Shareholder Derivative Action

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

The coming year promises to be a pivotal one in the world of securities and corporate governance litigation.  In particular, there are five developing issues we are watching that have the greatest potential to significantly increase or decrease the exposure of public companies and their directors, officers, and insurers.

1.  How Will Lower Courts Apply the Supreme Court’s Decision in Omnicare, Inc. v. Laborers Dist. Council Const. Industry Pension Fund?

If it is correctly understood and applied by defendants and the courts, we believe Omnicare will stand alongside Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), as one of the two most important securities litigation decisions since the Private Securities Litigation Reform Act of 1995.

In Omnicare, 135 S. Ct. 1318 (2015), the Supreme Court held that a statement of opinion is only false if the speaker does not genuinely believe it, and that it is only misleading if – as with any other statement – it omits facts that make it misleading when viewed in its full context.  The Court’s ruling on what is necessary for an opinion to be false establishes a uniform standard that resolves two decades of confusing and conflicting case law, which often resulted in meritless securities cases surviving dismissal motions.  And the Court’s ruling regarding how an opinion may be misleading emphasizes that courts must evaluate the fairness of challenged statements (both opinions and other statements) within a broad factual context, eliminating the short-shrift that many courts have given the misleading-statement analysis.

These are tremendous improvements in the law, and should help defendants win more cases involving statements of opinion, not only under Section 11, the statute at issue in Omnicare, but also under Section 10(b), since Omnicare’s holding applies to the “false or misleading statement” element common to both statutes.  The standards the Court set should also add to the Reform Act’s Safe Harbor, and expand the tools that defendants have to defend against challenges to earnings forecasts and other forward-looking statements, which are quintessential opinions.

Indeed, if used correctly, Omnicare should also help defendants gain dismissal of claims brought based on challenged statements of fact, because of its emphasis on the importance of considering the entire context of a statement when determining whether it was misleading.   For example, the Court emphasized that whether a statement is misleading “always depends on context,” so a statement must be understood in its “broader frame,” including “in light of all its surrounding text, including hedges, disclaimers, and apparently conflicting information,” and the “customs and practices of the relevant industry.”

A good motion to dismiss has always analyzed a challenged statement (of fact or opinion) in its broader factual context to explain why it was not misleading.  But many defense lawyers unfortunately choose to leave out this broader context, and as a result of this narrow record, courts sometimes take a narrower view.  With Omnicare, this superior method of analysis is now explicitly required.  This will be a powerful tool, especially when combined with Tellabs’s directive that courts must weigh 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.

Omnicare bolsters the array of weapons available to defendants to effectively defend allegations of falsity, and to set up and support the Safe Harbor defense and arguments against scienter.  Because of its importance, we plan to write a piece critiquing the cases applying Omnicare after its one-year anniversary in March.

2.  Will Courts Continue to Curtail the Use of 10b5-1 Plans as a Way to Undermine Scienter Allegations?

All successful securities fraud complaints must persuade the court that the difference between the challenged statements and the “corrective” disclosure was the result of fraud, and not due to a business reversal or some other non-fraudulent cause.  Because few securities class action complaints contain direct evidence of fraud, such as specific information that a speaker knew his statements were false, most successful complaints include allegations that the defendants somehow profited from the alleged fraud, such as through unusual and suspicious stock sales.

Thus, stock-sale allegations are a key battleground in most securities actions.  An important defensive tactic has been to point out that the challenged stock sales were made under stock-sale plans under SEC Rule 10b5-1, which provides an affirmative defense to insider-trading claims, if the plan was established in good faith at a time when they were unaware of material non-public information.  Although Rule 10b5-1 is designed to be an affirmative defense in insider-trading cases, securities class action defendants also use it to undermine stock-sale allegations, if the plan has been publicly disclosed and thus subject to judicial notice, since it shows that the defendant did not have control over the allegedly unusual and suspicious stock sales.

Plaintiffs’ argument in response to a 10b5-1 plan defense has always been that any plan adopted during the class period is just a large insider sale designed to take advantage of the artificial inflation in the stock price.  Plaintiffs claim that by definition, the class period is a time during which the defendants had material nonpublic information – although they often manipulate the class period in order to encompass stock sales and the establishment of 10b5-1 plans.

There have been surprisingly few key court decisions on this pivotal issue, but on July 24, 2015, the Second Circuit held that “[w]hen executives enter into a trading plan during the Class Period and the Complaint sufficiently alleges that the purpose of the plan was to take advantage of an inflated stock price, the plan provides no defense to scienter allegations.” Employees’ Ret. Sys. of Gov’t of the Virgin Island v. Blanford, 794 F.3d 297, 309 (2d Cir. 2015).

Plaintiffs’ ability to plead scienter will take a huge step forward if Blanford, decided by an important appellate court, starts a wave of similar holdings in other circuits.

3.  Will Delaware’s Endorsement of Forum Selection Bylaws and Rejection of Disclosure-Only Settlements Reduce Shareholder Challenges to Mergers?

For the past several years, there has been great focus on amending corporate bylaws to try to corral and curtail shareholder corporate-governance claims, principally shareholder challenges to mergers.  Meritless merger litigation is indeed a big problem.  It is a slap in the face to careful directors who have worked hard to understand and approve a merger, and to CEOs who have worked long hours to find and negotiate a transaction that is in the shareholders’ best interests.  It is cold comfort to know that nearly all mergers draw shareholder litigation, and that nearly all of those cases will settle before the transaction closes without any payment by the directors or officers personally.  It is proof that the system is broken when it routinely allows meritless suits to result in significant recoveries for plaintiffs’ lawyers, with virtually nothing gained by companies or their shareholders.

