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

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

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

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

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

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

The Potential Paths Forward

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

Elimination or Further Reform of Securities Class Actions

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

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

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

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

Formation of Industry Groups to Oversee Securities Class Actions

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Conclusion

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

This is the second of a three-part post evaluating who is winning the securities class action war.

Part I explained that this war is not just a scorecard of wins and losses, but rather a fight for strategic positioning—about achieving a system of securities litigation that sets up plaintiffs or defendants to win more cases over the long term.  Despite winning many of the battles, defendants are losing the war because of the defense side’s lack of a centralized command, which creates a mismatch in expertise, experience, and efficiency.

The plaintiffs’ bar is relatively small, with about a dozen firms in the core group.  Their lead partners are full-time securities litigators who prosecute cases around the country.  They don’t dabble in different kinds of cases—they aren’t securities litigators on some days and antitrust or IP lawyers on others.  Because the bar is small and specialized, it has the practical ability to take common strategic, economic, and legal positions, even if they don’t always see eye-to-eye or get along personally.

Below, I contrast this small and specialized plaintiffs’ bar with the defense bar, and conclude that:

  1. The splintered structure of the defense bar creates a fundamental mismatch between plaintiffs and defendants;
  2. Defendants can only overcome this mismatch with greater centralized command; and
  3. This organizing function can only come from D&O insurers—a proposition I’ll explain in depth next week in Part III of this post.

Part II: The Defense Bar

The Defense Bar is Splintered

In contrast to the small and specialized plaintiffs’ bar, there is an army of securities defense lawyers—but one with no coordinated set of strategic goals.  Every firm in the AmLaw 200 has a securities class action defense group and conceivably could be hired to defend a securities class action.  Each firm in the AmLaw 100 has a securities team they’d tout as a “leading” or otherwise strong practice—and among most of each of those firms, there are multiple partners who hold themselves out as securities litigation defense lawyers.  The number of defense lawyers who called themselves “securities litigators” skyrocketed during the 2005-08 stock option backdating scandal, which drew in more defense lawyers for separate representations and investigations.

All in, I’d guess there are 300 white-shoe U.S. law-firm partners who would advertise themselves as securities litigators for purposes of a securities case pitch, though most of these work on other types of commercial litigation as well, such as antitrust and IP.  The number of actual securities litigation senior partners on the defense side is a tiny fraction of this population—I’d bet around 30, or 10% of the so-called “securities defense bar.”

This small, specialized group comprises my mentors and my peers.  Although it is hired in enough cases to allow it to continue to defend securities cases full-time, it doesn’t handle the number or range of cases the group’s skill and experience otherwise justify because of the jam-packed defense field overall.  As a result, the average defense lawyer handles far fewer—and a narrower range of—cases than the average plaintiffs’ lawyer.

This is just one-half of a double-whammy for companies and their D&O insurers: the sub-optimal defense comes at an enormous cost to boot.  At the same time that the number of securities class actions filed against smaller companies is increasing—indeed, a recent study said that the size of securities cases had fallen to a level last seen in 1997—the amounts that most defense firms charge to defend litigation have increased exponentially.  This mismatch between 1997 case size and present-day law-firm economics creates the danger that a company’s D&O insurance program will be insufficient to cover the fees for a vigorous defense and the attendant price to resolve the case.  Indeed, I am greatly concerned that inadequate policy proceeds due to skyrocketing defense costs is becoming the biggest risk directors and officers face from securities litigation.

The defense-cost problem is exacerbated by the scarcity of securities litigation work for the hordes of litigation partners who hold themselves out as securities litigators.  Given the large group of lawyers competing for a limited number of cases, most of them are hired only sporadically—a case every year or two, at most—which creates pressure to maximize the billing revenue on each case.  That is also a key reason why defense hourly rates have increased so dramatically—by almost 50%—in less than ten years.

To illustrate the economic squeeze in securities class actions, consider hypothetical securities class actions against two smaller companies: 1997 Co., which carries $15 million in D&O insurance limits, and 2017 Co., which carries limits of $25 million.  (Smaller-company D&O insurance limits have increased since 1997, but not markedly.)  Assume settlements of $7.5 million in 1997 and $12.5 million in 2017.  Also assume that defense costs through summary judgment were $5 million in 1997 (cases against smaller companies are nevertheless often as labor-intensive as cases against larger companies) and $15 million in 2017, or triple the 1997 figure, corresponding to the tripling (or more) of the billing rates and partner profits of large law firms (“Big Law”).

  • Big Law defense of 1997 Co. makes some economic sense: $5 million in defense costs plus $7.5 million to settle equals $12.5 million—or $2.5 million less than the D&O insurance limits.
  • Big Law defense of 2017 Co. does not make economic sense: $15 million in defense costs plus $12.5 million to settle equals $27.5 million—or $2.5 million more than the D&O insurance limits.

However, when large firms with high billing rates and high associate-to-partner ratios try to reduce the cost of one case without changing their fundamental billing and staffing structure, they end up cutting corners by forgoing important tasks, delegating important roles in the case to junior attorneys or settling prematurely for an unnecessarily high amount.

It obviously makes no sense for a firm to charge $15 million to defend a case that can settle for $15 million.  It is even worse for that same firm to attempt to defend the case for $7 million instead of $15 million by cutting corners—whether by understaffing, overdelegating to junior lawyers, or avoiding important tasks.

