In a matter of first impression in the Ninth Circuit, the court applied the Supreme Court’s Omnicare standard for pleading the falsity of a statement of opinion in City of Dearborn Heights Act 345 Police & Fire Retirement System v. Align Technology, Inc., — F.3d —, 2017 WL 1753276 (9th Cir. May 5, 2017). The Ninth Circuit decision builds on the momentum for the defense bar following the 2016 Second Circuit opinion in Tongue v. Sanofi, 816 F.3d 199 (2d Cir. 2016), correctly applies the rationale of Omnicare to Section 10(b) cases, and applies the Omnicare falsity analysis to an important category of statements of opinion: accounting reserves.
I am grateful for the enthusiastic feedback I’ve received on my three-part blog post “Who is Winning the Securities Class Action War—Plaintiffs or Defendants?” I especially appreciate the time Kevin LaCroix took to write a post addressing my post in his leading blog, The D&O Diary.
With the benefit of 25 years’ experience defending directors and officers in securities class actions, shareholder derivative actions, and SEC investigations, I’ve had a front-row seat to the dynamics I described in my three-part post. Directors and officers expect that their D&O insurance will protect them when they are sued. They expect a high-quality defense at a cost that allows them to defend the litigation on the merits and to settle when it’s strategically smart, at a price that doesn’t bespeak guilt.
But I’m deeply concerned that directors and officers are getting far less than they expect—and it’s a double-whammy: while the cost of securities litigation defense has dramatically increased, the quality of this expensive defense has dramatically decreased. To be sure, a handful of defense firms provide a quality defense at a price that’s appropriate for the size of the litigation, especially in the so-called “mega cases.” However, in smaller cases, and overall, directors and officers face far greater reputational and financial risk than they appreciate. They expect better—and deserve better—from their lawyers and D&O insurance.
So my main message is simple: for defendants, the securities class action system is broken. The defense bar is highly splintered, comprising many dozens of firms, with multiple possible litigators within each firm. Far too many non-specialists are hired to defend cases simply because their law firm is well-known or handles the company’s corporate work. Although these lawyers know or can learn the basics of the law, they can never possess the things that set specialists apart, such as the years of investment necessary to build the trust of plaintiffs’ lawyers, mediators, and D&O insurers. The quality of defense, overall, is far lower than it should be. And, to add insult to injury, defendants typically pay a fortune for their defense, whether led by a specialist or generalist.
Securities class actions are manageable if they are defended correctly by the right lawyers for the particular case. But securities class action defendants can’t be reasonably expected to select the right lawyers for their unique case. The vast majority of director and officer defendants have never been through a securities class action before, and no one spends time researching whom they’d hire if they were to face a securities case someday.
Defendants are put in an awful position when a case is filed:
- From one side, dozens of defense firms descend on them and bombard them with bold boasts.
- From the other side, the company’s regular outside firm assures them that this is just a straightforward legal problem that their litigation department can easily handle just fine—and never mind that the law firm may have provided the legal advice on the very disclosures challenged in the litigation.
The result is near-anarchy—as I explained in Part II.
In contrast, as I explained in Part I, the plaintiffs’ bar comprises a relatively small number of full-time nationwide securities class action specialists. Within this small group, there is nevertheless a diversity of types of firms that allows them to efficiently cover all types of cases, large and small. The tailoring of plaintiffs’ firms to types of cases happens through self-selection inherent in firms picking particular cases to file, and through the lead plaintiff competition. The contingent-fee nature of their cases creates further efficiency.
Defendants can’t win the securities class action war unless the defense bar can match the plaintiffs’ bar’s effectiveness and efficiency. But to create the right defense bar, the defendants need help. The best sources of help—indeed the only practical sources—are D&O insurers, as I explained in Part III.
Defendants are entitled to a defense that allows them to get through securities litigation safely and comfortably, and without any real financial risk. Indeed, they already expect that their D&O insurers will take care of them. Giving insurers a greater role in defending securities class actions will allow insurers to do exactly that.
I feel strongly about these issues and am encouraged by the agreement and enthusiasm I’ve heard from readers. But I’ve heard a bit of skepticism too, and would like to briefly address it.
How can defendants be losing the war given the high dismissal rate and various legislative and Supreme Court successes?
The big picture. Before evaluating individual battles, it’s useful to look at the big picture—and it’s bleak. Securities litigation defense, as a practical matter, doesn’t even involve defending securities litigation anymore. Settlement values as a percentage of damages are increasing. Defense costs are skyrocketing. Cases can’t be defended through summary judgment without risking that there won’t be enough insurance limits to cover both defense costs and a settlement. In my experience, most of the defense bar doesn’t actually defend cases past the motion to dismiss stage anymore. If defendants lose the motion to dismiss and defense counsel aren’t prepared to press a defense through summary judgment and toward trial (because of stage fright, fear of an economic catastrophe, or both), the only rational economic approach is to settle the case—and the plaintiffs’ bar is keenly aware of that dynamic.
Indeed, the words “litigation” and “defense” in the phrase “securities litigation defense” are misnomers. It’s hard to say that defendants are winning the war when they don’t actually fight.
Dismissal rate. As I wrote in Part II, the relatively high dismissal rate masks the defense side’s dysfunction. The right question to ask is how much higher the dismissal rate would be if securities class action defense bar comprised specialists, not generalists. While there can be no accurate answer to this hypothetical, I firmly believe defendants would win more than they do now. And I would guess it would be a lot more—maybe even 50% more.
U.S. Supreme Court. Although defendants have technically prevailed in most of the U.S. Supreme Court securities cases over the last decade, most of the decisions haven’t been very helpful to defendants in the big picture, outside of clarifying the standards for pleading falsity (Omnicare) and scienter (Tellabs). For example, Janus and Dura basically just restated the law; Amgen and Halliburton I were virtually meaningless; Halliburton II may well have had the lowest impact-to-fanfare ratio of any Supreme Court decision, ever; and Morrison backfired.
Legislative. Although it has had some unintended consequences, the Private Securities Litigation Reform Act of 1995 was indeed a victory for the defense bar (as was the Securities Litigation Uniform Standards Act of 1998).
The Reform Act illustrates the benefits of a specialized defense bar. With support from Silicon Valley securities litigators—the primary firms for oft-sued technology companies—defendants literally changed the rules of engagement. Indeed, my ideal securities class action defense bar would be very similar to the experience and economics of the Silicon Valley defense bar as it existed in 1995—as I discussed in Part II.
Isn’t the plaintiffs’ bar splintered too, given the diversity in types of firms and target defendants?
Over the past several years, I have written extensively about the evolution of the securities class action plaintiffs’ bar—which I summarized in Part I. The plaintiffs’ bar is indeed diverse, and the leaders of the dozen or so firms that bring cases certainly aren’t best friends.
But my point isn’t that the plaintiffs’ firms are homogeneous or friendly. It’s that the plaintiffs’ bar is specialized and small enough that they can be cohesive. They know who’s who, and they know who’s doing what. And they have the capacity to appreciate what is, and isn’t, in the interests of the plaintiffs’ bar as a whole.
That type of cohesion is non-existent in the defense bar. It is simply too splintered—as I explained in Part II. Despite having defended securities litigation for 25 years and full time for the past 20 years, I don’t even recognize the names of many of the defense lawyers listed on the dockets.
How can insurers create better cohesion in the defense bar, given the highly competitive business of D&O insurance?
To be sure, the D&O insurance community is large and competitive, with more than 50 markets writing primary and excess policies. Despite these issues the D&O insurance community is structurally unified.
- The community of D&O insurers comprises a relatively small, strong, and specialized group of companies and people. There is a small number of repeat-player primary insurers. At the less frequent primary and excess insurers, the underwriting and claims leadership is knowledgeable and strong—some of the most prominent professionals work there. These insurers are represented by a small and highly specialized bar of outside lawyers, who drive thought leadership across all carriers. The leading D&O insurance brokers also drive thought leadership. Professional organizations such as Advisen and PLUS further bring people and ideas together. This community of shared interests creates a common analytic framework, lexicon, and culture.
- D&O insurers’ strongest structural bond is their economic incentive to win both individual securities class action battles and the securities class action war. Indeed, they are the only group that cares both about individual cases and the big picture. Defendants themselves only care about winning the individual cases against them. D&O insurers share this goal, but they also care about all of the other cases as well—not just the ones they insure, but the other cases too, because they shape the legal and economic landscape and thus the risks they insure.
D&O insurers have substantial securities litigation expertise. The leading D&O insurance professionals have multiples more experience evaluating defense and resolution strategies than even the most prominent securities defense lawyers, and can provide significant strategic insights. Indeed, if I were sued in a securities class action and could assemble a dream defense team, I would hire a prominent D&O insurance lawyer on the team as a strategic quarterback—on securities class action issues.
Defendants’ success or failure in the securities class action war has significant implications for D&O insurance professionals. The lack of actual litigation defense in securities class actions will eliminate the need for any real claims management. That, in turn, will result in the death of any meaningful role by D&O insurers in the defense of securities litigation. The role of D&O insurance claims professionals will be merely to determine when defense costs have exhausted the policy limits. What a tragedy that would be not just for them, but also for defendants and specialized defense counsel who value their input, insight, and collegiality.
Do public companies really want their D&O insurers involved in the defense of claims?
If I had one wish concerning D&O insurance, it would be to dispel the myth that public companies distrust D&O insurers and don’t want them to stick their noses into the defense of a claim.
This myth is perpetuated by frequently contentious claims experiences, in which insureds’ representatives argue for coverage of defense costs and settlements that insurers are reluctant to pay. But these disagreements are just a symptom of a problem—they don’t identify the underlying problem. In my experience, the problem is most often defense lawyers, who set up their clients to have a strained relationship with their insurers, so that the lawyers have maximum freedom to do whatever tasks they want, at whatever cost they want to charge. Most public companies have never been through a securities class action before and have no idea what tasks are required and what they should cost. But D&O insurers do. And that’s the root of the problem.
So, defense lawyers condition their clients to believe D&O insurers are an adversary. But pre-claim, directors and officers don’t think that way. As I look back on the clients I’ve defended or advised on D&O insurance procurement, I can’t think of any who believed the insurer was an adversary. Just the opposite is true: they’ve often expressly regarded the D&O insurer as a teammate in the defense of the case.
This has been true even in my most difficult securities fraud cases. I’ve never had an insurer even seriously threaten to deny coverage on the basis of the fraud exclusion. An actual fraud-exclusion coverage denial is almost unthinkable under current policies, which exclude coverage only for finally adjudicated fraud in the case at hand. Nearly all cases settle, so the fraud exclusion isn’t even in play. And even a finally adjudicated securities fraud judgment would not often trigger the fraud exclusion, since the scienter standard under Section 10(b) is “recklessness,” not intentional fraud. For these reasons, any concern about the need for “regular” Cumis counsel in duty-to-defend cases is misplaced; far from regular, it would be rare.
Would public companies buy a policy giving D&O insurers greater control of the defense?
I strongly believe that there would be high demand for D&O insurance that placed greater control of the defense of claims in the hands of insurers—including an optional duty to defend feature.
In exchange for a reduction in premium or the self-insured retention, such a policy would be highly attractive to public companies, especially smaller companies, for which even five- or six-figure savings can mean the difference between profit and loss, and success and failure.
I appreciate that the idea of greater insurer control of the defense of public company D&O claims is novel. But I strongly believe it’s time for D&O insurers and brokers to re-think the structure of defense of D&O claims.
Currently, the line between indemnity and duty-to-defend is drawn at public versus private companies. A much more commercially logical line would be smaller public companies versus larger public companies. Just as many private companies would prefer the flexibility of indemnity insurance, many smaller public companies would prefer the certainty and efficiency of a duty-to-defend option.
Smaller public companies—say those with market capitalization of $1 billion or less—often lack larger-company infrastructure. They need and would welcome more insurer control and less financial risk. And with the increasing number of claims by smaller plaintiffs’ firms against smaller public companies now a permanent part of the securities class action landscape, now is a good time for insurers to make this type of change.
But even many larger companies would welcome more insurer control of claims, including a duty-to-defend option, in exchange for some reduction in the premium or self-insured retention. I’ve never met a CFO who didn’t want to save money on insurance. And, unfortunately for us lawyers, very few individual defendants are beholden to any particular lawyer or law firm—that type of connection typically happens at the level of in-house counsel, who unlike directors and officers, are not named as individual defendants in securities class actions.
The key for the success of a D&O policy with greater insurer control would be the quality of the defense. As the party with the biggest financial stake in the individual case and overall, D&O insurers certainly would ensure that the quality of the defense is high, and as repeat players, they know who’s who and are better situated than defendants to pick the right lawyers.
So I strongly disagree with any assertion that public companies wouldn’t buy such a product and brokers wouldn’t sell it. If the quality of the defense is high, and the price is lower through lower premiums and/or retentions, companies will buy it. And if they will buy it, brokers will sell it. It’s just basic economics.
This is the third of a three-part post that analyzes why plaintiffs are winning the securities class action war and what defendants can do about it.
At stake is a system of securities litigation that sets up one side or the other to win more cases in the long term. It has real-world consequences for directors and officers—they expect companies, D&O insurers and brokers, and the securities defense bar to fight for a system of securities litigation defense that will allow them to get through a securities case comfortably and safely.
But despite winning many battles, defendants are losing the war.
Part I of this three-part post explained that the plaintiffs’ bar is back, and better than ever. It comprises a small group of about a dozen firms with lead partners who are full-time national securities litigators. Given the size and focus, the plaintiffs’ bar is specialized and has the capacity to coordinate.
