Does Item 303 of Regulation S-K matter in private securities litigation?  In Stratte-McClure v. Morgan Stanley, 776 F.3d 94 (2nd Cir. 2015), the Second Circuit held that Item 303 imposes a duty to disclose for purposes of Section 10(b), meaning that the omission of information required by Item 303 can provide the basis for a Section 10(b) claim.  This ruling is at odds with the Ninth Circuit’s opinion in In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046 (9th Cir. 2014), in which the court held that Item 303 does not establish such a duty.  The U.S. Supreme Court declined a cert petition in NVIDIA.

I’m glad the Supreme Court didn’t take the case, because while this issue seems important, it really isn’t – as a practical matter, a claim under Item 303 doesn’t add much, if anything, to a plain vanilla claim alleging that a statement was misleading for omitting the same information.

Evolution of the Legal Issue

SEC forms, under both the Securities Act and the Exchange Act, require the disclosure of various items described in SEC Regulation S-K.  Some of the most important disclosures are found in S-K Item 303(a), which includes “management’s discussion and analysis” (MD&A) of the company’s “financial condition, changes in financial condition and results of operations.”  And Item 303(a)(3)(ii) indicates that the MD&A must include a description of “any known trends or uncertainties that have had or that the [company] reasonably expects will have a material … unfavorable impact on net sales or revenues or income from continuing operations.”  This is a high hurdle for a plaintiff to clear: a company must actually know: (1) the facts underlying the trend or uncertainty, (2) those known facts yield a trend or uncertainty, and (3) the trend or uncertainty will have a negative and material impact.

The key liability provisions of the federal securities laws, Section 10(b) of the Securities Exchange Act of 1934 and Section 11 of the Securities Act of 1933, prohibit a false statement or omission of a fact that causes a statement to be misleading.  In addition, the text of Section 11 allows a claim to be based on the issuer’s failure to disclose “a material fact required to be stated” in a registration statement. 15 U.S.C. § 77k(a) (emphasis added).  One such requirement is Item 303.  Panther Partners Inc. v. Ikanos Communications, Inc., 681 F.3d 114, 120 (2nd Cir. 2012).  Based on this statutory language – which is unique to Section 11 – Section 11 claims thus appropriately can include claims based on Item 303.

Panther Partners is the decision that has fueled plaintiffs’ counsel’s use of Item 303. In Panther Partners, the Second Circuit held that Item 303 required the issuer, Ikanos Communications, to disclose information about a high product defect rate, and that the omission of this information from a registration statement gave rise to a cause of action under Section 11.  There are two important facets of the decision that have largely been forgotten.  First, the court emphasized Section 11’s language, which isn’t present in the statute or decisions under Section 10(b), that an issuer must disclose “a material fact required to be stated” in a registration statement.  Second, the court was troubled by the fact that the company’s risk factor about product defects suggested there were no defects when, in fact, there were:

In light of these allegations, the Registration Statement’s generic cautionary language that “[h]ighly complex products such as those that [Ikanos] offer[s] frequently contain defects and bugs” was incomplete and, consequently, did not fulfill Ikanos’s duty to inform the investing public of the particular, factually-based uncertainties of which it was aware in the weeks leading up to the Secondary Offering.

Id.at 122.  I could make a strong argument that the driver of the court’s decision was a false or misleading risk factor, and Item 303 was just the way the court articulated its conclusion.  As I’ve written, courts are often troubled by boilerplate risk factors, especially those that cast as hypothetical risks that have materialized.

In NVIDIA, plaintiffs alleged that several of NVIDIA’s SEC filings contained materially false and misleading statements because they omitted information relating to a defect in NVIDIA’s graphics processing unit (“GPU”) chips.  Plaintiffs also argued that certain omissions in filing statements were actionable under Section 10(b) because the chip defects constituted a “known trend” under Item 303 – but did not present this theory in the complaint itself.

The district court found that plaintiffs had pled “at least one” material misrepresentation – a risk factor saying that defects “might occur,” which falsely suggested that NVIDIA was not already aware of the same defect in other products.  The district court did not inquire into whether any of the other specific statements were also materially misleading.  Nonetheless, the district court dismissed the complaint on the ground that plaintiffs had failed to plead scienter.  The district court opinion only mentioned Item 303 briefly, as it was not (yet) a centerpiece of plaintiffs’ theory.

Before the Ninth Circuit, plaintiffs argued that the district court should have considered scienter in the context of Item 303, focusing on whether defendants had acted with scienter in violating that rule.  The Ninth Circuit rejected this line of argument on the ground that Item 303 does not establish an independent duty of disclosure for the purposes of Section 10(b).  The Ninth Circuit did not consider whether plaintiffs had successfully pled a material misrepresentation (as the district court had found), focusing instead on scienter, and affirming the district court’s judgment on this ground.

Shortly thereafter, the Second Circuit, in Stratte-McClure, held that Item 303 does establish an independent duty of disclosure for purposes of Section 10(b).  The court began with the cardinal rule that silence, absent a duty to disclose, is not actionable, and such a duty is created when a company omits facts that make a statement misleading.  768 F.3d at 101-02.  The court then grappled with whether omission of facts required to be disclosed under Item 303 creates a duty of disclosure for purposes of Section 10(b).  In analyzing this issue, the court relied on the Panther Partners holding, though the court compared Section 10(b)’s requirements to Section 12(a)(2) of the 1933 Act, which does not contain Section 11’s unique statutory language, i.e., Section 11 makes actionable not just a false or misleading statement, but also a failure to disclose “a material fact required to be stated” in a registration statement.

