result is now two classes of plaintiffs and plaintiffs’ firms:  larger firms with institutional investor clients, as Congress intended, and smaller plaintiffs’ firms with smaller individual clients, which Congress sought to displace.   In a sense, we’re back to where we started, but now with more aggressive institutional investors to boot.

As a result, from the defense perspective, I give the lead plaintiff procedures a C.

Discovery Stay – Grade: A

The Reform Act’s automatic stay of discovery was also meant to prevent plaintiffs from filing a lawsuit without adequate investigation, and conducting formal discovery to fish for facts to support it.  The discovery stay has saved defendants and their insurers many billions of dollars in discovery costs, and prevented millions of hours of unnecessary distraction by employees who have been able to focus on their jobs instead of helping their lawyers and electronic discovery consultants collect documents.  Although the statute contains several exceptions, there has been relatively little litigation over their application, especially over the last decade; the plaintiffs’ bar has shown restraint and efficiency in not over-litigating the discovery stay.  The discovery stay has worked well.

Conclusion:  The Reform Act’s Overall Grade

Grade: C+

In outlining this post, I originally organized my thoughts around this question: Are companies and their directors and officers really better off than they were 20 years ago?  Although it may seem absurd that a defense lawyer could even think about answering that question “no,” it really is a fair question.  I could make the case that the Reform Act’s tools have actually hindered the overall effectiveness of securities litigation defense by distracting from its core purpose: to convince a judge or jury that the defendants didn’t say anything false.  That is best done by thinking about the defense of the litigation overall, through trial – which not only sets the case up for a better defense on the merits, but results in better motion-to-dismiss results, for the reasons I’ve described.  But instead, the Reform Act tempts defense counsel to rely on technicalities, which can result in a mediocre defense, and an increased liability and economic exposure that overall are harmful to public companies, their directors and officers, and insurers.

 

* I never call the Reform Act the “PSLRA.”  The Reform Act was meant to reform securities litigation, not PSLRA-ize it.

In the world of securities and corporate governance litigation, we are always in the middle of a reform discussion of some variety.  For the past several years, there has been great focus on amendment of corporate bylaws to corral and curtail shareholder corporate-governance claims, principally shareholder challenges to mergers.*  Meritless merger litigation is indeed a big problem.  It is a slap in the face to careful directors who have worked hard to understand and approve a merger, or to CEOs who have spent many months or years working long hours to locate and negotiate a transaction in the shareholders’ best interest.  It is cold comfort to know that nearly all mergers draw shareholder litigation, and that nearly all of those cases will settle before the transaction closes without any payment by the directors or officers personally.  And we know the system is broken when it routinely allows meritless suits to result in significant recoveries for plaintiffs’ lawyers, with virtually nothing gained by companies or their shareholders.

There are three main solutions afoot, at different stages of maturity, involving amendments to corporate bylaws to require that: (1) there be an exclusive forum, chiefly Delaware, for shareholder litigation; (2) a losing shareholder pay for the litigation defense costs; and (3) a shareholder stake hold a minimum amount of stock to have standing to sue.  I refer readers to the blogs published by Kevin LaCroix, Alison Frankel, and Francis Pileggi for good discussions of these types of bylaws.  The purpose of this blog post is not to specifically chronicle each initiative, but to caution that they will cause unintended consequences that will leave us with a different set of problems than the ones they solved.

Exclusive-forum bylaws offer the most targeted solution, albeit with some negative consequences.

Exclusive-forum bylaws best address the fundamental problem with merger litigation: the inability to coordinate cases for an effective motion to dismiss before the plaintiffs and defendants must begin negotiations to achieve settlement before the merger closes.  Although the merger-litigation problem is virtually always framed in terms of the oppressive cost and hassle of multi-forum litigation, good defense counsel can usually manage the cost and logistics.  Instead, the bigger problem, and the problem that causes meritless merger litigation to exist, is the inability to obtain dismissals.  This is primarily so because actions filed in multiple forums can’t all be subjected to a timely motion to dismiss, and a dismissal in one forum that can’t timely be used in another forum is a hollow victory.  Exclusive litigation in Delaware for Delaware corporations is preferable, because of Delaware’s greater experience with merger litigation and likely willingness to weed out meritless cases at a higher rate.  But the key to eradicating meritless merger litigation is consolidation in some single forum, and not every Delaware corporation wishes to litigate in Delaware.

The closest historical analogy to such bylaws is the Securities Litigation Uniform Standards Act’s provision requiring that covered class actions be brought in federal court and litigated under federal law to ensure that the least meritorious cases are weeded out early, as Congress intended through the Reform Act.  The Reform Act’s emphasis on early dismissal of cases that lack merit has been its best feature, and requiring litigation in federal court helped achieved it.

