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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

***

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

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

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

Overview of the Reform Act

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

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

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

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

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

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

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

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

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

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

The Safe Harbor for Forward-Looking Statements

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

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

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

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

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

Lead Plaintiff Procedures

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

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

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

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

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

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

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

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

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

Conclusion

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

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

In this installment of the D&O Discourse series “5 Wishes for Securities Litigation Defense,” we discuss the third of five changes that would significantly improve securities litigation defense:  to make the Supreme Court’s Omnicare decision a primary tool in the defense of securities class actions.

As a reminder, in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318 (2015), the U.S. Supreme Court held that a statement of opinion is only false under the federal securities laws if the speaker does not genuinely believe it, and is only misleading if it omits information that, in context, would cause the statement to mislead a reasonable investor.  This ruling followed the path we advocated in an amicus brief on behalf of Washington Legal Foundation.

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

First, the Court made clear that an opinion is false only if it was not sincerely believed by the speaker at the time that it was expressed, a concept sometimes referred to as “subjective falsity.”  The Court thus explicitly rejected the possibility that a statement of opinion could be false because “external facts show the opinion to be incorrect,” because a company failed to “disclose[] some fact cutting the other way,” or because the company did not disclose that others disagreed with its opinion.  This ruling resolved two decades’ worth of confusing and conflicting case law regarding what makes a statement of opinion false, which had often permitted meritless securities cases to survive dismissal motions.

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

Omnicare governs the falsity analysis for all types of challenged statements.  Obviously, Omnicare should be used to defend against challenges to all forms of opinions, including statements regarded as “puffery” and forward-looking statements protected by the Reform Act’s Safe Harbor for forward-looking statements.  But defense counsel should also take advantage of the Supreme Court’s direction in Omnicare that courts evaluate challenged statements in their full factual context.  Evaluating challenged statements in their broader context almost always benefits defendants, because it helps the court better understand the challenged statements and makes them seem fairer than they might in isolation. Omnicare now explicitly requires courts to evaluate challenged statements—both statements of fact and statements of opinion—within their broader contexts.

Although Omnicare arose from a claim under Section 11 of the Securities Act, all of its core concepts are equally applicable to Section 10(b) of the Securities Exchange Act and other securities laws with similar falsity elements.  Due to the importance of its holdings and the detailed way in which it explains them, Omnicare is the most significant post-Reform Act Supreme Court case to analyze the falsity element of a securities class-action claim, laying out the core principles of falsity in the same way that the Court did for scienter in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007).  If used correctly, Omnicare thus has the potential to be the most helpful securities case for defendants since Tellabs, providing attorneys with a blueprint for how to structure their falsity arguments in order to defeat more complaints on motions to dismiss.

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

Yet Omnicare will fail to achieve its full potential unless defense lawyers understand and use the decision correctly.  Following the Omnicare decision, many defense lawyers commented publicly that Omnicare expanded the basis for defendants’ liability, and was otherwise plaintiff-friendly.  That is simply wrong.  We have published several articles that address these misunderstandings, explain how defense counsel should use the decision, and analyze how lower courts are applying it.  The early returns show that Omnicare is already helping defendants win more motions to dismiss.

Here is a link to our most recent article, Omnicare, Inc. One Year Later: Its Salutary Impact on Securities-Fraud Class Actions in the Lower Federal CourtsCritical Legal Issues Working Paper Series, Washington Legal Foundation (No. 195, June 2016).

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Grading the Reform Act’s Key Provisions

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

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

Following are my grades for each of these provisions:

Falsity Pleading Standard – Grade: D

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

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

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

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

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

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

Scienter Pleading Standard – Grade: C

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

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

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

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

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

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

Safe Harbor – Grade: D

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

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

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

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

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

So, I give the Safe Harbor a D.

Lead Plaintiff Procedures – Grade C

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

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

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

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

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

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

Discovery Stay – Grade: A

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

Conclusion:  The Reform Act’s Overall Grade

Grade: C+

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

 

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

In 1995, public companies and their directors and officers received one of the greatest statutory gifts in the history of American corporate law:  the Private Securities Litigation Reform Act.  The Reform Act established heightened standards for pleading falsity and scienter, among other protections, to allow for dismissal before discovery in a fair percentage of cases.  That was a tremendous change from the pre-Reform Act world, in which dismissals were infrequent and expensive discovery was the norm.