It is worse still for law firms to charge $2 million through the motion-to-dismiss briefing and then, if they lose, to settle for more than $15 million just because they can’t defend the case economically past that point.  And it is a strategic and ethical minefield for a defense firm to charge $15 million and then settle for a larger amount than necessary so that the fees appear to be in line with the size of the case.

Obviously, companies and their directors and officers should not be subjected to these hazards—which are created not by the securities class action itself, but by the incentives inherent in law firm economics.

So, to sum up, we have a defense bar that is both (1) under-experienced and (2) over-priced and/or that cuts corners.  Quite obviously, on the defense side, the system is broken.

Nevertheless, the Defense Bar Wins a Lot of Battles

Yet a reasonable reader would ask, “if the defense bar is so over-matched, why do defendants win so many motions to dismiss?

The defense bar obviously wins a lot of dismissals at the pleading stage.  But those victories are short-lived if the court grants the dismissal without prejudice, allowing the plaintiffs an opportunity to more carefully replead—often with the benefit of the court’s roadmap identifying the various defects in the initial complaint.  The skeptics need look no further than the liberal law of amendment, which courts often relax further to counterbalance the Reform Act’s pleading standards.  One court put it this way: “The PSLRA requires a plaintiff to plead a complaint of securities fraud with an unprecedented degree of specificity and detail. … In this technical and demanding corner of the law, the drafting of a cognizable complaint can be a matter of trial and error.” Eminence Capital, LLC v. Aspeon, Inc., 316 F.3d 1048, 1053 (9th Cir. 2002).

Cases that survive a motion to dismiss are increasingly settled before the cost of discovery mounts.  In days gone by, if the court denied the motion to dismiss, defendants would oppose class certification and defend the litigation through a summary judgment motion—in other words, defendants would actually defend the case.  Today, given skyrocketing defense costs, cases increasingly settle soon after the court denies a motion to dismiss, to avoid the danger that a company’s D&O insurance program will be insufficient to cover the fees for a vigorous defense and a settlement later in the case.  The splintered defense bar plays a role too: because of the absence of a coordinated strategic approach to issues of class certification and summary judgment, there often appears to be little strategic benefit to using these potentially valuable mechanisms to defeat plaintiffs’ claims.  Thus, in this era of ineffective and inefficient securities defense, securities class action defense involves use of only one of three pre-trial escape hatches—the motion to dismiss—and leaves class certification and summary judgment on the table.

So motions to dismiss are the whole ballgame these days.  And while, again, defendants obviously win a lot, they would win a lot more if the defense bar were more specialized and took a better strategic approach more often.  In keeping track of pending securities cases, I read a lot of motions to dismiss in cases around the country.  Some of them are good, but a great many of them are not.  Although some of the poor motions yield a dismissal anyway, too many cases aren’t dismissed that should be—and certainly the reason for many of those is a poorly constructed motion.

Whatever success defendants have under the Reform Act’s pleading standards, it comes at a high price.  It almost always makes sense to give a motion to dismiss a shot, even if it’s a long one.  And, whether the motion is an easy or difficult one, many defense firms take advantage of the Reform Act’s defense-friendly standards to do more work than is necessary at that point, rationalizing the extra work along these lines:

“If the motion is granted, no one will really mind if we’ve billed a lot.  Plus, we’ll ‘lose’ the case before we get to bill a lot in discovery.  If the motion is not granted, the extra work we did will give us a head start on the rest of the case.”

Indeed, a cynic would say that the system is a rigged game for defense firms.  Win or lose, they “win.”  If the case is dismissed, the defense firm has done a healthy amount of work and added a victory to its win-loss record.  And if the case isn’t dismissed, the defense firm still “wins,” because the case goes into discovery, which is notoriously expensive and almost impossible for a client or insurer to capably oversee.  The opaqueness of the system is exacerbated by the swashbuckling style of many defense lawyers, who set up a criticism-free moat around themselves by dint of being a prominent partner at a powerful law firm.

So, in a nutshell, (1) the defense bar’s lack of effectiveness squanders dismissal opportunities, while (2) their lack of efficiency (to put it politely) squanders insurance resources. The Reform Act’s high pleading standards tend to mask this problem—but a problem it is.

A reasonable reader would also ask, “if the defense bar is so over-matched, how have they accomplished so many Supreme Court and Legislative victories?

This is more complex, but also supports my lament.  The Private Securities Litigation Reform Act of 1995 was a huge victory for the defense bar.  Although many people played a hand in its passage, a key group was the Silicon Valley securities defense bar—which in 1995 was a fairly small and experienced group of lawyers, including my former firm Wilson Sonsini, who defended a very high volume of securities litigation.  Indeed, in many ways, what I am arguing for is a return to the Silicon Valley firm defense bar and economics of the 1995.

On the judicial front, I don’t think the 10-year run of Supreme Court securities decisions has been very helpful outside of Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), and Omnicare, Inc. v. Laborers Dist. Council Const. Indus. Pension Fund, 135 S. Ct. 1318 (2015).  Most of the decisions have been neutral—though they all caused a huge stir, and competing claims of victory, because they were Supreme Court decisions.