So too would litigation in an exclusive forum, because it would yield a more meaningful motion to dismiss process, which would weed out less-meritorious cases early, which in turn would deter plaintiffs’ lawyers from bringing as many meritless cases.  The solution is that simple.  There will be consequences, though.  Plaintiffs’ lawyers, of course, will tend to bring more meritorious cases that present greater risk, exposure, and stigma, and will bring more in Delaware, which is a defendant-friendly forum for good transactions but a decidedly unfriendly one for bad transactions.  So while it certainly isn’t good that there are shareholder challenges to 95% of all mergers, the current system reduces the stigma of being sued and tends to result in fairly easy and cheap resolutions.  In contrast, cases that focus on the worst deals and target defendants that the plaintiffs’ lawyers regard as the biggest offenders will require more expensive litigation and significant settlements and judgments.

Fee-shifting and minimum-stake bylaws are overly broad and will cause a different set of problems.

So exclusive-forum bylaws attack the merger-litigation problem in a focused and effective fashion, albeit with downside risk.  In contrast, fee-shifting bylaws and minimum-stake bylaws attack the merger-litigation problem, but do so in an overly broad fashion, and will cause significant adverse consequences.

Fee-shifting bylaws, of course, attempt to curtail the number of cases by forcing plaintiffs who bring bad cases to pay defendants’ fees.  I find troubling the problem of deterring plaintiffs’ lawyers from bringing meritorious cases as well, since many plaintiffs’ lawyers would be very conservative and thus refuse to bring any case that might not succeed, even if strong.  That concern probably will cause the downfall of fee-shifting bylaws, where the Delaware Senate just passed a bill that would outlaw fee-shifting bylaws, and the issue now goes to the Delaware House.  (The same bill authorizes bylaws designating Delaware as the exclusive forum for shareholder litigation.)  But to me, the bigger problem is an inevitable new category of super-virulent cases, involving tremendous reputational harm (e.g. the plaintiffs’ firm decided to risk paying tens of millions of dollars in defense fees because they decided those defendants are that guilty) and intractable litigation that quite often would head to trial – at great cost not just financially, but to the law as well because it is indeed true that bad facts make bad law.

The Reform Act’s pleading standards have created analogous negative consequences, but much less severe and costly.  The pleading standards (and the Rule 11 provision) weed out bad cases early on, but almost never is there a financial penalty to a plaintiff for bringing a bad case.  Instead, the bigger plaintiffs’ firms have tended to be more selective in the cases they bring, which has yielded a pretty good system overall – even though they sometimes still bring meritless cases, and meritless cases sometimes get past motions to dismiss.  The bigger and still-unsolved problem with pleading standards is the overly zealous and necessarily imperfect confidential-witness investigations they cause, to attempt to satisfy the statute’s elevated pleading requirements.  The fee-shifting bylaws would occasion those sorts of problems as well, in addition to the virulent-case problem I’ve described.

Fee-shifting bylaws advocates’ push for ultra-meritorious lawsuits strikes me as an extreme case of “be careful what you wish for.”  But it brings to mind a more mainstream situation that has worried me for many years: aggressive arguments in demand motions for pre-litigation board demands and shareholder inspections of books and records.  In arguing that a shareholder derivative lawsuit should be dismissed for failure to make a demand on the board, defendants have long asserted that a shareholder failed to even ask the company for records under Section 220 of the Delaware General Corporation Law or similar state laws, to attempt to investigate the corporate claims he or she is pressing.  Delaware courts, in turn, have chastised shareholders for failing to utilize 220, though thus far have stopped short of requiring it.  Likewise, defendants, sometimes with great disdain, have criticized shareholders for not making a pre-suit demand on the board.

Although these are correct and appropriate litigation arguments, I have observed that, over time, they have succeeded in spawning more 220 inspection demands and pre-suit demands on boards, which over time will create more costly and virulent derivative cases than plain vanilla demand-excused cases brought without the aid of books and records.  The solution is to just get those highly dismiss-able cases dismissed, without trying to shame the derivative plaintiffs into making a 220 or demand on the board next time.

Minimum-stake bylaws are problematic as well.  They have as their premise that shareholders with some “skin in the game” will evaluate cases better, and will help prevent lawyer-driven litigation.  Like fee-shifting bylaws, they will prevent shareholders from brining meritless lawsuits, and likewise tend to yield more expensive and difficult cases to defend and resolve.  But they also will create a more difficult type of plaintiff to deal with, much the same way as the Reform Act’s lead-plaintiff provisions have created a class of plaintiffs that sometimes make us yearn for the days when the plaintiffs’ lawyers had more control.  More invested plaintiffs increase litigation cost, duration, and difficulty, and increase the caliber and intensity of plaintiffs’ lawyering.