The provisions of the Reform Act make motions to dismiss in securities cases different from those in any other area of law, and guide our strategy in every case that we litigate.  As a full-time securities litigation defense lawyer, I feel a responsibility to understand the Reform Act and the cases applying it with as much sophistication as possible.  I have a sense of pride in my Reform Act analysis.  It may sound hokey, but I consider myself a craftsman, and I know that some of the most effective full-time securities litigators tend to feel the same.

I was recently asked about the biggest threats to the Reform Act’s protections, and have since been giving that question a lot of thought.  To be blunt, the biggest threat is the failure by many defense firms to make rigorous arguments on motions to dismiss that hold plaintiffs to the strict pleading standards of the Reform Act, allowing for court decisions that likewise lack rigor and fail to enforce the Act’s high pleading burdens.

This lack of technical rigor has many causes.  One factor is the dwindling number of securities litigation defense specialists, caused by the downturn in classic securities litigation cases calling for straightforward Reform Act motions to dismiss.  Beginning in 2006, securities litigation defense has mostly consisted of stock-option backdating derivative cases, large credit-crisis cases, and merger objection cases.  Through these waves, very few securities litigators remained dedicated to studying Reform Act developments and devising better arguments that take advantage of its provisions.  As a result, today there are relatively few practitioners whose practices are devoted to securities litigation defense – defense lawyers who sweat over subtleties in the law that in isolation may seem trivial, but which collectively make a big difference in the development of the law.

Another factor is the biglaw approach to writing motions to dismiss “by committee.”  Biglaw firms tend to write motions with large teams composed of new associates, mid-level associates, senior associates, and partners.  Writing by committee doesn’t work.  It is not only expensive, it is ultimately far less effective.  If the first draft of a motion is written without sufficient intellectual rigor and sophisticated understanding of the law and practice of securities litigation, it is difficult to reach an end result that will compensate for these deficiencies.  To draft the best motion to dismiss possible, Reform Act “craftsmen” should be involved in the process from the beginning, the entire drafting team needs to coordinate closely on the strategic objectives of the motion, and all the attorneys need to be well trained to appreciate the subtleties of the law.

Whatever the cause, the declining quality of many motions to dismiss is leading to a deterioration of the law that is eroding the Reform Act’s protections.  The rate of dismissals remains relatively high, but I predict that the dismissal rate will decrease, perhaps dramatically, over time as the law becomes more lax.

Below, I discuss the building blocks of a strong motion to dismiss and then address flaws found in many that I have seen filed lately – both by practitioners who do not specialize in the field, and by some “go to” biglaw firms with departments that specialize in securities litigation.

Constructing a Strong Motion to Dismiss

The Reform Act erected high hurdles for plaintiffs to clear before requiring a company to be put through the burdens of discovery:

  • To plead the falsity of a challenged statement of fact, plaintiffs must plead inconsistent contemporaneous facts.
  • To plead a false statement of opinion, in most circuits plaintiffs must plead that the statement was both objectively false and subjectively false, meaning they must show the speaker did not genuinely believe the opinion expressed.
  • To plead that the defendant made a false statement with intent to defraud, plaintiffs must plead facts demonstrating a strong inference that the defendant either knew the statement was false or was extremely and deliberately reckless in choosing not to find out whether it was true or false.
  • Even if plaintiffs plead facts demonstrating it was false, a forward-looking statement is not actionable under the Safe Harbor provisions of the Reform Act if either: (1) the statement was accompanied by meaningful cautionary statements, or (2) plaintiffs fail to plead that the speaker had actual knowledge of the statement’s falsity.

A rigorous motion to dismiss uses the Reform Act’s pleading tools in the most advantageous way possible, by really understanding them and maximizing their usefulness.  These tools give defense lawyers the opportunity to delve into factual issues in a manner that is unusual in motion -to-dismiss practice, and which may feel unnatural to attorneys who are not securities litigation specialists or who didn’t become securities litigation specialists during the Reform Act era.  An effective motion to dismiss not only dismantles the complaint with these tools, but capitalizes upon them to tell the judge a compelling story of an honest company that did its best to make straightforward disclosures to the market.