In 2015, the Delaware legislature and courts took significant steps to curb meritless merger litigation.

First, the legislature added new Section 115 to the Delaware General Corporation Law (“DGCL”), which provides:

The certificate of incorporation or the bylaws may require, consistent with applicable jurisdictional requirements, that any or all internal corporate claims shall be brought solely and exclusively in any or all of the courts in this State.

This provision essentially codified the holding in Boilermakers Local 154 Ret. Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013), in which the Delaware Court of Chancery upheld the validity of bylaws requiring that corporate governance litigation be brought only in Delaware state and federal courts.  The Delaware legislature also amended the DGCL to ban bylaws that purport to shift fees.  In new subsection (f) to Section 102, the certificate of incorporation “may not contain any provision that would impose liability on a stockholder for the attorneys’ fees or expenses of the corporation or any other party in connection with an internal corporate claim.” See also DGCL Section 109(b) (similar).

Second, in a series of decisions in 2015, the Delaware Court of Chancery rejected or criticized so-called disclosure-only settlements, under which the target company supplements its proxy-statement disclosures in exchange for a payment to the plaintiffs’ lawyers.  See Acevedo v. Aeroflex Holding Corp., et al., C.A. No. 7930-VCL (Del. Ch. July 8, 2015) (TRANSCRIPT) (rejecting disclosure-only settlement); In re Aruba Networks S’holder Litig., C.A. No. 10765-VCL (Del. Ch. Oct. 9, 2015) (TRANSCRIPT) (same); In re Riverbed Tech., Inc., S’holder Litig., 2015 WL 5458041, C.A. No. 10484-VCG (Del. Ch. Sept. 17, 2015) (approving disclosure-only settlement with broad release, but suggesting that approval of such settlements “will be diminished or eliminated going forward”); In re Intermune, Inc., S’holder Litig., C.A. No. 10086–VCN (Del. Ch. July 8, 2015) (TRANSCRIPT) (noting concern regarding global release in disclosure-only settlement).

We will be closely watching the impact of these developments, with the hope that they will deter plaintiffs from reflexively filing meritless merger cases.  Delaware exclusive-forum bylaws will force plaintiffs to face the scrutiny of Delaware courts, and the Court of Chancery has indicated that it may no longer allow an easy exit from these cases through a disclosure-only settlement.  And with cases in a single forum, defendants will now be able to coordinate them for early motions to dismiss.  Thus, the number of mergers subject to a shareholder lawsuit should decline – and the early returns suggest that this may already be happening.

Yet defendants should brace for negative consequences.  Plaintiffs’ lawyers will doubtless bring more cases outside of Delaware against non-Delaware corporations, or against companies that haven’t adopted a Delaware exclusive-forum bylaw.  And within Delaware, plaintiffs’ lawyers will tend to bring more meritorious cases that present greater risk, exposure, and stigma – and while Delaware is a defendant-friendly forum for good transactions, it is a decidedly unfriendly one for bad ones.  If disclosure-only settlements are no longer allowed, defendants will no longer have the option of escaping these cases easily and cheaply.  This means that those cases that are filed will doubtless require more expensive litigation, and result in more significant settlements and judgments.  Thus, although the current system is undoubtedly badly flawed, many companies may well look back on the days of this broken system with nostalgia, and conclude that they were better off before it was “fixed.”

4.  Will Item 303 Claims Make a Difference in Securities Class Actions?

The key liability provisions of the federal securities laws, Section 10(b) of the Securities Exchange Act of 1934 and Section 11 of the Securities Act of 1933, both require that plaintiffs establish a false statement, or a statement that is rendered misleading by the omission of facts.  Over the last several years, plaintiffs’ lawyers have increasingly tried to bypass this element by asserting claims for pure omissions, detached from any challenged statement.

Plaintiffs base these claims on Item 303 of SEC Regulation S-K, which requires companies to provide a “management’s discussion and analysis” (MD&A) of the company’s “financial condition, changes in financial condition and results of operations.”  Item 303(a)(3)(ii) indicates that the MD&A must include a description of “any known trends or uncertainties that have had or that the [company] reasonably expects will have a material … unfavorable impact on net sales or revenues or income from continuing operations.”

Both Section 10(b) and Section 11 prohibit a false statement or omission of a fact that causes a statement to be misleading, while Section 11 also allows a claim based on an issuer’s failure to disclose “a material fact required to be stated” in a registration statement. 15 U.S.C. § 77k(a) (emphasis added).  Item 303 is one regulation that lists such “material fact(s) required to be stated.”  Panther Partners Inc. v. Ikanos Communications, Inc., 681 F.3d 114, 120 (2d Cir. 2012).  Based on this unique statutory language, Section 11 claims thus appropriately can include claims based on Item 303.

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

Claims based on Item 303 seem innocuous enough, and even against plaintiffs’ interest. Plaintiffs face a high hurdle in showing that information was wrongfully excluded under Item 303, since they must show that a company actually knew:  (1) the facts underlying the trend or uncertainty, (2) those known facts yield a trend or uncertainty, and (3) the trend or uncertainty will have a negative and material impact.  In virtually all cases, these sorts of omitted facts would also render one or more of defendants’ affirmative statements misleading, and thus be subject to challenge regardless.  Moreover, in Section 11 cases, Item 303 injects knowledge and causation requirements in a statute that normally doesn’t require scienter and only includes causation as an affirmative defense.