And I have no doubt that, despite the bylaws, smaller shareholders and plaintiffs’ firms will find a way back into the action, much as we’re seeing recently with retail investors and smaller plaintiffs’ firms brining more and smaller securities class actions that institutional investors and the larger plaintiffs’ firms with institutional-investor clients don’t find worth their time and money to bring.  So with securities class actions, I think a two-headed monster is emerging: a relatively small group of larger and virulent cases, and a growing group of smaller cases.  That, too, likely would happen, somehow, with minimum-stake bylaws.

What’s the harm with taking a shot at as many fixes as possible?

Even if someone could see the big picture well enough to judge that these problems aren’t sufficient to outweigh the benefits of fee-shifting and minimum-stake bylaws, I would still hesitate to advocate their widespread adoption, because governments and shareholder advocacy groups would step in to regulate under-regulation caused by reduced shareholder litigation.  That would create an uncertain governance environment, and quite probably a worse one for companies.  Fear of an inferior alternative was my basic concern about the prospect that the Supreme Court in Halliburton Co. v. Erica P. John Fund, Inc. would overrule Basic v. Levinson and effectively abolish securities class actions.

Beyond the concern about an inferior replacement system, I worry about doing away with the benefits shareholders and plaintiffs’ lawyers provide, albeit at a cost.  Shareholders and plaintiffs’ lawyers are mostly-rational economic actors who play key roles in our system of disclosure and governance; the threat of liability, or even the hassle of being sued, promotes good disclosure and governance decisions.  Even notorious officer and director liability decisions, such as the landmark 1985 Delaware Supreme Court decision in Smith v. Van Gorkom, are unfortunate for the defendants involved but do improve governance and disclosure.

One final thought.  Shareholder litigation’s positive impact on governance and disclosure makes me wonder: will the quality of board oversight of cybersecurity, and corporate disclosure of cybersecurity issues, improve without the shock of a significant litigation development?

 

* Although indiscriminate merger litigation is the primary target of bylaw amendments, other types of securities and corporate-governance lawsuits, such as securities class actions and non-merger derivative litigation, are sometimes part of the discussion.  Those types of cases, however, do not pose the same problems as merger litigation.  And it is doubtful whether a company’s bylaws could regulate securities class actions, which are not an intra-corporate dispute between a current shareholder and the company, but instead direct class-period claims brought by purchasers or sellers, who do not need to be, and often are not, current shareholders.

This year will be remembered as the year of the Super Bowl of securities litigation, Halliburton Co. v. Erica P. John Fund, Inc. (“Halliburton II”), 134 S. Ct. 2398 (2014), the case that finally gave the Supreme Court the opportunity to overrule the fraud-on-the-market presumption of reliance, established in 1988 in Basic v. Levinson.

Yet, for all the pomp and circumstance surrounding the case, Halliburton II may well have the lowest impact-to-fanfare ratio of any Supreme Court securities decision, ever.  Indeed, it does not even make my list of the Top 5 most influential developments in 2014 – developments that foretell the types of securities and corporate-governance claims plaintiffs will bring in the future, how defendants will defend them, and the exposure they present.

Topping my Top 5 list is a forthcoming Supreme Court decision in a different, less-heralded case – Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund.  Despite the lack of fanfare, Omnicare likely will have the greatest practical impact of any Supreme Court securities decision since the Court’s 2007 decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308  (2007).  After discussing my Top 5, I explain why Halliburton II does not make the list.

5.         City of Providence v. First Citizens BancShares:  A Further Step Toward Greater Scrutiny of Meritless Merger Litigation

In City of Providence v. First Citizens BancShares, 99 A.3d 229 (Del. Ch. 2014), Chancellor Bouchard upheld the validity of a board-adopted bylaw that specified North Carolina as the exclusive forum for intra-corporate disputes of a Delaware corporation.  The ruling extended former Chancellor Strine’s ruling last year in Boilermakers Local 154 Retirement Fund v. Chevron, 73 A.3d 934 (Del Ch. 2013), which validated a Delaware exclusive-forum bylaw.  These types of bylaws largely are an attempt to bring some order to litigation of shareholder challenges to corporate mergers and other transactions.

Meritless merger litigation is a big problem.  Indiscriminate merger litigation is a slap in the face to careful directors who have worked hard to understand and approve a merger, or to CEOs who have spent many months or years working long hours to locate and negotiate a transaction in the shareholders’ best interest.  It is cold comfort to know that nearly all mergers draw shareholder litigation, and that nearly all of those cases will settle before the transaction closes without any payment by the directors or officers personally.  And we know the system is broken when it routinely allows meritless suits to result in significant recoveries for plaintiffs’ lawyers, with virtually nothing gained by companies or their shareholders.