Some of the decisions are an attractive nuisance.  For example, in Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014), the Court held that a defendant may rebut the fraud-on-the-market presumption of reliance at the class certification stage with evidence that the alleged misrepresentations did not impact the stock price.  Although it is a rare case in which a price-impact class certification can make a real difference in a case, it takes a lot of impulse control for a defense lawyer to turn down the chance to take a shot.  Others are examples of “be careful what you wish for.” For example, the jurisdictional limitations the Court set in Morrison v. National Australia Bank, 561 U.S. 247 (2010), have yielded enormously expensive multi-front international litigation that can’t easily be settled.

And despite the defense bar’s successes, such as they are, there is a complete inability for any coordination about the decision to seek Congressional or judicial change.  This is in large part due to the lack of visibility by other lawyers into what is happening in cases and the lack of familiarity with each other in the defense bar.  The plaintiffs’ bar, with its smaller size and greater specialization, doesn’t have those problems, at least to the same extent.  The prominent plaintiffs’ lawyers know what’s happening across the cases and know each other, and thus can at least try to stop someone from taking a misguided strategy.

We defense lawyers don’t have the same visibility or capacity to coordinate.  Even when defense counsel support an appeal on behalf of amici, they are forced to work within a trial and appellate strategy in which they weren’t involved, and which is sometimes shaped by a defense lawyer who isn’t a true specialist.  Certainly, the nature of the clients that plaintiffs and defendants represent can come into play—for example, a large pension fund cares about the state of the law more than Acme, which might only care about the case against it.  But the splintered structure of the defense bar prevents these discussions from even happening.

The Solution: Greater Insurer Control

These problems—a splintered, relatively inexperienced, and highly inefficient defense bar—are fundamental and structural.  There is a simple solution: in every securities class action, there is a group of D&O insurer representatives associated with the defense of the litigation.  As a group, D&O insurers see the big picture in securities class action in a way no defense lawyer ever could, and could easily provide input that would help solve these problems.

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

Next week, I’ll explain in detail why and how the D&O insurance community can perform this critical function.  Please stay tuned.

 

The securities class action war is about far more than the height of the pleading hurdles plaintiffs must clear, the scorecard of motions to dismiss won and lost, or median settlement amounts.  It is a fight for strategic positioning—about achieving a system of securities litigation that sets up one side or the other to win more cases over the long term.  How this war plays out has real-world consequences for the people sued in securities class actions.

Defendants win a lot of battles.  The Private Securities Litigation Reform Act of 1995 was an enormous victory for the defense bar, imposing high pleading burdens on plaintiffs and establishing a safe harbor for forward-looking statements that, in Bill Lerach’s famous words, gives defendants “license to lie.”  The rate of dismissal is markedly higher than the dismissal rate in other types of complex federal litigation.  And cases that survive motions to dismiss typically settle for predictable amounts.

But despite their success in battle, defendants are losing the war.  The root of the problem is the defense side’s lack of a centralized command, which creates a mismatch in expertise, experience, and efficiency.

  • While the plaintiffs’ bar is relatively small, with about a dozen firms that dominate, the defense bar is highly splintered, comprising many dozens of firms that can credibly pitch a case, with multiple possible lead partners within each firm—some qualified and some, frankly, not qualified.  As a result, the average plaintiffs’ partner is many times more experienced than the average defense partner.
  • While the plaintiffs’ bar’s specialized composition and small size yield a unified approach, the splintered nature of the defense bar makes this impossible for defendants.
  • While the defense bar has achieved significant legislative and judicial success, it has come with costly collateral consequences.
  • While the plaintiffs’ bar’s contingent-fee structure incentivizes efficiency, the defense bar is wildly inefficient due to hourly billing and the view that D&O insurance reimbursement is “free money.”  This penalizes the defense firms’ clients—both in individual cases and on the whole—by leaving less insurance money for a vigorous defense and settlement.

How can the defense bar approximate the plaintiffs’ bar’s advantages?  Given the competitive legal environment and large-firm economics, the defense bar can’t achieve a centralized command on its own.  The only way to do so is to give greater control to D&O insurers, the player with the greatest economic and strategic stake in both individual cases and on the whole.

Winning the securities litigation war isn’t an abstraction or a dispute about allocation of money between law firms and insurance companies. It’s about the safety and comfort of real people who face securities litigation.  At the core of every securities case are people accused of doing something wrong—not just directors and officers, but also hard-working company employees who find themselves at the center of a securities suit.  Just the idea of securities class actions makes businesspeople uncomfortable.

So the most fundamental question we on the defense side must ask ourselves is: how does the system of securities litigation defense position directors and officers to withstand securities litigation safely and comfortably?

To state the obvious, defendants are entitled to a system that allows them a fair fight with sufficient insurance resources.

I have divided this analysis into three blog posts.  In this post (Part I), I explain how and why the plaintiffs’ bar is stronger than ever.  In my next post (Part II), I’ll analyze the current state of the defense bar and explain why defendants are losing the war despite winning many battles.  In the last post (Part III), I’ll explain why and how the solution to solving the current mismatch between counsel for plaintiffs and defendants lies in giving D&O insurers greater control of securities class action defense.

Part I: The Plaintiffs’ Bar Is Back—and Better than Ever

When I was a young lawyer, most of my cases were against Milberg Weiss Bershad Hynes & Lerach.  I still remember the San Diego office’s phone number by heart (619-231-1058)—remember when we had to call people to communicate with them?  Of course, there were several other strong plaintiffs’ firms and prominent lawyers, including some of my favorite lawyers in the plaintiffs’ bar—though from my vantage point, Lerach and Weiss loomed large.