Part II explained that, in contrast, the defense bar is splintered, relatively inexperienced, and highly inefficient.
This third and final part discusses how defendants can overcome these disadvantages and close the gap between the plaintiffs’ bar and defense bar.
The Potential Paths Forward
Because the current path is leading to a strategic and economic cliff—as I’ve mapped out in Part I and Part II—we need to backtrack, examine the landscape, and pick the right path forward. What are the possible paths?
Elimination or Further Reform of Securities Class Actions
One alternative path is to try to kill securities class actions, or further undermine them. Over the years, various constituents have sought to eliminate or reform securities cases. Most recently, in Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014), the U.S. Chamber of Commerce and others supported Halliburton in trying to abolish the fraud-on-the-market presumption established in Basic Inc. v. Levinson, 485 U.S. 224 (1988)—the legal mechanism that allows securities cases to proceed as class actions. And, of course, industry groups achieved a significant legislative victory in 1995, through the Private Securities Litigation Reform Act.
Continuing to try to kill securities class actions would be an enormous error. Securities class actions are far superior for defendants than the alternatives. If securities class actions didn’t exist, the plaintiffs’ bar would adjust, not perish. In place of class actions, they would file non-class securities actions that would be vastly less manageable than class actions. For evidence of what would happen without a class action mechanism, we need look no further than the global securities class action landscape in the wake of Morrison v. National Australia Bank, 561 U.S. 247 (2010). And without securities class actions as an enforcement safety net, the SEC would doubtless increase enforcement. Companies are better off with one of a handful of plaintiffs’ lawyers as an adversary than an often-unknown and aggressive SEC enforcement lawyer. (I examined this question in depth, in my post “Be Careful What You Wish For, Part II: Would Companies Be Better Off Without the Fraud-on-the-Market Doctrine?”)
Further legislative reform could be helpful. The Reform Act mostly has helped defendants—though it has come with a steep price tag, as I mentioned in Part I. Although I could come up with some additional defendant-friendly reforms, they would mostly be about correcting problems the Reform Act has caused (see, for example, my post ”Be Careful What You Wish For, Part I: Does the Reform Act Need Reforming?”) or improving litigation procedures (see, for example, my post “5 Wishes for Securities Litigation Defense: Early Damages Analysis and Discovery”).
Most defense lawyers would probably suggest further raising the pleading standards. I don’t think that would help much. I’ve always believed that the top of the plaintiffs’ bar isn’t really bothered by higher pleading burdens—at core, pleading a fraud claim involves convincing a judge that the defendants are bad-guys, and a good motion to dismiss involves convincing a judge that the defendants are good-guys. The pleading standards are just a way to convey those arguments. Plaintiffs’ lawyers are still able to get past motions to dismiss in a high percentage of cases and certainly in the lion’s share of difficult cases. Even with even higher pleading standards, the plaintiffs would still file cases they think are the right ones, and I’d predict they’d defeat motions to dismiss at roughly the same rate.
Formation of Industry Groups to Oversee Securities Class Actions
Another alternative path is to form industry groups to create cohesion among groups of defendants—for example, technology companies, biotechs, retailers, etc. Many years ago, this type of securities-litigation cohesion worked for accounting firms who, as a group, were a formidable foe. They were represented by a small group of lawyers—there were just a few key lawyers. Although the accounting firms were fierce competitors in the business of auditing, they took a big-picture approach to the industry’s litigation risk. Together, they basically chased off the plaintiffs’ securities bar. Indeed, today accounting firms are typically joined as a securities class action defendant along with its audit client only in the very largest cases.
Part of accounting firms’ success, and the reason they aren’t sued much anymore, is the Supreme Court’s abolition of aiding-and-abetting liability, in Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994). But it’s more than that. Auditors make statements that can still yield primary liability—most typically, by opining that a company’s financial statements conform with GAAP and the audit was performed in accordance with GAAS. But accounting firms, with their small bar of specialized lawyers, helped to largely insulate those statements from attack under the securities laws. And when accounting firms were sued along with their audit clients, the accounting firms’ specialized and experienced lawyers brought significant firepower to the defense group—making the claim against the main defendants, the company and their officers and directors, more difficult. As a result, plaintiffs’ firms have sued accounting firms less and less.
Can public companies adopt this type of cohesive approach as a path forward? Unfortunately, a number of factors suggest it wouldn’t work. The types of companies sued in securities class actions are far more numerous and diverse than the Big-X accounting firms. I watch the cases come over the transom, and the companies sued are a real mishmash, even if the types of cases seem to align in a dozen or so buckets. Even the technology industry—historically the most frequently sued type of company, and the industry that primarily spurred the adoption of the Reform Act—isn’t sued with the consistency it once was. Biotech companies are probably the best candidate for a cohesive approach, but most of those companies have their heads down working on their drug candidates, without the time or resources necessary to coordinate.
But most fundamentally, it’s hard to imagine that any group of potential-defendant companies could come together and agree on a small, focused set of securities defense specialists to defend cases against them—or to engage in enough repeat hiring that such a set would naturally develop. Once again, one of the core problems with securities litigation defense is the hordes of lawyers who comprise the so-called “securities defense bar.” Until that fundamental problem is fixed, the quality of defense will continue to suffer, and the cost of even the current low-quality defense will remain ridiculously high.
Greater Control by D&O Insurers Is the Only Clear Path
While there is no group of defendants that can replicate the accounting-firm model, D&O insurers can play a similar unifying role across all categories of defendants.
In nearly every securities class action, there is a group of D&O insurer representatives associated with the defense of the litigation. D&O insurers are the only repeat players on the defense side and as a group, they see the big picture in a way no defense firm ever could. They have the greatest economic interest in the outcome—both overall and in individual cases. A victory for the defendants is a victory for them. They employ highly experienced claims professionals, many of whom have been involved in exponentially more securities class actions than even the most experienced defense lawyers. I have achieved superior results for many clients by working collegially with insurers—from helping shape motion-to-dismiss arguments, to learning insights about particular plaintiffs’ lawyers and their latest tricks, to selecting the right mediator for a particular case, to achieving favorable settlements that don’t leave the impression of guilt.
Given this expertise and alignment of interests, defense counsel should involve insurers in the defense of the case as part of their responsibility to their clients. Defense counsel should involve insurers in key strategic decisions—working with them to help find the right defense counsel for the particular case, to help shape the overall defense strategy at the inception of the case, and to help make good decisions about the use of policy proceeds. And defense counsel who involve insurers undoubtedly help their clients make it through securities cases more successfully, efficiently, and comfortably than those who don’t.
Yet insurers usually are shut out of meaningful involvement in the defense, with most defense lawyers treating them almost like adverse parties and other defense lawyers merely humoring them as they would a rich relative. Although this dysfunction is rooted in a complex set of factors, it could easily be fixed.
When the general public thinks about insurance, they usually think of auto insurance or other duty-to-defend insurance, under which the insurer assumes the defense of the claim for the insureds. But public-company D&O insurance is indemnity insurance: The insurer is obligated to reimburse the company and its directors and officers for reasonable and necessary defense costs and settlement payments, up to the policy’s liability limit.
Indemnity insurance gives the defendants control over the litigation, including counsel selection and strategic approach, with the insurer retaining limited rights to participate in key decisions. Although those rights give insurers a foot in the door, the rights are not robust or frequently exercised.
Insurers often take a relatively hands-off approach to D&O claims because they assume that their customers want them to stay out of the defense of the claim. But in my experience, this is a misconception. The priority for most companies and their directors and officers is simply the greatest protection possible, including assurances that they will not be left to pay any uncovered legal fees or settlement payments. In fact, not only do most insureds not want to be stuck paying their lawyers for short-pays, they don’t even want to write any checks at all after satisfying the deductible. Instead, they prefer that the insurer take charge of the bills and pay the lawyers and vendors directly.
In other words, most public companies actually want their D&O insurance to respond more like duty-to-defend insurance, particularly if it were offered at a slightly lower price or with lower self-insured retentions. This is especially so for smaller public companies, for which the cost of D&O insurance and the self-insured retention can be real hardships and who often lack the resources of larger companies, such as in-house counsel. Significantly, these are the types of companies against which the plaintiffs’ bar is bringing more and more securities class actions. Outside directors also lack intense allegiance to any particular defense firm. Loyalty to particular law firms is typically rooted at the level of in-house counsel, who are often beholden to particular law firms for personal reasons. In contrast, smaller public companies and outside directors typically just want to be defended well, at no cost to them.
So why do insurers mistakenly think that the insureds would rather have them stay out of the defense of the claim? To be sure, after a claim is filed, the insurer often gets an earful from the insureds’ lawyers and broker about the insureds’ indemnity-insurance freedoms. But these aggressive positions are typically not the positions of the insureds themselves. Instead, these positions are driven by defense counsel, usually for self-interested reasons: to get hired, to justify excessive billing, or to settle a case for a bloated amount because the defense is compromised by mounting costs or the defense lawyer’s inability to take the case to trial.
Frequently, defense lawyers will set the stage for their clients to have a strained relationship with their insurers by feeding them a number of stock lines:
- “This is a bet-the-company case that requires us to go all-out to defend you, so we have to pull out all the stops and do whatever is necessary, no matter what the insurer has to say.”
- “The insurer may ask you to interview several defense firms before choosing your lawyers. Don’t do that. They’ll just want to get some inferior, cut-rate firm that will save them money. But you’ll get what you pay for—we’re expensive for a reason! And don’t forget that we’ve stood by you through thick and thin since before your IPO, back when you were a partner here. Plus, we gave you advice on your disclosures and stock sales, so we’re in this thing together.”
- “The business of any insurance company is to try to avoid paying on claims, so the insurer may try to curtail our level of effort and even refuse to pay for some of our work. But trust us to do what we need to do for you. You might need to make up the difference between our bills and what the insurer pays, but we can go after the insurer later to try to get them to pay you back for those amounts.”
- “We’ll need you to support us in these insurance disputes. You don’t have to get involved directly—we can work with the insurer and broker directly if you agree. Agree? Good.”
That’s how defense lawyers set the insurer up as an adversary, but these self-serving talking points get several key things wrong:
- Most importantly, D&O insurers are not the insured’s adversaries in the defense of a securities class action. To the contrary, insurers’ economic interests are aligned with those of the insureds. Insurers want to help minimize the risk of liability through good strategic decisions. Although keeping defense costs to a reasonable level certainly benefits the insurer, it also benefits the insureds by preserving policy proceeds for related or additional claims on the policy, so that the insureds will not need to pay any defense or settlement costs out-of-pocket, and will avoid a significant premium increase upon renewal.
- Insurers want their insureds to have superior lawyers—inferior lawyers would increase their exposure. Their interest in counsel selection is to help their insureds choose the defense counsel that is right for the particular case. The key to defense counsel selection in securities class actions, for insureds and insurers alike, is to find the right combination of expertise and economics for the particular case—in other words, to find good value.
- A D&O insurer’s business is not to avoid paying claims. D&O insurance is decidedly insured-friendly, which isn’t surprising given its importance to a company’s directors and officers. D&O insurers pay billions of dollars in claims each year, and there is very little D&O insurance coverage litigation. Although D&O insurance excludes coverage for fraud, the fraud exclusion typically requires a final adjudication—it does not even come into play when the claim is settled, and even if the case went to trial and there was a verdict for the plaintiffs, it would only be triggered under limited circumstances.
- If utilized correctly, D&O insurers can be highly valuable colleagues in securities class action defense. Because they are repeat players in securities class actions, they are able to offer valuable insights in defense-counsel selection, motion-to-dismiss strategy, and overall defense strategy. They have the most experience with securities class action mediators and plaintiffs’ counsel, and they often have key strategic thoughts about how to approach settlement. The top outside lawyers and senior claims professionals for the major insurers have collectively handled many thousands of securities class actions. Although their role is different from that of defense counsel, these professionals are more sophisticated about securities litigation practice than the vast majority of defense lawyers.
D&O insurers most definitely have the practical ability to effect these changes. Although the number of insurers may seem large to many, from my perspective it is a relatively small and close-knit group. Every major D&O insurer has highly experienced internal or external claims personnel who track securities litigation developments very closely, in individual cases and the big picture. There is a relatively small number of primary insurers who write the lion’s share of primary D&O policies. And there is a handful of professionals who drive thought leadership. Without question, the D&O insurance community is well-suited to be the glue that fixes the fractured defense bar.
All that would be necessary are a few simple D&O insurance contract modifications. A duty to defend structure for a “Securities Claim” would work best, and I am certain it would be highly attractive to smaller companies, if offered at a lower premium or with a lower self-insured retention. Since very few cases actually involve exclusion of coverage under the fraud exclusion, the lurking problem of conflicts of interest is often not present, and in any event can be cured by Cumis counsel (i.e., an attorney employed by a defendant in a lawsuit when there is a liability insurance policy covering the claim and there is a conflict between the defendant and the insurer arising from a coverage issue).
But even within the current indemnity structure, D&O insurers could easily tweak terms to give insurers a stronger voice in three areas:
> Select the right defense counsel for the particular case—which would tend to create a defense bar that rivals the specialization of the plaintiffs’ bar. Insurers don’t need to choose counsel for defendants to make sure that they have the right counsel in place. They can require insureds to conduct an interview process that includes firms that they believe would be right for the case for strategic and/or economic reasons. Currently, insurers can’t unreasonably refuse to consent to the insureds’ choice of counsel. Although stronger counsel-selection language could easily be added—for example, that the insurer can propose a range of firms, and the insureds can’t unreasonably refuse to consent to the insurers’ options—even the current formulation allows insurers to reasonably refuse to consent to counsel who aren’t sufficiently experienced or are too expensive for the particular case.