The Reform Act’s standards give judges enormous discretion; they can dismiss most complaints, or not, with very little room to challenge their decisions upon appeal.  Winning motions recognize the human element to  this discretion.  Even if a complaint is technically deficient, judges are less likely to dismiss it (certainly less likely to dismiss it with prejudice) if they nevertheless get the feeling that the defendants committed fraud.  Effective motions use the leeway given to defendants by the Reform Act to give judges a sense of comfort that they are not only following the law, but that by strictly applying the Reform Act’s protections, they are also serving justice.  On the other hand, one of the most common flaws in ineffective motions to dismiss is the use of formulaic and hyper-technical arguments, which fail to take advantage of the Reform Act to dig into the facts of the individual case, expose the flaws of each complaint in detail, and tell the judge a compelling story of the case that negates the inference of scienter.

Flaws Found in Many Motions to Dismiss

Flaws in Arguments against Falsity

The first element of a claim under Rule 10b-5(b) – the classic securities claim – is a false or misleading statement.  As we recently wrote, it is an incorrect statement of law to characterize this element as requiring a “materially false statement or omission.”  An omission is only actionable if it made what the defendant said materially misleading (or he or she otherwise had a duty to disclose it, which is a rare assertion as the main claim in a securities class action).

Yet if I had a dollar for every motion to dismiss that contained this misstatement of law, I would be writing this blog from a vacation home in Hawaii.  This is not a semantic issue; the difference between an “omission” and a “misleading statement” is enormous.  Every disclosure problem involves dozens or even hundreds of omitted facts that seem “material” in the sense that an investor would want to know them, but far fewer involve statements that were materially misleading (it is the statement that must be material, not the omitted fact) as a result of the omission.  I realize that many courts, including the U.S. Supreme Court, use this incorrect terminology.  But that doesn’t mean we need to parrot it – and every time that we do, we weaken the standard that is an explicit part of the Reform Act statute.

Defense lawyers’ loose language is a symptom of a bigger problem:  a lack of focus on falsity.  The allegedly false statements frame the entire case; other defense arguments are derived from the attack on plaintiffs’ falsity claims.  Foremost among the arguments derived from a strong falsity argument is the argument against scienter.  Scienter requires plaintiffs to show that a speaker knew what he or she said was false.  Falsity thus sets the stage for the scienter analysis – if there was no false statement to begin with, there can be no knowledge of that falsity.  On the other hand, the more egregiously false plaintiffs can make a statement appear, the easier it will be for them to show knowledge of falsity.  A strong scienter argument has as its North Star, “scienter as to what?”  That “what” must be a false statement, and a good motion to dismiss will enforce that structure from the beginning.  I cringe when I read a motion to dismiss that addresses scienter before falsity.  That is simply backwards.

The lack of focus on falsity infects the way defense firms tend to argue against falsity.  The Reform Act falsity standard generally requires the plaintiffs to allege contemporaneous facts that are inconsistent with each challenged statement.  That is a high hurdle.

To be sure, it isn’t easy to make a fact-specific argument against falsity; it requires a great command of the complaint and judicially noticeable documents, which isn’t the forte of most litigators.  And it can seem “too factual” to general litigators, or to many senior securities litigators who became securities litigation specialists under the pre-Reform Act regime, where motions to dismiss had to be simple and safe to have any chance of success under lenient pleading standards.  Perhaps for these reasons, in addition to those discussed above, a large number of motions to dismiss bypass this advantageous and fundamental argument, or fail to emphasize it, and instead opt for arguments that lump statements together by type and argue against them as a group in a boilerplate fashion.  In my view, one of the worst arguments of this type is the “puffery” defense – which basically concedes that a statement was false, but contends it was too immaterial to be actionable.  The subtext is cavalier, and unlikely to reassure a dubious judge: “sure the defendant lied, but it doesn’t matter because no one cared.”  Although courts do sometimes accept this argument, whether to do so or not amounts to an unprincipled coin-flip, and it is often made at the expense of better and more definite arguments.  For example, statements constituting “puffery” also generally qualify as statements of opinion, which have a standard for falsity that is protective and can be analyzed specifically.