The court’s comparison of Section 10(b) to Section 12(a)(2) instead of to Section 11 resulted in a large legal leap.  The court in Panther Partners stated that “[o]ne of the potential bases for liability under §§ 11 and 12(a)(2) is an omission in contravention of an affirmative legal disclosure obligation” (i.e. making actionable the omission of “a material fact required to be stated” in a registration statement).  681 F.3d at 120.  But, in fact, only Section 11, and not Section 12(a)(2), contains that provision.  Instead, Section 12(a)(2), like Section 10(b), imposes liability for a false or misleading statement, and doesn’t contain the alternative basis of liability for a failure to disclose “a material fact required to be stated ….”  As a result, Stratte-McClure doesn’t fairly portray the rationale for the holding in Panther Partners.

Nevertheless, the court in Stratte-McClure supplied a separate basis, grounded in Section 10(b)’s requirement of a false or misleading statement, for concluding that Item 303 supplies a duty to disclose that can be actionable under Section 10(b):

Due to the obligatory nature of [Item 303], a reasonable investor would interpret the absence of an Item 303 disclosure to imply the nonexistence of “known trends or uncertainties … that the registrant reasonably expects will have a material … unfavorable impact on … revenues or income from continuing operations.” …  It follows that Item 303 imposes the type of duty to speak that can, in appropriate cases, give rise to liability under Section 10(b).

776 F.3d at 102 (citations omitted).  In other words, a company that fails to disclose information required to be disclosed by Item 303 has misled investors by creating an impression of a state of affairs (that there are no materially negative trends or uncertainties) that differs from the one that actually exists (that there are such trends or uncertainties).  Thus, what the court implicitly held is that an Item 303 omission makes the whole set of the company’s affirmative statements misleading.

Item 303’s Lack of Practical Impact

The Item 303 issue is certainly interesting.  My colleagues and I have had lively discussions about the questions it raises.  But we keep concluding that it doesn’t really add anything.

We first reached this conclusion in a roundabout way in a case a few years ago.  There were two offerings at issue, and just after Panther Partners, plaintiffs’ counsel featured the Item 303 allegations.  We drafted a detailed motion to dismiss section on the Item 303 issue.  As we evaluated our arguments in light of the page limit, we kept shortening the Item 303 argument.  In the end, we decided that the Item 303 claim was redundant: the court wasn’t going to deny the motion to dismiss under Item 303 without also finding that the plaintiffs had sufficiently pleaded a false statement and scienter, because the plaintiffs challenged many statements and pleaded scienter using the same allegations that formed the basis of the Item 303 claim.  So in the filed version of the motion, the argument became a fraction of the size of the original one.  And in the reply brief, the Item 303 argument was in a short footnote.

Since then, the plaintiffs’ bar’s focus on the issue, and various court decisions, and even a cert petition, have kept me re-thinking the importance of Item 303 to securities claims.  But I haven’t changed my view that Item 303 is redundant: very rarely, if ever, would there be an omitted fact that gives rise to an Item 303 claim without also rendering false or misleading one or more challenged statements; and the knowledge required under Item 303 is at least as great as is necessary to establish scienter.  Even under Section 11, where the unique statutory language allows for a claim, Item 303’s multiple knowledge requirements, if appropriately applied, make the claim difficult to plead and prove.

The NVIDIA case provides a good illustration.  Recall that the plaintiffs alleged that NVIDIA made false statements related to a defect in its GPU chips, and argued that the chip defects constituted a known trend under Item 303.  The complaint challenged many statements, and the district court concluded that “at least one” was misleading as a result of the defects:

*          “Our core businesses are continuing to grow as the GPU becomes increasingly central to today’s computing experience in both the consumer and professional market segments.”

*          “Fiscal 2008 was another outstanding and record year for us. Strong demand for GPUs in all market segments drove our growth. Relative to Q4 one year ago, our discrete GPU business grew 80%.”

*          “As we have in the past, we intend to use this [R&D] strategy to achieve new levels of graphics, networking and communications features and performance and ultra-low power designs, enabling our customers to achieve superior performance in their products.”

*          “[W]e believe that close relationships with OEMs, ODMs and major system builders will allow us to better anticipate and address customer needs with future generations of our products.”

*          “The growth of GPUs continues to outpace the PC market. We shipped 42 percent more GPUs this quarter compared to the same period a year ago, resulting in our best first quarter ever. … We expect this positive feedback loop to continue to drive our growth.”

*          “In the past, we have discovered defects and incompatibilities with customers’ hardware in some of our products. Similar issues in the future may result in delays or loss of revenue to correct any defects or incompatibilities.”

*          “If our products contain significant defects our financial results could be negatively impacted, our reputation could be damaged and we could lose market share.”

*          In a statement disclosing the defects: “We are evaluating the potential scope of this situation, including the nature and cause of the alleged defect and the merits of the customer’s claim, and to what extent the alleged defect might occur with other of our products.”

This list of challenged statements illustrates that companies affirmatively say many things on the subject matter of an omission sufficient to yield an Item 303 claim.  Indeed, it’s hard to imagine a case in which an issue is so major as to require Item 303 disclosure but isn’t something about which the company has spoken.