The downfall of Lerach and Weiss is well-known, so I won’t recount it here.  Many defense lawyers still discuss it with odd glee.  To me, it was sad and unfortunate.  My direct contacts with them made huge impressions on me.  For example, one of Bill Lerach’s oral arguments remains the most impressive advocacy I’ve ever witnessed.  And I’ll always remember the throng of defense lawyers at the first IPO Securities Litigation hearing turning to watch Mel Weiss enter the Daniel Patrick Moynihan U.S. Courthouse Ceremonial Courtroom, on September 7, 2001.

Lerach and Weiss helped shape and police our system of disclosure and governance, and our markets, corporate governance, and retirement savings are better off for it.  I believe that most public company disclosure deciders see the image of Bill Lerach when they decide whether or not to disclose something.

So their exit naturally left a void in the plaintiffs’ bar.  But a remarkable thing has happened: their protégés, who are my contemporaries and counterparts—as well as other senior plaintiffs’ lawyers and their protégés, plus some new entrants into the plaintiffs’ securities class action market, described below—have not only filled the gap, but have bolstered the bar.  The plaintiffs’ bar is now back, and better than ever.

Looking back, several things converged to cause this.  The first was the stock options backdating scandal, which began with a study by University of Iowa professor Eric Lie that showed an unusually large number of stock option grants to executives at stock price lows.  Since few of the companies exposed in the scandal suffered stock-price drops, the vast majority of the dozens of options cases were filed as shareholder derivative claims, on behalf of the company, alleging breaches of fiduciary duty and proxy-statement misstatements.

At the time, the most prolific securities class action firm was Coughlin Stoia Geller Rudman & Robbins, the successor of Bill Lerach’s firm and the predecessor of Robbins Geller Rudman & Dowd.  If they filed a derivative suit on behalf of a company, it meant they could not sue the company in a securities class action.  For this simple reason, many people, including me, did not think they would file many options backdating derivative cases.

But they did—and they filed a lot of them.  Not only did they file a lot of them, they defeated motions to dismiss and achieved settlements involving unprecedented types of corporate governance reforms and plaintiffs’ attorneys’ fee awards.  Their large fee awards increased the fee awards of smaller plaintiffs’ firms.  By the time they were finished, the plaintiffs’ firms that filed options backdating cases made a mint.

Then, toward the end of the options backdating scandal, the credit crisis happened and started a new wave of shareholder litigation, this time both securities class actions and shareholder derivative actions.  The plaintiffs’ bar had a war chest and was ready for battle.  The larger plaintiffs’ firms won lead plaintiff roles in the mega securities class actions and also represented plaintiffs in large individual actions.

While that was going on, the Chinese reverse-merger scandal happened.  That created a new breed of securities class action plaintiffs’ firms.  Historically, the Reform Act’s lead plaintiff provisions incentivized plaintiffs’ firms to recruit institutional investors to serve as plaintiffs.  For the most part, institutional investors have retained the larger plaintiffs’ firms, and smaller plaintiffs’ firms have been left with individual investor clients who usually can’t beat out institutions for the lead-plaintiff role.  At the same time, securities class action economics tightened in all but the largest cases, placing a premium on experience, efficiency, and scale.  As a result, 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.

The China cases changed this dynamic.  Smaller plaintiffs’ firms initiated the lion’s share of them, as the larger firms were swamped with credit-crisis cases and likely were deterred by the relatively small damages, potentially high discovery costs, and uncertain insurance and company financial resources.  Moreover, these cases fit smaller firms’ capabilities well; nearly all of the cases had “lawsuit blueprints” such as auditor resignations and/or short-seller reports, thereby reducing the smaller firms’ investigative costs and increasing their likelihood of surviving a motion to dismiss (and thus reducing the likelihood of dismissal and no recovery).  The dismissal rate was indeed low, and limited insurance and company resources prompted early settlements in amounts that, while on the low side, yielded good outcomes for the smaller plaintiffs’ firms.

With these recoveries, these firms built up momentum that kept them going even after the wave of China cases subsided.  For the last several years, 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 (reducing the plaintiffs’ firms’ investigative costs) for which they can win the lead plaintiff role and that they can prosecute at a sufficient profit margin.

As smaller firms have gained further momentum, they have expanded the cases they initiate beyond “lawsuit blueprint” cases—and they continue to initiate and win lead-plaintiff contests primarily in cases against smaller companies brought by retail investors.  The securities litigation landscape now clearly consists of a combination of two different types of cases: smaller cases brought by a set of smaller plaintiffs’ firms on behalf of retail investors, and larger cases pursued by the larger plaintiffs’ firms on behalf of institutional investors.  This change is now more than five years old, and appears to be here to stay.

Plaintiffs firms thus have us surrounded—no public company can fly under the radar anymore.  Plaintiffs’ firms of all types have made a lot of money over the past decade.  They’re now filing a record number of cases, even subtracting out the federal-court merger cases.  And on the whole, they’re strong lawyers, with some genuine superstars among them.

Yet, though expanded, the number of firms is small, with about a dozen in the core group.  This gives them the practical ability to take common strategic, economic, and legal positions—even if they don’t always see eye-to-eye or get along.