The Reform Act called out forward-looking statements for special analysis and protection.  As we have previously written, the Safe Harbor is not as safe as Congress intended.  Because they think it goes too far, and can give companies a “license to lie,” many judges go to great lengths to avoid the statute’s plain language.  Many defense lawyers’ arguments not only fail to address this judicial skepticism, but actually reinforce it.  They do this by relying solely on the Safe Harbor’s technical elements, while failing to simultaneously contend that the forward-looking statements in question also had a reasonable basis, and the company’s cautionary language was a good-faith effort to describe specific risks the company faced.  Such arguments based only on the letter of the Safe Harbor ring of “caveat emptor,” which the law has been trying to shake for centuries.

Flaws in Arguments against Scienter

Scienter allegations are of two types:  allegations pleading facts about what the defendant knew, to attempt to plead that he or she knew the challenged statements were false; and, far more prevalent, allegations that the defendant “must have” meant to lie, based on circumstantial considerations such as a defendants’ stock sales, corporate transactions, the temporal proximity of the challenged statement to the disclosure of the “truth,” and the relationship of the subject of the challenged statements to the company’s “core operations.”  As with falsity, the primary flaw in most defense arguments against scienter is with their failure to engage in a fact-specific analysis of the complaint’s allegations about what the defendants knew in regard to each specific challenged statement. All too often, defendants allow themselves to be drawn to the plaintiffs’ preferred ground of battle, focusing just on arguing about the sufficiency of the circumstantial evidence that plaintiffs use to create the impression that the defendants must have done something wrong.

Circumstantial scienter allegations are only ways to try to make an educated guess about what the speaker knew or intended.  But the Reform Act’s scienter standard requires particularized pleading yielding a “strong inference” that the defendant lied on purpose – a very high standard.  So it makes no sense for defense counsel not to approach the issue directly, by making it clear that the speaker did not lie, and holding plaintiffs to the strict standard of showing specific scienter as to each challenged statement.

For this reason, all effective motions to dismiss start by testing the complaint’s allegations that the defendants actually knew, or were intentionally reckless about not knowing, the facts establishing falsity.  This means that, for each statement and each defendant, the motion to dismiss needs to isolate the statement and the reasons that the complaint alleges it was false, and analyze what the complaint alleges each defendant knew about those facts at the time he or she made each challenged statement. Without this focus on each specific challenged statement, the scienter inquiry is vague, and becomes more about whether the defendant seems bad, or had generally bad motives, than whether he lied on purpose.  A good motion to dismiss does not let plaintiffs get away with these kinds of generalized allegations.

The problem is made worse if defense counsel approaches falsity categorically, without careful scrutiny of the reasons the complaint alleges the challenged statements were false.  Without this focus, defense counsel can’t meaningfully answer the central question in the Reform Act analysis – “scienter as to what?” – because there isn’t a sufficient nexus between the challenged statements and contemporaneous facts that made the statements false.  The scienter inquiry thus becomes unmoored from knowledge that specific statements were false.  The result is a lower burden for plaintiffs:  if they are able to plead falsity, and the defendants seemed to know something about the general subject matter, scienter is almost a foregone conclusion.

This problem is even worse under the “core operations” inference of scienter, and the “corporate scienter” doctrine.  Each of these theories allows a plaintiff to avoid pleading specific facts establishing the speaker’s scienter.  For example, the core operations inference posits that scienter can be inferred where it would be “absurd to suggest” that a senior executive doesn’t know facts about the company’s “core operations.”  Many motions to dismiss set up some formulation of this statement as a legal rule and make a simplistic syllogistic argument from it.  Such arguments devolve into “did not, did so” debates, and thus play into plaintiffs’ hands because they are detached from knowledge of falsity.