And given that is the case, and Item 303’s disclosure requirements are infused with knowledge requirements, it also would be an anomalous case in which there is an Item 303 violation but not scienter.  For example, if a company violates Item 303 by not disclosing that its biggest customer is switching suppliers next quarter, and proceeds to say things about its business and financial outlook as it of course would, it has made misleading statements with intent to defraud.  The Item 303 claim adds nothing.  Stratte-McClure, on its face, is an anomalous case.  After concluding that Morgan Stanley had a duty to disclose certain facts about subprime lending that were likely to cause material trading losses, the court concluded that the failure to disclose those facts wasn’t done with scienter.  The analysis is fact-specific and technical.  Suffice it to say that I could easily re-write the opinion, using the court’s own scienter analysis, to conclude that no disclosure was required under Item 303 in the first place – it’s really a matter of six of one, half a dozen of another.

Why, then, have plaintiffs’ counsel pushed Item 303 claims so hard?  I believe it’s mostly to combat the cardinal rule that silence, absent a duty to disclose, is not misleading. Companies omit thousands of facts every time they speak, and it’s relatively easy for a plaintiff to identify omitted facts – but it’s analytically difficult work, and often unsuccessful, to challenge affirmative statements.

Another important reason is defendants’ attack on the fraud on the market presumption of reliance over the past several years – first to the legitimacy of Basic v. Levinson, which gave rise to securities class actions, and now to its viability in specific cases under the price-impact rule of Halliburton II.  Claims of pure omission under Item 303 arguably would fall under the Affiliated Ute presumption of reliance, rather than under Basic, which would make class certification easier and more certain.  But the court’s reasoning in Stratte-McClure that an Item 303 violation makes what the company said misleading would make the claim a statement-based claim that would be evaluated under Basic, not Affiliated Ute.

Whatever the reason, I hope parties and courts don’t waste time litigating over Item 303 further.  It just doesn’t matter.

In my last D&O Discourse post, “The Future of Securities Class Action Litigation,” I discussed why changes to the securities litigation defense bar are inevitable: in a nutshell, the economic structures of the typical securities defense firms – mostly national law firms – result in defense costs that significantly exceed what is rational to spend in a typical securities class action.  As I explained, the solution needs to come from outside the biglaw paradigm; when biglaw firms try to reduce the cost of one case without changing their fundamental billing and staffing structure, they end up cutting corners by foregoing important tasks or settling prematurely for an unnecessarily high amount.  That is obviously unacceptable.

The solution thus requires us to approach securities class action defense in a new way, by creating a specialized bar of securities defense lawyers from two groups: lawyers from national firms who change their staffing structure and lower their billing rates, and experienced securities litigators from regional firms with economic structures that are naturally more rational.

But litigation venues are regional.  We have state courts and federal courts organized by states and areas within states.  Since lawyers need to go to the courthouse to file pleadings, attend court hearings, and meet with clients in that location, the lawyer handling a case needs to live where the judge and clients live.

Right?

Not anymore.

Although the attitude that a case needs a local lawyer persists, that is no longer how litigation works.  We don’t file pleadings at the courthouse.  We file them on the internet from anywhere – even from an airplane.  There are just a handful of in-person court hearings in most cases.  And the reality is that most clients don’t want their lawyers hanging around in person at their offices – email, phone calls, and Skype suffice.  Even document collection can be done mostly electronically and remotely.  And with increasingly strict deposition limits, and witnesses located around the country and world, depositions don’t require much time in the forum city either.

In a typical Reform Act case, where discovery is stayed through the motion-to-dismiss process, the amount of time a lawyer needs to spend in the forum city is especially modest.  If a case is dismissed on a motion to dismiss, the case activities in the forum city in a typical case amount only to (1) a short visit to the clients’ offices to learn the facts necessary to assess the case and prepare the motion to dismiss, and (2) the motion-to-dismiss argument, if there is one.  Indeed, assuming that a typical securities case requires a total of 1,000 hours of lawyer time through an initial motion to dismiss, fewer than 50 of those hours – one-half of one percent – need to be spent in the forum city.  The other 99.5% can be spent anywhere.

Discovery doesn’t change these percentages much.  Assume that it takes another 10,000 hours of attorney time to litigate a case through a summary judgment motion, or 11,000 total hours.  Four lawyers/paralegals spending four weeks in the forum city for document collection and depositions (a generous allotment) yields only another 640 hours.  So in my hypothetical, only 0.63% of the defense of the case requires a lawyer to be in the forum city.  The other 99.37% of the work can be done anywhere.  Because a biglaw firm would litigate a securities class action with a larger team, the total number of hours in a typical biglaw case would be much higher – both the total defense hours and the total number of hours spent in the forum city – but the percentages would be similar.

Nor does the cost of travel move the economic needle.  Of course, if a firm is willing not to charge for travel time and travel costs to the forum city, there is no economic issue.  My firm is willing to make this concession, and I would bet others are as well.  Even if a firm does charge for travel cost and travel time, the cost is miniscule in relationship to total defense costs.  For example, my total travel costs for a five-night trip to New York City – both airfare and lodging – are typically less than the cost of two biglaw partner hours.

Of course, there are some purposes for which local counsel is necessary, or at least ideal – someone who knows the local rules, is familiar with the local judges, and is admitted in the forum state.  But the need to utilize local counsel for a limited number of tasks doesn’t present any economic or strategic issue either, if the lawyers’ roles are clearly defined.  Depending on the circumstances, I like to work either with a local lawyer in a litigation boutique that was formed by former large-firm lawyers with strong local connections, or with a lawyer from a strong regional firm.  I just finished a case in which the local firm was a boutique, and a case in which the local firm was another regional firm.  In both cases, the local firms charged de minimis amounts.  In some cases, the local firm can and should play a larger role, but whatever the type of firm and its role, the lead and local lawyers can develop the right staffing for the case and work together essentially as one firm – if they want to.