Why, then, have plaintiffs’ counsel pushed Item 303 claims so hard?  We believe they’ve done so to combat the cardinal rule that silence, absent a duty to disclose, is not misleading.  Companies omit thousands of facts every time they speak, and it is relatively easy for a plaintiff to identify omitted facts – but much more difficult to explain how those omissions rendered an affirmative statement misleading.  Plaintiffs likely initially saw these claims as a way to maintain class actions in the event the Supreme Court overruled Basic v. Levinson as a result of attacks in the Amgen and Halliburton cases.  And even though the Supreme Court declined to overrule Basic in Halliburton II, the Court’s price-impact rule presents problems for plaintiffs in some cases.  As a result, plaintiffs may believe it is in their strategic interests to assert Item 303 claims, which plaintiffs have contended fall under the Affiliated Ute presumption of reliance, rather than under Basic.

But whatever plaintiffs’ rationale, Item 303 is largely a red herring.  Although it shouldn’t matter to securities litigation, it will matter, as long as plaintiffs continue to bring such claims.  And they probably will continue to bring them, given the current strategic considerations, and the legal footing they have been given by key appellate rulings in Panther Partners and Stratte-McClure.  Defense attorneys will have to pay close attention to these trends and mount sophisticated defenses to these claims, to ensure that Item 303 claims do not take on a life of their own.

5.  Cyber Security Securities and Derivative Litigation: Will There Be a Wave or Trickle?

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

We remain convinced that a wave is coming, perhaps a tidal wave, and that it will include not just derivative litigation, but securities class actions and SEC enforcement matters as well.  To date, plaintiffs generally haven’t filed cyber security securities class actions because stock prices have not significantly dropped when companies have disclosed breaches.  That is bound to change as the market begins to distinguish companies on the basis of cyber security.  There have been a number of shareholder derivative actions asserting that boards failed to properly oversee their companies’ cyber security.  Those actions will continue, and likely increase, whether or not plaintiffs file cyber security securities class actions, but they will increase exponentially if securities class action filings pick up.

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

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

Conclusion

Of course, there are a number of other important issues that deserve to be on watch lists.  But given the line we’ve drawn – issues that will cause the most volatility in securities litigation liability exposure – we regard the issues we’ve discussed as the top five.

And the top one – whether lower courts will properly apply Omnicare – is a rare game-changer.  If defense counsel understands and uses Omnicare correctly, and if lower courts apply it as the Supreme Court intended, securities litigation decisions will be based on reality, and therefore far fairer and more just.  But if either defense counsel or lower courts get it wrong, companies and their directors and officers will suffer outcomes that are less predictable, more arbitrary, and often wrong.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

One of the foremost uncertainties in securities and corporate governance litigation is the extent to which cybersecurity will become a significant D&O liability issue. Although many D&O practitioners have been bracing for a wave of cybersecurity D&O matters, to date there has been only a trickle. Some have come to believe that at most, there will be a surge of derivative litigation, due to the lack of significant and sustained stock drops on the announcement of even large cybersecurity breaches.

Yet I remain convinced that a wave is coming, perhaps a tidal wave, and it will include not just derivative litigation, but securities class actions and SEC enforcement matters as well. In this post, I will focus on securities class actions, since that is where most of the uncertainty lies, including the question I begged in my previous post on cybersecurity securities class actions: what will trigger securities class actions when, to date, even the largest breaches haven’t caused significant and sustained stock-price drops?   Unlike shareholder derivative actions, which do not require a significant stock drop, securities class actions require misrepresentations to cause loss to stock purchasers – loss that materializes upon the disclosure of bad news that causes the stock to drop. Thus, the advent of cybersecurity securities class actions will not occur unless stock prices begin to drop.

So why do I think stock prices will drop? It’s easiest to start to answer that question by thinking about why stock prices generally haven’t dropped to date. I’m not an economist, of course, but I’ve discussed this issue with some and have read and thought about it a lot. I believe that stock prices generally haven’t dropped significantly because the market believes that all companies are susceptible to a cyber-attack, and it’s basically random and unlucky when a company suffers one – it’s Company A this week and Company B next week, and so on. So a breach isn’t fundamental to the company’s business and doesn’t portend future negative financial consequences. That means that the market assesses the cost of the breach as the cost of remedying it through consumer notices, litigation defense and the like – which involves great but manageable and predictable cost, and does not view the breach as a fundamental or long-term problem.

That dynamic is bound to change, for several reasons. First, many companies have improved their cybersecurity and cybersecurity oversight significantly over the past few years. Those that are leaders will begin to tout their leadership, and criticize competitors who have had or may have problems. Cybersecurity thus will become a competitive issue, and the market will begin to pick winners and losers instead of regard as simply unlucky a company that suffered a breach.

Second, as companies begin to tout their cybersecurity for competitive reasons, they will do so through statements that will be susceptible to challenge as false or misleading if they suffer a breach. The most difficult statements to defend in securities class actions often are those based on business braggadocio, and I think cybersecurity statements ultimately will be no different. In terms of stock price impact, such statements will bake strong cybersecurity into companies’ stock prices, leading to disappointment and thus stock drops when a seemingly strong cybersecurity company suffers a breach.

Third, the number of companies that disclose breaches will increase, leading to a larger universe of companies who might suffer stock drops. To date, virtually the only type of companies to disclose breaches are consumer-oriented companies, driven by breach-notification privacy laws. There have been few disclosures of significant breaches by non-consumer companies, whose disclosure decisions are based not on consumer breach-notification laws, but on SEC disclosure requirements.

That will change. The SEC is focused on cybersecurity disclosure, and inevitably will start to more aggressively police disclosure by companies that aren’t compelled to disclose breaches under privacy laws. (Of course, SEC enforcement over cybersecurity disclosures will not require a stock drop.) Also, I predict that whistleblowers from IT departments will start to surface, drawn by increasingly large whistleblower bounties. And auditors will begin to prompt disclosure as they too increase their focus on the financial impact of cybersecurity breaches.