Instead, the right approach to the core operations inference is to understand that it requires a falsity so blatant that we can strongly infer that the executive had knowledge of the exact facts that made the statement false – not just the subject matter of the facts.  The most effective defense against the core operations inference thus focuses on falsity first, to show that even if a statement is false, it is at least a close call – making it hard for plaintiffs to contend that defendants must have known of this falsity.  This can’t be done effectively, of course, if the argument against falsity is categorical (i.e., embraces arguments such as “puffery,” rather than discussing the specific statements), or otherwise fails to address the falsity allegations in detail.  Of course, it is impossible to make this argument effectively if the scienter section precedes the falsity section of the brief.

***

We plan to address in greater depth some of the technical Reform Act issues in later posts, in hopes that we can improve the craftsmanship of motions to dismiss.  These are important issues to discuss as a defense bar, because each motion to dismiss that fails to maximize the Reform Act’s protections runs the risk of weakening the law for the rest of us.

 

 

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.

In defending a securities class action, a motion to dismiss is almost automatic, and in virtually all cases, it makes good strategic sense.  In most cases, there are only four main arguments:

  • The complaint hasn’t pleaded a false or misleading statement
  • The challenged statements are protected by the Safe Harbor for forward-looking statements
  • The challenged statements weren’t made with scienter, even if the complaint has adequately pleaded their falsity
  • The complaint hasn’t adequately pleaded loss causation

For me, the core argument of virtually every brief is falsity – I think that standing up for a client’s statements provides the foundation for all of the other arguments.  For most clients, it is important to stand up and say “I didn’t lie.”   And an emphasis on challenging the falsity allegations encompasses clients’ most fundamental responses to the lawsuit:  they reported accurate facts; made forecasts that reflected their best judgment at the time; gave opinions about their business that they genuinely believed; issued financial statements that were the result of a robust financial-reporting process; etc.

The Reform Act, and the cases which have interpreted it, provide securities defense lawyers with broad latitude to attack falsity.  In my mind, a proper falsity analysis always starts by examining each challenged statement individually, and matching it up with the facts that plaintiffs allege illustrate its falsity.   Then, we can usually support the truth of what our clients said in numerous ways that are still within the proper scope of the motion to dismiss standard:  showing that the facts alleged do not actually undermine the challenged statements, because of mismatch of timing or substance; pointing out gaps, inconsistencies, and contradictions in plaintiffs’ allegations; showing that the facts that plaintiffs assert are insufficiently detailed under the Reform Act; attacking allegations that plaintiffs claim to be facts, but which are really opinions, speculation, and unsupported conclusions; putting defendants’ allegedly false or misleading statements in their full context to show that they were not misleading; and pointing to judicially noticeable facts that contradict plaintiffs’ theory.  These arguments must be supplemented by a robust understanding of the relevant factual background, which defines and frames the direction of any argument we ultimately make based on the complaint and judicially noticeable facts.

Yet many motions to dismiss do not make a forceful argument against falsity, supported with a specific challenge to the facts alleged by the plaintiffs.  Some motions superficially assert that the allegations are too vague to satisfy the pleading standard, and do not engage in a detailed defense of the statements with the available facts.  Others simply attack the credibility of the “confidential witnesses,” without addressing in sufficient detail the content of the information the complaint attributes to them.  And others fall back on the doctrine of “puffery,” which posits that even if false, the challenged statements were immaterial.*  By focusing on these and similar approaches, a brief may leave the judge  with the impression that defendants concede falsity, and that the real defense is that the false statements were not made with scienter.

That’s risky.

It’s risky for several reasons.  First, detailed, substantive arguments against falsity are some of the strongest arguments that defendants can make.  Second, those arguments provide the foundation for the rest of the motion.  The exclusion of a strong falsity argument weakens the argument against scienter, and fails to paint the best possible no-fraud picture for the judge – which is ultimately what helps a judge to be comfortable in granting a motion to dismiss.

Failing to emphasize the falsity argument weakens the scienter argument.

The element of scienter requires a plaintiff to demonstrate that the defendant said something knowingly or recklessly false – in order to do this, plaintiffs must tie their scienter allegations to each particular challenged statement.  It is not enough to generally allege, as plaintiffs often do, that defendants had a general “motive to lie.”  When I analyze scienter allegations, I ask myself, “scienter as to what?”  Asking this question often unlocks strong arguments against scienter, because complaints often make scienter allegations that are largely detached from their allegations of falsity.  Often, this is the case because the falsity allegations are insufficient to begin with.  But many motions to dismiss are unable to point out this lack of connection, because they don’t focus on falsity in a rigorous and thorough way.