All of these considerations show that securities litigation defense can and should be a nationwide practice.  It is no longer local.  We need look no farther than the other side of the “v” for a good example.  Our adversaries in the plaintiffs’ bar have long litigated cases around the country, often teaming up with local lawyers from different firms.  Like securities defense, plaintiffs’ securities work requires a full-time focus that has led to a relatively small number of qualified firms.  The qualified firms litigate cases around the country, not just in their hometowns or even where their firms have lawyers.

This all seems relatively simple, but it requires us all to abandon old assumptions about the practice of law that are no longer applicable, and embrace a new mindset.  Biglaw defense lawyers need to obtain more economic freedom within their firms to reduce their rates and staffing for typical securities cases, or they must face the reality that their firms perhaps are well suited only for the largest cases.  Regional firms must recruit more full-time securities litigation partners and be willing not to charge for travel time and costs.  And companies and insurers must appreciate that securities litigation defense will improve – through better substantive and economic results in both individual cases and overall – if they recognize that a good regional firm with dedicated securities litigators can defend a securities class action anywhere in the country, and can usually do so more effectively and efficiently than a biglaw firm.

Securities litigation has a culture defined by multiple elements: the types of cases filed, the plaintiffs’ lawyers who file them, the defense counsel who defend them, the characteristics of the insurance that covers them, the way insurance representatives approach coverage, the government’s investigative policies – and, of course, the attitude of public companies and their directors and officers toward disclosure and governance.

This culture has been largely stable over the nearly 20 years I’ve defended securities litigation matters full time.  The array of private securities litigation matters (in the way I define securities litigation) remains the same – in order of virulence: securities class actions, shareholder derivative litigation matters (derivative actions, board demands, and books-and-records inspections), and shareholder challenges to mergers.  The world of disclosure-related SEC enforcement and internal corporate investigations is basically unchanged as well.  And the art of managing a disclosure crisis, involving the convergence of shareholder litigation, SEC enforcement, and an internal investigation, involves the same basic skills and instincts.

But I’ve noted significant changes to other characteristics of securities-litigation culture recently, which portend a paradigm shift.  Over the past few years, smaller plaintiffs’ firms have initiated more securities class actions on behalf of individual, retail investors, largely against smaller companies that have suffered what I call “lawsuit blueprint” problems such as auditor resignations and short-seller reports.  This trend – which has now become ingrained into the securities-litigation culture – will significantly influence the way securities cases are defended and by whom, and change the way that D&O insurance coverage and claims need to be handled.

Changes in the Plaintiffs’ Bar

Discussion of the history of securities plaintiffs’ counsel usually focuses on the impact of the departures of former giants Bill Lerach and Mel Weiss.  But although the two of them did indeed cut a wide swath, the plaintiffs’ bar survived their departures just fine.  Lerach’s former firm is thriving, and there are strong leaders there and at other prominent plaintiffs’ firms.

The more fundamental shifts in the plaintiffs’ bar concern changes to filing trends.  Securities class action filings are down significantly over the past several years, but as I have written, I’m confident they will remain the mainstay of securities litigation, and won’t be replaced by merger cases or derivative actions.  There is a large group of plaintiffs’ lawyers who specialize in securities class actions, and there are plenty of stock drops that give them good opportunities to file cases. Securities class action filings tend to come in waves, both in the number of cases and type.  Filings have been down over the last several years for multiple reasons, including the lack of plaintiff-firm resources to file new cases as they continue to litigate stubborn and labor-intensive credit-crisis cases, the rising stock market, and the lack of significant financial-statement restatements.

While I don’t think the downturn in filings is, in and of itself, very meaningful, it has created the opportunity for smaller plaintiffs’ firms to file more securities class actions.  As D&O Discourse readers know, 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 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 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 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.

These dynamics are confirmed by recent securities litigation filing statistics.  Cornerstone Research’s “Securities Class Action Filings: 2014 Year in Review,” concludes that (1) aggregate market capitalization loss of sued companies was at its lowest level since 1997, and (2) the percentage of S&P 500 companies sued in securities class actions “was the lowest on record.”  Cornerstone’s “Securities Class Action Filings: 2015 Midyear Assessment” reports that two key measures of the size of cases filed in the first half of 2015 were 43% and 65% lower than the 1997-2014 semiannual historical averages.  NERA Economic Consulting’s “Recent Trends in Securities Class Action Litigation:  2014 Full-Year Review” reports that 2013 and 2014 “aggregate investor losses” were far lower than in any of the prior eight years.  And PricewaterhouseCoopers’ “Coming into Focus: 2014 Securities Litigation Study” reflects that in 2013 and 2014, two-thirds of securities class actions were against small-cap companies (market capitalization less than $2 billion), and one-quarter were against micro-cap companies (market capitalization less than $300 million).*  These numbers confirm the trend toward filing smaller cases against smaller companies, so that now, most securities class actions are relatively small cases.

Consequences for Securities Litigation Defense

Securities litigation defense must adjust to this change.  Smaller securities class actions are still important and labor-intensive matters – a “small” securities class action is still a big deal for a small company and the individuals accused of fraud, and the number of hours of legal work to defend a small case is still significant.  This is especially so for the “lawsuit blueprint” cases, which typically involve a difficult set of facts.

Yet most securities defense practices are in firms with high billing rates and high associate-to-partner ratios, which make it uneconomical for them to defend smaller litigation matters.  It obviously makes no sense for a firm to charge $6 million to defend a case that can settle for $6 million.  It is even worse for that same firm to attempt to defend the case for $3 million instead of $6 million by cutting corners – whether by under-staffing, over-delegation to junior lawyers, or avoiding important tasks.  It is worse still for a firm to charge $2 million through the motion to dismiss briefing and then, if they lose, to settle for more than $6 million just because they can’t defend the case economically past that point.  And it is a strategic and ethical minefield for a firm to charge $6 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.  .