> Make defendant-focused strategic and settlement decisions—which would approximate the strategic coherence of the plaintiffs’ bar. Insurers don’t need to have an attorney-client relationship with defense counsel to have a meaningful say in strategic decisions. The current cooperation clause already gives them this right, and it could be slightly enhanced to make clear that insurers can and should provide strategic input about the full range of decisions. In this way, insurers could not only make a difference in individual cases, but in the big picture, similar to a portfolio manager’s investment decision-making.
> Use policy proceeds only for defense costs that further the defendants’ interests—which would allow defendants to approach the efficiency the plaintiffs’ bar achieves through their contingent- fee structure. Insurers should be allowed to refuse to pay defense expenses that are not in the interests of the defendants—including billing rates and staffing practices that exceed what is reasonable and necessary. Insurers simply need the contractual right to require a defense firm to live with the insurers’ decisions and prevent a defense firm from seeking reimbursement of unpaid amounts from the defendants. In my experience, defendants actually believe that insurers are better able to judge what is reasonable than they are and are perfectly willing to defer to the insurer. The rancor typically comes from defense counsel, not the insureds.
Again, a duty-to-defend option would be the very best way to accomplish necessary change. But even these types of modest changes within the current indemnity-contract framework would enable D&O insurers to greatly improve securities class action defense.
A key consideration, of course, is whether brokers would be motivated to sell policies with these modifications. I’m absolutely certain that directors and officers would want to buy them.
And I’m confident that client-focused brokers would want to give their clients the option to purchase a policy that would help the particular client and the broader public-company community to defend securities class actions better.
The only way for defendants to win the securities class action war is to make the defense bar more effective and efficient. And the only way to do so is for D&O insurers to have greater control of claims. Defendants are entitled to a defense that allows them to get through securities litigation safely and comfortably, and without any real financial risk. Indeed, they already expect that their D&O insurers will take care of them. Giving insurers a greater role in defending securities class actions will allow insurers to do exactly that.
This is the second of a three-part post evaluating who is winning the securities class action war.
Part I explained that this war is not just a scorecard of wins and losses, but rather a fight for strategic positioning—about achieving a system of securities litigation that sets up plaintiffs or defendants to win more cases over the long term. Despite winning many of the battles, defendants are losing the war because of the defense side’s lack of a centralized command, which creates a mismatch in expertise, experience, and efficiency.
The plaintiffs’ bar is relatively small, with about a dozen firms in the core group. Their lead partners are full-time securities litigators who prosecute cases around the country. They don’t dabble in different kinds of cases—they aren’t securities litigators on some days and antitrust or IP lawyers on others. Because the bar is small and specialized, it has the practical ability to take common strategic, economic, and legal positions, even if they don’t always see eye-to-eye or get along personally.
Below, I contrast this small and specialized plaintiffs’ bar with the defense bar, and conclude that:
- The splintered structure of the defense bar creates a fundamental mismatch between plaintiffs and defendants;
- Defendants can only overcome this mismatch with greater centralized command; and
- This organizing function can only come from D&O insurers—a proposition I’ll explain in depth next week in Part III of this post.
Part II: The Defense Bar
The Defense Bar is Splintered
In contrast to the small and specialized plaintiffs’ bar, there is an army of securities defense lawyers—but one with no coordinated set of strategic goals. Every firm in the AmLaw 200 has a securities class action defense group and conceivably could be hired to defend a securities class action. Each firm in the AmLaw 100 has a securities team they’d tout as a “leading” or otherwise strong practice—and among most of each of those firms, there are multiple partners who hold themselves out as securities litigation defense lawyers. The number of defense lawyers who called themselves “securities litigators” skyrocketed during the 2005-08 stock option backdating scandal, which drew in more defense lawyers for separate representations and investigations.
All in, I’d guess there are 300 white-shoe U.S. law-firm partners who would advertise themselves as securities litigators for purposes of a securities case pitch, though most of these work on other types of commercial litigation as well, such as antitrust and IP. The number of actual securities litigation senior partners on the defense side is a tiny fraction of this population—I’d bet around 30, or 10% of the so-called “securities defense bar.”
This small, specialized group comprises my mentors and my peers. Although it is hired in enough cases to allow it to continue to defend securities cases full-time, it doesn’t handle the number or range of cases the group’s skill and experience otherwise justify because of the jam-packed defense field overall. As a result, the average defense lawyer handles far fewer—and a narrower range of—cases than the average plaintiffs’ lawyer.
This is just one-half of a double-whammy for companies and their D&O insurers: the sub-optimal defense comes at an enormous cost to boot. At the same time that the number of securities class actions filed against smaller companies is increasing—indeed, a recent study said that the size of securities cases had fallen to a level last seen in 1997—the amounts that most defense firms charge to defend litigation have increased exponentially. This mismatch between 1997 case size and present-day law-firm economics creates the danger that a company’s D&O insurance program will be insufficient to cover the fees for a vigorous defense and the attendant price to resolve the case. Indeed, I am greatly concerned that inadequate policy proceeds due to skyrocketing defense costs is becoming the biggest risk directors and officers face from securities litigation.
The defense-cost problem is exacerbated by the scarcity of securities litigation work for the hordes of litigation partners who hold themselves out as securities litigators. Given the large group of lawyers competing for a limited number of cases, most of them are hired only sporadically—a case every year or two, at most—which creates pressure to maximize the billing revenue on each case. That is also a key reason why defense hourly rates have increased so dramatically—by almost 50%—in less than ten years.
To illustrate the economic squeeze in securities class actions, consider hypothetical securities class actions against two smaller companies: 1997 Co., which carries $15 million in D&O insurance limits, and 2017 Co., which carries limits of $25 million. (Smaller-company D&O insurance limits have increased since 1997, but not markedly.) Assume settlements of $7.5 million in 1997 and $12.5 million in 2017. Also assume that defense costs through summary judgment were $5 million in 1997 (cases against smaller companies are nevertheless often as labor-intensive as cases against larger companies) and $15 million in 2017, or triple the 1997 figure, corresponding to the tripling (or more) of the billing rates and partner profits of large law firms (“Big Law”).
- Big Law defense of 1997 Co. makes some economic sense: $5 million in defense costs plus $7.5 million to settle equals $12.5 million—or $2.5 million less than the D&O insurance limits.
- Big Law defense of 2017 Co. does not make economic sense: $15 million in defense costs plus $12.5 million to settle equals $27.5 million—or $2.5 million more than the D&O insurance limits.
However, when large firms with high billing rates and high associate-to-partner ratios try to reduce the cost of one case without changing their fundamental billing and staffing structure, they end up cutting corners by forgoing important tasks, delegating important roles in the case to junior attorneys or settling prematurely for an unnecessarily high amount.
It obviously makes no sense for a firm to charge $15 million to defend a case that can settle for $15 million. It is even worse for that same firm to attempt to defend the case for $7 million instead of $15 million by cutting corners—whether by understaffing, overdelegating to junior lawyers, or avoiding important tasks.
It is worse still for law firms to charge $2 million through the motion-to-dismiss briefing and then, if they lose, to settle for more than $15 million just because they can’t defend the case economically past that point. And it is a strategic and ethical minefield for a defense firm to charge $15 million and then settle for a larger amount than necessary so that the fees appear to be in line with the size of the case.
Obviously, companies and their directors and officers should not be subjected to these hazards—which are created not by the securities class action itself, but by the incentives inherent in law firm economics.
So, to sum up, we have a defense bar that is both (1) under-experienced and (2) over-priced and/or that cuts corners. Quite obviously, on the defense side, the system is broken.
Nevertheless, the Defense Bar Wins a Lot of Battles
Yet a reasonable reader would ask, “if the defense bar is so over-matched, why do defendants win so many motions to dismiss?”
The defense bar obviously wins a lot of dismissals at the pleading stage. But those victories are short-lived if the court grants the dismissal without prejudice, allowing the plaintiffs an opportunity to more carefully replead—often with the benefit of the court’s roadmap identifying the various defects in the initial complaint. The skeptics need look no further than the liberal law of amendment, which courts often relax further to counterbalance the Reform Act’s pleading standards. One court put it this way: “The PSLRA requires a plaintiff to plead a complaint of securities fraud with an unprecedented degree of specificity and detail. … In this technical and demanding corner of the law, the drafting of a cognizable complaint can be a matter of trial and error.” Eminence Capital, LLC v. Aspeon, Inc., 316 F.3d 1048, 1053 (9th Cir. 2002).
Cases that survive a motion to dismiss are increasingly settled before the cost of discovery mounts. In days gone by, if the court denied the motion to dismiss, defendants would oppose class certification and defend the litigation through a summary judgment motion—in other words, defendants would actually defend the case. Today, given skyrocketing defense costs, cases increasingly settle soon after the court denies a motion to dismiss, to avoid the danger that a company’s D&O insurance program will be insufficient to cover the fees for a vigorous defense and a settlement later in the case. The splintered defense bar plays a role too: because of the absence of a coordinated strategic approach to issues of class certification and summary judgment, there often appears to be little strategic benefit to using these potentially valuable mechanisms to defeat plaintiffs’ claims. Thus, in this era of ineffective and inefficient securities defense, securities class action defense involves use of only one of three pre-trial escape hatches—the motion to dismiss—and leaves class certification and summary judgment on the table.
So motions to dismiss are the whole ballgame these days. And while, again, defendants obviously win a lot, they would win a lot more if the defense bar were more specialized and took a better strategic approach more often. In keeping track of pending securities cases, I read a lot of motions to dismiss in cases around the country. Some of them are good, but a great many of them are not. Although some of the poor motions yield a dismissal anyway, too many cases aren’t dismissed that should be—and certainly the reason for many of those is a poorly constructed motion.
Whatever success defendants have under the Reform Act’s pleading standards, it comes at a high price. It almost always makes sense to give a motion to dismiss a shot, even if it’s a long one. And, whether the motion is an easy or difficult one, many defense firms take advantage of the Reform Act’s defense-friendly standards to do more work than is necessary at that point, rationalizing the extra work along these lines:
“If the motion is granted, no one will really mind if we’ve billed a lot. Plus, we’ll ‘lose’ the case before we get to bill a lot in discovery. If the motion is not granted, the extra work we did will give us a head start on the rest of the case.”
Indeed, a cynic would say that the system is a rigged game for defense firms. Win or lose, they “win.” If the case is dismissed, the defense firm has done a healthy amount of work and added a victory to its win-loss record. And if the case isn’t dismissed, the defense firm still “wins,” because the case goes into discovery, which is notoriously expensive and almost impossible for a client or insurer to capably oversee. The opaqueness of the system is exacerbated by the swashbuckling style of many defense lawyers, who set up a criticism-free moat around themselves by dint of being a prominent partner at a powerful law firm.
So, in a nutshell, (1) the defense bar’s lack of effectiveness squanders dismissal opportunities, while (2) their lack of efficiency (to put it politely) squanders insurance resources. The Reform Act’s high pleading standards tend to mask this problem—but a problem it is.
A reasonable reader would also ask, “if the defense bar is so over-matched, how have they accomplished so many Supreme Court and Legislative victories?”
This is more complex, but also supports my lament. The Private Securities Litigation Reform Act of 1995 was a huge victory for the defense bar. Although many people played a hand in its passage, a key group was the Silicon Valley securities defense bar—which in 1995 was a fairly small and experienced group of lawyers, including my former firm Wilson Sonsini, who defended a very high volume of securities litigation. Indeed, in many ways, what I am arguing for is a return to the Silicon Valley firm defense bar and economics of the 1995.
On the judicial front, I don’t think the 10-year run of Supreme Court securities decisions has been very helpful outside of Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), and Omnicare, Inc. v. Laborers Dist. Council Const. Indus. Pension Fund, 135 S. Ct. 1318 (2015). Most of the decisions have been neutral—though they all caused a huge stir, and competing claims of victory, because they were Supreme Court decisions.
Some of the decisions are an attractive nuisance. For example, in Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014), the Court held that a defendant may rebut the fraud-on-the-market presumption of reliance at the class certification stage with evidence that the alleged misrepresentations did not impact the stock price. Although it is a rare case in which a price-impact class certification can make a real difference in a case, it takes a lot of impulse control for a defense lawyer to turn down the chance to take a shot. Others are examples of “be careful what you wish for.” For example, the jurisdictional limitations the Court set in Morrison v. National Australia Bank, 561 U.S. 247 (2010), have yielded enormously expensive multi-front international litigation that can’t easily be settled.
And despite the defense bar’s successes, such as they are, there is a complete inability for any coordination about the decision to seek Congressional or judicial change. This is in large part due to the lack of visibility by other lawyers into what is happening in cases and the lack of familiarity with each other in the defense bar. The plaintiffs’ bar, with its smaller size and greater specialization, doesn’t have those problems, at least to the same extent. The prominent plaintiffs’ lawyers know what’s happening across the cases and know each other, and thus can at least try to stop someone from taking a misguided strategy.
We defense lawyers don’t have the same visibility or capacity to coordinate. Even when defense counsel support an appeal on behalf of amici, they are forced to work within a trial and appellate strategy in which they weren’t involved, and which is sometimes shaped by a defense lawyer who isn’t a true specialist. Certainly, the nature of the clients that plaintiffs and defendants represent can come into play—for example, a large pension fund cares about the state of the law more than Acme, which might only care about the case against it. But the splintered structure of the defense bar prevents these discussions from even happening.