I don’t know if this all means that cybersecurity securities class actions will become the most prominent type of securities class action. I doubt it. But I do think that the risk is high enough that all companies need to pay more attention to their cybersecurity disclosures, and insurers, brokers and risk managers need to be mindful of the inevitable increase of securities class action risk in this area.

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

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

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

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

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

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

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

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

4.         SEC v. Citigroup:  The Forgotten Important Case

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Why Halliburton II is Not a Top-5 Development

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

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

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

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

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

***

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

Last fall, I wrote about board oversight of cybersecurity and derivative litigation in the wake of cybersecurity breaches.  I plan to update my thoughts later this year, after we see developments in the recently filed Target and Wyndham derivative actions, and learn the results of the 2014 installment of Carnegie Mellon’s bi-annual CyLab Governance of Enterprise Security Survey, which explores oversight of cybersecurity by boards of directors and senior management.

In this post, I’d like to focus on cybersecurity disclosure and the inevitable advent of securities class actions following cybersecurity breaches.  In all but one instance (Heartland Payment Systems), cybersecurity breaches, even the largest, have not caused a stock drop big enough to trigger a securities class action.  But there appears to be a growing consensus that stock drops are inevitable when the market better understands cybersecurity threats, the cost of breaches, and the impact of threats and breaches on companies’ business models.  When the market is better able to analyze these matters, there will be stock drops.  When there are stock drops, the plaintiffs’ bar will be there.

And when plaintiffs’ lawyers arrive, what will they find?  They will find companies grappling with cybersecurity disclosure.  Understandably, most of the discussion about cybersecurity disclosure focuses on the SEC’s October 13, 2011 “CF Disclosure Guidance: Topic No. 2” (“Guidance”) and the notorious failure of companies to disclose much about cybersecurity, which has resulted in a call for further SEC action by Senator Rockefeller and follow-up by the SEC, including an SEC Cybersecurity Roundtable on March 24, 2014.  But, as the SEC noted in the Guidance, and Chair White reiterated in October 2013, the Guidance does not define companies’ disclosure obligations.  Instead, disclosure is governed by the general duty not to mislead, along with more specific disclosure obligations that apply to specific types of required disclosures.

Indeed, plaintiffs’ lawyers will not even need to mention the Guidance to challenge statements allegedly made false or misleading by cybersecurity problems.  Various types of statements – from statements about the company’s business operations (which could be imperiled by inadequate cybersecurity), to statements about the company’s financial metrics (which could be rendered false or misleading by lower revenues and higher costs associated with cybersecurity problems), to internal controls and related CEO and CFO certifications, to risk factors themselves (which could warn against risks that have already materialized) – could be subject to challenge in the wake of a cybersecurity breach.

Plaintiffs will allege that the challenged statements were misleading because they omitted facts about cybersecurity (whether or not subject to disclosure under the Guidance).  In some cases, this allegation will require little more than coupling a statement with the omitted facts.  In cybersecurity cases, plaintiffs will have greater ability to learn the omitted facts than in other cases, as a result of breach notification requirements, privacy litigation, and government scrutiny, to name a few avenues.  The law, of course, requires more than simply coupling the statement and omitted facts; plaintiffs must explain in detail why the challenged statement was misleading, not just incomplete, and companies can defend the statement in the context of all of their disclosures.  But in cybersecurity cases, plaintiffs will have more to work with than in many other types of cases.

Pleading scienter likely will be easier for plaintiffs as well.  With increased emphasis on cybersecurity oversight at the senior officer (and board) level, a CEO or CFO will have difficulty (factually and in terms of good governance) suggesting that she or he didn’t know, at some level, about the omitted facts that made the challenged statements misleading.  That doesn’t mean that companies won’t be able to contest scienter.  Knowledge of omitted facts isn’t the test for scienter; the test is intent to mislead purchasers of securities.  However, this important distinction is often overlooked in practice.  Companies will also be able to argue that they didn’t disclose certain cybersecurity matters because, as the Guidance contemplates, some cybersecurity disclosures can compromise cybersecurity.  This is a proper argument for a motion to dismiss, as an innocent inference under Tellabs, but it may feel too “factual” for some judges to credit at the motion to dismiss stage.

As this analytic overview shows, cybersecurity securities class actions, on the whole, likely will be virulent.  Companies, of course, are talking about cybersecurity risks in their boardrooms – and they should also think about how to discuss those risks with their investors.  The best way for companies to lower their risk profile is to start to address this issue now, by thinking about cybersecurity in connection with all of their key disclosures, and enhancing their disclosures as appropriate.

Perfection and prescience are not required.  Effort matters most.  Companies that don’t even try will stand out.  As I’ve written in the context of the Reform Act’s Safe Harbor for forward-looking statements, judges are skeptical of companies whose risk factors remain static over time, and look favorably on companies who appear to try to draft meaningful risk factors.  I thus construct a defense of forward-looking statements by emphasizing, to the extent I can, ways in which the company’s risk disclosures evolved, and were tailored and focused.  I predict that the same approach will prove effective in cybersecurity cases.

 

Shareholder litigation comes in waves.  There is a widespread belief that the next big wave will be shareholder derivative litigation – a shareholder’s assertion of a claim belonging to the corporation, typically brought against directors and officers, alleging corporate harm for a board’s failure to prevent corporate problems.