Nor is the answer to hire general commercial litigators at lower rates.  Securities class actions are specialized matters that demand expertise, consisting not just of knowledge of the law, but of relationships with plaintiffs’ counsel, defense counsel, economists, mediators, and D&O brokers and insurers.

Rather, what is necessary is genuine reform of the economics of securities litigation defense through the creation of a class of experienced securities litigators who charge lower rates and exhibit tighter economic control.  Undoubtedly, that will be difficult to achieve for most securities defense lawyers, who practice at firms with supercharged economics.  The lawyers who wish to remain securities litigation specialists will thus face a choice:

  1. Accept that the volume of their case load will be reduced, as they forego smaller matters and focus on the largest matters (which Biglaw firms are uniquely situated to handle well, on the whole);
  2. Reign in the economics of their practices, by lowering billing rates of all lawyers on securities litigation matters, and by reducing staffing and associate-to-partner ratios; and/or
  3. Move their practices to smaller, regional defense firms that naturally have more reasonable economics.

I’ve taken the third path, and I hope that a number of other securities litigation defense lawyers will also make that shift toward regional defense firms.  A regional practice can handle cases around the country, because litigation matters can be effectively and efficiently handled by a firm based outside of the forum city.  And they can be handled especially efficiently by regional firms outside of larger cities, which can offer a better quality of life for their associates, and a more reasonable economic model for their clients.

Consequences for D&O Insurance

D&O insurance needs to change as well.  For public companies, D&O insurance is indemnity insurance, and the insurer doesn’t have the duty or right to defend the litigation.  Thus, the insured selects counsel and the insurer has a right to consent to the insured’s selection, but such consent can’t be unreasonably withheld.  D&O insurers are in a bad spot in a great many cases.  Since most experienced securities defense lawyers are from expensive firms, most insureds select an expensive firm.  But in many cases, that spells a highly uneconomical or prejudicial result, through higher than necessary defense costs and/or an early settlement that doesn’t reflect the merits, but which is necessary to avoid using most or all of the policy limits on defense costs.

Given the economics, it certainly seems reasonable for an insurer to at least require an insured to look at less expensive (but just as experienced) defense counsel before consenting to their choice of counsel – if not outright withholding consent to a choice that does not make economic sense for a particular case.  If that isn’t practical from an insurance law or commercial standpoint, insurers may well need to look at enhancing their contractual right to refuse consent, or even to offer a set of experienced but lower-cost securities defense practices in exchange for a lower premium.  It is my strong belief that a great many public company CFOs would choose a lower D&O insurance premium over an unfettered right to choose their own defense lawyers.

Since I’m not a D&O insurance lawyer, I obviously can’t say what is right for D&O insurers from a commercial or legal perspective.  But it seems obvious to me that the economics of securities litigation must change, both in terms of defense costs and defense-counsel selection, to avoid increasingly irrational economic results.

 

* Median settlement values are falling as well.  In 2014, the median settlement was just $6.5 million according to NERA and $6.0 million according to Cornerstone.  NERA found that “[o]n an inflation-adjusted basis, 2014 median settlement was the third-lowest since the passage of the PSLRA: only in 1996 and in 2001 were median settlement amounts lower on an inflation-adjusted basis.”  Cornerstone reports that 62% of settlements in 2014 were $10 million or less, compared to an average of 53% over 2005-13.  Since settlements in 2014 were of cases filed in earlier years, when the size of cases was larger, it stands to reason that median settlements should remain small or decrease further in future years.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

4.         SEC v. Citigroup:  The Forgotten Important Case

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Why Halliburton II is Not a Top-5 Development

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

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

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

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

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

***

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Holding in Halliburton II

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

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

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

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

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

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

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

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

The Court summarized its price-impact holding as follows:

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

Id. at 22-23

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

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

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

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

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

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

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

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

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

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

How Can Companies Avoid Securities Litigation?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

I disagree.

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

There are three primary possible outcomes in the Supreme Court:

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

2.  The Court will adjust Basic.

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

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

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

What would happen then?

The plaintiffs’ securities bar would adjust. 

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

Worse, the largest firms with large institutional investor clients – clients the Private Securities Litigation Reform Act encouraged them to court, and with which they now work closely to identify and pursue securities claims – would file large individual and non-class collective actions.  Smaller plaintiffs’ firms would also file individual and non-class collective actions.  The damages in cases filed by smaller firms would tend to be smaller, but the litigation burdens would be similar.

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

In a new non-class era of securities litigation, the settlement logistics would be vastly more difficult – it’s hard enough to mediate with one plaintiffs’ firm and one lead plaintiff.  Imagine mediation with a dozen or more plaintiffs’ firms and even more plaintiffs.  One reason we sometimes oppose lead-plaintiff groups is the difficulty of dealing with a group of plaintiffs instead of just one.

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

The government would act.

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

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

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

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

 

Cyber security is top of mind for companies, and cyber-security oversight is top of mind for corporate directors.  I recently co-moderated a panel discussion for directors on board oversight of cyber security and cyber-security disclosures.  I thought I’d share my thoughts on some of the key issues.

What are the board’s fiduciary duties in the area of cyber-security oversight?  Board oversight of cyber security conceptually is no different than oversight of any other area of risk.  The board must take good-faith steps to ensure that the company has systems designed to address cyber-attack prevention and mitigation, and to follow up on red flags it sees.  The board’s decision-making is protected by the business judgment rule.

