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

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

Overview of the Reform Act

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

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

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

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

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

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

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

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

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

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

The Safe Harbor for Forward-Looking Statements

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

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

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

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

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

Lead Plaintiff Procedures

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

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

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

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

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

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

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

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

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

Conclusion

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

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

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

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

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

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

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

1. The Securities Class Action Landscape Has Fundamentally Changed

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

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

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

As smaller firms have gained further momentum, they have expanded the cases they initiate beyond “lawsuit blueprint” cases—and they continue to initiate and win lead-plaintiff contests primarily in cases against smaller companies brought by retail investors.  To be sure, the larger firms still mostly can and will beat out the smaller firms for the cases they want.  But it increasingly seems clear that the larger firms don’t want to take the lead in initiating many of the cases against smaller companies, and are content to focus on larger cases on behalf of their institutional investor clients.

The securities litigation landscape now clearly consists of a combination of two different types of cases: smaller cases brought by a set of smaller plaintiffs’ firms on behalf of retail investors, and larger cases pursued by the larger plaintiffs’ firms on behalf of institutional investors.  This change—now more than five years old—appears to be here to stay.

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

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

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

2. Sanofi Shows Omnicare’s Benefits

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Additional Significant Developments

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

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

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

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

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

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

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

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

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

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

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

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

One of my “5 Wishes for Securities Litigation Defense” (April 30, 2016 post) is to require an interview process for the selection of defense counsel in all cases.

When a public company purchases a significant good or service, it typically seeks competitive proposals.  From coffee machines to architects, companies invite multiple vendors to bid, evaluate their proposals, and choose one based on a combination of quality and cost.  Yet companies named in a securities class action frequently fail to engage in a competitive interview process for their defense counsel, and instead simply retain litigation lawyers at the firm they use for their corporate work.

To be sure, it is difficult for company management to tell their outside corporate lawyers that they are going to consider hiring another firm to defend a significant litigation matter.  The corporate lawyers are trusted advisors, often former colleagues of the in-house counsel, and have usually made sacrifices for the client that make the corporate lawyers expect to be repaid through engagement to defend whatever litigation might arise.  A big litigation matter is what makes all of the miscellaneous loss-leader work worth it.  “You owe me,” is the unspoken, and sometimes spoken, message.

Corporate lawyers also make the pitch that it will be more efficient for their litigation colleagues to defend the litigation since the corporate lawyers know the facts and can more efficiently work with the firm’s litigators.  Meanwhile, they tell the client that there is no conflict—even if their work on the company’s disclosures is at issue, they assure the company that they will all be on the same side in defending the disclosures, and if they have to be witnesses, the lawyer-as-witness rules will allow them to work around the issue.

All of these assertions are flawed.  It is always—without exception—in the interests of the defendants to take a day to interview several defense firms of different types and perspectives.  And it is never—without exception—in the interests of the defendants to simply hand the case off to the litigators of the company’s corporate firm.  Even if the defendants hire the company’s corporate firm at the end of the interview process, they will have gained highly valuable strategic insights from multiple perspectives; cost concessions that only a competitive interview process will yield; better relationships with their insurers, who will be more comfortable with more thoughtful counsel selection; greater comfort with the corporate firm’s litigators, whom the defendants sometimes have never even met; and better service from the corporate firm.

Problems with Using Corporate Counsel

A Section 10(b) claim involves litigation of whether the defendants:  (1) made a false statement, or failed to disclose a fact that made what they said misleading in context; and (2) made any such false or misleading statements with intent to defraud (i.e. scienter).

Corporate counsel is very often an important fact witness for the defendants on both of these issues.  For example, in a great many cases, corporate counsel has:

  • Drafted the disclosures that plaintiffs challenge, so that the answer to the question “why did you say that?” is “our lawyers wrote it for us.”
  • Advised that omitted information wasn’t required to be disclosed, so that the answer to the question “why didn’t you disclose that” is “our lawyers told us we didn’t have to.”
  • Reviewed disclosures without questioning anything, or not questioning the challenged portion.
  • Drafted the risk factors that are the potential basis of the protection of the Reform Act’s Safe Harbor for forward-looking statements.
  • Not revised the risk factors that are the potential basis of Safe Harbor protection.
  • Advised on the ability of directors and officers to enter into 10b5-1 plans and when to do so, and on the ability of directors and officers to sell stock at certain times, given the presence or absence of material nonpublic information.
  • Advised on individual stock purchases.