Derivative cases filed as tag-alongs to securities class actions have long been commonplace, and frequently are little more than a nuisance.  Over the years, there have been sporadic large derivative actions concerning other areas of legal compliance – typically over a very large corporate problem.   Non-disclosure derivative litigation filings recently have seemed more frequent, and there have been some large settlements that have come as a result.  And the specter of cyber liability derivative suits looms large – not surprisingly, Target shareholders just filed derivative litigation related to the recent customer data breach.  Whether the forecasted non-disclosure derivative-litigation wave materializes, or remains a sporadic occurrence in the larger world of D&O litigation, is one of the issues I’m watching closely in 2014 and beyond.

This potential wave raises issues that are unique to derivative litigation.  One key issue that has not been analyzed enough is representation: which lawyers can and should represent the company and the individual defendants in derivative litigation?

Because a derivative litigation claim belongs to the corporation, it puts the corporation in an odd spot.  A shareholder, as one of the corporation’s “owners” (usually a really, really small owner – but an owner nevertheless), is trying to force the company to bring a claim against the people who run the company.  The law says, however, that those people, the directors, get to decide whether the company should sue someone – including themselves – unless a shareholder can show that they couldn’t make a disinterested and independent decision.   Thus, to bring a derivative action, a shareholder must allege that it would have been futile to demand that the board take action, and defendants will typically challenge the lawsuit with a motion to dismiss for failure to make a demand (“demand motion”) on the basis that the demand-futility allegations aren’t sufficiently probative or particularized.

It is often said that the interests of the company and defendants are aligned through the demand motion, because they all have an interest in making sure that the shareholder follows proper governance procedures – namely, making a pre-suit demand on the board.  But this sort of statement prejudges the demand-futility allegations; it assumes that the allegations of futility are insufficient.  In Delaware and states that follow its demand law, proper corporate governance procedures require a shareholder either to make a demand or to plead demand-futility.  Only if and when the court rules that demand was required can we truly say that the interests of the company and defendants on the demand issue were aligned.  However, I don’t think this means that legal ethics require the company to be separately represented from the inception of a derivative action in all cases; the shared-interest view is arguable.   So if there are good practical reasons for joint representation from inception, and it causes no harm, so be it.  (That the primary lawyers are expensive relative to the D&O insurance limits isn’t a good reason for joint representation – it’s a good reason why those lawyers were the wrong lawyers for the matter.  But I digress.)

There’s also a compelling strategic reason to separate the representation from the beginning of the case.  A demand motion asks the court to allow the defendants to be the judge – to require the plaintiff to ask the directors to evaluate and bring claims against themselves and senior officers.  Thus, the company must overcome a judge’s skepticism that such an evaluation presents a “fox-guarding-the-chicken-coop” problem.  This is far easier to do if the company is separately represented and makes the demand motion.  It is true that courts frequently grant demand motions made during joint representation of the company and defendants.  But it is also true that joint representation always carries strategic risk, and the more serious the derivative litigation, the more unwise it is to take the risk.  Rather than make judgments in advance about which derivative litigation is serious, warranting a split, and which isn’t, allowing joint representation, I advocate splitting the representation from the outset – since the representation must be split up if demand is excused, splitting it from the outset imposes relatively little additional cost burden, if there’s appropriate coordination.

Representation between and among the defendants has strategic components, in addition to ethical considerations.  It can be strategically advantageous for individuals who aren’t accused of active wrongdoing to be separately represented from those who are.  That typically means officers and outside directors are represented separately in groups.  With this division, the court can see that the directors who would evaluate a demand don’t have the same lawyers as the people who allegedly engaged in active wrongdoing.  However, I don’t think that’s as strategically important for purposes of the demand motion as splitting up the company and defendants.  In evaluating a demand, the directors, acting as directors and not director-defendants, should be represented by counsel other than their litigation defense counsel.  Moreover, demand futility is judged at the time the suit is filed, not when the court decides the demand motion.  Thus, it isn’t technically necessary or legally accurate to send a “signal” of independence to the court through splitting up the representation further.  That said, in a very significant derivative case, and/or one in which the judge is new to derivative litigation, such an approach could be strategically advantageous.

It can sometimes be appropriate to consider even more divisions – for example, splitting the outside directors into audit-committee and non-audit-committee groups where audit-committee oversight is the main oversight allegation.  Such divisions may be ethically prudent or necessary later, but for purposes of the demand motion, they often don’t add much, if anything, since the demand motion is about the ability of a majority of the full board to consider a demand.

So, a typical case needs at least two lawyers from the outset – one for the company, and another for the individual defendants.  The type of derivative litigation we’re discussing often arises in the context of an underlying legal problem for which the company has lawyers – in a disclosure-related matter for a related securities class action, and in non-disclosure matters for other types of underlying matters (FCPA, antitrust, privacy, etc.).   To what extent should the lawyers defending the underlying matters be involved in the derivative action?

In general, I believe that the lawyers defending the underlying proceedings that created the corporate liability or harm (actual or potential) at issue in the derivative case should not defend the derivative case.  The reasons are similar to those I have written about in the context of using corporate counsel to defend a securities class action that may involve corporate counsel’s advice – there are tricky and hidden conflict issues, and the lawyers can be of better service to their clients as witnesses.

In derivative litigation, the problem can be even worse.  Corporate counsel typically advises on relevant corporate governance issues, such as compliance programs, the severity of legal risks that ultimately trigger the derivative litigation, board review of various risks, and preparation or review of board minutes.  Some companies are heavily guided in these areas by their corporate counsel, either directly in the boardroom or indirectly through advice to in-house counsel.   It is in the interests of the company and the board to be able to testify that they took a course of action, or didn’t do so, because of their lawyers’ advice.  The problem is greater than that of lawyer-as-witness – defense counsel should not be in the position of making judgments or recommendations that might be influenced by the law firm’s concerns about the public airing of its corporate work.