It is important for directors to understand that cyber-security oversight isn’t exotic.  Because cyber security is a highly technical area, some directors may feel out of their depth – which may help explain why Carnegie Mellon’s 2012 CyLab survey revealed that some boards are not sufficiently focused on cyber-security oversight.  But with the help of experts – on which directors are entitled to rely – boards can ask the same types of questions they’re used to asking about other types of risk, and gain a similar degree of comfort.

How do I pick the right experts?  Directors should be comfortable that they are receiving candid and independent advice, and need to be mindful that the company’s internal IT group may have trouble being self-critical.  So in addition to receiving appropriate reports from the IT group, directors should periodically consult outside advisors who are capable of giving independent advice.

Given the importance of cyber security, will courts impose a higher standard on directors?  Directors’ basic duties are not heightened by general political and economic concerns about cyber security, or even the magnitude of harm that the company itself could suffer from a cyber attack.  But the magnitude of potential harm does matter.  If a substantial portion of a company’s value depends on the security of its cyber assets, common sense dictates that directors will naturally spend relatively more time on cyber security.  In my experience, that’s the way directors think and work – they analyze and devote more time to their companies’ most important issues.  And from a practical perspective, directors’ actions, or inaction, will be judged against the backdrop of a really bad problem.  Judges are human beings, and often do make decisions that are influenced by the presence of particularly severe harm.

How does cyber insurance fit in to the board’s job?   Cyber insurance allows the company to shift a specific and potentially very large risk.  As such, it is important that boards consider cyber insurance among the types of expenditures appropriate to prevent and mitigate cyber attacks.  Shifting risk through cyber insurance also can help directors avoid a shareholder derivative action, by reducing the attractiveness of the suit to plaintiffs’ lawyers, or reduce the severity of an action that is filed, making it easier and less expensive to resolve.

Are there any court decisions on directors’ duties in the area of cyber security?  No.  Although a TJX Companies, Inc. shareholder brought a derivative suit following a significant data breach, Louisiana Municipal Police Employees Retirement Fund v. Alvarez, Civil Action No. 5620-VCN (Del. Ch. July 2, 2010), the case settled early in the litigation.  As a result, the court never had the opportunity to make any substantive rulings on the plaintiffs’ allegations that the board failed to adequately oversee the company’s cyber security.

What is the board’s role in overseeing the company’s disclosures concerning cyber security?  The board’s duty is the same as it is with any corporate disclosure.

Does the SEC’s October 13, 2011 guidance on cyber-security disclosures enhance the board’s oversight responsibilities?   No.  As the guidance itself notes, it does not change disclosure law, but rather interprets existing law.  The guidance does, however, put a sharper focus on cyber-security disclosures, and provides the SEC and plaintiffs’ counsel with a checklist of potential criticisms – though those criticisms would really just be based on existing law.

The sharper focus on cyber-security disclosure isn’t meaningless, however.  The SEC has issued cyber-security comments to approximately 50 public companies since issuing its guidance.  The guidance, moreover, provides another opportunity for the board to discuss cyber security with management, and the increased focus should result in incrementally better disclosure.  And the SEC may well speak again on the subject; last spring, Senator Rockefeller asked new SEC Chair Mary Jo White to further address cyber-security disclosures.  (For a good discussion of the SEC’s guidance, I recommend an article by Dan Bailey, which was reprinted in the D&O Diary, and a recent D&O Diary post discussing a Willis survey of cyber-security disclosures.)

Are there any disclosure securities class actions alleging a false or misleading statement based on failure to follow the guidance?  No.  There was a securities class action against Heartland Payment Systems for a stock price drop that plaintiffs attributed to Heartland’s alleged misstatements concerning its cyber-security protections.  In re Heartland Payment Sys., Inc. Sec. Litig., CIV. 09-1043, 2009 WL 4798148 (D.N.J. Dec. 7, 2009).  The litigation was dismissed because the plaintiffs had not sufficiently alleged that the company made a false or misleading statement or, if it had, did so with scienter.  However, that case was filed prior to the SEC’s cyber-security guidance.  At least one commentator has suggested the outcome might have been different if the SEC guidance had informed the analysis.

Is there a wave of cyber-security shareholder suits coming?  What type of suits will there be?  If there is a wave, it looks like the lawsuits primarily will be shareholder derivative actions, not securities class actions.

There has not been a wave of cyber-attack securities class actions because companies’ stock prices generally haven’t fallen significantly following disclosure of cyber attacks.  If that trend remains, shareholder litigation over cyber security primarily will take the form of shareholder derivative litigation, seeking to recover from directors and officers damages for the harm to the corporation caused by a cyber attack.

The vast majority of options backdating lawsuits were derivative actions due to the lack of significant stock drops, and many of them survived motions to dismiss and resulted in significant settlements.  However, unlike the options backdating cases, in which many motions to dismiss for failure to make a demand on the board were complicated by directors’ receipt of allegedly backdated options or service on compensation committees that allegedly approved backdated options, directors’ governance of cyber security should be judged by more favorable legal standards and with a more deferential judicial attitude.  For that reason, I anticipate that plaintiffs’ attorneys will file derivative cases mostly over larger cyber-security breaches, in which the litigation environment will help them overcome the legal obstacles, and will not routinely file over less significant breaches.

 

 

As I have previously written, the Sixth Circuit’s erroneous interpretation of the scienter component of the Supreme Court’s decision in Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011), is one of the biggest threats to the protections of the Private Securities Litigation Reform Act. 