The fact that the lawyer has given such advice, or not given such advice, can win the case for the defendants.  For example, for any case turning on a statement of opinion, the lawyer’s advice that the opinion had a reasonable basis virtually guarantees that the defendants won’t be liable.  Likewise, a lawyer’s drafting, revising, or advising on disclosures virtually guarantees that the defendants didn’t make the misrepresentation with scienter, and a lawyer’s advice on the timing of entering into 10b5-1 plans or selling stock makes the sales benign for scienter purposes.

To the defendants, it doesn’t matter if the lawyer was right or wrong.  As long as the advice wasn’t so obviously wrong that the client could not have followed it in good faith, the lawyer’s advice protects the defendants.  But to the lawyer, it matters a great deal for purposes of professional reputation and liability.  Deepening the conflict is the specter of the law firm defending its advice on the basis that the client didn’t tell them everything.  The interests of the lawyer and defendant client thus can diverge significantly.

That this information may be privileged doesn’t change this analysis.  Of course, the privilege belongs to the client, who can decide whether to use the information in his or her defense, or not.  But with corporate counsel’s litigation colleagues guiding the development of the facts, privileged information is rarely analyzed, much less discussed with the client.  The reality is that most privileged information isn’t truly sensitive to the client, but instead reflects a client seeking advice—and seeking the liability protection the lawyer’s advice provides.  But from the lawyer’s perspective, there can be much to protect.  Privileged communications may reflect poor legal advice, and internal files may contain candid discussions about the client and the client’s issues that would result in embarrassment to the firm, and possible termination, if produced.

Perhaps even more importantly, regular corporate counsel’s litigation colleagues may often fail to assess the case objectively, in part because it implicates the work of their corporate colleagues, and in part because of a desire not to ask hard questions that could strain the law firm’s relationship with the client.  Sometimes the problem arises from a deliberate attempt by the lawyers to protect a particular person who may have made an error leading to the litigation, such as the General Counsel (often is a former colleague), the CFO, or the CEO—all of whom are important to the client relationship.  Sometimes, though, the failure to thoughtfully analyze a case is due to a more generalized alliance with the people with whom the law firm works regularly.  It’s hard for a lawyer to scrutinize someone who will be in the firm’s luxury box at the baseball game that night, much less report a serious problem with him or her to the board.

Yet the defendants, including the board of the corporate client, need candid advice about the litigation to protect their interests.  For example, some problematic cases should be settled early, before the insurance limits are significantly eroded by defense costs and documents are produced that that will make the case even more difficult, and could even spawn other litigation or government investigations.  Defendants and corporate boards need to know this.

Corporate firms might counter that their litigation colleagues will give sound and independent advice, because they are a separate department and will face no economic or other pressure from the corporate department.  But that undermines one of the main reasons corporate lawyers urge that their litigation colleagues be hired: that it is more efficient to use the firm’s litigators since they work closely with the corporate lawyers, if not the company itself.  The corporate firm can’t have it both ways: either the litigators are close to the corporate lawyers and the company, and suffer from the problems outlined above, or they are independent, and their involvement yields little or no benefit in efficiency.  Indeed, it is most likely that the corporate firm’s litigators will be hindered by conflict, while nevertheless failing to create greater efficiency.  Just because lawyers are in a same firm doesn’t mean that they can read each other’s minds.  They still have to talk to one another, just as litigators from an outside firm would have to do.

So Why is Corporate Counsel Used So Often?

I doubt many directors or officers would disagree with the analysis above.  So why do so many companies turn to their corporate counsel without conducting an audition process?  Several practical factors impede the proper analysis of counsel selection in the initial days of a securities class action.

The single most important factor is probably that the corporate firm is first on the scene. Many companies reflexively hire their corporate firm immediately after the initial complaint is filed, or even after the stock drop, before a complaint is even filed.  By the time the defendants start to hear from other securities defense practices, they often have retained counsel.  And then it’s very difficult from a personal and practical perspective to walk the decision back.