In derivative cases based on a disclosure problem, another representation issue arises:  whom should the securities class action defense counsel represent – the company or the defendants?   Securities class action defense counsel take different approaches to dividing derivative litigation representation.  Some will represent the company only, and have their securities class action individual defendant clients be represented by a different firm.  Others represent the individual defendants in the derivative action, and have the company represented by a different firm.   The right approach is a judgment call, but I prefer to have the securities class action defense counsel represent the individual defendants in the derivative action and have another firm represent the company.  That approach allows the lawyers in defense mode to fully remain in defense mode – they can defend the lack of merit to the charges of wrongdoing in all proceedings.   It also allows the defending lawyers to avoid the tension involved in simultaneously defending individuals in the securities class action and representing the potentially adverse company in the related derivative action.  This approach is possible with the right waivers, but I prefer the pure-defense approach.

Once the right lawyers are in place, how can and should the lawyers interact to prepare motions to dismiss and conduct other preliminary projects effectively – and cost-effectively?  The gating question is who should make the demand motion – the company or the defendants?  The company is really the right movant.  The demand motion is about the company’s corporate governance procedures, and the directors are involved not as directors but as individual defendants, so the purest approach is for the company to make the demand motion.

The same result makes sense from a strategic perspective.  The defendants have 12(b)(6) motions to make, and having them make both motions is awkward.   Although both motions say that the allegations (not the claims) aren’t good enough – the demand motion asserts that the allegations don’t raise a substantial likelihood of liability or other disabling interest sufficient to excuse demand, and the 12(b)(6) motion asserts they are not sufficient to state a claim – having the directors simultaneously assert that they could impartially consider a demand, but that the claims should be dismissed, is slicing the issues pretty finely.   If the defendants don’t make a 12(b)(6) motion, that problem is alleviated.  Many defense lawyers – including me from time to time – opine that the 12(b)(6) motions will fail if the demand motion fails, so defendants should just forego the 12(b)(6) motion entirely and make a 12(c) motion later, if necessary.  However, that foregoes the initial line of defense for the individuals.

It will be interesting to see if there is indeed a wave of more serious derivative litigation coming.  I will be on the look-out, and will write about other derivative-litigation issues that I think are of interest.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

Last Tuesday, new SEC Chairman Mary Jo White said at The Wall Street Journal’s annual CFO Network Event that the SEC “in certain cases” will seek admissions of liability as part of settlements. The statement made headlines, and for good reason: for decades, the SEC has allowed settling defendants to neither admit nor deny wrongdoing. The policy shift, moreover, comes during the appeal to the Second Circuit of District Judge Jed Rakoff’s rejection of the SEC-Citigroup settlement, where he rejected a no-admit-or-deny settlement based in part on his determination that any consent judgment that is not supported by “proven or acknowledged facts” would not serve the public interest. (Last year, the SEC stopped allowing civil defendants to neither admit nor deny fraud, if they had already pleaded guilty in a parallel criminal case.)

Chairman White’s remarks last Tuesday indicated that a new policy requiring admissions of liability will be applied in cases of “widespread harm to investors” and “egregious intentional misconduct.” An internal SEC email from co-directors of the SEC Enforcement Division to the Enforcement staff, obtained by Alison Frankel of Reuters, and author of the blog On the Case, elaborates on the scope of the policy’s application:

“While the no admit/deny language is a powerful tool, there may be situations where we determine that a different approach is appropriate,” Ceresney and Canellos said in the email, which was provided to me by an SEC representative. “In particular, there may be certain cases where heightened accountability or acceptance of responsibility through the defendant’s admission of misconduct may be appropriate, even if it does not allow us to achieve a prompt resolution. We have been in discussions with Chair White and each of the other commissioners about the types of cases where requiring admissions could be in the public interest. These may include misconduct that harmed large numbers of investors or placed investors or the market at risk of potentially serious harm; where admissions might safeguard against risks posed by the defendant to the investing public, particularly when the defendant engaged in egregious intentional misconduct; or when the defendant engaged in unlawful obstruction of the commission’s investigative processes. In such cases, should we determine that admissions or other acknowledgement of misconduct are critical, we would require such admissions or acknowledgement, or, if the defendants refuse, litigate the case.”

What will this mean in actual SEC enforcement matters and related shareholder cases? Comments from plaintiffs’ lawyers and defense lawyers in Frankel’s blog post provide a useful start to the discussion. Not surprisingly, plaintiffs’ lawyers Max Berger, Gerald Silk and Steve Toll feel the policy will help them by providing them with ammunition to use to bolster their private securities cases. My former partner Boris Feldman of Wilson Sonsini said that the “proof of the sausage is in the making,” and feels the policy won’t change SEC enforcement matters much because the SEC will only insist on an admission when “the defendant is hosed anyway.” Thomas Gohrman of Dorsey & Whitney is worried that, “unless applied on a very sparing basis,” the policy “may well significantly undercut the entire enforcement program” because defendants will refuse to settle and the SEC will expend its resources litigating these cases.

My view lies somewhere in between these. The SEC doesn’t currently have the enforcement resources to litigate a significant additional number of additional cases, so in the near term it really can only apply the policy to particularly gnarly cases, where there is egregious or notorious misconduct, and where they are very confident they would win at trial. This approach won’t impact defendants significantly, because in cases that fall into these categories, the defendants already have significant problems stemming from the underlying facts, and there would be little collateral damage from the admission the SEC seeks.