Two years ago, I advocated for procedures requiring shareholder lawsuits to be brought in the company’s state of incorporation.  Exclusive state-of-incorporation litigation would attack the root cause of the merger-litigation problem: the inability to consolidate cases and subject them to a motion to dismiss early enough to obtain a ruling before negotiations to achieve settlement before the transaction closes must begin.  Although the problem is virtually always framed in terms of the oppressive cost and hassle of multi-forum litigation, good defense counsel can usually manage the cost and logistics.  Instead, the bigger problem, and the problem that causes meritless merger litigation to exist, is the inability to obtain dismissals.  This is primarily so because actions filed in multiple forums can’t all be subjected to a timely motion to dismiss, and a dismissal in one forum that can’t timely be used in another forum is a hollow victory.  If there were a plenary and meaningful motion-to-dismiss process, less-meritorious cases would be weeded out early, and plaintiffs’ lawyers would bring fewer meritless cases.  The solution is that simple.

Exclusive litigation in Delaware for Delaware corporations is preferable, because of Delaware’s greater experience with merger litigation and likely willingness to weed out meritless cases at a higher rate.  But the key to eradicating meritless merger litigation is consolidation in some single forum, and not every Delaware corporation wishes to litigate in Delaware.  So I regard First Citizens’ extension of Chevron to a non-Delaware exclusive forum as a key development.

4.         SEC v. Citigroup:  The Forgotten Important Case

On June 4, 2014, in SEC v. Citigroup, 752 F.3d 285 (2d Cir. 2014), the Second Circuit held that Judge Rakoff abused his discretion in refusing to approve a proposed settlement between the SEC and Citigroup that did not require Citigroup to admit the truth of the SEC’s allegations.  Judge Rakoff’s decision set off a series of events that culminated in the ruling on the appeal, about which people seemed to have forgotten because of the passage of time and intervening events.

Once upon a time, way back in 2012, the SEC and Citigroup settled the SEC’s investigation of Citigroup’s marketing of collateralized debt obligations.  In connection with the settlement, the SEC filed a complaint alleging non-scienter violations of the Securities Act.  The same day, the SEC also filed a proposed consent judgment, enjoining violations of the law, ordering business reforms, and requiring the company to pay $285 million. As part of the consent judgment, Citigroup did not admit or deny the complaint’s allegations.  Judge Rakoff held a hearing to determine “whether the proposed judgment is fair, reasonable, adequate, and in the public interest.”  In advance, the court posed nine questions, which the parties answered in detail.  Judge Rakoff rejected the consent judgment.

The rejection order rested, in part, on the court’s determination that any consent judgment that is not supported by “proven or acknowledged facts” would not serve the public interest because:

  • the public would not know the “truth in a matter of obvious public importance”, and
  • private litigants would not be able to use the consent judgment to pursue claims because it would have “no evidentiary value and      no collateral estoppel effect”.

The SEC and Citigroup appealed.  While the matter was on appeal, the SEC changed its policy to require admissions in settlements “in certain cases,” and other federal judges followed Judge Rakoff’s lead and required admissions in SEC settlements.  Because of the SEC’s change in policy, many people deemed the appeal unimportant.  I was not among them; the Second Circuit’s decision remained of critical importance, because the extent to which the SEC insists on admissions will depend on the amount of deference it receives from reviewing courts – which was the issue before the Second Circuit.  It stands to reason that the SEC would have insisted on more admissions if courts were at liberty to second-guess the SEC’s judgment to settle without them.  Greater use of admissions would have had extreme and far-reaching consequences for companies, their directors and officers, and their D&O insurers.

So it was quite important that the Second Circuit held that the SEC has the “exclusive right” to decide on the charges, and that the SEC’s decision about whether the settlement is in the public interest “merits significant deference.”

3.         Wal-Mart Stores, Inc. v. Indiana Elec. Workers Pension Trust Fund IBEW:  Delaware Supreme Court’s Adoption of the Garner v. Wolfinbarger “Fiduciary” Exception to the Attorney-Client Privilege Further Encourages Use of Section 220 Inspection Demands

On July 23, 2014, the Delaware Supreme Court adopted the fiduciary exception to the attorney-client privilege, which originated in Garner v. Wolfinbarger, 430 F.2d 1093 (5th Cir. 1970), and held that stockholders who make a showing of good cause can inspect certain privileged documents.  Although this is the first time the Delaware Supreme Court has expressly adopted Garner, it had previously tacitly adopted it, and the Court of Chancery had expressly adopted it in Grimes v. DSC Communications Corp., 724 A.2d 561 (Del. Ch. 1998).