This decision, moreover, is often made by the legal department, sometimes in consultation with the CEO and CFO.  The board is often not involved.  Instead, the board is merely presented with the decision, which can seem natural because the firm hired is familiar to them.  The directors often aren’t personally named in the initial complaint, so they might not pay as much attention as they would if they understood if they were likely to become defendants later – either in the main securities action, especially if the case involves a potential Section 11 claim, or in a tag-along shareholder derivative action.

Initial complaints can also mislead the company as to the real issues at stake.  Regular corporate counsel and the defendants may review the first complaint and incorrectly conclude that the allegations don’t implicate the lawyer’s work.  But these initial complaints are merely placeholders, because the Reform Act specifies that the lead plaintiff appointed by the court can later file an amended complaint.  Initial filers have little incentive to invest the time or effort into making detailed allegations in the initial complaint, because they may be beaten out for the lead plaintiff role.  The lead plaintiff’s amended complaint thus typically greatly expands the case to include new alleged false and misleading statements, more specific reasons why the challenged statements were false or misleading, and more detailed scienter allegations, including stock-sale and confidential-witness allegations that most initial complaints lack.  If a conflict becomes apparent at that point, however, it can be very difficult and even prejudicial to the defendants for corporate counsel to bow out.

Regular corporate counsel will often advise their clients that there is no issue with them defending the litigation, or even that doing so makes sense because they advised on the underlying disclosures.  But even if the corporate firm is trying to be candid and look out for its client’s interests, it may have blind spots in seeing its potential conflicts—especially when the corporate lawyers are facing pressure from their firm management to “hold the client.”

The pressures that lead a company to hire its corporate firm to defend the securities litigation are very real, and sometimes this decision is ultimately fine.  But I strongly believe that it is never in a client’s interest to take its corporate counsel’s advice on these issues without obtaining analysis from other securities practices as part of a competitive interview process.

The Benefits of a Competitive Process

In addition to obtaining important perspectives about potential problems with corporate counsel’s defense of the securities class action, an interview process involves myriad benefits – including tens of thousands of dollars of free legal advice.  The only cost to the company is a few hours to select the 3-5 firms that it wants to interview, and a day spent hearing presentations from those firms and discussing their analysis and approach with them.

An interview process gives defendants the opportunity to hear from several experienced securities litigators, who will offer a range of analyses and strategies on how best to defend the case.  It also allows defendants to evaluate professional credentials and personal compatibility, which are both important criteria.  It is difficult, if not impossible, for a company to evaluate how their corporate counsel’s litigators stack up against other litigators in this specialized and national practice area, without first hearing from some other firms.  Sometimes, a company will not even meet its corporate firm’s securities litigators in person before engaging them, which obviously makes it impossible for them to make judgments about personal compatibility and trust.

An interview process, if properly structured, is highly substantive.  The firms that fare best in a new-case interview typically prepare thorough discussions of the issues, and come prepared to analyze the case in great detail.  And the best ones look beyond the issues in the initial complaint to the issues that might emerge in the amended complaint, analyzing the full range of the company’s disclosures, to forecast future disclosure and scienter allegations, and evaluating the defenses that will remain even after allegations are added.

An interview process also helps the company to achieve a better deal on billing rates, staffing, and alternative fee arrangements.  Without an interview process, a law firm is much more likely to charge rack rates and do its work in the way it sees fit—which defendants are rarely in a position to challenge without having done some comparison shopping.  Even though securities class action defense costs are covered by D&O insurance, price matters in defense-counsel selection.  It is a mistake to treat D&O insurance proceeds as “free money.”  Without appropriate cost control, defendants run the risk of not having enough insurance proceeds to defend and resolve the case.  Appropriate cost control can help the litigation from resulting in a difficult or expensive D&O insurance renewal, and can allow the company to save money if the fees are less than the deductible.

An interview process also helps get the defendants off to a better start with its D&O insurers.  In addition to appreciating the cost control that an interview process yields, insurers also appreciate the defendants making a thoughtful decision on defense counsel, including vetting the potential problems with use of the company’s corporate firm.  D&O insurers and brokers are “repeat players” in securities litigation, and know the qualifications of defense counsel better than anyone else—a seasoned D&O insurance claims professional has overseen hundreds of securities class actions.  Asking insurers and brokers to help identify defense counsel to interview may therefore not only yield helpful suggestions, but may also make it easier to develop a relationship of strategic trust with the insurers—which will make it easier to obtain consent to settle early if appropriate, and if not, to defend the case through summary judgment or to trial.