The resulting flawed analysis – which I call “summary scienter analysis” – appears to be a battleground issue for plaintiffs’ securities litigation attorneys.  Their advocacy of summary scienter analysis in In re VeriFone Holdings, Inc. Sec. Litig., 704 F.3d 694 (9th Cir. 2012), while technically unsuccessful, resulted in an opinion that could cause collateral harm to scienter analysis in the Ninth Circuit. 

Unsatisfied with the court’s conclusions in  VeriFone, attorneys from Cohen Milstein Sellers & Toll recently attacked the decision in a May 2013 article titled, The Dangers of Missing the Forest: The Harm Caused by VeriFone Holdings in a Tellabs World,  44 Loyola U. Chi. L. J. 1457 (2013).  The article posits that the Supreme Court has delivered “repeated and clear instructions” that courts are to only analyze scienter allegations holistically and collectively.  It then relies on behavioral economic studies that purportedly show that judges are more likely to dismiss cases when undertaking a segmented analysis as opposed to a holistic one.

Although the article demonstrates why plaintiffs may be anxious to disregard an individual analysis of scienter allegations (because it results in more dismissals), the article is wrong as a matter of law.  The Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 324 (2007), expressly endorsed the sort of individualized scienter analysis the authors attack.  And Matrixx did not – and could not have, under Section 10(b) and the Reform Act – reverse course.   

The main threat is not a scienter analysis that carefully analyzes each individual scienter allegation within, and as an essential part of, a collective scienter analysis under Tellabs.  Such a methodology explicitly requires courts to go through an allegation-by-allegation analysis before they perform a collective analysis, imposing greater discipline and protecting against analytic sloppiness and error.  Rather, the main threat is the position that careful analysis of each individual scienter allegation is not required at all – or, in the view of the Sixth Circuit, is not even allowed

Origin of Summary Scienter Analysis

This advocacy of solely “collective “ scienter analysis traces back to the Supreme Court’s 2011 decision in Matrixx.  The issue in Matrixx was whether adverse health events from the company’s cold remedy Zicam were material – and thus were required to be disclosed to make what Matrixx said not misleading – if the number of events was not statistically significant.  Matrixx argued for a bright-line rule that disclosure is only required if the number of events is statistically significant.  The district court dismissed the complaint.  The Ninth Circuit reversed. 

In an opinion by Justice Sotomayor, the Supreme Court unanimously affirmed the Ninth Circuit, with most of the opinion devoted to the holding on the primary issue on appeal: statistical significance is not required to trigger a duty to disclose adverse events if what the company said is rendered misleading by the omission, or disclosure is otherwise required by law.  That ruling meant that Matrixx made material misrepresentations by virtue of omitting the adverse events from its public statements.

Following the materiality analysis, the Supreme Court’s affirmance of the Ninth Circuit’s scienter ruling was straightforward.  The Supreme Court articulated Tellabs’ scienter standard, without altering it in any way.  Then, applying Tellabs, the Court considered defendants’ non-culpable explanation: consistent with the lack of statistical significance, the adverse events were not a problem, and thus any misleading statements were not made with intent to defraud.  The Court found the culpable explanation of the allegations more compelling.  The allegations detailed instances of Matrixx’s concern about the events, such as hiring a consultant and convening a panel of physicians and scientists on the matter.  And, “[m]ost significantly, Matrixx issued a press release that suggested that studies had confirmed that Zicam does not cause anosmia [loss of smell] when, in fact, it had not conducted any studies relating to anosmia and the scientific evidence at that time, according to the panel of scientists, was insufficient to determine whether Zicam did or did not cause anosmia. “  131 S. Ct. at 1324.  In other words, the complaint alleged a misrepresentation that was either intentional or highly reckless.   

The vast majority of the commentary about the Matrixx decision concerned the materiality ruling.  The scienter holding did not appear to break any new ground – at least until the Sixth Circuit held that it did.  In Frank v. Dana Corp., 646 F.3d 954, 961 (6th Cir. 2011), the Sixth Circuit reversed the district court’s dismissal of the plaintiffs’ complaint.  In analyzing the complaint’s scienter allegations, the court noted that its Reform Act decisions had analyzed complaints “by sorting through each allegation individually before concluding with a collective approach” under Tellabs.  But the court decided to “decline to follow that approach in light of the Supreme Court’s recent decision in Matrixx …,” which the Sixth Circuit said “provided for us a post-Tellabs example of how to consider scienter pleadings ‘holistically’ ….  Writing for the Court, Justice Sotomayor expertly addressed the allegations collectively, did so quickly, and, importantly, did not parse out the allegations for individual analysis.”  646 F.3d at 961.

But Matrixx was not concerned with the proper methodology of scienter analysis under Tellabs.   Indeed, its comments on scienter were almost an afterthought.  The Court did not hold – or even suggest – that the “quick[]” way it addressed the scienter allegations was the required method of analysis.  Its analysis presumably was “quick[]” because it didn’t need to be lengthy, given the nature of the allegations, the secondary nature of the scienter issue in relationship to the disclosure issue,  and the procedural setting, i.e., a review of a scienter finding by the Ninth Circuit.  Thus, the Sixth Circuit read into Matrixx a holding that the Court didn’t reach.  To date, only the Tenth Circuit has endorsed the Sixth Circuit’s mis-reading of Matrixx – with a holding that seems to include a dangerous endorsement of “conclusory” scienter analysis.  See In re Level 3 Communications, Inc. Securities Litig., 667 F.3d 1331 (10th Cir. 2012) (“While its analysis was conclusory, the district court was under no duty to catalog and individually discuss the reports and witnesses plaintiff described.”) (citing Dana).   