In my view, the importance of Wal-Mart is not so much in its adoption of Garner – given its previous tacit adoption – but instead is in the further encouragement it gives stockholders to use Section 220.  Delaware courts for decades have encouraged stockholders to use Section 220 to obtain facts before filing a derivative action.  Yet the Delaware Supreme Court, in the Allergan derivative action, Pyott v. Louisiana Municipal Police Employees’ Retirement System  (“Allergan”), 74 A.3d 612 (Del. 2013), passed up the opportunity to effectively require pre-litigation use of Section 220.  In Allergan, the court did not adopt Vice Chancellor Laster’s ruling that the plaintiffs in the previously dismissed litigation, filed in California, provided “inadequate representation” to the corporation because, unlike the plaintiffs in the Delaware action, they did not utilize Section 220 to attempt to determine whether their claims were well-founded.  Upholding the Court of Chancery’s presumption against fast-filers would have strongly encouraged, if not effectively required, shareholders to make a Section 220 demand before filing a derivative action.

In Wal-Mart, however, the Delaware Supreme Court provided the push toward Section 220 that it passed up in Allergan.  Certainly, expressly adopting Garner will encourage plaintiffs to make more Section 220 demands.  That should cause plaintiffs to conduct more pre-filing investigations, which will decrease filings to some extent.  But increased use of 220 also means that the cases that are filed will be more virulent, because they are selected with more care, and are more fact-intensive – and thus tend to be more difficult to dispose of on a motion to dismiss.

2.         City of Livonia Employees’ Retirement System v. The Boeing Company:  Will Defendants Win the Battle but Lose the War?

On August 21, 2014, Judge Ruben Castillo of the Northern District of Illinois ordered plaintiffs’ firm Robbins Geller Rudman & Dowd to pay defendants’ costs of defending a securities class action, as Rule 11 sanctions for “reckless and unjustified” conduct related to reliance on a confidential witness (“CW”) whose testimony formed the basis for plaintiffs’ claims.  2014 U.S. Dist. LEXIS 118028 (N.D. Ill. Aug. 21, 2014).

I imagine that some readers may believe that, as a defense lawyer, I’m including this development because one of my adversaries suffered a black eye.  That’s not the case at all.  Although I’m not in a position to opine on the merits of the Boeing CW matter, I can say that I genuinely respect Robbins Geller and other top plaintiffs’ firms.  And beware those who delight in the firm’s difficulties: few lawyers who practice high-stakes litigation at a truly high level will escape similar scrutiny at some point in a long career.

But beyond that sentiment, I have worried about the Boeing CW problem, as well as similar problems in the SunTrust and Lockheed cases, because of their potential to cause unwarranted scrutiny of the protections of the Private Securities Litigation Reform Act.  I believe the greatest risk to the Reform Act’s protections has always been legislative backlash over a perception that the Reform Act is unfair to investors. The Reform Act’s heavy pleading burdens have caused plaintiffs’ counsel to seek out former employees and others to provide internal information.  The investigative process is often difficult and is ethically tricky, and the information it generates can be lousy.  This is so even if plaintiffs’ counsel and their investigators act in good faith – information can be misunderstood, misinterpreted, and/or misconstrued by the time it is conveyed from one person to the next to the next to the next.  And, to further complicate matters, CWs sometimes recant, or even deny, that they made the statements on which plaintiffs rely.  The result can be an unseemly game of he-said/she-said between CWs and plaintiffs’ counsel, in which the referee is ultimately an Article III judge.  At some point, Congress will step in to reform this process.

Judge Rakoff seemed to call for such reform in his post-dismissal order in the Lockheed matter:

The sole purpose of this memorandum … is to focus attention on the way in which the PSLRA and decisions like Tellabs have led plaintiffs’ counsel to rely heavily on private inquiries of confidential witnesses, and the problems this approach tends to generate for both plaintiffs and defendants.  It seems highly unlikely that Congress or the Supreme Court, in demanding a fair amount of evidentiary detail in securities class action complaints, intended to turn plaintiffs’ counsel into corporate ‘private eyes’ who would entice naïve or disgruntled employees into gossip sessions that might help support a federal lawsuit. Nor did they likely intend to place such employees in the unenviable position of having to account to their employers for such indiscretions, whether or not their statements were accurate. But as it is, the combined effect of the PSLRA and cases like Tellabs are likely to make such problems endemic.

Rather than tempt Congress to revisit the Reform Act’s protections (which defendants should want to avoid) and/or allow further unseemly showdowns (which plaintiffs and courts should want to avoid), plaintiffs, defendants, and courts can begin to reform the CW process through some basic measures, including requiring declarations from CWs, requiring them to read and verify the complaint’s allegations citing them, and requiring plaintiffs to plead certain information about their CWs.  As I’ve previously written, these reforms would have prevented the problems at issue in the Boeing, SunTrust, and Lockheed matters, and would result in more just outcomes in all cases.