Perhaps most importantly, an interview process results in a closer relationship between the defendants and their lawyers, whoever they end up being.  Most securities class action defendants are troubled by being sued, and need lawyers that they can trust to walk them through the process.  An interview process is the best way to find the lawyers who have the right combination of relevant characteristics—including skills, strategy, and bedside manner—that will best fit the needs of the defendants.

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

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

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

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

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

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

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

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

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

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

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

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

On March 24, 2015, the U.S. Supreme Court issued its opinion in Omnicare, Inc. v. Laborers Dist. Council Const. Industry Pension Fund, 135 S. Ct. 1318 (2015).  My partner Claire Davis and I are publishing a forthcoming one-year anniversary article on Omnicare.  In addition to discussing the lower courts’ application of the decision, we take apart the fallacy that Omnicare is “plaintiff-friendly” – a proposition that led to my June 2015 rant “Hey There Fellow Securities Defense Lawyers: Omnicare is GOOD for Us!”  We will post a link to the anniversary article when it’s out.  For now, I want to further explain why I care so much about Omnicare.

As a reminder, Omnicare holds 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.  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.

In my tax law class in law school, my professor said that he could teach all of tax law through the U.S. Supreme Court case Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929).  Similarly, Omnicare provides the foundation for multiple legal and strategic elements of a strong defense of a securities class action.  It is truly a case study in how to defend a securities case.  Below, I address three of those components. 

1. Omnicare’s directive that courts consider context better allows defense lawyers to show the defendants said nothing false.

Our North Star in defending any securities class action is to explain that the defendants said nothing false.  At the core of every securities class action is a person who is alleged to have lied.  Clients generally feel strongly that they did their best and told the truth.  The reasons for their belief are always the right place to start constructing the defense, and usually remain the gist of the defense after categorizing the facts under the relevant legal standards.

Sticking up for the truth of what our clients said also gives them a voice during the long initial stages of the motion-to-dismiss process.  Although the Reform Act’s prolonged introductory stages were designed to help defendants, they don’t allow defendants to tell their side of the story – which is frustrating and often harmful to the reputations of real people.

But the Reform Act, and now Omnicare’s context standard, leave securities defense lawyers with broad latitude to support the truth of what their clients said, and to attack allegations of falsity, as to both statements of fact and statements of opinion.  A proper falsity analysis always starts by examining each challenged statement individually, and matching it up with the facts that plaintiffs allege illustrate its falsity.  From there, the truth of what the defendants said can be supported in numerous ways that are still within the proper scope of the motion-to-dismiss standard:  showing that the facts alleged do not actually undermine the challenged statements, because of mismatch of timing or substance; pointing out gaps, inconsistencies, and contradictions in plaintiffs’ allegations; demonstrating that the facts that plaintiffs assert are insufficiently detailed under the Reform Act; attacking allegations that plaintiffs claim to be facts, but which are really opinions, speculation, and unsupported conclusions; putting defendants’ allegedly false or misleading statements in their full context to show that they were not misleading; and pointing to judicially noticeable facts that contradict plaintiffs’ theory.

A good motion to dismiss has always analyzed a challenged statement (of fact or opinion) in its broader factual context to explain why it’s not false or misleading.  But many defense lawyers unfortunately leave out the broader context, and courts have sometimes taken a narrower view.  Now, this type of superior, full-context analysis is clearly required by Omnicare.  And combined with the Supreme Court’s directive in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), that courts consider scienter inferences based not only on the complaint’s allegations, but also on documents on which the complaint relies or that are subject to judicial notice, courts clearly must now consider the full array of probative facts in deciding both whether a statement was false or misleading and, if so, whether it was made with scienter.  Plaintiffs can’t cherry-pick what the court considers anymore. 

2. Omnicares subjective falsity holding allows us to stick up for the truth of all of our clients’ statements.  

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, earnings forecasts, and progress toward corporate goals.  Indeed, I would guess that more than 75% of all securities class actions involve one or more statements of opinion as a core allegation.