But, to be sure, the SEC is bound to apply the policy to some close cases as well, because of a misapprehension of the case’s strength, or an overly zealous interpretation of White’s edict by the SEC staff. (There may also be a temptation by the SEC to apply this policy too broadly to high-profile cases of questionable merit, although I believe that tendency will be limited by a concern over suffering too many high-profile defeats.) The defendants will refuse to agree to settlements requiring admissions in most close cases, because of collateral consequences in otherwise defensible cases, thus yielding an increase in the number of cases the SEC litigates. How many more cases will be litigated will depend in large part on the rigor of the SEC’s screening process and on whether the SEC staff facilitates frank and meaningful discussions with defense counsel about the facts of each case.

What we know for sure is that the amount of litigation will increase in proportion to the SEC’s implementation of this new policy. Unless the new policy is interpreted very narrowly, the SEC will very quickly have a decision to make: it will either need to find new resources to finance the additional litigation; divert resources into litigation from investigation and enforcement, resulting in fewer actions being filed in the first place; or pull back on the implementation of the new policy.

I predict that after some initial overreaching, the SEC will re-calibrate its no-admission policy to limit its application to only the gnarliest cases with the worst facts. Otherwise, the government will have to fundamentally rethink the SEC’s funding and/or its enforcement role, in order to accommodate substantially more active litigation. This is possible, of course, but it seems unlikely.

On the other hand, the SEC is in control of the process only up to the point of judicial review of a proposed settlement. The uncertainty surrounding judicial review of no-admit-or-deny settlements is a wild card – increased judicial insistence on admissions likely would prompt the SEC to apply its policy to more cases than it otherwise would. Thus, the Second Circuit’s response to Judge Rakoff in the SEC-Citigroup case remains an important development to watch.

As I previously wrote, increased insistence on admissions, whether by the SEC or courts, would have significant consequences on private litigation and D&O insurance coverage. Obviously, making these admissions would increase the risk of liability in related private litigation, while at the same time creating insurance coverage problems – not to mention the impact they would have on a company’s reputation and directors’ and officers’ careers.

Deciding to litigate with the SEC will create difficult issues as well. Increased litigation will strain D&O insurance policies, not just because it creates another piece of litigation, but because it is inherently expensive litigation, which is likely to go to trial and will frequently require separate representation for each defendant. That will leave less insurance to settle the private cases, which in turn will mean that more private shareholder cases will go to trial as well.

These forces, along with the problem of increasing defense costs (about which I’ve posted here and here), will create a financial problem for many companies and their directors and officers. And, of course, they could create a serious liability problem as well, since the odds are that a decent percentage of the cases that go to trial under these circumstances will result in determinations of liability. Depending upon how these factors play out, it will become even more critical for defense counsel to adopt a more efficient, effective, and trial-focused approach to securities litigation.

I recently had occasion to review a number of motion-to-dismiss rulings, including some in which denial of the motion seemed to be an easy call.  I’ve since been mulling over whether there are circumstances in which it would be strategically advantageous not to make a motion to dismiss in a Reform Act case, or a motion to dismiss for failure to make a demand on the board in a derivative case.  I have never foregone such a motion, even when it was relatively weak.  But is that the right strategic and economic approach?*

Routine motions to dismiss are certainly part of the predominant, formulaic approach to securities litigation defense.  As I noted in my recent Law360 Q&A, a formulaic approach can yield inefficiency and insufficient strategic thought.  Two obvious examples are class certification and document discovery:

  • Courts rarely deny class certification motions based on shortcomings in the proposed class representative – and often, even if they did, it would not be to the advantage of the defense.  Yet in virtually every case, defense attorneys travel around the country to take depositions of class representatives to support futile class certification oppositions.
  • The universe of important documents in a securities case usually distills to a relatively small number.  Yet in virtually every case, defense attorneys review every page of a vast number of documents collected as potentially responsive to overreaching document requests – ignoring the efficiency and other advantages of a more strategic approach.

I’ve vowed to take a more strategic and efficient approach in these and other areas.  A superior defense doesn’t require that we do everything, including tasks with little or no strategic value.  It means that we position the case for the best possible resolution.  That goal involves strategic and economic considerations.

So, then, what about motions to dismiss:  are there circumstances in which it would make sense to forego one?  It’s hard to imagine all conceivable circumstances under which this question may be posed, but I think the answer is probably “no.”  But in all cases, including those in which the motion to dismiss is weak, we need to think about how we use the motion to the defendants’ strategic advantage.

In my experience, there is a small group of cases – maybe 10% of those filed – that are bound to get past a motion to dismiss.  In those cases, neither the quality of the lawyers, on either side, nor the temperament or ability of the judge even matters.  Among these cases, some are meritorious and some aren’t.  Sometimes the initial allegations appear strong, although the plaintiffs’ ultimate case is not, and sometimes they involve high-profile situations or defendants, in which a judge is almost certain to allow the plaintiffs a chance to develop their case.  Regardless, these are all hard cases that are not going to be dismissed on a motion.

I can make a strong prima facie strategic case for not moving to dismiss this class of case, especially cases that are ultimately defensible.  The motion to dismiss is the judge’s first look at the case.  Judges are people, and they form first impressions.  The emphasis that a motion to dismiss can bring to the one-sided presentation of the “evidence” in the complaint can do harm to later rulings.  So, I could argue that a better strategy is to answer the complaint and wait for a chance to make a good first impression with the judge, at a time when the defendants can introduce favorable evidence.  This strategy also has the benefit of saving the client and/or carriers a substantial amount of money.