The Solution: Greater Insurer Control
These problems—a splintered, relatively inexperienced, and highly inefficient defense bar—are fundamental and structural. There is a simple solution: in every securities class action, there is a group of D&O insurer representatives associated with the defense of the litigation. As a group, D&O insurers see the big picture in securities class action in a way no defense lawyer ever could, and could easily provide input that would help solve these problems.
Although the number of D&O insurers may seem large to many, from my perspective it is a relatively small and close-knit group. Every major D&O insurer has highly experienced internal or external claims personnel who track securities litigation developments very closely, in individual cases and the big picture. There is a relatively small number of primary insurers who write the lion’s share of primary D&O policies. And there is a handful of professionals who drive thought leadership. Without question, the D&O insurance community is well-suited to be the glue that fixes the fractured defense bar.
Next week, I’ll explain in detail why and how the D&O insurance community can perform this critical function. Please stay tuned.
Small, development stage biotech companies are widely considered to be attractive targets for securities actions given the inherent risks of the industry and the volatility of their stock prices. As a result, many of these companies have relatively limited D&O insurance options. But are the assumptions that act to limit their options correct? Do biotech startups actually pose greater securities class action risk than other companies?
As described below, we surveyed all biotech securities class actions in the past decade to better understand how they have fared in the federal courts, and found that they were actually more likely than other types of cases to be dismissed early in the litigation, saving defendants (and insurers) from the bulk of potential legal costs. This turns the conventional wisdom on its head and suggests a number of important insights that can help biotech companies avoid and successfully defend against securities suits, and help insurers make better coverage decisions regarding these companies.
In short, biotech cases are manageable risks if they are defended correctly, especially if biotech management takes proactive steps to manage its disclosures in a way that will further limit its risks. Below, we describe the study we undertook and its results, in light of which we then identify four of the biggest myths surrounding biotech securities cases and explain why each is unfounded. Finally, we describe and analyze the real driving forces behind these decisions, and we explain how biotech companies, their attorneys, and insurers can use these insights to greatest advantage.
II. Study Methodology and Results
We searched for and reviewed all of the district court decisions on motions to dismiss biotech securities cases within the past eleven years in order to identify the subset of cases that concern development-stage biotech companies’ efforts to bring their first drug or device to market.[i] Only decisions that met all of the following criteria were included in our study set: final district court decisions[ii] on motions to dismiss federal securities claims where the biotech company did not already have a drug or device on the market and its alleged false or misleading statements concerned clinical trials or the FDA approval process for its primary drug or device candidate.[iii]
Of the 61 decisions in our study set that met these criteria, 69% resulted in complete dismissals. Moreover, the dismissal rate appears to have increased in recent years: 78% of the decisions in the study set from 2012-2016 resulted in complete dismissals, compared with only 56% of decisions from 2005-2011. Interestingly, this shift seems to have occurred even as more securities class actions were being filed against small biotech companies: 36 decisions in the study set came from the most recent five years, versus only 25 decisions from the previous seven years. Contrary to conventional wisdom, this analysis indicates that federal securities claims brought against biotech companies regarding the regulatory approval process actually are dismissed more frequently than average at an early stage in the litigation.[iv]
III. Four Myths about Biotech Securities Cases
These findings overturn several important assumptions that currently guide biotech management and are baked into the insurance market for young biotech companies:
Myth #1: Cases against biotech companies for failed clinical trials or products that are not approved by the FDA are risky and expensive.
FACT: Our analysis shows that about two-thirds of these cases are dismissed in full, and with self-insured retentions that average a million dollars or more most such cases will not even exhaust the company’s retention. A well-managed motion to dismiss process for a young biotech should cost no more than $500,000 – $750,000, and often far less, and is highly likely to result in a favorable early outcome for defendants in these actions.
Myth #2: Management puts the company at risk if it speaks too positively regarding its expectations of clinical trial results, FDA approval, or product commercialization.
FACT: As discussed in more detail below, statements of opinion will be protected under Omnicare,[v] so long as they are genuinely held and not misleading when considered in their full context. Optimistic forward-looking statements will also generally be protected by the Private Securities Litigation Reform Act’s (“Reform Act”) safe harbor for forward-looking statements, provided they are accompanied by sufficiently specific cautionary language.[vi] Courts recognize the inherent uncertainty in the FDA approval process and understand that predictions sometimes will prove wrong; the important thing is for companies to make a meaningful effort to help investors understand these risks. Effective legal counsel can help companies manage their disclosures in a way that allows for optimistic statements while protecting against future litigation.
Myth #3: Once negative results become public, any positive spin given by management will be viewed as misleading.
FACT: Even in the face of bad news, positive statements of opinion will not be viewed as false or misleading if they are honestly held and are made within the proper context, especially where the company accurately discloses the underlying facts. Courts do not require companies to be pessimistic in assessing arguably negative results; they merely require that companies be honest in their statements and forthcoming with the relevant underlying facts. See, e.g., Sarafin v. BioMimetic Therapeutics, Inc., 2013 WL 139521, at *13-14 (M.D. Tenn. Jan. 10, 2013) (dismissing where defendant characterized clinical trial results positively even though FDA had expressed concerns and contemporaneous news reports described the results as disappointing).
Myth #4: Cases will not get dismissed if the company raises capital or insiders sell stock during the class period.
FACT: These facts may contribute to an inference of scienter in some circumstances, but they are not determinative. Far more important is the overall story, and whether the alleged motivation to commit fraud makes sense in the context of this larger narrative. When courts are convinced that the defendants were trying their best for the company and were honest and forthright in their public statements, they tend not to be concerned about capital raising or insider sales during the class period. See, e.g., Brennan v. Zafgen, Inc., 2016 WL 4203413, at *2 (D. Mass. Aug. 9, 2016) (“[T]he complaint’s circumstantial allegations concerning scienter—a patchwork of scientific literature and unsuspicious insider sales—are insufficient to support a strong inference of defendants’ conscious intent to defraud or high degree of recklessness.” (internal quotation marks omitted)); In re MELA Sciences, Inc. Sec. Lit., 2012 WL 4466604, at *5 (S.D.N.Y. Sep. 19, 2012) (“To the extent the [proposed amended complaint] relies on MELA’s capital raised during the Class Period, the court finds this inadequate to support an allegation of intent to commit fraud.”). But see Gargiulo v. Isolagen, Inc., 527 F. Supp. 2d 384, 390 (E.D. Pa. 2007) (scienter was sufficiently pleaded based on several factors, including that defendants allegedly sold their respective securities at the time for “considerable gain”).
IV. Case Trends and Practice Tips
Careful review of the decisions in the study set not only upends the myths described above, but also reveals important insights into how courts actually decide these cases and what companies and legal counsel can do to head off and defend against these suits.
A. Decisions are often driven by the court’s overall feeling about whether or not the company was being forthright and dealing honestly.
District court judges, like anyone else, are influenced by their overall impressions of the parties and the facts, even at the earliest stages in litigation. Motions to dismiss frequently turn on how the court chooses to characterize the pleadings, which leaves significant room for outcome-driven analysis. This may seem obvious, but has important practice implications, as discussed below.
Decisions in our study set—both those that dismissed and those that did not—showed again and again that in applying the pleading standard and securities laws to young biotech companies, judges appeared to be swayed by their overall sense of whether or not company management had honestly been doing its best to bring a product to market and inform investors of significant developments in a timely manner. Where courts saw little indication of good faith, they rarely dismissed. As one court put it:
“[N]otwithstanding the defendants’ contentions to the contrary, their allegedly misleading statements bear no hallmarks of good faith error. The defendants are sophisticated scientists running a regulated, publicly traded corporation; they are alleged to have misrepresented their regulator’s feedback, misrepresented the legal context in which they operated, heralded scientific results which they knew to be the product of empirically faulty procedures and manipulated statistical analysis, and claimed a level of external review that simply did not exist. If the defendants have good faith explanations for these misstatements…they do not emerge from the complaint.”
Frater v. Hemispherx Bipharma, Inc., et al., 996 F. Supp.2d 335, 350 (E.D. Pa. 2014). See also, e.g., KB Partners I, L.P. v. Pain Therapeutics, Inc., 2015 WL 7760201, at *1 (W.D. Tex. Dec. 1, 2015) (refusing to dismiss where complaint plausibly alleged defendants intentionally concealed the nature and extent of problems with their drug candidate after its first NDA was rejected, and did so while lining their own pockets with “unjustifiable compensation packages”).
But when defendants presented a credible narrative evidencing good-faith, courts seemed inclined to run with it, absent specific, compelling allegations to the contrary. See In re Axonyx Sec. Lit., 2009 WL 812244, at *3 (S.D.N.Y. Mar. 27, 2009) (dismissing and noting that “[t]he idea that this company, highly dependent on the success of the new drug, would knowingly or recklessly carry on a defective trial—so that any defects were not remedied—virtually defies reason, unless the company was bent on defrauding the FDA and the suffering people who might use the drug. Nothing of that sort is even suggested in the complaint.”); see also, e.g., Kovtun v. VIVUS, Inc., 2012 WL 4477647, at *3, 10 (N.D. Cal. Sep. 27, 2012) (dismissal appears partly influenced by fact that drug was ultimately approved after the class period, making alleged intentional misrepresentations re approvability improbable).
This seeming inclination to dismiss when presented with a convincing defense narrative appears to reflect two underlying beliefs that favor biotech defendants and may help drive the high dismissal rate in these cases: (1) that the research and development of new drugs and medical devices constitutes an important public good, and (2) that investment in development-stage companies, which have no existing revenue stream, is inherently particularly risky. As courts explicitly have noted:
“There is a significant public interest in the development of life-saving drugs. For every drug that succeeds, others do not. Clinical trials are phased into stages: some drugs never make it past the first stage, others never make it past the second stage, and so on. The costs of failure are high, but the rewards for success are also high. The relationship and ratio between the two determines whether, as a matter of economics, the costs of experimentation are worth it. Publicly traded pharmaceutical companies have the same obligations as other publicly traded companies to comply with the securities laws, but they take on no special obligations by virtue of their commercial sector. It would indeed be unjust—and could lead to unfortunate consequences beyond a single lawsuit—if the securities laws become a tool to second guess how clinical trials are designed and managed. The law prevents such a result; the Court applies that law here, and thus dismisses these actions.” In re Keryx Biopharmas., Inc., Sec. Lit., 2014 WL 585658, at *1 (S.D.N.Y. 2014).
“Ultimately, investments in experimental drugs are inherently speculative. Investors cannot, after failing in this risky endeavor, hedge their investment by initiating litigation attacking perfectly reasonable-if overly optimistic statements proved wrong only in hindsight.” In re Vical Inc. Sec. Lit., 2015 WL 1013827, at *8 (S.D. Cal. Mar. 9, 2015).
“[I]nvesting in a start-up pharmaceutical company like Adolor involves a certain amount of risk on the part of investors. No matter how safe that risk may seem at the time, there are no guarantees, and Defendants never suggested otherwise. The fact that Plaintiffs now suffer from buyer’s remorse does not entitle them to relief under Rule 10b-5.” In re Adolor Corp. Sec. Lit., 616 F. Supp. 2d 551, 570 (E.D. Pa. 2009).
Against this backdrop, biotech defendants are well-positioned to secure early dismissals if they simply tell their stories and frame the facts in a manner that demonstrates their good faith. On the front end, this means companies will benefit from getting legal counseling on their disclosures, so that if trouble arises the disclosures will show a pattern of being honest and forthright and avoid indications of fraud in the context of the company’s particular situation (i.e., the state of its communications with the FDA, financing, stock sales, etc.).
Once biotech defendants have been sued, however, they should focus on selecting counsel who will tell their overall story in a way that emphasizes their honestly and does not just focus on a technical defense. Too many defense attorneys feel constrained to make narrow, technical arguments at the motion to dismiss stage—when plaintiff’s factual pleadings are to be taken as true—rather than mounting a normative defense of their clients’ conduct. As the decisions (and results) in our study set show, this is a missed opportunity. The decision in Omnicare expressly allows and even encourages defendants to tell their versions of the story by declaring that whether a statement of opinion (or, by clear implication, a statement of fact) was misleading “always depends on context.” 135 S. Ct. at 1330. Under this standard, courts are required to consider not only the challenged statements and the immediate contexts in which they were made, but also other statements made by the company and other publicly available information, including the customs and practices of the industry.
Evaluating challenged statements in this broader context nearly always benefits defendants, since it helps courts better understand the statements and makes them seem fairer than they might on their own. Moreover, in combination with the Supreme Court’s directive in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), to assess scienter based on not only the complaint’s allegations but also documents on which it relies or that are subject to judicial notice, Omnicare now clearly requires courts to consider a broad set of probative facts each time they decide a motion to dismiss federal securities claims. Effective defense counsel will take advantage of this mandate and continue to use the motion to dismiss to tell their client’s story in a way that frames the facts and issues favorably and helps the court feel comfortable dismissing the suit.
B. Statements of opinion and forward-looking statements are generally safe, even more so after Omnicare.
The sorts of forward-looking statements of opinion that biotech companies often most want to make about their flagship products are not actually likely to get them into trouble, so long as the statements are honestly believed and are accompanied by disclosures that acknowledge specific, relevant uncertainties.