***

Next week, in Part II, I’ll analyze the current state of the defense bar and explain why defendants are losing the war despite winning key legislative and judicial battles.  And the following week, in Part III, I’ll discuss why and how giving greater control of securities class action defense to D&O insurers would solve the current mismatch between counsel for plaintiffs and defendants.  Please stay tuned.

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.

Following is an article I wrote for Law360, which gave me permission to republish it here:

Among securities litigators, there is no consensus about the importance of developments in securities and corporate governance litigation.  For some, a Supreme Court decision is always supreme.  For others, a major change in a legal standard is the most critical.  For me, the key developments are those that have the greatest potential to significantly increase or decrease the frequency or severity of claims against public companies and their directors and officers.

Given my way of thinking, there are three developments in 2016 that stand out as noteworthy:

  • The persistence of securities class actions brought against smaller public companies primarily by smaller plaintiffs’ firms on behalf of retail investors—a trend that began five years ago and now appears to represent a fundamental shift in the securities class action landscape.
  • The 2nd Circuit’s robust application of the Supreme Court’s Omnicare decision in Sanofi, illustrating the significant benefits of Omnicare to defendants.
  • The demise of disclosure-only settlements under the Delaware Court of Chancery’s Trulia decision and the 7th Circuit’s subsequent scathing Walgreen opinion by Judge Posner.

I discuss each of these developments in detail, and then list other 2016 developments that I believe are important as well.

1. The Securities Class Action Landscape Has Fundamentally Changed

The Private Securities Litigation Reform Act’s lead plaintiff process incentivized plaintiffs’ firms to recruit institutional investors to serve as plaintiffs.  For the most part, institutional investors, whether smaller unions or large funds, have retained the more prominent plaintiffs’ firms, and smaller plaintiffs’ firms have been left with individual investor clients who usually can’t beat out institutions for the lead-plaintiff role.  At the same time, securities class action economics tightened in all but the largest cases.  Dismissal rates under the Reform Act are pretty high, and defeating a motion to dismiss often requires significant investigative costs and intensive legal work.  And the median settlement amount of cases that survive dismissal motions is fairly low.  These dynamics placed a premium on experience, efficiency, and scale.  Larger firms filed the lion’s share of the cases, and smaller plaintiffs’ firms were unable to compete effectively for the lead plaintiff role, or make much money on their litigation investments.

This started to change with the wave of cases against Chinese companies 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 was 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 momentum that has kept them going, even after the wave of China cases subsided.  For the last several years, 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 (reducing the plaintiffs’ firms’ investigative costs) for which they can win the lead plaintiff role and that they can prosecute at a sufficient profit margin.

As smaller firms have gained further momentum, they have expanded the cases they initiate beyond “lawsuit blueprint” cases—and they continue to initiate and win lead-plaintiff contests primarily in cases against smaller companies brought by retail investors.  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 securities litigation landscape now clearly consists of a combination of two different types of cases: smaller cases brought by a set of smaller plaintiffs’ firms on behalf of retail investors, and larger cases pursued by the larger plaintiffs’ firms on behalf of institutional investors.  This change—now more than five years old—appears to be here to stay.

In addition to this fundamental shift, two other trends are an indicator of further changes to the securities litigation landscape.

First, the smaller plaintiffs’ firms often file cases against U.S. companies in New York City or California—regardless where the company is headquartered—diverging from the larger plaintiffs’ firms’ practice of filing in the forum of the defendant company’s headquarters.  In addition to inconvenience, filing cases in New York City and California against non-resident companies results in sticker-shock, since defense firms based in those venues are much more expensive than their home town firms.  The solution to this problem will need to include greater defense of cases in New York City and California by a more economically diverse set of defense firms.

Second, plaintiffs’ firms, large and small, are increasingly rejecting the use of historical settlement values to shape the settlement amounts.  This practice is increasing settlement amounts in individual cases, and will ultimately raise settlement amounts overall.  And it will be increasingly difficult for defendants and their insurers to predict defense costs and settlement amounts, as more mediations fail and litigation proceeds past the point they otherwise would.

2. Sanofi Shows Omnicare’s Benefits

In Tongue v. Sanofi, 816 F.3d 199 (2nd Cir. 2016), the Second Circuit issued the first significant appellate decision interpreting the Supreme Court’s decision in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318 (2015).  Sanofi shows that Omnicare provides powerful tools for defendants to win more motions to dismiss.

As a reminder, the Supreme Court in Omnicare held that a statement of opinion is only false under the federal securities laws if the speaker does not genuinely believe it, and is only misleading if it omits information that, in context, would cause the statement to mislead a reasonable investor.  This ruling followed the path Lane Powell advocated in an amicus brief on behalf of Washington Legal Foundation.

The Court’s ruling in Omnicare was a significant victory for the defense bar for two primary reasons.

First, the Court made clear that an opinion is false only if it was not sincerely believed by the speaker at the time that it was expressed, a concept sometimes referred to as “subjective falsity.”  The Court thus explicitly rejected the possibility that a statement of opinion could be false because “external facts show the opinion to be incorrect,” because a company failed to “disclose[] some fact cutting the other way,” or because the company did not disclose that others disagreed with its opinion.  This ruling resolved two decades’ worth of confusing and conflicting case law regarding what makes a statement of opinion false, which had often permitted meritless securities cases to survive dismissal motions.  Omnicare governs the falsity analysis for all types of challenged statements. Although Omnicare arose from a claim under Section 11 of the Securities Act, all of its core concepts are equally applicable to Section 10(b) of the Securities Exchange Act and other securities laws with similar falsity elements.