1.         Omnicare:  In My Opinion, the Most Important Supreme Court Case Since Tellabs

Omnicare concerns what makes a statement of opinion false.  Opinions are ubiquitous in corporate communications.  Corporations and their officers routinely share subjective judgments on issues as diverse as asset valuations, strength of current performance, risk assessments, product quality, loss reserves, and progress toward corporate goals.  Many of these opinions are crucial to investors, providing them with unique information and insight.  If corporate actors fear liability for sharing their genuinely held beliefs, they will be reluctant to voice their opinions, and shareholders would be deprived of this vital information.

The standard that the federal securities laws use to determine whether an opinion is “false” is therefore of widespread importance. Although this case only involves Section 11, it poses a fundamental question: What causes an opinion or belief to be a “false statement of material fact”?  The Court’s answer will affect the standards of pleading and proof for statements of opinion under other liability provisions of the federal securities laws, including Section 10(b), which likewise prohibit “untrue” or “false” statements of “material fact.”

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

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

It thus seems unlikely from the tone of the argument that the Court will affirm the Sixth Circuit’s holding that an opinion is false if it is “objectively” untrue.  If the pointed opening question from Chief Justice Roberts is any indication, the Court also may not fully accept Omnicare’s position, which is that an opinion can only be false or misleading if it was not actually believed by the speaker.  It seems more probable that the Supreme Court will take one of two middle paths – one that was advocated by the Solicitor General at oral argument, essentially a “reasonable basis” standard, or one that was advanced in our brief for the WLF, under which a statement of opinion is subjected to the same sort of inquiry about whether it was misleading as for any other statement.  Under WLF’s proposed standard, plaintiffs would be required to demonstrate either that an opinion was false because it was not actually believed, or that omitted facts caused the opinion – when considered in the full context of the company’s other disclosures – to be misleading because it “affirmatively create[d] an impression of a state of affairs that differs in a material way from the one that actually exists.” Brody v. Transitional Hosps. Corp., 280 F.3d 997, 1006 (9th Cir. 2002).

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

Why Halliburton II is Not a Top-5 Development

After refusing to overrule Basic, the Halliburton II decision focused on defendants’ fallback argument that plaintiffs must show that the alleged misrepresentations had an impact on the market price of the stock, as a prerequisite for the presumption of reliance.  The Court refused to place on plaintiffs the burden of proving price impact, but agreed that a defendant may rebut the presumption of reliance, at the class certification stage, with evidence of lack of price impact.

Halliburton II has a narrow reach.  The ruling only affects securities class actions that have survived a motion to dismiss – class certification is premature before then.  It wouldn’t be economical to adjudicate class certification while parties moved to dismiss under Rule 12(b)(6) and the Reform Act, and adjudicating class certification before rulings on motions to dismiss could result in defendants waiving their right to a discovery stay under the Reform Act.  Moreover, most securities class actions challenge many statements during the class period.  Although there could be strategic defense benefit to obtaining a ruling that a subset of the challenged statements did not impact the stock price – for example, shortening the class period or dismissing especially awkward statements – a finding that some statements had an impact would support certification of some class, and thus would allow the case to proceed.

Defendants face legal and economic hurdles as well.  For example, in McIntire v. China MediaExpress Holdings, Inc., 2014 U.S. Dist. LEXIS 113446, *40 (S.D.N.Y. Aug. 15, 2014), the court held that a “material misstatement can impact a stock’s value either by improperly causing the value to increase or by improperly maintaining the existing stock price.”  Under this type of analysis, even if a challenged statement does not cause the stock price to increase, it may have kept the stock price at the same artificially inflated level, and thus impacted the price.  Plaintiff-friendly results were predictable from experience in the Second and Third Circuits before the Supreme Court’s rulings in Amgen Inc. v. Connecticut Retirement Plans and Trust Funds, 133 S. Ct. 1184 (2013), and Halliburton II.  Despite standards for class certification that allowed defendants to contest materiality and price impact, defendants seldom defeated class certification.

Halliburton II may also be unnecessary; it is debatable whether the decision even gives defendants a better tool with which to weed out cases that suffer from a price-impact problem.  For example, cases that suffer from a price-impact problem typically also suffer from some other fatal flaw, such as the absence of loss causation or materiality.  Indeed, the price-impact issue in Halliburton was based on evidence about the absence of loss causation.

Yet defendants no doubt will frequently oppose class certification under Halliburton II.  But they will do so at a cost beyond the economic cost of the legal and expert witness work:  they will lose the ability to make no-price-impact arguments in settlement discussions in the absence of a ruling about them.  Now, defendants will make and obtain rulings on class certification arguments that they previously could have asserted would be resolved in their favor at summary judgment or trial, if necessary. Plaintiffs will press harder for higher settlements in cases with certified classes.