1. Claims challenging statements of opinion—including optimistic predictions—are likely to be dismissed under the Omnicare
Even before the Supreme Court’s recent decision in Omnicare, courts tended to find statements of opinion to be non-actionable on a variety of different theories (e.g., puffery, lack of falseness, immateriality, etc.). After all, “[p]unishing a corporation and its officers for expressing incorrect opinions does not comport with Rule 10b-5’s goals.” In re Vical Inc. Secs. Lit., 2015 WL 1013827, at *8 (S.D. Cal. Mar. 9, 2015). So, for example, the court in Shah v. GenVec, Inc., 2013 WL 5348133 (D. Md. Sep. 20, 2013), found the defendants’ positive characterizations of interim data to be immaterial “puffery” and, therefore, non-actionable:
“Plaintiffs properly characterize their challenge as Defendants placing ‘an unjustifiably positive spin on the data available at the time of the [first interim analysis] by using terms like “encouraging” and “bullish[.]”’ Such vague and general statements of optimism constitute no more than puffery and are understood by reasonable investors as such. Accordingly, they are immaterial and not actionable under § 10(b).”
Id. at *15 (internal citations omitted). See also, e.g., Kovtun v. VIVUS, Inc., 2012 WL 4477647, at *11 (N.D. Cal. Sep. 27, 2012) (“[S]tatements referring to [the drug candidate’s] ’excellent’ or ‘compelling’ risk/benefit profile, or statements to the effect that the trials had shown ‘remarkable’ safety and efficacy, . . . are simply vague assertions of corporate optimism and therefore are not actionable . . . .”); In re MELA Sciences, Inc. Sec. Lit., 2012 WL 4466604, at *13 (S.D.N.Y. Sep. 19, 2012) (characterizing positive statements about clinical results as opinions and dismissing because “Plaintiffs cannot premise a fraud claim upon a mere disagreement with how defendants chose to interpret the results of the clinical trial.”).
The decision in Omnicare, however, as discussed above, established a clear, unified, and even more defendant-friendly standard for assessing statements of opinion in securities cases: an opinion is only false if the speaker does not believe it, and it is only misleading if it omits facts that make it misleading when viewed in its full, broadly understood context. See id. at 1328-30. Thus, a company’s statements of opinion—including optimistic projections about clinical results or FDA approval—are not actionable as long as the company actually believed them at the time and they were not misleading in their full context. For example, applying this standard in Gillis v. QRX Pharma Ltd., 2016 WL 3685095 (S.D.N.Y. July 6, 2016), the court concluded that the defendants’ optimistic statements that it was “encouraged” by FDA feedback and was “confident that [its drug candidate would] receive approval” were opinions, and plaintiffs had failed sufficiently to allege that defendants did not believe them or that they were misleading in context. Id. at *21-23. See also, e.g., Corban v. Sarepta, 2015 WL 1505693, at *8 (D. Mass. Sep. 30, 2015) (“[T]he company’s statements that it was encouraged by the feedback and believed its data would be sufficient for a filing constituted an expression of opinion,” which the court found not to be actionable).
Both the district court (before Omnicare) and the Second Circuit (after Omnicare) came to the same conclusion regarding the optimistic predictions at issue in In re Sanofi Securities Litigation.[vii] There, plaintiffs alleged that the defendants’ optimistic statements concerning a drug candidate’s likelihood of approval and its clinical results were misleading where they failed to disclose that the FDA repeatedly had expressed concerns about the company’s use of single-blind studies. In re Sanofi Sec. Litig., 87 F. Supp. 3d 510, 517 (S.D.N.Y. 2015). Applying the Second Circuit’s pre-Omnicare standard, the district court concluded that the challenged statements all were statements of opinion, and dismissed because plaintiffs had not established either that the opinions were not honestly held or that they were “objectively false.” Id. at 531-33. The Second Circuit affirmed, but took the opportunity to apply the Supreme Court’s then-recent Omnicare standard to the facts at hand, emphasizing in particular the larger context in which the challenged statements were made:
“Plaintiffs are sophisticated investors, no doubt aware that projections provided by issuers are synthesized from a wide variety of information, and that some of the underlying facts may be in tension with the ultimate projection set forth by the issuer. . . . These sophisticated investors, well accustomed to the “customs and practices of the relevant industry,” would fully expect that Defendants and the FDA were engaged in a dialogue, as they were here, about the sufficiency of various aspects of the clinical trials and that inherent in the nature of a dialogue are differing views.”
Tongue v. Sanofi, 816 F.3d 199, 211 (2d Cir. 2016). As previously discussed, this highly-contextual analysis favors defendants, and makes it even more likely that claims challenging defendants’ statements of opinion—including optimistic predictions concerning FDA approval or interpretations of clinical results—will be dismissed, provided the defendants genuinely held those opinions.
Of course, even statements of opinion can be false if they’re not genuinely believed; making an optimistic projection about FDA approval when a company has specific reason to believe the drug will not in fact be approved is likely to get it into trouble. So, for example, in In re Pozen Sec. Lit., 386 F. Supp. 2d 641 (M.D. N. Car. 2005), the court refused to dismiss claims regarding optimistic statements by the defendant touting its drug candidates’ effectiveness and implying their approvability, where the company knew at the time that it was applying a statistical analysis different from what it had agreed to with the FDA and knew that the drugs had failed in part to meet a critical clinical measure it had specifically agreed upon with the FDA ahead of time. Id. at 646-47. The court noted that the defendants might well have had other reasons to believe their own expressions of optimism at the time—which would make these statements of opinion not false—but it found the allegations sufficient to survive a motion to dismiss. Id.
2. Predictions of clinical trial success or FDA approval usually are also protected forward-looking statements
Not only are most optimistic projections statements of opinion, subject to Omnicare’s rigorous standard, they also tend to be forward-looking statements protected under the Reform Act’s safe harbor.
Courts in the study set usually found expressions of optimism regarding clinical trial results or the likelihood of FDA approval to be forward-looking statements protected under the Reform Act’s safe harbor where the statements were accompanied by specific cautionary language that warned investors of the most significant risks. As one court explained:
“Projections about the likelihood of FDA approval are forward-looking statements. They are assumptions related to the company’s plan for its product, and as such fall under the PSLRA’s safe harbor rule. Each VIVUS press release or other public statement cited by plaintiff included warnings about the uncertainties of forward-looking statements, and also referred to VIVUS’ SEC filings. Those filings, in turn, were replete with discussion of risk factors, including potential difficulties with obtaining FDA clearances and approval; the known side-effects of Qnexa’s two components, and the possibility of FDA required labeling restrictions; the risk that the FDA might require additional, expensive trials; and concerns regarding Qnexa’s association with Fen-Phen.”
Kovtun v. VIVUS, Inc. 2012 WL 4477647, at *12 (N.D. Cal. Sep. 27, 2012) (dismissing); see also, e.g., Gillis v. QRX Pharma Ltd., 2016 WL 3685095, at *23 (S.D.N.Y. July 6, 2016) (“QRX’s statement that it was ‘confident that MOXDUO will receive approval,’ SAC ¶ 48, is, separately, shielded by the PSLRA safe harbor.”).
In fact, some courts found optimistic projections to be protected even where the cautionary language was fairly minimal. For example, in Oppenheim v. Encysive Pharmas., Inc., 2007 WL 2720074 (S.D. Tex. Sep. 18, 2007), the court concluded that statements by the defendant (1) that it had a “good shot” at receiving priority review from the FDA (but where it had clearly acknowledged that it was “an FDA decision of course”), and (2) that it did not expect the FDA to require additional clinical trials (but where it had stated “you never know what’s going to happen when you get into a regulatory process”), were protected under the safe harbor. Id. at *3.
3. Challenges to clinical methodology and analysis are generally rejected, as long as the defendants do not appear to have been manipulating data.
Courts also routinely dismiss challenges to a company’s clinical methodology or analysis. Statements interpreting clinical trial results often are found to be non-actionable expressions of opinion. See, e.g., Corban v. Sarepta, 2015 WL 1505693, at *6 (D. Mass. Sep. 30, 2015) (applying pre-Omnicare standard and dismissing claims re statements touting the strength of clinical trial results in part because “many of the challenged statements consist of interpretations of the company’s data,” which the court found to be nonactionable expressions of opinion).
Likewise, courts tend to dismiss suits where plaintiffs’ theory boils down to a mere disagreement with the company’s clinical trial methodology. See, e.g., Davison v. Ventrus Biosciences, Inc., 2014 WL 1805242, at *7 (S.D.N.Y. May 5, 2014) (dismissing claims that optimistic statements were misleading because they failed to disclose that the small sample size allegedly distorted results, and noting that “[t]he Second Circuit has emphasized that in scrutinizing a Section 10(b) claim, a court does not judge the methodology of a drug trial, but whether a defendant’s statements about that study were false and misleading”); In re Keryx Biopharmas., Inc., 2014 WL 585658, at *10-12 (S.D.N.Y. Feb. 14, 2014) (dismissing claims based on statements re clinical results that plaintiffs allege were misleading due to extensive methodological flaws); Abely v. Aeterna Zentaris, Inc., 2013 WL 2399869, at *6-10 (S.D.N.Y. May 29, 2013) (dismissing claims because plaintiff’s allegations “merely amount to a competing view of how the trial should have been designed” and “[p]ublic statements about clinical studies need not incorporate all potentially relevant information or findings, or even adhere to the highest research standards, provided that its findings and methods are described accurately”). As long as a biotech company describes its clinical and interpretive methodologies accurately, courts generally will not pass judgment on the soundness of those approaches. See id. at *6 (“The Second Circuit and other tribunals have concluded that the securities laws do not recognize a fraud claim premised on criticisms of a drug trial’s methodology, so long as the methodology was not misleadingly described to investors.” (emphasis added)).
Where plaintiffs put forth specific, credible allegations indicating that defendants were intentionally misrepresenting or manipulating data, however, courts often allow these cases to go forward. See, e.g., In re Delcath Systems, Inc. Sec. Lit., 36 F. Supp. 3d 320, 333 (S.D.N.Y. 2014) (dismissing claims re optimistic projections concerning drug approval, but allowing claims re alleged misrepresentations and omissions concerning clinical results because “[t]he allegations here do not involve differing interpretations of disclosed data, but rather data that was not disclosed”); In re Immune Response Sec. Lit., 375 F. Supp. 2d 983, 1018-22 (S.D. Cal. 2005) (refusing to dismiss claims alleging that defendants continuously misrepresented clinical results that they knew were incomplete and flawed, where complaint included specific corroborating details suggesting intentional misconduct); In re Vicuron Pharmas. Inc. Sec. Lit., 2005 WL 2989674, at *6 (E.D. Pa. July 1, 2005) (allowing claims re positive statements about Phase III clinical results to move forward where court seemed convinced by allegations that defendant actually knew clinical results were problematic and approval was unlikely).
Thus, it is best for biotech companies accurately to disclose the details of their clinical trial methodology and underlying data along with the company’s interpretation of that data, in order to avoid plausible claims of subterfuge later on.
C. Other than cases where companies appear to have made false statements of fact, the riskiest areas for companies are disclosures made relative to FDA feedback.
One category of statements sticks out in the study set as particularly troublesome for defendants: alleged misrepresentations concerning feedback from or interactions with the FDA. On the one hand,
“[N]umerous courts have concluded that a defendant pharmaceutical company does not have a duty to reveal interim FDA criticism regarding study design or methodology. Indeed, such courts frequently reason that interim FDA feedback is not material because dialogue between the FDA and pharmaceutical companies remain ongoing throughout the licensing process, rendering such criticism subject to change and not binding in regards to ultimate licensing approval.”
Vallabhaneni v. Endocyte, Inc., 2016 WL 51260, at *12 (S.D. Ind. Jan. 4, 2016) (dismissing claims that defendant misled investors by touting Phase II results without disclosing that the FDA had questioned how efficacy was determined in the study, because FDA concerns expressed were not so severe as to suggest the drug could not be approved, and the FDA subsequently allowed Phase III to move forward). See also Tongue v. Sanofi, 815 F.3d 199, 214 (2d Cir. 2016) (affirming dismissal) (“Reasonable investors understand that dialogue with the FDA is an integral part of the drug approval process, and no sophisticated investor familiar with standard FDA practice would expect that every view of the data taken by Defendants was shared by the FDA.”).
On the other hand, claims concerning statements or omissions about interactions with the FDA seem to survive motions to dismiss more often than other types of statements in biotech cases, perhaps because companies too often cherry-pick the FDA feedback they choose to disclose.
In assessing these sorts of claims, courts carefully distinguish between optimistic projections regarding approval, which tend to be protected forward-looking statements, and statements regarding past FDA interactions or feedback, which pertain to verifiable historical facts. For example, in In re Mannkind Sec. Actions, 835 F. Supp. 2d 797 (C.D. Cal. 2011), the court refused to dismiss claims regarding defendants’ repeated assurances that the FDA had “blessed,” “approved,” “accepted,” and “agreed to” the company’s methodological approach in its clinical trials, when it later became clear that the FDA had done no such thing:
“Courts must of course be careful to distinguish between forward-looking statements later deemed to be unduly optimistic, and statements of historical fact later shown to be false when made…
… [S]tatements touting the merits of the bioequivalency studies, can be fairly read as misguided opinion or ‘corporate optimism,’ [but] it is harder to escape the conclusion that Defendants’ statements concerning the FDA cross the line from exaggeration and ‘corporate optimism’ into outright misstatement of historical fact.”
Id. at 809-11 (emphasis in original).