Yet for decades before Omnicare, it was difficult to defend the truth of an opinion.  The law was hopelessly muddled.  For a full discussion, I invite you to review pages 13-19 of our Omnicare amicus brief on behalf of Washington Legal Foundation.  To argue the truth of statements of opinion, we would provide the best possible statement of the legal standard under the law of the circuit we were in, try to convince the court that the real standard should be the standard that is now the Omnicare standard, and then argue that the opinion was true and not misleading under the standard we advanced.  Now, under Omnicare, we can stick up for the truth of all of our clients’ statements, both fact and opinion, without having to first engage in a mini-argument of the law governing opinions.

3. Omnicare allows judges wider latitude to rule in defendants’ favor.

Judges want to figure out if the defendants tried to tell the truth.  The law provides wide latitude for judges to dismiss claims, and we want to give them every reason to do so.  If the judge accepts that the defendants did their best to be fair and candid in their public statements, he or she will be more inclined to accept other arguments.

So the argument against falsity, utilizing the tools Omnicare has provided, is the right place to start, even if there are stronger alternative arguments.  For example, in an earnings forecast case, the best approach is to first defend the truth of the forecast – a statement of opinion – and then use the Reform Act’s Safe Harbor as a fallback argument.  Likewise, a strong argument against scienter is best set up by a strong argument against falsity.  The element of scienter requires plaintiffs to demonstrate that the defendants said something knowingly or recklessly false – in order to do this, plaintiffs must tie their scienter allegations to each particular challenged statement.  A scienter argument that doesn’t build on a strong falsity argument is a strategic mistake.

I hope that this short guide to how to use the powerful tool the Court gave us in Omnicare is helpful.  If we in the defense bar use the decision correctly, companies and their directors and officers will have greater freedom to speak without undue fear of liability, and we will win more cases in which their opinions are challenged.

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

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

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

Grading the Reform Act’s Key Provisions

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

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

Following are my grades for each of these provisions:

Falsity Pleading Standard – Grade: D

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

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

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

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

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

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

Scienter Pleading Standard – Grade: C

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

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

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

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

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

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

Safe Harbor – Grade: D

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

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

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

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

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

So, I give the Safe Harbor a D.

Lead Plaintiff Procedures – Grade C

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

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

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

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

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

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

Discovery Stay – Grade: A

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

Conclusion:  The Reform Act’s Overall Grade

Grade: C+

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

 

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

When a public company purchases a significant good or service, it typically seeks competitive proposals.  From coffee machines to architects, companies invite multiple vendors to bid, evaluate their proposals, and choose one based on a combination of quality and cost.  Yet companies named in a securities class action frequently fail to engage in a competitive interview process for their defense counsel, and instead simply retain litigation lawyers at the firm they use for their corporate work.

To be sure, it is difficult for company management to tell their outside corporate lawyers that they are going to consider hiring another firm to defend a significant litigation matter.  The corporate lawyers are trusted advisors, often former colleagues of the in-house counsel, and have usually made sacrifices for the client that make the corporate lawyers expect to be repaid through engagement to defend whatever litigation might arise.  A big litigation matter is what makes all of the miscellaneous loss-leader work worth it.  “You owe me,” is the unspoken, and sometimes spoken, message.

Corporate lawyers also make the pitch that it will be more efficient for their litigation colleagues to defend the litigation since the corporate lawyers know the facts and can more efficiently work with the firm’s litigators.  Meanwhile, they tell the client that there is no conflict – even if their work on the company’s disclosures is at issue, they assure the company that they will all be on the same side in defending the disclosures, and if they have to be witnesses, the lawyer-as-witness rules will allow them to work around the issue.

All of these assertions are flawed.  It is always – without exception – in the interests of the defendants to take a day to interview several defense firms of different types and perspectives.  And it is never – without exception – in the interests of the defendants to simply hand the case off to the litigators of the company’s corporate firm.  Even if the defendants hire the company’s corporate firm at the end of the interview process, they will have gained highly valuable strategic insights from multiple perspectives; cost concessions that only a competitive interview process will yield; better relationships with their insurers, who will be more comfortable with more thoughtful counsel selection; greater comfort with the corporate firm’s litigators, whom the defendants sometimes have never even met; and better service from the corporate firm.