Focusing on falsity also is necessary because of how courts analyze falsity and scienter.  Although falsity and scienter are separate elements – and should be analyzed separately – courts often analyze them together.   See, e.g., Ronconi v. Larkin, 253 F.3d 423, 429 (9th Cir. 2001) (“Because falsity and scienter in private securities fraud cases are generally strongly inferred from the same set of facts, we have incorporated the dual pleading requirements of 15 U.S.C. §§ 78u-4(b)(1) and (b)(2) into a single inquiry.”).  Arguing a lack of falsity thus provides essential ingredients for this combined analysis.  Even when courts analyze falsity and scienter separately,  a proper scienter analysis requires a foundational falsity analysis, because as noted above, scienter analysis asks whether the defendant knew that a particular statement was false.  Without an understanding of exactly why that challenged statement was false, and what facts allegedly demonstrate that falsity, the scienter analysis meanders, devolving into an analysis of knowledge of facts that may or may not be probative of the speaker’s state of mind related to that statement.

The tendency to lump scienter and falsity together is exemplified by the scienter doctrines that I call “scienter short-cuts:” (1) the corporate scienter doctrine (see, e.g., Teamsters Local 445 Freight Division Pension Fund v. Dynex Capital, Inc., 531 F.3d 190, 195-96 (2d Cir. 2008) and Makor Issues & Rights, Ltd. v. Tellabs Inc., 513 F.3d 702 (7th Cir. 2008)), and (2) the core operations inference of scienter (see, e.g., Glazer Capital Management LP v. Magistri, 549 F.3d 736 (9th Cir. 2008)).  Under these doctrines, courts draw inferences about what the defendants knew based upon the prominence of the falsity allegations.  The more blatant the falsity, the more likely courts are to infer scienter.  A superficial falsity argument weakens defendants’ ability to attack these scienter short-cuts, which plaintiffs are asserting more and more routinely.

Failing to emphasize the falsity argument fails to paint the best possible no-fraud picture for the judge.

I contend that it is a good strategy for a defendant to thoroughly argue lack of falsity, even if there are better alternative grounds for dismissal, and even if the challenge to falsity is unlikely to be successful as an independent grounds for dismissal.  This is for the simple reason that judges are humans – they will feel better about dismissing a case based on other grounds if you can make them feel comfortable that there was not a false statement to begin with.  For example, courts are often reluctant to dismiss a complaint solely on Safe Harbor grounds because it is seen as a “license to lie,” so it is strategically wise also to argue that forward-looking statements were not false in the first place.  Similarly, even if lack of scienter is the best basis for dismissal, it is good strategy to defend on the basis that no one said anything wrong, rather than appearing to concede falsity and being left to contend, “but they didn’t mean to.”

Judges have enough latitude under the pleading standards to dismiss or not, in most cases.  The pivotal “fact” is, in my opinion, whether the judge feels the case is really a fraud case, or not.  A motion to dismiss that vigorously defends the truth of what the defendants said is more likely to make the judge feel that there really is no fraud there.  Conversely, if defendants make an argument that essentially concedes falsity and relies solely on the argument that the falsity was immaterial, wasn’t intentional, or is not subject to challenge under the Safe Harbor, a judge may stretch to find a way to allow the case to continue.  Put simply, a judge is more likely to dismiss a case in which a defendant says “I didn’t lie,” than when defendants argue that “I may have lied, but I didn’t mean to,” or “I may have lied, but it doesn’t matter,” or “I may have lied, but the law protects me anyway.”  Even when a complaint might ultimately be dismissed on other grounds, I think that a strong challenge to falsity is essential to help the judge feel that he or she has reached a just result.