Second, Omnicare declared that whether a statement of opinion (and by clear implication, a statement of fact) was misleading “always depends on context.”  The Court emphasized that showing a statement to be misleading is “no small task” for plaintiffs, and that the court must consider not only the full statement being challenged and the context in which it was made, but must also consider other statements made by the company, and other publicly available information, including the customs and practices of the relevant industry.

A good motion to dismiss has always analyzed a challenged statement (of fact or opinion) in its broader factual context to explain why it’s not false or misleading.  But many defense lawyers unfortunately leave out the broader context, and courts have sometimes taken a narrower view.  Now, this type of superior, full-context analysis is clearly required by Omnicare.  And combined with the Supreme Court’s directive in Tellabs that courts consider scienter inferences based not only on the complaint’s allegations, but also on documents on which the complaint relies or that are subject to judicial notice, courts clearly must now consider the full array of probative facts in deciding both whether a statement was false or misleading and, if so, whether it was made with scienter.   

Due to the importance of its holdings and the detailed way in which it explains them, Omnicare is the most significant post-Reform Act Supreme Court case to analyze the falsity element of a securities class-action claim, laying out the core principles of falsity in the same way that the Court did for scienter in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007).  If used correctly, Omnicare thus has the potential to be the most helpful securities case for defendants since Tellabs, providing attorneys with a blueprint for how to structure their falsity arguments in order to defeat more complaints on motions to dismiss.

The early returns show that Omnicare is already helping defendants win more motions to dismiss.  The most significant such decision is Sanofi. In Sanofi, the Second Circuit became the first appeals court to discuss Omnicare in detail, and to examine the changes that it brought about in the previously governing law.  Sanofi was not, as some securities litigation defense lawyers have claimed, a “narrow” reading of the Court’s decision.  Rather, it was a straightforward interpretation of Omnicare that emphasized the Supreme Court’s ruling on falsity, and the intensive contextual analysis required to show that a statement is misleading.  It correctly took these concepts beyond the Section 11 setting and applied them to allegations brought under Section 10(b).

Statements about Lemtrada, a drug in development for treatment of multiple sclerosis, were at issue in the case.  Sanofi and its predecessor had conducted “single-blind” clinical trials for Lemtrada (studies in which either the researcher or the patient does not know which drug was administered), despite the fact that the U.S. Food and Drug Administration had repeatedly expressed concerns about these trials and recommended “double-blind” clinical studies (studies in which both the researcher and the patient do not know which drug was administered).

The plaintiffs alleged that Sanofi’s failure to disclose FDA’s repeated warnings that a single-blind study might not be adequate for approval caused various statements made by the company to be misleading, including its projection that FDA would approve the drug, its expressions of confidence about the anticipated launch date of the drug, and its view that the results of the clinical trials were “unprecedented” and “nothing short of stunning.”  Although FDA eventually approved Lemtrada without further clinical trials, the agency initially refused approval based in large part on the single-blind studies concern, causing a large drop in the price of Sanofi stock.

In an opinion issued before Omnicare, the district court dismissed the claims, in part because it found that plaintiffs had failed to plead that the challenged statements of opinion were subjectively false, under the standard employed by the Second Circuit in Fait v. Regions Financial Corp.  The Second Circuit stated that it saw “no reason to disturb the conclusions of the district court,” but wrote to clarify the impact of Omnicare on prior Second Circuit law.

The court acknowledged that Omnicare affirmed the previous standard that a statement of opinion may be false “if either ‘the speaker did not hold the belief she professed’ or ‘the supporting fact she supplied were untrue.’”  However, it noted that Omnicare went beyond the standard outlined by Fait in holding that “opinions, though sincerely held and otherwise true as a matter of fact, may nonetheless be actionable if the speaker omits information whose omission makes the statement misleading to a reasonable investor.”

In reality, Omnicare did not represent a change in Second Circuit law.  Although Fait only discussed falsity, without considering what it would take to make an opinion “misleading,” prior Second Circuit law had been clear that “[e]ven a statement which is literally true, if susceptible to quite another interpretation by the reasonable investor, may properly be considered a material misrepresentation.”  Kleinman v. Elan Corp., 706 F.3d 145 (2nd Cir. 2013) (citation and internal quotation marks omitted).  Omnicare simply brought together these two lines of authority, by correctly clarifying that, like any other statement, a statement of opinion can be literally true (i.e., actually believed by the speaker), but can nonetheless omit information that can cause it to be misleading to a reasonable investor.

The Second Circuit highlighted the Omnicare Court’s focus on context, taking note of its statement that “an omission that renders misleading a statement of opinion when viewed in a vacuum may not do so once that statement is considered, as is appropriate, in a broader frame.”  Since Sanofi’s offering materials “made numerous caveats to the reliability of the projections,” a reasonable investor would have considered the opinions in light of those qualifications.  Similarly, the Second Circuit recognized that reasonable investors would be aware that Sanofi would be engaging in continuous dialogue with FDA that was not being disclosed, that Sanofi had clearly disclosed that it was conducting single-blind trials for Lemtrada, and that FDA had generally made clear through public statements that it preferred double-blind trials. In this broader context, the court found that Sanofi’s optimistic statements about the future of Lemtrada were not misleading even in the context of Sanofi’s failure to disclose FDA’s specific warnings regarding single-blind trials.