***

In addition to Halliburton II, there were many other important 2014 developments in or touching on the world of securities and corporate governance litigation, including: rare reversals of securities class action dismissals in the Fifth Circuit, Spitzberg v. Houston American Energy Corp., 758 F.3d 676 (5th Cir. 2014), and Public Employees’ Retirement System of Mississippi v. Amedisys, Inc., 769 F.3d 313 (5th Cir. 2014); the filing of cybersecurity shareholder derivative cases against Target (pending) and Wyndham (dismissed); a trial verdict against the former CFO of a Chinese company, Longtop Financial Technologies; the Second Circuit’s significant insider trading decision, United States v. Newman, — F.3d —, 2014 U.S. App. LEXIS 23190 (2d Cir. Dec. 10, 2014); increasingly large whistleblower bounties, including a $30 million award; the Supreme Court’s SLUSA decision in Chadbourne & Parke LLP v. Troice, 134 S. Ct. 1058 (2014); the Delaware Supreme Court’s ruling on a fee-shifting bylaw in ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014), and the resulting legislative debate in Delaware and elsewhere; the Supreme Court’s ERISA decision in Fifth Third Bancorp v. Dudenhoeffer, 134 S. Ct. 2459 (2014); the Ninth Circuit’s holding that the announcement of an internal investigation, standing alone, is insufficient to establish loss causation, Loos v. Immersion Corp., 762 F.3d 880 (9th Cir. 2014); the Ninth Circuit’s rejection of Item 303 of Regulation S-K as the basis of a duty to disclose for purposes of a claim under Section 10(b), In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046 (9th Cir. 2014); and the Ninth Circuit’s holding that Rule 9(b) applies to loss-causation allegations, Oregon Public Employees Retirement Fund v. Apollo Group Inc., — F.3d —, 2014 U.S. App. LEXIS 23677 (9th Cir. Dec. 16, 2014).

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

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

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

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

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

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

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

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

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

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

 

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

At long last, the United States Supreme Court is going to address the viability and/or prerequisites of the fraud-on-the-market presumption of reliance established by the Court in 1988 in Basic v. Levinson.  Securities litigators, on both sides of the aisle, are understandably anxious, because our entire industry is about to change – either a little or a lot.

I say “change,” and not something more ominous like “be obliterated,” because the Supreme Court’s ruling in Halliburton cannot and will not do away with securities litigation.  If the Court’s ruling were to undermine class actions, the plaintiffs’ securities bar would adjust – likely through burdensome large individual and non-class collective actions, and class actions that attempt to work around whatever ruling the Court makes – and the government would act to facilitate some type of securities class action and/or expand government enforcement of the securities laws.  Worse outcomes for companies in a new no-Basic era are far easier for me to imagine than better ones.  I’ll explain why, after a quick review of how we got here.

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

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

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

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

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

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

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

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

As Justice Thomas wrote in his dissent (joined by Justice Scalia (in part) and Justice Kennedy), the majority essentially “reverse[d]” the inquiry.  Although class certification is supposed to be decided early in the litigation, and depends upon a showing of materiality to invoke the fraud-on-the-market presumption, the majority effectively said that that portion of the class certification inquiry can be skipped, merely because it is also a question that will be asked at the merits stage. Justice Thomas wrote: “A plaintiff who cannot prove materiality does not simply have a claim that is ‘dead on arrival’ at the merits. . .he has a class that never should have arrived at the merits at all because it failed in Rule 23(b)(3) certification from the outset.”

Perhaps the most striking part of the Amgen decision was Justice Alito’s one paragraph concurrence, which baldly called for a reconsideration of the fraud-on-the-market presumption.  Alito concurred with the majority, but only with the understanding that Amgen had not asked for Basic to be revisited. Alito thus signaled that he agreed with Thomas’s contention in footnote 4 of the dissent that the Basic decision was “questionable.”  The majority, in turn, did not come to the defense of Basic, but simply noted with apparent relief (in footnote 2) that even Justice Thomas had acknowledged that the Court had not been asked to revisit that issue.  Considered together, these three opinions put out a welcome mat for the right case challenging Basic’s fraud-on-the-market presumption, with four votes already supporting the view that the decision was “questionable,” and the other five failing to come to its defense.