On balance, however, I think that other strategic considerations outweigh the advantages of foregoing motions to dismiss.  The vast majority of securities and derivative complaints are potentially dismiss-able.  Plaintiffs assume that a motion to dismiss will be made and – because of the high pleading standards required for complaints in Reform Act cases, and to excuse demand in derivative cases – they fear dismissal even in the strongest cases.  Thus, to not make a motion to dismiss would be significant, and would suggest to plaintiffs (and to the judge, too, if she or he is experienced in securities cases) that the plaintiffs’ case is extraordinarily strong.  It might even seem to be a concession of some kind.  Just as importantly, a motion to dismiss is the defendants’ only real leverage before summary judgment, and because of the discovery stay, the defendants have an informational advantage during the motion-to-dismiss process (setting aside the availability of a books and records inspection in the context of derivative litigation).

The combination of these factors strongly suggests that defendants make a motion to dismiss, even if they know it is very unlikely to succeed – but that they do so within a larger strategic framework geared toward the best ultimate resolution of the case.  In a great many cases, mediating while the motion to dismiss is still pending will be the right strategy, to take advantage of the leverage and the informational advantage that defendants have during this time.  This strategy requires the utmost strategic thought and risk analysis at the outset of the case, and then impeccable communication among the defendants, defense counsel, and the insurers and broker.  Even if this process leads these parties to the conclusion that it is better to continue to litigate the case, rather than attempt an early settlement, it will lend strategic shape and direction to the litigation process.

The worst strategy – although it unfortunately seems to be a prevalent one – is to simply litigate the case full tilt, without serious evaluation of whether an early settlement is strategically or economically wise, and without adequate communication with the client or the carriers about the risks of the case.

 

* I don’t include merger cases in this analysis, because they present special considerations – principally quick settlements and multi-jurisdictional issues – that often make a motion to dismiss impractical.

 

On April 4, 2013, in the Allergan decision, the Delaware Supreme Court reversed the Court of Chancery’s ruling last year that the dismissal of a shareholder derivative action in California did not preclude other stockholders from bringing the same corporate claim in Delaware.  The Delaware Supreme Court’s decision was based on a Constitutional Full Faith and Credit analysis.

The Court of Chancery, in contrast, had looked to Delaware’s internal affairs doctrine and demand futility requirement, which the Supreme Court said was error.  Central to the Court of Chancery’s analysis was a presumption that the California plaintiffs provided inadequate representation because they did not conduct a Section 220 books and records inspection before filing.  However, the Supreme Court rejected this “‘fast filer’ irrebuttable presumption of inadequacy,” holding that plaintiffs who fail to do a Section 220 action are not necessarily inadequate.

The commentary about the Delaware Supreme Court’s decision understandably has focused on the Full Faith and Credit analysis and the Supreme Court’s apparent rejection of a Delaware-centric attitude toward shareholder litigation involving Delaware corporations.  Defense lawyers have lauded the decision as a step towards solving the problem of multi-jurisdictional shareholder litigation.

In my opinion, however, the more important and enduring feature of the decision is the Delaware Supreme Court’s rejection of the “fast filer” presumption of inadequacy.  For a further discussion of the fast-filer issue, please see my prior post on the Allergan and Hecla Mining Court of Chancery decisions.  For a helpful discussion of the Allergan Delaware Supreme Court decision, please see Kevin LaCroix’s blog, The D&O Diary.

Upholding the Court of Chancery’s presumption against fast-filers would have strongly encouraged, if not effectively required, shareholders to make a Section 220 demand before filing a derivative action.  Such a rule inevitably would have reduced the number of shareholder cases filed, because plaintiffs’ counsel would have had to be more selective about the cases in which it invested the time and money to investigate.  Thus, the Delaware Supreme Court passed up an opportunity to actually reduce the number of shareholder derivative actions – especially those without merit.   On the other hand, as I wrote in my prior post, a 220 requirement would make cases that are filed more virulent, because they would be more difficult to dispose of on a motion to dismiss.

Leaving the system as is, however, means that stockholders will continue to file a lot of bad cases – in Delaware and elsewhere, and sometimes in multiple places.  And the root cause of the multi-jurisdictional shareholder litigation problem is more this reflexive, thoughtless filing of meritless cases than the fact that they are filed in multiple jurisdictions.  The Delaware Supreme Court thus passed up an opportunity to craft a rule that would have had profound impact on all shareholder litigation, including merger cases.

But I doubt that the Full Faith and Credit aspect of the decision in Allergan will have a significant impact on merger litigation, the most prolific and meritless type of shareholder litigation.  This is so for two reasons.

First, Allergan was a shareholder derivative action concerning the board’s alleged failure to prevent an off-label marketing problem, asserting the derivative claim that the corporation was damaged by the board’s breaches of fiduciary duties.  Most merger cases are filed as class actions asserting shareholders’ direct claims, not as derivative actions asserting corporate claims.  The collateral estoppel analysis in Allergan was dependent upon a determination of privity that is unique to the context of a shareholder derivative action.  Thus, Allergan’s collateral estoppel analysis doesn’t break new ground regarding merger class actions, and therefore would have no direct effect on most merger litigation.

Second, few merger cases are litigated to dispositive decisions that a Delaware court is even asked to respect.  The vast majority of them settle long before that point.  As a result, there has hardly been a wave of Delaware decisions failing to honor another state’s dismissal of a merger case.  Indeed, one of the central problems with merger litigation is the fact that there are too few decisions on the merits.  In a prior post on merger litigation, I discuss some of the reasons why there is too little merits litigation in merger cases.

A rule requiring stockholders to use Section 220 would be a mixed bag – as discussed above, there may be fewer cases, but those that remained would be harder to dispose of on a motion to dismiss.  But the Delaware Supreme Court’s rejection of such a rule was a bit of a letdown.  Such a presumption against fast filers, even if fashioned strictly in the context of derivative actions, would likely have had a domino effect, and also led to greater investigation by stockholders before filing merger class actions.  That would have had a positive impact; even a little more investigation would be better than the current system of no investigation at all.