*Many statements that defense counsel argue are “puffery” are really statements of opinion that could and should be analyzed under the standard that originated in the U.S. Supreme Court’s Virginia Bankshares decision:  in order to adequately allege that a statement of opinion is false or misleading, a plaintiff must plead with particularity not only that the opinion was “objectively” false or misleading, but also that it was “subjectively” false or misleading, meaning that the opinion was not sincerely held by the speaker.  My partner Claire Davis recently posted a discussion of statements of opinion.

Public companies around the country labor under a misunderstanding:  that the Private Securities Litigation Reform Act’s Safe Harbor protects them from liability for their guidance and projections if they simply follow the statute’s requirements.  But the Safe Harbor is not so safe – because they think it goes too far, many judges go to great lengths to avoid the statute’s plain language.  Companies and their securities litigation defense counsel can usually work around this judicial attitude and take advantage of the statute’s protections, however, with the right approach to preparing and defending the company’s disclosures.

The Safe Harbor was a key component of the 1995 reforms of securities class action litigation. Congress sought “to encourage issuers to disseminate relevant information to the market without fear of open-ended liability.”  H. R. Rep. No. 104-369, at 32 (1995), as reprinted in 1995 U.S.C.C.A.N. 730, 731.  The Safe Harbor, by its plain terms, is straightforward.  A material forward-looking statement is not actionable if it either (1) is “accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement,” or (2) is made without actual knowledge of its falsity.  15 U.S.C. § 77z-2(c)(1); 15 U.S.C. § 78u-5(c)(1).

Yet courts’ application of the Safe Harbor has been anything but straightforward.  Indeed, courts have committed some really basic legal errors in their attempts to nullify the Safe Harbor.  Foremost among them is the tendency to collapse the two prongs – thus essentially reading “or” to mean “and” – to hold that actual knowledge that the forward-looking statement is false means that the cautionary language can’t be meaningful.  See, e.g., In re SeeBeyond Techs. Corp. Sec. Litig., 266 F. Supp. 2d 1150, 1163-67 (C.D. Cal. 2003); In re Nash Finch Co. Sec. Litig., 502 F. Supp. 2d 861, 873 (D. Minn. 2007); Freeland v. Iridium World Commc’ns, Ltd., 545 F. Supp. 2d 59, 74 (D.D.C. 2008); Freudenberg v. E*Trade Fin. Corp., 712 F. Supp. 2d 171, 193-94 (S.D.N.Y. 2010).  Courts also engage in other types of legal gymnastics to take the statements out of the Safe Harbor, such as straining to convert forward-looking statements into present-tense declarations.  The court in City of Providence v. Aeropostale, Inc., No. 11 Civ. 7132, 2013 WL 1197755 (S.D.N.Y. Mar. 25, 2013), recently did so, characterizing a number of statements related to the company’s earnings guidance to be statements of present fact outside the Safe Harbor’s protection – and thereby essentially taking the guidance out of the Safe Harbor as well.  Even worse, the court articulated an incorrect rule of law: “the safe harbor does not apply to material omissions.”  Id. at *12.  But, of course, all forward-looking statements rely on, and necessarily omit, myriad facts – a prediction is, by definition, the bottom line of analysis.

The most notorious erroneous Safe Harbor decision was written by one of the country’s most renowned judges, Judge Frank Easterbrook. In Asher v. Baxter, 377 F.3d 727 (7th Cir. 2004), Judge Easterbrook read into the Safe Harbor the word “the” before “important” in the phrase “identifying important factors,” to then hold that discovery was required to determine whether the company’s cautionary language contained “the (or any of the) ‘important sources of variance’” between the forecast and the actual results.  Id. at 734.  The statute only requires a company to identify “important factors,” not the important factors.  Judge Easterbrook’s mis-reading of the statute injected a subjective component into an objective inquiry; it purported to require courts to evaluate the company’s disclosure decisions – what the company thought were “the” important factors.  This error led the court to permit discovery on what the company thought was “important” – a procedure directly contrary to Congress’s clear intent that courts apply the Safe Harbor on a motion to dismiss and “not [] provide an opportunity for plaintiff counsel to conduct discovery on what factors were known to the issuer at the time the forward-looking statement was made.”  H.R. Rep. No. 104-369, at 44 (1995), as reprinted in 1995 U.S.C.C.A.N. 730, 743.