Problems with Using Corporate Counsel

A Section 10(b) claim involves litigation of whether the defendants:  (1) made a false statement, or failed to disclose a fact that made what they said misleading in context; and (2) made any such false or misleading statements with intent to defraud (i.e. scienter).

Corporate counsel is very often an important fact witness for the defendants on both of these issues.  For example, in a great many cases, corporate counsel has:

  • Drafted the disclosures that plaintiffs challenge, so that the answer to the question “why did you say that?” is “our lawyers wrote it for us.”
  • Advised that omitted information wasn’t required to be disclosed, so that the answer to the question “why didn’t you disclose that” is “our lawyers told us we didn’t have to.”
  • Reviewed disclosures without questioning anything, or not questioning the challenged portion.
  • Drafted the risk factors that are the potential basis of the protection of the Reform Act’s Safe Harbor for forward-looking statements.
  • Not revised the risk factors that are the potential basis of Safe Harbor protection.
  • Advised on the ability of directors and officers to enter into 10b5-1 plans and when to do so, and on the ability of directors and officers to sell stock at certain times, given the presence or absence of material nonpublic information.
  • Advised on individual stock purchases.

The fact that the lawyer has given such advice, or not given such advice, can win the case for the defendants.  For example, for any case turning on a statement of opinion, the lawyer’s advice that the opinion had a reasonable basis virtually guarantees that the defendants won’t be liable.  Likewise, a lawyer’s drafting, revising, or advising on disclosures virtually guarantees that the defendants didn’t make the misrepresentation with scienter, and a lawyer’s advice on the timing of entering into 10b5-1 plans or selling stock makes the sales benign for scienter purposes.

To the defendants, it doesn’t matter if the lawyer was right or wrong.  As long as the advice wasn’t so obviously wrong that the client could not have followed it in good faith, the lawyer’s advice protects the defendants.  But to the lawyer, it matters a great deal for purposes of professional reputation and liability.  Deepening the conflict is the specter of the law firm defending its advice on the basis that the client didn’t tell them everything.  The interests of the lawyer and defendant client thus can diverge significantly.

That this information may be privileged doesn’t change this analysis.  Of course, the privilege belongs to the client, who can decide whether to use the information in his or her defense, or not.  But with corporate counsel’s litigation colleagues guiding the development of the facts, privileged information is rarely analyzed, much less discussed with the client.  The reality is that most privileged information isn’t truly sensitive to the client, but instead reflects a client seeking advice – and seeking the liability protection the lawyer’s advice provides.  But from the lawyer’s perspective, there can be much to protect.  Privileged communications may reflect poor legal advice, and internal files may contain candid discussions about the client and the client’s issues that would result in embarrassment to the firm, and possible termination, if produced.

Perhaps even more importantly, regular corporate counsel’s litigation colleagues may often fail to assess the case objectively, in part because it implicates the work of their corporate colleagues, and in part because of a desire not to ask hard questions that could strain the law firm’s relationship with the client.  Sometimes the problem arises from a deliberate attempt by the lawyers to protect a particular person who may have made an error leading to the litigation, such as the General Counsel (often is a former colleague), the CFO, or the CEO – all of whom are important to the client relationship.  Sometimes, though, the failure to thoughtfully analyze a case is due to a more generalized alliance with the people with whom the law firm works regularly.  It’s hard for a lawyer to scrutinize someone who will be in the firm’s luxury box at the baseball game that night, much less report a serious problem with him or her to the board.

Yet the defendants, including the board of the corporate client, need candid advice about the litigation to protect their interests.  For example, some problematic cases should be settled early, before the insurance limits are significantly eroded by defense costs and documents are produced that that will make the case even more difficult, and could even spawn other litigation or government investigations.  Defendants and corporate boards need to know this.