Likewise, in In re Cell Therapeutics, Inc. Class Action Lit., 2011 WL 444676 (W.D. Wa. Feb. 4, 2011), the court dismissed claims challenging the defendants’ optimistic statements about the drug candidate’s progress in clinical trials and the company’s hopes for FDA approval because these were forward-looking statements accompanied by sufficient cautionary language. Id. at *7-8. At the same time, however, the court allowed claims to move forward regarding defendants’ repeated statements indicating that its Special Protocol Assessment (“SPA”)—an agreement with the FDA that the drug would be approved if the company followed the agreed-upon protocol and the drug proved effective[viii]—was still in effect even after defendants knew that they had invalidated the SPA. Id.; see also, e.g., Frater v. Hemispherx Biopharma, Inc., 996 F. Supp. 2d 335, 346 (E.D. Pa. 2014) (declining to dismiss claims re statements that allegedly mischaracterized FDA feedback by (1) omitting FDA statements indicating that it probably would not be receptive to company’s intended clinical approach and (2) incorrectly stating that the FDA had withdrawn its request for a new clinical trial as part of a resubmitted New Drug Application).
In light of these cases, how does a company decide what to disclose when it is in constant communications with the FDA? This is a prime area where a company can mitigate its risk by getting expert disclosure advice. As a starting point, review of our case study set suggests the following:
- Context and clarity are important. Omnicare will protect statements of opinion so long as they are genuinely held and not misleading in their full context. If a company wants to express an opinion regarding its interactions with the FDA, it can protect itself by accurately and clearly disclosing the important underlying facts (positive and negative) regarding that interaction as well. Moreover, if a company wants to make optimistic projections regarding the approval process more generally, it should keep in mind that any negative feedback from the FDA, whether disclosed or not, will be part of the overall context in which those statements of opinion are judged.
- Companies need to be careful not to mislead. Selective disclosure of some facts but not others can create difficulties and must be done with care and transparency. If a company chooses to disclose interim FDA feedback, it should do so fairly, reporting both positive and significant negative components of that feedback at the same time. With expert guidance, it is possible to emphasize the positive while acknowledging the negative in a way that will not leave the company open to challenge at a later date.
- Companies should be careful not to overstate or misconstrue FDA opinions. These can later be contradicted by the agency when an approval decision is made, opening the company up to allegations that it intentionally misrepresented the interim feedback it received. A biotech company most often will be best served by couching any optimism it wants to express in terms of the company’s opinions and expectations—rather than positively characterizing the FDA’s feelings or intentions—and sticking to accurate, factual accounts of FDA feedback.
Our study shows that, contrary to popular belief, development-stage biotech companies actually have less to fear from federal securities cases than do many other types of corporate defendants that have a far easier time securing insurance coverage. Over the last decade, these cases have been dismissed at a high rate early in the litigation process, and even more so in recent years. Biotech startups may well end up being sued if and when their flagship products are not approved by the FDA, but courts are sympathetic to the inherent risks of the industry and seem primed to dismiss these suits when defendants can present a credible narrative of good faith conduct. By getting expert disclosure advice before making important announcements, and by hiring litigation counsel who will affirmatively tell the company’s story at the motion to dismiss stage, small biotech companies and their insurers can guard against litigation and give the company an excellent shot at early dismissal in any securities suits that are ultimately brought against them.
[i] Specifically, we applied the following, over-inclusive search terms to all federal district court decisions from March 6, 2005 through October 3, 2016 in the Westlaw database: (pslra “private securities litigation reform”) & (FDA “food and drug administration” f.d.a.) /p (clinical medical bio! biotech! genom! gene genetic phase trial drug study therapy treatment) & “motion to dismiss.” This produced 298 results, only 61 of which met our study set criteria as described above (additional cases met the same criteria except that they were brought against companies that already had at least one drug or device on the market).
[ii] In each case, only the district court’s final decision on the defense’s motion(s) to dismiss was included in the study set. Any earlier dismissals, where plaintiffs were allowed to amend the complaint and the court then ruled on a subsequent motion to dismiss, were excluded so that sequential opinions in the same action were not double-counted. Likewise, cases that did not yet have a final decision on the motion to dismiss were excluded (e.g., if the court initially dismissed with leave to amend and a subsequent motion to dismiss was pending).
[iii] Decisions where the securities fraud claims concerned something other than the clinical trial and FDA approval process for their primary drug or device candidate (e.g., alleged financial improprieties, marketing, sales, post-approval manufacturing issues, etc.) were not included in the study set.
[iv] See Svetlana Starykh & Stefan Boettrich, NERA Economic Consulting, Recent Trends in Securities Class Action Litigation: 2015 Full-Year Review, at 19, available at http://www.nera.com/content/dam/nera/publications/2016/2015_Securities_Trends_Report_NERA.pdf (only 54% of the securities class action motions to dismiss that were resolved between January and December 2015 were granted, with or without prejudice).
[v] Omnicare, Inc. v. Laborers Dist. Council Const. Indus. Pension Fund, 135 S. Ct. 1318 (2015).
[vi] The Reform Act provides a safe harbor for forward-looking statements that are identified as such and accompanied by “meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement.” 15 U.S.C. § 78u–5(c)(1)(A)(i).
[vii] This district court dismissal was excluded from our primary study set because, although it otherwise met our study criteria, Sanofi is a well-established pharmaceutical company with numerous drugs already on the market.
[viii] As the court explained: “[A]n SPA can only be modified by written agreement between the FDA and the sponsor and then only if it is intended to improve the study. Failure to follow the agreed-upon protocol constitutes an understanding that the SPA is no longer binding.” In re Cell Therapeutics, 2011 WL 444676, at *1.
The villain in the fight against securities class actions is the fraud-on-the-market presumption of reliance established by the U.S. Supreme Court in 1988 in Basic Inc. v. Levinson, 485 U.S. 224 (1988). Without Basic, the thinking goes, a plaintiff could not maintain a securities class action, and without securities class actions, executives could speak their minds without worrying so much about securities law liability. In the current environment, the risk of further attacks on Basic seems high. (A general class action reform bill, the “Fairness in Class Action Litigation Act of 2017,” has already been introduced in the House—analyzed by Alison Frankel here, and by Kevin LaCroix here.)
But Basic ballasts the system of securities-law enforcement by protecting investors, while providing companies with predictable procedures and finality upon settlement. We have a lead plaintiff and class representative who prosecutes a claim that defendants can settle with a broad class-wide release. Because the private plaintiffs’ bar is doing its job, the SEC stays away in most cases. Honest executives have nothing to fear with the current system—they routinely get through securities litigation without any real reputational or personal financial risk.
On the other hand, without Basic, plaintiffs’ lawyers would still file securities litigation. In place of class actions, each plaintiffs’ firm would file an individual or multi-plaintiff collective action, resulting in multiple separate actions in courts around the country. These would be difficult to manage, expensive to defend, and impossible to settle with finality until the statute of limitations expires. SEC enforcement would become more frequent. Companies and their D&O insurers and brokers would be unable to predict and properly insure against the risk of a disclosure problem.
Moreover, I have never understood the supposed benefits of abolishing Basic. Although it is possible that the frequency of securities litigation would decline, I doubt it would. A disclosure problem that would trigger a securities class action today would result in at least several non-class securities actions in a post-Basic system.
And any decrease in frequency would come at a high cost—in addition to the increased cost of defending and resolving those cases that are filed, investors and the economy would suffer from more securities fraud resulting from the diminished deterrence that class actions provide. Even an executive who detests securities class actions pictures prominent plaintiffs’ lawyers when he or she decides whether to omit an important fact.
So, to those who bash Basic, be careful what you wish for.
A Brief History of the Fraud-on-the-Market Doctrine
The fraud-on-the-market doctrine concerns the reliance element of a Section 10(b) claim. Absent some way to harmonize individual issues of reliance, class treatment of a securities class action is not possible; individual issues overwhelm common ones, precluding certification under Federal Rule of Civil Procedure 23(b)(3). In Basic, the Supreme Court provided a solution: a rebuttable presumption of reliance based on the fraud-on-the-market theory, which provides that a security traded on an efficient market reflects all public material information. Purchasers (or sellers) rely on the integrity of the market price, and thus on a material misrepresentation. Decisions following Basic have established three conditions to its application: market efficiency, a public misrepresentation, and a purchase (or sale) between the misrepresentation and the disclosure of the “truth.”
Over the years, defendants have argued that, absent a showing by plaintiffs that the challenged statements were material, or upon a showing by defendants that they were not, the presumption is not applicable or has been rebutted. And, in a twist on such arguments, defendants sometimes argued that the absence of loss causation rebutted the presumption. In Erica P. John Fund, Inc. v. Halliburton Co., 563 U.S. 804 (2011), the Supreme Court unanimously rejected the latter argument, finding that loss causation is not a condition of the presumption of reliance. But the Court explicitly left the door open for the argument that plaintiffs must prove materiality for the presumption of reliance to apply.
Later, the Court granted certiorari in Amgen Inc. v. Conn. Ret. Plans and Trust Funds, 133 S. Ct. 1184 (2013), to review the Ninth Circuit’s decision that plaintiffs are not required to prove materiality for the presumption to apply, and that the district court is not required to allow defendants to present evidence rebutting the applicability of the presumption before certifying a class. In a majority opinion authored by Justice Ginsburg, and joined by Chief Justice John Roberts and Justices Breyer, Alito, Sotomayor, and Kagan, the Amgen Court concluded that proof of materiality was not necessary to demonstrate, as Rule 23(b)(3) requires, that questions of law or fact common to the class will “predominate over any questions affecting only individual members.”
As Amgen was being litigated in the Supreme Court, the parties in Halliburton were briefing the plaintiffs’ class certification motion on remand. The district court certified a class, prior to the Supreme Court’s decision in Amgen. Halliburton sought and obtained Rule 23(f) certification from the Fifth Circuit, which affirmed, after the Supreme Court decided Amgen. The Halliburton case ended up before the Supreme Court once again, this time with the viability of Basic squarely presented. The Court rejected Halliburton’s argument that Basic is inconsistent with modern economic theory, under which market efficiency is not a binary “yes or no” issue. Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014). Thus, Basic survived the Halliburton battle.
What Would Securities Litigation Look Like without Basic?
Our current securities class action system is straightforward and predictable. Like any other action, a securities class action starts with the filing of a complaint by a plaintiff. But after that, the procedure for these actions is unique. The Reform Act mandates that the first plaintiff to file a securities class action publish a press release giving notice of the lawsuit and advising class members that they can attempt to be the “lead plaintiff” by filing a motion with the court within 60 days of the press release. Additional plaintiffs will often file their own complaints in advance of the deadline, or they may simply file a motion to become lead plaintiff at the deadline.
The Reform Act provides that the “presumptively most adequate lead plaintiff” is the one who “has the largest financial interest in the relief sought by the class” and otherwise meets the requirements of Rule 23 of the Federal Rules of Civil Procedure, which governs class actions. The Reform Act’s standards for lead plaintiff selection have caused plaintiffs’ firms to pursue institutional investors and pension funds as plaintiffs, since they are more likely to be able to show the financial interest necessary to be designated as lead plaintiffs. But as I have chronicled, in recent years, smaller plaintiffs’ firms have won lead-plaintiff contests with retail investors as lead plaintiffs, primarily in securities class actions against smaller companies. About half of all securities class actions are filed against smaller companies by these smaller plaintiffs’ firms.
This deeper and more diverse new roster of plaintiffs’ firms means that securities litigation won’t just go away if they can’t file securities class actions. The larger plaintiffs’ firms have strong client relationships with the institutional investors the Reform Act incentivized them to develop. Claims by the retail investors that the Reform Act sought to replace have made a resurgence through relationships with smaller plaintiffs’ firms. Together, these plaintiffs and plaintiffs’ firms fully cover the securities litigation landscape. These firms are competitive with one another. One will rush to file a case, and if one files, others will too. They are specialized securities lawyers, and they aren’t going to become baristas or bartenders if Basic is abolished. They will seek out cases to file.
So the plaintiffs’ bar would adjust, just as they have adjusted to limited federal-court jurisdiction under Morrison v. National Australia Bank, 561 U.S. 247 (2010). And if the post-Morrison framework is any indication of what we would face post-Basic, look out—Morrison has caused the proliferation of unbelievably expensive litigation around the world, without the ability to effectively coordinate or settle it for a reasonable amount with certain releases.
In a post-Basic world, the plaintiffs’ firms with institutional investor clients would likely file large individual and non-class collective actions. Smaller plaintiffs’ firms would also file individual and non-class collective actions. The damages in cases filed by smaller firms would tend to be smaller, but the litigation burdens would be similar.
Non-class securities actions would be no less expensive to defend than today’s class actions, since they would involve litigation of the same core merits issues. In fact, non-class litigation would be even more expensive in certain respects because, for example, there would be multiple damages analyses and vastly more complex case management. And if securities class action opt-out litigation experience is indicative of the settlement value of such cases, they would tend to settle for a larger percentage of damages than today’s securities class actions.
In a new non-class era of securities litigation, the settlement logistics would be vastly more difficult. It’s hard enough to mediate with one plaintiffs’ firm and one lead plaintiff. Imagine mediation with a dozen or more plaintiffs’ firms and even more plaintiffs. We often object to lead-plaintiff groups because of the difficulty of dealing with a group of plaintiffs instead of just one. In a world without securities class actions, the adversary would be far, far worse—a collection of plaintiffs and plaintiffs’ firms with no set of rules for getting along.