Frequently, courts simply avoid defendants’ Safe Harbor arguments, choosing either to treat the Safe Harbor as a secondary issue or to avoid dealing with it at all.  The Safe Harbor was meant to create a clear disclosure system: if companies have meaningful risk disclosures, they can make projections without fear of liability.  When judges avoid the Safe Harbor, companies’ projections are judged by legal rules and pleading requirements that result in less certain and less protective outcomes, even if judges get to the right result on other grounds.  And if they come to realize that they do not have the clear Safe Harbor protection Congress meant to provide, companies will make fewer and/or less meaningful forward-looking statements.

The root of these problems is that many judges don’t like the idea that the Safe Harbor allows companies to escape liability for knowingly false forward-looking statements.  Some courts have explicitly questioned the Safe Harbor’s effect.  For example, in In re Stone & Webster, Inc. Securities Litigation, the First Circuit called the Safe Harbor a “curious statute, which grants (within limits) a license to defraud.”  414 F.3d 187, 212 (1st Cir. 2005).  And the Second Circuit, in its first decision analyzing the Safe Harbor – 15 years after the Reform Act was enacted, illustrating the degree of judicial avoidance – correctly interpreted “or” to mean “or,” but stated that “Congress may wish to give further direction on …. the reference point by which we should judge whether an issuer has identified the factors that realistically could cause results to differ from projections. May an issuer be protected by the meaningful cautionary language prong of the safe harbor even where his cautionary statement omitted a major risk that he knew about at the time he made the statement?”  Slayton v. American Express Co., 604 F.3d 758, 772 (2d Cir. 2010).  (Soon after the Second Circuit decided American Express, the Ninth Circuit also interpreted “or” to mean “or.”  In re Cutera, Inc. Sec. Litig., 610 F.3d 1103, 1112-13 (9th Cir. 2010).)

This judicial antipathy for the Safe Harbor won’t change.  So it is up to companies to draft cautionary statements that will be effective in the face of this skepticism, and for securities defense counsel to make Safe Harbor arguments that resonate with dubious judges.

I have had success in obtaining dismissal under the Safe Harbor when I am able to demonstrate that the company’s Safe Harbor cautionary statements show that it really did its best to warn of the risks it faced.  Judges can tell if a company’s risk factors aren’t thoughtful and customized.  Too often, the risk factors become part of the SEC-filing boilerplate, and don’t receive careful thought with each new disclosure.  But risk factors that don’t change period to period, especially when it’s apparent that the risks have changed, are less likely to be found meaningful.  And even though many risks don’t fundamentally change every quarter, facets of those risks often do, or there might be another, more specific risk that could be added.

Companies can help to inoculate themselves from lawsuits – or lay the groundwork for an effective defense – if they simply spend time thinking about their risk factors each quarter, and regularly supplement and adjust those factors.  There are situations in which competitive harm or other considerations will outweigh the benefit of making negative elective risk disclosures.  But companies should at least evaluate and balance the relevant considerations, so that they maximize their Safe Harbor protection without harming their business and shareholders.

I have also had success with Safe Harbor arguments that defend the honesty of the challenged forward-looking statements.  For example, the complaint, along with incorporated and judicially noticeable facts, often allow defense counsel to support the reasonableness of challenged earnings guidance.  Some defense lawyers avoid this approach because it is fact-intensive, which they worry may cause judges to believe that dismissal isn’t appropriate.  I have found, however, that judges who believe that the forward-looking statements have a reasonable basis (and are thus assured that they were not knowingly dishonest) are more comfortable applying the Safe Harbor, or granting the motion on another basis, such as lack of falsity.

On the other hand, I believe the least effective arguments are those that rest on the literal terms on the Safe Harbor, which create the impression that defendants are trying to skate on a technicality.  It is these types of arguments – lacking in a sophisticated supporting analysis of the context of the challenged forward-looking statements and of the thoughtfulness of the cautionary language – that cause the courts to try to evade what they see as the unjust application of the Safe Harbor.  Defense counsel need to appreciate that Safe Harbor “law” includes not just the statute and decisions interpreting it, but also the skepticism with which Safe Harbor arguments are evaluated by many judges.