Corporate firms might counter that their litigation colleagues will give sound and independent advice, because they are a separate department and will face no economic or other pressure from the corporate department.  But that undermines one of the main reasons corporate lawyers urge that their litigation colleagues be hired: that it is more efficient to use the firm’s litigators since they work closely with the corporate lawyers, if not the company itself.  The corporate firm can’t have it both ways: either the litigators are close to the corporate lawyers and the company, and suffer from the problems outlined above, or they are independent, and their involvement yields little or no benefit in efficiency.  Indeed, it is most likely that the corporate firm’s litigators will be hindered by conflict, while nevertheless failing to create greater efficiency.  Just because lawyers are in a same firm doesn’t mean that they can read each other’s minds.  They still have to talk to one another, just as litigators from an outside firm would have to do.

So Why is Corporate Counsel Used So Often?

I doubt many directors or officers would disagree with the analysis above.  So why do so many companies turn to their corporate counsel without conducting an audition process?  Several practical factors impede the proper analysis of counsel selection in the initial days of a securities class action.

The single most important factor is probably that the corporate firm is first on the scene. Many companies reflexively hire their corporate firm immediately after the initial complaint is filed, or even after the stock drop, before a complaint is even filed.  By the time the defendants start to hear from other securities defense practices, they often have retained counsel.  And then it’s very difficult from a personal and practical perspective to walk the decision back.

This decision, moreover, is often made by the legal department, sometimes in consultation with the CEO and CFO.  The board is often not involved.  Instead, the board is merely presented with the decision, which can seem natural because the firm hired is familiar to them.  The directors often aren’t personally named in the initial complaint, so they might not pay as much attention as they would if they understood if they were likely to become defendants later – either in the main securities action, especially if the case involves a potential Section 11 claim, or in a tag-along shareholder derivative action.

Initial complaints can also mislead the company as to the real issues at stake.  Regular corporate counsel and the defendants may review the first complaint and incorrectly conclude that the allegations don’t implicate the lawyer’s work.  But these initial complaints are merely placeholders, because the Reform Act specifies that the lead plaintiff appointed by the court can later file an amended complaint.  Initial filers have little incentive to invest the time or effort into making detailed allegations in the initial complaint, because they may be beaten out for the lead plaintiff role.  The lead plaintiff’s amended complaint thus typically greatly expands the case to include new alleged false and misleading statements, more specific reasons why the challenged statements were false or misleading, and more detailed scienter allegations, including stock-sale and confidential-witness allegations that most initial complaints lack.  If a conflict becomes apparent at that point, however, it can be very difficult and even prejudicial to the defendants for corporate counsel to bow out.

Regular corporate counsel will often advise their clients that there is no issue with them defending the litigation, or even that doing so makes sense because they advised on the underlying disclosures.  But even if the corporate firm is trying to be candid and look out for its client’s interests, it may have blind spots in seeing its potential conflicts – especially when the corporate lawyers are facing pressure from their firm management to “hold the client.”

The pressures that lead a company to hire its corporate firm to defend the securities litigation are very real, and sometimes this decision is ultimately fine.  But I strongly believe that it is never in a client’s interest to take its corporate counsel’s advice on these issues without obtaining analysis from other securities practices as part of a competitive interview process.

The Benefits of a Competitive Process

In addition to obtaining important perspectives about potential problems with corporate counsel’s defense of the securities class action, an interview process involves myriad benefits – including tens of thousands of dollars of free legal advice.  The only cost to the company is a few hours to select the 3-5 firms that it wants to interview, and a day spent hearing presentations from those firms and discussing their analysis and approach with them.

An interview process gives defendants the opportunity to hear from several experienced securities litigators, who will offer a range of analyses and strategies on how best to defend the case.  It also allows defendants to evaluate professional credentials and personal compatibility, which are both important criteria.  It is difficult, if not impossible, for a company to evaluate how their corporate counsel’s litigators stack up against other litigators in this specialized and national practice area, without first hearing from some other firms.  Sometimes, a company will not even meet its corporate firm’s securities litigators in person before engaging them, which obviously makes it impossible for them to make judgments about personal compatibility and trust.

An interview process, if properly structured, is highly substantive.  The firms that fare best in a new-case interview typically prepare thorough discussions of the issues, and come prepared to analyze the case in great detail.  And the best ones look beyond the issues in the initial complaint to the issues that might emerge in the amended complaint, analyzing the full range of the company’s disclosures, to forecast future disclosure and scienter allegations, and evaluating the defenses that will remain even after allegations are added.