But the plaintiffs certainly caught the Ninth Circuit’s attention with their  summary-scienter-analysis argument in In re VeriFone Holdings, Inc. Sec. Litig., 704 F.3d 694, 703 (9th Cir. 2012).  Following the Supreme Court 2007 decision Tellabs, the Ninth Circuit had evaluated its prior cases and decided on a two-step approach to scienter analysis:  courts must first analyze scienter allegations individually, and then analyze them collectively.   Zucco Partners, LLC v. Digimarc Corp., 552 F.3d 981, 991-92 (2009).  In VeriFone, the Ninth Circuit rejected the argument that Matrixx prohibits its two-step analysis:  “Matrixx on its face does not preclude this approach and we have consistently characterized this two-step or dual inquiry as following from the Court’s directive in Tellabs.”  704 F.3d at 703.  The court then reviewed other appellate decisions, and held that “[b]ecause the Court in Matrixx did not mandate a particular approach, a dual analysis remains permissible so long as it does not unduly focus on the weakness of individual allegations to the exclusion of the whole picture.”  Id.  

Yet the Verifone court then decided to skip the first step (a review of each individual allegation to determine if any of them itself is sufficient to plead scienter) and, instead, to “approach this case through a holistic review of the allegations,” though it emphasized that “we do not simply ignore the individual allegations and the inferences drawn from them.”  Id.   It found that the allegations – which included allegations of multiple significant accounting manipulations directed by the individual defendants – holistically sufficed to plead scienter.

Although the Ninth Circuit correctly understood that Matrixx did not alter the Tellabs scienter standard, its willingness to abandon an explicit two-step scienter analysis is an unfortunate consequence of the incorrect interpretation of Matrixx advanced by the plaintiffs.   The result is the implicit endorsement of an approach that could yield a more cursory analysis of individual scienter allegations by district courts.  This is troubling, because scrutiny of each scienter allegation, to understand and weigh it in relationship to each challenged statement, allows a court to properly weigh the allegations collectively.  Without such scrutiny, there is a risk that courts will under- or over-value one or more of the individual allegations and thus spoil the collective analysis. 

To the extent that they allow (or require) district courts to stray from this particularized analysis, both Dana and Verifone are incorrect, because individual  scrutiny of scienter allegations is required by the controlling law:   Tellabs and the two statutes at issue, Section 10(b) and the Reform Act.

Scienter Analysis under Tellabs

The Tellabs Court began its analysis by announcing several “prescriptions” about scienter analysis under the Reform Act.  The second prescription is that “courts must consider the complaint in its entirety, as well as other sources courts ordinarily examine when ruling on Rule 12(b)(6) motions to dismiss, in particular, documents incorporated in the complaint by reference, and matters of which a court may take judicial notice.”  551 U.S. at 322.  The Court’s third prescription is that “courts must take into account plausible opposing inferences.”  The Court noted that “[t]he strength of an inference cannot be decided in a vacuum.  The inquiry is inherently comparative.  How likely is it that one conclusion, as compared to others, follows from the underlying facts?”  Id. at 323.

In order to conduct this analysis, the Court expressly contemplated analyzing individual scienter allegations, and indeed itself analyzed two types of individual allegations:  financial motive, and knowledge of falsity.

  • Tellabs contended that the lack of a financial motive for fraud was dispositive.  The Court held that financial motive is a factor to be considered among other considerations.  Consideration of financial motive, in turn, requires an examination of stock sales and their context to determine whether they add up to a sufficient motive.   This, of course, amounts to scrutiny of individual allegations. 
  • Tellabs also contended that the complaint’s allegations were too vague and ambiguous to plead knowledge of falsity.  The Court agreed that “omissions and ambiguities count against inferring scienter,” though reiterated that courts must consider such shortcomings in light of the complaint’s other allegations.   Analyzing “omissions and ambiguities,” as the Court directed, is the core variety of individualized scienter analysis.  It involves looking at the complaint’s allegations of falsity, statement by statement, and analyzing the complaint’s allegations of knowledge of falsity, statement by statement. s. 

Thus, the Supreme Court in Tellabs expressly contemplated, and performed, the type of individualized scienter analysis that plaintiffs wrongly contend that Matrixx rejected.

Scienter Analysis under the 1934 Act and Reform Act

Matrixx, moreover, could not have departed from analysis of individual scienter allegations, because individualized scienter analysis is statutorily required by the 1934 Act and the Reform Act.  Section 10(b) and Rule 10b-5 prohibit the making of a false statement with intent to defraud.  If a complaint challenges two statements, it isn’t permissible under Section 10(b) – for example – to find scienter for Statement 2 and apply that finding to Statement 1.  If there is no scienter for Statement 1, it isn’t actionable.  And the Reform Act requires plaintiffs to plead scienter for each statement:

(b) Requirements for securities fraud actions(2) Required state of mind

In any private action arising under this chapter in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.

15 U.S. C. § 78u-4(b)(2) (emphasis added).

So, under the relevant statutes, courts must engage in a scienter analysis for each and every statement the complaint challenges.  To do so requires examination of, in Tellabs’ words, “omissions and ambiguities” in the factual allegations about each statement, as well as pecuniary motivation and other factors present at the time the defendant made the challenged statement.  Such an analysis is exactly the type of scrutiny that plaintiffs’ attorneys are attacking through their incorrect interpretation of Matrixx

This issue will remain a key Reform Act issue to monitor.  I will blog about further significant developments.