Under the Omnicare standards, the Second Circuit thus found nothing false or misleading about the challenged statements, holding that Omnicare imposes no obligation to disclose facts merely because they tended to undermine the defendants’ optimistic projections.  In particular, the Second Circuit found that “Omnicare does not impose liability merely because an issuer failed to disclose information that ran counter to an opinion expressed in a registration statement.”  It also reasoned that “defendants’ statements about the effectiveness of [the drug] cannot be misleading merely because the FDA disagreed with the conclusion—so long as Defendants conducted a ‘meaningful’ inquiry and in fact held that view, the statements did not mislead in a manner that is actionable.”

3. Companies May Regret the Decline of Disclosure-Only Settlements

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 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 timeliest and most 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 to 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 the 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’ lawyers, 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.

Additional Significant Developments

There were a number of other 2016 developments that I believe may also significantly impact the frequency and severity of securities claims against public companies and their directors and officers.  These include:

  • The ongoing wave of Securities Act cases in state court, especially in California, and the Supreme Court cert petitions in Cyan, Inc. v. Beaver County Employees Retirement Fund, No. 15-1439, and FireEye, Inc., et al., v. Superior Court of California, Santa Clara County, No. 16-744.
  • The lack of a wave of cyber security shareholder litigation, and the conclusion in favor of the defendants in the Target and Home Depot shareholder derivative cases, which follows the dismissal of the Wyndham derivative case in 2014.
  • The challenge to the SEC’s use of administrative proceedings, including Lynn Tilton’s tilt at the process.
  • The Supreme Court’s decision on insider trading in Salman v. U.S. 137 S. Ct. 420 (2016), rejecting the 2nd Circuit’s heightened personal benefit requirement established in U.S. v. Newman, 773 F.3d 438 (2nd Cir. 2014).
  • The persistence and intractability of securities class actions against foreign issuers after Morrison v. National Australia Bank, 561 U.S. 247 (2010).
  • The 8th Circuit’s reversal of class certification under Halliburton II in IBEW Local 98 Pension Fund v. Best Buy Co., 818 F.3d 775, 777 (8th Cir. 2016).
  • The 9th Circuit becoming the first appellate court to hold that Section 304 of Sarbanes-Oxley allows the SEC to seek a clawback of compensation from CEOs and CFOs in the event of a restatement even if it did not result from their misconduct. U.S. Securities & Exchange Commission v. Jensen, 835 F.3d 1100 (2016).
  • The 2nd Circuit’s lengthy and wide-ranging decision in In re Vivendi, S.A. Securities Litigation, 838 F.3d 223 (2nd Cir. 2016), affirming the district court’s partial judgment against Vivendi following trial.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Roots of D&O Insurance

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

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

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

The history of securities litigation is marked by particular types of cases that come in waves:

  • the IPO laddering cases, which involved more than 300 issuers and their underwriters;
  • the Sarbanes-Oxley era “corporate scandal” cases, which involved massive litigation against Enron, WorldCom, Tyco, Adelphia, HealthSouth, and others;
  • the mutual fund market timing cases;
  • the stock options backdating cases, most of which were actually derivative cases, but many plaintiffs’ firms devoted class action resources to them;
  • the credit crisis cases; and
  • the Chinese reverse-merger cases.

In fact, the out-of-the-ordinary type of securities case has become ordinary; we have been in a series of waves for the past 20 years.

But we are not in one now, and I’m often asked, “What’s next?”

Although I don’t know if we’re about to enter a period of quirky cases, like stock options backdating, I’m confident that we’re going to experience a storm of securities class actions caused by a convergence of factors: an increasing number of SEC whistleblower tips, a drumbeat for more aggressive securities regulation, a stock market poised for a drop, and an expanded group of plaintiffs’ firms that initiate securities class actions.

The SEC’s Whistleblower Program

The Dodd-Frank Wall Street Reform and Consumer Protection Act directed the SEC to give bounties to certain whistleblowers.  With awards in the range of 10 percent to 30 percent of monetary sanctions over $1 million, the bounties were designed to attract meaningful tips.

The program caused a stir.  Plaintiffs’ law firms established whistleblower practice groups and hired former SEC enforcement officials.  The SEC created the Office of the Whistleblower, increased staffing, set up a website and hotline system, etc.  Corporate firms published myriad client alerts and held hundreds of seminars—and braced for their own bounties, in the form of new work caused by more internal and SEC investigations, and resulting securities class actions.  I told my family that I’d see them when I retired.

Yet it took a while for the whistleblower program to get rolling.  The number and amount of the early awards were surprisingly low.  But, as featured on the SEC’s website, they have increased steadily, and are now at significant levels.  In total, the SEC has paid out more than $100 million in bounties.  The number of tips has increased from 3,000 in the program’s first fiscal year to 4,000 last year.  SEC Chair Mary Jo White calls the bounty program a “game changer” and Director of Enforcement Andrew Ceresney says it has had a “transformative impact on the agency.”  Indeed, last year, the SEC filed 868 enforcement actions, a single-year high.

Calls for Increased Government Enforcement

Just as the bounty program is hitting its stride, the political environment again seems to be turning against corporations due to the perceived failure of the government’s securities enforcement efforts in the aftermath of the credit crisis and the recent Wells Fargo scandal, among other factors.  And, of course, this election season has been marked by widespread anti-establishment sentiment.