An interview process also helps the company to achieve a better deal on billing rates, staffing, and alternative fee arrangements.  Without an interview process, a law firm is much more likely to charge rack rates and do its work in the way it sees fit – which defendants are rarely in a position to challenge without having done some comparison shopping.  Even though securities class action defense costs are covered by D&O insurance, price matters in defense-counsel selection.  It is a mistake to treat D&O insurance proceeds as “free money.”  Without appropriate cost control, defendants run the risk of not having enough insurance proceeds to defend and resolve the case.  Appropriate cost control can help the litigation from resulting in a difficult or expensive D&O insurance renewal, and can allow the company to save money if the fees are less than the deductible.

An interview process also helps get the defendants off to a better start with its D&O insurers.  In addition to appreciating the cost control that an interview process yields, insurers also appreciate the defendants making a thoughtful decision on defense counsel, including vetting the potential problems with use of the company’s corporate firm.  D&O insurers and brokers are “repeat players” in securities litigation, and know the qualifications of defense counsel better than anyone else – a seasoned D&O insurance claims professional has overseen hundreds of securities class actions.  Asking insurers and brokers to help identify defense counsel to interview may therefore not only yield helpful suggestions, but may also make it easier to develop a relationship of strategic trust with the insurers – which will make it easier to obtain consent to settle early if appropriate, and if not, to defend the case through summary judgment or to trial.

Perhaps most importantly, an interview process results in a closer relationship between the defendants and their lawyers, whoever they end up being.  Most securities class action defendants are troubled by being sued, and need lawyers that they can trust to walk them through the process.  An interview process is the best way to find the lawyers who have the right combination of relevant characteristics – including skills, strategy, and bedside manner – that will best fit the needs of the defendants.

There are several bits of D&O Discourse news to share:

1.  I hope that you can attend conferences at which I’m speaking this fall:

  • I am co-chairing ACI’s D&O Liability Forum in New York City on September 17-18, and moderating a panel discussing significant securities litigation developments.  Readers of D&O Discourse can receive a discount off the current price.  Please email me: greened@lanepowell.com.
  • I am co-chairing and speaking on a panel discussing board oversight of cybersecurity at a meeting of the National Association of Corporate Directors, Northwest Chapter, in Seattle on October 20, 2015.

2.  The ABA is accepting nominations for the list of the Top 100 Law Blogs.  If you are so inclined, I’d be grateful for your nomination of D&O Discourse. Nominations are due by the end of the day on August 16.  Here is the link to the nomination page.  Thank you.

3.  We continue to try to make D&O Discourse as useful as possible.  We now have three features:

  • The D&O Discourse blog itself:  In the blog, we provide opinion about key issues in the law and practice of securities and corporate governance litigation and SEC enforcement.  We write an opinion-based piece roughly monthly.
  • Twitter:  Because the D&O Discourse blog doesn’t attempt to chronicle current events, we started a Twitter feed to identify current developments that we think would be most important to our readers.  You can follow us by reading our Twitter feed on the left-hand side of the D&O Discourse blog, or on Twitter, @DandODiscourse.
  • LinkedIn:  We recently set up a special LinkedIn page, where we publish thoughts that are too long for Twitter but too short for a blog post.  Here is an example:

“In writing my 2014 year-in-review piece, it occurred to me that the judicial environment for securities and corporate governance litigation seems about as neutral as it has been in a long time. We’ve seen streaks of decisions that feel pro-plaintiff or pro-defendant, driven in part by judicial skepticism caused by the waves of corporate scandals since Enron and WorldCom. But over the past year or so, the decisions feel pretty even. The 2nd Circuit / 9th Circuit split over whether omission of matters covered by Item 303 of S-K can be actionable epitomizes the current judicial environment.”

Here is a link to our LinkedIn page.  Please click “Follow” to receive updates in your LinkedIn feed.

4.  In the upcoming issue of the PLUS Journal, my partner Claire Davis and I are publishing an article about the importance of the U.S. Supreme Court’s decision in Omnicare, based on one of our D&O Discourse blog posts.  As our readers know, Claire and I wrote an amicus brief that shaped the Supreme Court’s Omnicare opinion.

We hope you enjoy the rest of your summer.