Even when settlement could be achieved, it wouldn’t preclude suits by other purchasers during the period of inflation, because there would be no due process procedure to bind them, as there is when there’s a certified class with notice and an opportunity to object or opt out. Indeed, there likely would develop a trend of random follow-up suits by even smaller plaintiffs’ firms after the larger cases have settled. There would be no peace absent the expiration of the statute of limitations.
These unmanageable and unpredictable economics would disrupt D&O insurance purchasing decisions and cost. Under the current system, D&O insurers and brokers can reliably predict the risk a particular company faces based on its size and other characteristics. A company can thus purchase a D&O insurance program that fits its risk profile.
Compounding the uncertainty of all of this would be the role of SEC and other government enforcement. Even with the current U.S. administration’s relatively hands-off regulatory approach, the job of the human beings who work at the SEC is to investigate and enforce the securities laws. They aren’t going to not do their jobs just because government regulation has been eased in the bigger picture. And they will step in to fill the void left by the inability of plaintiffs to bring securities class actions. Experienced defense counsel can predict how plaintiffs’ firms will litigate and resolve a case, but they have much less ability to predict how an enforcement person with whom he or she may never have dealt will approach a case.
Executives who do their best to tell the truth really have nothing to fear under the securities laws. The law gives them plenty of protection, and the predictability of the current system allows them to understand their risk and resolve litigation with certainty. It would be a mistake to try to abolish securities class actions. Abandoning Basic would backfire—badly.
Following is an article I wrote for Law360, which gave me permission to republish it here:
Among securities litigators, there is no consensus about the importance of developments in securities and corporate governance litigation. For some, a Supreme Court decision is always supreme. For others, a major change in a legal standard is the most critical. For me, the key developments are those that have the greatest potential to significantly increase or decrease the frequency or severity of claims against public companies and their directors and officers.
Given my way of thinking, there are three developments in 2016 that stand out as noteworthy:
- The persistence of securities class actions brought against smaller public companies primarily by smaller plaintiffs’ firms on behalf of retail investors—a trend that began five years ago and now appears to represent a fundamental shift in the securities class action landscape.
- The 2nd Circuit’s robust application of the Supreme Court’s Omnicare decision in Sanofi, illustrating the significant benefits of Omnicare to defendants.
- The demise of disclosure-only settlements under the Delaware Court of Chancery’s Trulia decision and the 7th Circuit’s subsequent scathing Walgreen opinion by Judge Posner.
I discuss each of these developments in detail, and then list other 2016 developments that I believe are important as well.
1. The Securities Class Action Landscape Has Fundamentally Changed
The Private Securities Litigation Reform Act’s lead plaintiff process incentivized plaintiffs’ firms to recruit institutional investors to serve as plaintiffs. For the most part, institutional investors, whether smaller unions or large funds, have retained the more prominent plaintiffs’ firms, and smaller plaintiffs’ firms have been left with individual investor clients who usually can’t beat out institutions for the lead-plaintiff role. At the same time, securities class action economics tightened in all but the largest cases. Dismissal rates under the Reform Act are pretty high, and defeating a motion to dismiss often requires significant investigative costs and intensive legal work. And the median settlement amount of cases that survive dismissal motions is fairly low. These dynamics placed a premium on experience, efficiency, and scale. Larger firms filed the lion’s share of the cases, and smaller plaintiffs’ firms were unable to compete effectively for the lead plaintiff role, or make much money on their litigation investments.
This started to change with the wave of cases against Chinese companies in 2010. Smaller plaintiffs’ firms initiated the lion’s share of these cases, as the larger firms were swamped with credit-crisis cases and likely were deterred by the relatively small damages, potentially high discovery costs, and uncertain insurance and company financial resources. Moreover, these cases fit smaller firms’ capabilities well. Nearly all of the cases had “lawsuit blueprints” such as auditor resignations and/or short-seller reports, thereby reducing the smaller firms’ investigative costs and increasing their likelihood of surviving a motion to dismiss. The dismissal rate was low, and limited insurance and company resources have prompted early settlements in amounts that, while on the low side, appear to have yielded good outcomes for the smaller plaintiffs’ firms.
The smaller plaintiffs’ firms thus built up momentum that has kept them going, even after the wave of China cases subsided. For the last several years, following almost every “lawsuit blueprint” announcement, a smaller firm has launched an “investigation” of the company, and they have initiated an increasing number of cases. Like the China cases, these cases tend to be against smaller companies. Thus, smaller plaintiffs’ firms have discovered a class of cases—cases against smaller companies that have suffered well-publicized problems (reducing the plaintiffs’ firms’ investigative costs) for which they can win the lead plaintiff role and that they can prosecute at a sufficient profit margin.
As smaller firms have gained further momentum, they have expanded the cases they initiate beyond “lawsuit blueprint” cases—and they continue to initiate and win lead-plaintiff contests primarily in cases against smaller companies brought by retail investors. To be sure, the larger firms still mostly can and will beat out the smaller firms for the cases they want. But it increasingly seems clear that the larger firms don’t want to take the lead in initiating many of the cases against smaller companies, and are content to focus on larger cases on behalf of their institutional investor clients.
The securities litigation landscape now clearly consists of a combination of two different types of cases: smaller cases brought by a set of smaller plaintiffs’ firms on behalf of retail investors, and larger cases pursued by the larger plaintiffs’ firms on behalf of institutional investors. This change—now more than five years old—appears to be here to stay.
In addition to this fundamental shift, two other trends are an indicator of further changes to the securities litigation landscape.
First, the smaller plaintiffs’ firms often file cases against U.S. companies in New York City or California—regardless where the company is headquartered—diverging from the larger plaintiffs’ firms’ practice of filing in the forum of the defendant company’s headquarters. In addition to inconvenience, filing cases in New York City and California against non-resident companies results in sticker-shock, since defense firms based in those venues are much more expensive than their home town firms. The solution to this problem will need to include greater defense of cases in New York City and California by a more economically diverse set of defense firms.
Second, plaintiffs’ firms, large and small, are increasingly rejecting the use of historical settlement values to shape the settlement amounts. This practice is increasing settlement amounts in individual cases, and will ultimately raise settlement amounts overall. And it will be increasingly difficult for defendants and their insurers to predict defense costs and settlement amounts, as more mediations fail and litigation proceeds past the point they otherwise would.
2. Sanofi Shows Omnicare’s Benefits
In Tongue v. Sanofi, 816 F.3d 199 (2nd Cir. 2016), the Second Circuit issued the first significant appellate decision interpreting the Supreme Court’s decision in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318 (2015). Sanofi shows that Omnicare provides powerful tools for defendants to win more motions to dismiss.
As a reminder, the Supreme Court in Omnicare held that a statement of opinion is only false under the federal securities laws if the speaker does not genuinely believe it, and is only misleading if it omits information that, in context, would cause the statement to mislead a reasonable investor. This ruling followed the path Lane Powell advocated in an amicus brief on behalf of Washington Legal Foundation.
The Court’s ruling in Omnicare was a significant victory for the defense bar for two primary reasons.
First, the Court made clear that an opinion is false only if it was not sincerely believed by the speaker at the time that it was expressed, a concept sometimes referred to as “subjective falsity.” The Court thus explicitly rejected the possibility that a statement of opinion could be false because “external facts show the opinion to be incorrect,” because a company failed to “disclose some fact cutting the other way,” or because the company did not disclose that others disagreed with its opinion. This ruling resolved two decades’ worth of confusing and conflicting case law regarding what makes a statement of opinion false, which had often permitted meritless securities cases to survive dismissal motions. Omnicare governs the falsity analysis for all types of challenged statements. Although Omnicare arose from a claim under Section 11 of the Securities Act, all of its core concepts are equally applicable to Section 10(b) of the Securities Exchange Act and other securities laws with similar falsity elements.
Second, Omnicare declared that whether a statement of opinion (and by clear implication, a statement of fact) was misleading “always depends on context.” The Court emphasized that showing a statement to be misleading is “no small task” for plaintiffs, and that the court must consider not only the full statement being challenged and the context in which it was made, but must also consider other statements made by the company, and other publicly available information, including the customs and practices of the relevant industry.
A good motion to dismiss has always analyzed a challenged statement (of fact or opinion) in its broader factual context to explain why it’s not false or misleading. But many defense lawyers unfortunately leave out the broader context, and courts have sometimes taken a narrower view. Now, this type of superior, full-context analysis is clearly required by Omnicare. And combined with the Supreme Court’s directive in Tellabs that courts consider scienter inferences based not only on the complaint’s allegations, but also on documents on which the complaint relies or that are subject to judicial notice, courts clearly must now consider the full array of probative facts in deciding both whether a statement was false or misleading and, if so, whether it was made with scienter.
Due to the importance of its holdings and the detailed way in which it explains them, Omnicare is the most significant post-Reform Act Supreme Court case to analyze the falsity element of a securities class-action claim, laying out the core principles of falsity in the same way that the Court did for scienter in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007). If used correctly, Omnicare thus has the potential to be the most helpful securities case for defendants since Tellabs, providing attorneys with a blueprint for how to structure their falsity arguments in order to defeat more complaints on motions to dismiss.
The early returns show that Omnicare is already helping defendants win more motions to dismiss. The most significant such decision is Sanofi. In Sanofi, the Second Circuit became the first appeals court to discuss Omnicare in detail, and to examine the changes that it brought about in the previously governing law. Sanofi was not, as some securities litigation defense lawyers have claimed, a “narrow” reading of the Court’s decision. Rather, it was a straightforward interpretation of Omnicare that emphasized the Supreme Court’s ruling on falsity, and the intensive contextual analysis required to show that a statement is misleading. It correctly took these concepts beyond the Section 11 setting and applied them to allegations brought under Section 10(b).
Statements about Lemtrada, a drug in development for treatment of multiple sclerosis, were at issue in the case. Sanofi and its predecessor had conducted “single-blind” clinical trials for Lemtrada (studies in which either the researcher or the patient does not know which drug was administered), despite the fact that the U.S. Food and Drug Administration had repeatedly expressed concerns about these trials and recommended “double-blind” clinical studies (studies in which both the researcher and the patient do not know which drug was administered).
The plaintiffs alleged that Sanofi’s failure to disclose FDA’s repeated warnings that a single-blind study might not be adequate for approval caused various statements made by the company to be misleading, including its projection that FDA would approve the drug, its expressions of confidence about the anticipated launch date of the drug, and its view that the results of the clinical trials were “unprecedented” and “nothing short of stunning.” Although FDA eventually approved Lemtrada without further clinical trials, the agency initially refused approval based in large part on the single-blind studies concern, causing a large drop in the price of Sanofi stock.
In an opinion issued before Omnicare, the district court dismissed the claims, in part because it found that plaintiffs had failed to plead that the challenged statements of opinion were subjectively false, under the standard employed by the Second Circuit in Fait v. Regions Financial Corp. The Second Circuit stated that it saw “no reason to disturb the conclusions of the district court,” but wrote to clarify the impact of Omnicare on prior Second Circuit law.
The court acknowledged that Omnicare affirmed the previous standard that a statement of opinion may be false “if either ‘the speaker did not hold the belief she professed’ or ‘the supporting fact she supplied were untrue.’” However, it noted that Omnicare went beyond the standard outlined by Fait in holding that “opinions, though sincerely held and otherwise true as a matter of fact, may nonetheless be actionable if the speaker omits information whose omission makes the statement misleading to a reasonable investor.”
In reality, Omnicare did not represent a change in Second Circuit law. Although Fait only discussed falsity, without considering what it would take to make an opinion “misleading,” prior Second Circuit law had been clear that “[e]ven a statement which is literally true, if susceptible to quite another interpretation by the reasonable investor, may properly be considered a material misrepresentation.” Kleinman v. Elan Corp., 706 F.3d 145 (2nd Cir. 2013) (citation and internal quotation marks omitted). Omnicare simply brought together these two lines of authority, by correctly clarifying that, like any other statement, a statement of opinion can be literally true (i.e., actually believed by the speaker), but can nonetheless omit information that can cause it to be misleading to a reasonable investor.
The Second Circuit highlighted the Omnicare Court’s focus on context, taking note of its statement that “an omission that renders misleading a statement of opinion when viewed in a vacuum may not do so once that statement is considered, as is appropriate, in a broader frame.” Since Sanofi’s offering materials “made numerous caveats to the reliability of the projections,” a reasonable investor would have considered the opinions in light of those qualifications. Similarly, the Second Circuit recognized that reasonable investors would be aware that Sanofi would be engaging in continuous dialogue with FDA that was not being disclosed, that Sanofi had clearly disclosed that it was conducting single-blind trials for Lemtrada, and that FDA had generally made clear through public statements that it preferred double-blind trials. In this broader context, the court found that Sanofi’s optimistic statements about the future of Lemtrada were not misleading even in the context of Sanofi’s failure to disclose FDA’s specific warnings regarding single-blind trials.
Under the Omnicare standards, the Second Circuit thus found nothing false or misleading about the challenged statements, holding that Omnicare imposes no obligation to disclose facts merely because they tended to undermine the defendants’ optimistic projections. In particular, the Second Circuit found that “Omnicare does not impose liability merely because an issuer failed to disclose information that ran counter to an opinion expressed in a registration statement.” It also reasoned that “defendants’ statements about the effectiveness of [the drug] cannot be misleading merely because the FDA disagreed with the conclusion—so long as Defendants conducted a ‘meaningful’ inquiry and in fact held that view, the statements did not mislead in a manner that is actionable.”