During my nearly 25 years as a securities defense lawyer, I have seen the pendulum swing back and forth, from outrage against corporations, to outrage against the unfairness of SEC enforcement and the ethics of plaintiffs’ lawyers.  Although I don’t think anti-corporate sentiment significantly changes the rate of government enforcement—they do the most they can with their resources, and are constrained by burdens of proof—I do strongly believe that anti-corporate sentiment increases the number and severity of private securities class actions.

We evaluate the state of the securities class action litigation environment primarily by reference to the rate at which cases are dismissed.  Over the history of securities litigation, the biggest driver of the rate of dismissal is not any legal standard, but instead is the overall public attitude toward the value of private securities litigation.  Whether facts are “particularized,” or an inference of scienter is “strong,” are subjective judgments that give judges wide latitude to dismiss a complaint, or not.  Judges are people.  They read the news.  They talk to friends.  They have children who are Millennials.  They have seen people they thought were good do bad things.  When public sentiment is anti-corporation, the judicial environment is inevitably influenced.

When the judicial environment changes, plaintiffs’ lawyers increase their investment in securities litigation—both in the number of cases they file, and how hard they litigate cases.  Two waves of cases provide examples:

  • In the Chinese reverse merger cases, plaintiffs’ firms filed securities class actions against virtually every Chinese company about which there was a report of a problem.  Plaintiffs defeated nearly every motion to dismiss, especially in the Central District of California.  Although the economic recoveries in those cases weren’t substantial due to a lack of company and insurance resources, several smaller plaintiffs’ firms went all in.
  • In the stock option backdating cases, plaintiffs’ firms filed against nearly every company that had a potential backdating problem.  Plaintiffs defeated motions to dismiss at a high rate, and settled cases for relatively large amounts.  The backdating cases greatly raised the level of derivative settlements, established several smaller plaintiffs’ derivative firms as players in shareholder litigation, and were incredibly lucrative for larger plaintiffs’ firms.

Expansion of Plaintiffs’ Securities Class Action Firms

The stock-options backdating cases and the Chinese reverse merger cases have another thing in common: they have fueled an expansion of the plaintiffs’ bar.

The Reform Act’s lead plaintiff process incentivized plaintiffs’ firms to recruit institutional investors to serve as plaintiffs.  For the most part, institutional investors, whether smaller unions or large funds, have retained a handful of prominent plaintiffs’ firms, and smaller plaintiffs’ firms have been left with individual investor clients who usually can’t beat out institutions for the lead-plaintiff role.  At the same time, securities class action economics tightened in all but the largest cases.  Dismissal rates under the Reform Act are pretty high, and defeating a motion to dismiss often requires significant investigative costs and intensive legal work.  And the median settlement amount for cases that survive dismissal motions is fairly low.

These dynamics placed a premium on experience, efficiency, and scale.  Larger firms thus filed the lion’s share of the cases, and smaller plaintiffs’ firms were unable to compete effectively for the lead plaintiff role, or make much money on their litigation investments.

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

These outcomes built on gains smaller plaintiffs’ firms made during the stock options backdating cases, in which several smaller plaintiffs’ firms did quite well picking up matters in which the larger plaintiffs’ firms didn’t win the lead role, or working with the larger firms as co-counsel. Fueled by their economic and lead-plaintiff successes, these smaller firms have built up a head of steam that has kept them going, even after the wave of China cases subsided.  For the last several years, 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.

Although it isn’t possible for me to know for sure, I strongly believe that there is a very large amount of capacity among the larger and smaller plaintiffs’ firms to increase securities class action filings.  Larger plaintiffs’ firms have only recently finished working through the bulge of the credit crisis cases, and employ a large number of securities class action specialists who have time for more cases.  And the smaller firms are aggressively filing cases and pursuing lead-plaintiff roles.

One of my mentors used to say that “nature abhors a vacuum,” when predicting that there would always be a steady supply of securities litigation.  In a twist on this maxim, I like to say that plaintiffs’ securities class action specialists aren’t going to become doctors or dentists—or even derivative litigation lawyers.  Instead, this large group of lawyers will always file as many securities class actions as they can.  And now, with smaller plaintiffs’ firms hitting their stride, the supply of plaintiffs’ securities class action lawyers is very large, and is looking for more work.

Is There a Securities-Litigation Storm on the Horizon?

I believe that the convergence of these factors, as well as the predicted drop in the stock market, will significantly increase the number of securities class actions.  Indeed, the next big wave in securities litigation may well not be a type of case caused by a unique event, such as options backdating, but instead a perfect storm of cases caused by a competitive blitz by plaintiffs’ firms, as companies report bad earnings results as the economy and stock market decline, and as whistleblower bounties and other SEC enforcement tools unearth disclosure problems.  And throw in other lawsuit-drivers, such as short-seller hit-pieces, and we could see an unprecedented storm of securities class actions.

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Doug Greene

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.

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

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

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

Greater Involvement by Directors in Securities Litigation Defense

Why Should Directors Care?

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

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

The Economics of Securities Litigation Matter

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

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

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

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

The Importance of Directors’ Involvement in Defense-Counsel Selection

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

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

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

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

Directors’ Oversight of D&O Insurance

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

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

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

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

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

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

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

Conclusion

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

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.