As Amgen was being litigated in the Supreme Court, the parties in Halliburton were briefing the plaintiffs’ class certification motion on remand.  The district court certified a class, prior to the Supreme Court’s decision in Amgen.  Halliburton sought and obtained Rule 23(f) certification from the Fifth Circuit, which affirmed, after the Supreme Court decided Amgen.  The Fifth Circuit held that the inquiry of the challenged statements’ lack of impact on the price of Halliburton’s stock was more analogous to materiality than it is to the permissible prerequisites to the fraud-on-the-market presumption (market efficiency and a public misrepresentation).  The Fifth Circuit reasoned that while price impact is not an element, as is materiality, “a plaintiff must nevertheless prevail on this fact in order to establish loss causation.”  Thus, “if Halliburton were to successfully rebut the fraud-on-the-market presumption by proving no price impact, the claims of all individual plaintiffs would fail because they could not establish an essential element of the action.”  Because the Fifth Circuit believed that the absence of price impact would doom all individual claims, it concluded that price impact is not relevant to common-issue predominance and is therefore not relevant at class certification.

Halliburton filed a petition for a writ of certiorari, and the Court granted the petition on Friday November 15, 2013.  That day, many plaintiffs’ and defense lawyers predicted the demise of securities litigation as we know it.  One defense lawyer put it in blunt terms:  “If the Supreme Court rejects the ‘fraud-on-the-market presumption of reliance altogether, then it would effectively end securities class action litigation in the United States.”

I disagree.

What’s Next?  How Will the Supreme Court Rule?  If the Court Overrules Basic, What Will Happen?   

There are three primary possible outcomes in the Supreme Court:

1.  The Court will affirm the Fifth Circuit without overruling or adjusting Basic.  This seems unlikely.

2.  The Court will adjust Basic.

One adjustment might be to require that a putative class plaintiff show that the market for the issuer’s stock be efficient as to the specific information that the defendants allegedly misrepresented – which is Halliburton’s alternative grounds for relief, and a proposition that Amgen included in a footnote in its Supreme Court briefs.  I predict that this will be what the Supreme Court decides.  Such a decision would address the primary economic criticism of the fraud-on-the-market presumption – that market efficiency is not a binary “yes” or “no” question, and instead depends on the specific information at issue – and would preserve salutary features of private securities litigation, which long has been an important means of securities regulation.

Another adjustment might be to allow the fraud-on-the-market presumption for purposes of satisfying the element of reliance, but require proof of actual reliance on the challenged statements for purposes of recovering money damages.  This is the position taken in an amicus brief in support of cert filed by a group of prominent law professors and former SEC commissioners, primarily relying on the elements of the Exchange Act’s only express private right of action, set forth in Section 18.

3.  The Court will overrule Basic and leave nothing in its place – thus negating the primary support for securities class actions.

What would happen then?

The plaintiffs’ securities bar would adjust. 

The plaintiffs’ bar would seek to work around Halliburton in some fashion.  That would result in much uncertainty and expensive litigation of the scope of Halliburton in the district courts, circuit courts, and likely the Supreme Court.

Worse, the largest firms with large institutional investor clients – clients the Private Securities Litigation Reform Act encouraged them to court, and with which they now work closely to identify and pursue securities claims – would 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.  Non-class litigation would be even more expensive in certain respects – e.g. 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.  One reason we sometimes oppose lead-plaintiff groups is the difficulty of dealing with a group of plaintiffs instead of just one.

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.

The government would act.

The government would not allow the securities markets to be profoundly less regulated.  So it would do something.  It might legislatively enable securities class actions.  If it did so, would it also make other adjustments, such as lessen the Reform Act’s protections?  Who knows, but I wouldn’t bet on an improvement for companies.  I strongly believe that the biggest securities-litigation threat to companies is erosion of the Reform Act’s protections.

The government might also, or instead, enhance public enforcement of the securities laws.  This would be a negative development.  Companies have much greater ability to predict the cost and outcome of today’s securities class action than they do the outcome of a government enforcement action.  Experienced defense counsel can predict how plaintiffs’ firms will litigate and resolve a case.  Defense counsel have much less ability to predict how an enforcement person with whom he or she may have never dealt will approach a case.

Finally, I must say that I am not one who thinks that the fraud-on-the-market presumption results in much injustice, especially given the protections of the Reform Act.  The Reform Act weeds out a lot of cases.  To be sure, some cases incorrectly survive motions to dismiss.  The only real policy problem with class actions regarding Basic is with the subset of these cases that also are certified as class actions at the class-certification stage but are destined to be decertified at summary judgment or trial – defendants in those cases are unjustly subjected to burdensome class action litigation.  The combination of these errors, however, isn’t frequent.  And even when it does occur, experienced plaintiffs’ and defense counsel are able to handicap the merits on both counts, i.e. the lack of merit to the claims and to the case temporarily surviving as a class action, and adjust the settlement value of the case accordingly.

This is just a start on our analysis.  We’ll certainly write more during the long wait for the Court’s ruling.