3. Companies May Regret the Decline of Disclosure-Only Settlements
In combination with the Delaware Court of Chancery’s decision in In re Trulia, Inc. Stockholder Litigation, 129 A.3d 884 (Del. Ch. 2016), Judge Posner’s blistering opinion In re Walgreen Company Stockholder Litigation, 2016 WL 4207962 (7th Cir. Aug. 10, 2016), may well close the door on disclosure-only settlements in shareholder challenges to mergers. That certainly feels just. And it may well go a long way toward discouraging meritless merger litigation. But I am concerned that we will regret it. Lost in the cheering over Trulia and Walgreen is a simple and practical reality: the availability of disclosure-only settlements is in the interests of merging companies as much as it is in the interests of shareholder plaintiffs’ lawyers, because disclosure-only settlements are often the timeliest and most efficient way to resolve shareholder challenges to mergers, even legitimate ones.
I am offended by meritless merger litigation, and have long advocated reforms to fix the system that not only allows it, but encourages and incentivizes it. Certainly, strict scrutiny of disclosure-only settlements will reduce the number of merger claims—it already has. Let’s say shareholder challenges to mergers are permanently reduced from 90% to 60% of transactions. That would be great. But how do we then resolve the cases that remain? Unfortunately, there aren’t efficient and generally agreeable alternatives to disclosure-only settlements to dispose of a merger lawsuit before the closing of the challenged transaction. Of course, the parties can increase the merger price, though that is a difficult proposition. The parties can also adjust other deal terms, but few merger partners want to alter the deal unless and until the alteration doesn’t actually matter, and settlements based on meaningless deal-structure changes won’t fare better with courts than meaningless disclosure-only settlements.
If the disclosure-only door to resolving merger cases is shut, then more cases will need to be litigated post-close. That will make settlement more expensive. Plaintiffs lawyers are not going to start to settle for less money, especially when they are forced to litigate for longer and invest more in their cases. And in contrast to adjustments to the merger transaction or disclosures, in which 100% of the cash goes to lawyers for the “benefit” they provided, settlements based on the payment of cash to the class of plaintiffs require a much larger sum to yield the same amount of money to the plaintiffs’ lawyers. For example, a $500,000 fee payment to the plaintiffs under a disclosure-only settlement would require around $2 million in a settlement payment to the class to yield the same fee for the plaintiffs’ lawyers, assuming a 25% contingent-fee award.
The increase in the cash outlay required for companies and their insurers to deal with post-close merger litigation will actually be much higher than my example indicates. Plaintiffs’ lawyers will spend more time on each case, and demand a higher settlement amount to yield a higher plaintiffs’ fee. Defense costs will skyrocket. And discovery in post-close cases will inevitably unearth problems that the disclosure-only settlement landscape camouflaged, significantly increasing the severity of many cases. It is not hard to imagine that merger cases that could have settled for disclosures and a six-figure plaintiffs’ fee will often become an eight-figure mess. And, beyond these unfortunate economic consequences, the inability to resolve merger litigation quickly and efficiently will increase the burden upon directors and officers by requiring continued service to companies they have sold, as they are forced to produce documents, sit for depositions, and consult with their defense lawyers, while the merger case careens toward trial.
Again, it’s hard to disagree with the logic and sentiment of these decisions, and the result may very well be more just. But this justice will come with a high practical price tag.
Additional Significant Developments
There were a number of other 2016 developments that I believe may also significantly impact the frequency and severity of securities claims against public companies and their directors and officers. These include:
- The ongoing wave of Securities Act cases in state court, especially in California, and the Supreme Court cert petitions in Cyan, Inc. v. Beaver County Employees Retirement Fund, No. 15-1439, and FireEye, Inc., et al., v. Superior Court of California, Santa Clara County, No. 16-744.
- The lack of a wave of cyber security shareholder litigation, and the conclusion in favor of the defendants in the Target and Home Depot shareholder derivative cases, which follows the dismissal of the Wyndham derivative case in 2014.
- The challenge to the SEC’s use of administrative proceedings, including Lynn Tilton’s tilt at the process.
- The Supreme Court’s decision on insider trading in Salman v. U.S. 137 S. Ct. 420 (2016), rejecting the 2nd Circuit’s heightened personal benefit requirement established in U.S. v. Newman, 773 F.3d 438 (2nd Cir. 2014).
- The persistence and intractability of securities class actions against foreign issuers after Morrison v. National Australia Bank, 561 U.S. 247 (2010).
- The 8th Circuit’s reversal of class certification under Halliburton II in IBEW Local 98 Pension Fund v. Best Buy Co., 818 F.3d 775, 777 (8th Cir. 2016).
- The 9th Circuit becoming the first appellate court to hold that Section 304 of Sarbanes-Oxley allows the SEC to seek a clawback of compensation from CEOs and CFOs in the event of a restatement even if it did not result from their misconduct. U.S. Securities & Exchange Commission v. Jensen, 835 F.3d 1100 (2016).
- The 2nd Circuit’s lengthy and wide-ranging decision in In re Vivendi, S.A. Securities Litigation, 838 F.3d 223 (2nd Cir. 2016), affirming the district court’s partial judgment against Vivendi following trial.
Earlier this month, I spent a week in the birthplace of D&O insurance, London. In addition to moderating a panel at Advisen’s European Executive Risks Insights Conference, I met with many energetic and talented D&O insurance professionals, both veterans and rising stars, to discuss U.S. securities litigation and regulatory risks. Themes emerged on some key issues. What follows is a collection of my impressions and opinions about three of them—not quotes from any particular company or person.
1. Greater frequency of securities class actions against smaller public companies gives D&O insurers an opportunity to innovate.
As I’ve observed over the past several years, a significant risk to companies is that ever-increasing securities defense fees no longer match the economics of most cases, and are quickly outpacing D&O policy limits. In the past, securities class actions were initiated by an oligopoly of larger plaintiffs’ firms with significant resources and mostly institutional clients that tended to bring larger cases against larger companies. But in recent years, smaller plaintiffs’ firms with retail-investor clients have been initiating more cases, primarily against smaller companies. Indeed, in recent years, approximately half of all securities class actions were filed against companies with $750 million or less in market capitalization. As a result, securities class actions have shrunken in size to a level last seen in 1997.
Yet at the same time, the litigation costs of the typical defense firms (mainly firms with marquee names) have increased exponentially. This two-decade mismatch—between 1997 securities-litigation economics and present-day law-firm economics—creates the danger that a company’s D&O policy will be insufficient to cover the fees for a vigorous defense and the price to resolve the case. Indeed, in my view, inadequate policy proceeds due to skyrocketing defense costs is the biggest risk directors and officers face from securities litigation—by far.
D&O insurers face a double-whammy: They are paying defense costs on smaller claims that are out of proportion to the actual risk because the lion’s share of cases against all companies, both large and small, are defended by the typical defense firms. At the same time, insurers are unable to charge a sufficient premium for this risk, due to the softness of the market.
I strongly believe the solution lies in a more tailored D&O insurance option for smaller public companies. Today, every public company buys some form of D&O indemnity insurance, which allows the company to choose their own lawyers and control their defense strategy. Under this approach, securities litigation defense lawyers effectively control the D&O insurance claims process; even the most veteran in-house lawyers are almost always securities litigation rookies. Is that in the insureds’ interest? Is the one-size-fits-all D&O insurance model right for smaller public companies, whose insurance proceeds are being disproportionately being spent on defense costs? Is there demand for an optional product that gives insurers greater control, up to and including an optional duty to defend D&O product for smaller companies?
London insurers and brokers are working through these issues. I’m extremely hopeful that there will be innovation for smaller public companies and their directors and officers—insureds who most need the guidance and protection of their insurance professionals.
2. In the wake of Morrison, greater strategic control is needed to deal with the risk of separate actions around the world.
In Morrison v. National Australia Bank, 561 U.S. 247 (2010), the U.S. Supreme Court held that the U.S. securities laws only apply to “transactions in securities listed on domestic exchanges, and domestic transactions in other securities.” In the aftermath of the decision, it was widely assumed that the frequency of U.S. securities class actions against foreign issuers would decline. Yet it has not. For more background, I refer you to Kevin LaCroix’s September 26, 2016 post in his blog, The D&O Diary.
Despite Morrison, foreign issuers whose securities are traded in the U.S. are still subject to a securities class action with respect to those securities. To add insult to injury, plaintiffs’ lawyers are also bringing separate actions around the world to recover for losses suffered from securities purchased outside of the U.S. The result is vastly more expensive claim resolution due to multiple actions around the world, with many lawyers madly working in each jurisdiction, and a greater practical settlement value due to the “let’s just get this over with” dynamic—but with uncertainty about the ability to obtain a worldwide release. So insurers now face a world in which claims are more severe, and in which the anticipated decline in the number of claims has not materialized.
London insurers and brokers are grappling with how to bring some order to this chaos. I don’t see an easy fix. As long as U.S. courts can’t accommodate all claims, worldwide litigation can’t be “won”—it can only be managed and settled as efficiently as possible. This requires strong strategic control of the overall litigation, both to orchestrate settlements in the most efficient fashion and to avoid lawyers in every jurisdiction doing duplicative and unproductive legal work.
Critically, strong strategic control must be imposed by an independent lawyer—someone who would obviously be paid for his or her time, but who otherwise has no financial interest in the worldwide work. Independence would give the strategic lawyer freedom from law-firm economics when making decisions about which lawyers should be doing what—and which lawyers should be doing nothing—as well as about when to settle. In other words, if Dewey Cheatham & Howe is worldwide defense counsel, with multiple offices and dozens of lawyers working on the case, the strategic leader should not be a Dewey Cheatham & Howe lawyer.
But who would play such a role? Although many companies of course have excellent in-house lawyers, very few have in-house lawyers who formerly were prominent securities litigators. So should the strategic quarterback be a securities litigator from a firm other than the worldwide defense firm? Should it be the broker? Should it be a lawyer for the primary or a low excess carrier? These are all good possibilities. And how can this arrangement be put in place before the litigation defense is already beyond control? Having the discussion is an important first step, and London insurers and brokers are working hard to figure this out.
3. The danger of a wave of D&O claims relating to cyber security remains real.
One of the foremost uncertainties in securities and corporate governance litigation is the extent to which cyber security will become a significant D&O liability issue. Although many practitioners and D&O insurers and brokers have been bracing for a wave of cyber security D&O matters, to date there has been only a trickle. Yet among D&O insurers and brokers in London and elsewhere, there remains a concern that a wave is coming.
I share that concern. To date, plaintiffs generally haven’t filed cyber security securities class actions because stock prices have not significantly dropped when companies have disclosed breaches. That is bound to change as the market begins to distinguish companies on the basis of cyber security. There have been a number of shareholder derivative actions asserting that boards failed to properly oversee their companies’ cyber security. Those actions will continue, and likely increase, whether or not plaintiffs file cyber security securities class actions, but they will increase exponentially if securities class action filings pick up.
I also worry about SEC enforcement actions concerning cyber security. The SEC has been struggling to refine its guidance to companies on cyber security disclosure, trying to balance the concern of disclosing too much and thus providing hackers with a roadmap, with the need to disclose enough to allow investors to evaluate companies’ cyber security risk. But directors and officers should not assume that the SEC will announce new guidance or issue new rules before it begins new enforcement activity in this area. All it takes to trigger an investigation of a particular company is some information that the company’s disclosures were rendered false or misleading by inadequate cyber security. And all it takes to trigger broader enforcement activity is a perception that companies are not taking cyber security disclosure seriously. As in all areas of legal compliance, companies need to be concerned about whistleblowers, including overworked and underpaid IT personnel, lured by the SEC’s whistleblower bounty program, and about auditors, who will soon be asking more frequent and difficult questions about cyber security.
In addition to an increase in frequency, I worry about severity because of the notorious statistics concerning a lack of attention by companies and boards to cyber security oversight and disclosure. Indeed, the shareholder litigation may well be ugly: The more directors and officers are on notice about the severity of cyber security problems, and the less action they take while on notice, the easier it will be for plaintiffs to prove their claims.
Cyber security has improved, albeit not enough, in part because of the thought leadership and product development by insurers and brokers. So even if there is never a wave of D&O cyber security matters, the excellent work by insurers and brokers in London and around the world will have been worthwhile.
The Roots of D&O Insurance
London insurers and brokers are also focused on finding the right coverages for entities and individuals in the Yates-memo regulatory environment. This of course can create tension between entities, who would like their investigations costs covered, and individuals, for whom D&O insurance was created.
I am a D&O insurance fundamentalist—director and officer protection should always be our North Star. But a company can find the right path to protection of both individuals and the company with good communication between and among the company, its directors and officers, broker, and insurers—both at policy inception and when a claim arises.
It was a privilege to discuss this fundamental D&O insurance question, and many others, with thoughtful D&O insurance professionals who work just down the street from Edward Lloyd’s coffee house.
The fifth of my “5 Wishes for Securities Litigation Defense” (April 30, 2016 post) is to move securities class action damages expert reports and discovery ahead of fact discovery. This simple change would allow the defendants and their D&O insurers to understand the real economics of cases that survive a motion to dismiss, and allow the parties to make more informed litigation and settlement decisions.
Securities class actions are often labeled “bet the company” cases because they assert large theoretical damages and name the company’s senior management and sometimes the board as defendants. In reality, however, very few securities class actions pose a real threat to the company or its directors and officers. Most securities class actions follow a predictable course of litigation and resolution. Nearly all cases settle before trial. And, with the help of economists, experienced defense lawyers and D&O insurance professionals can predict with reasonable accuracy the settlement “value” of a case based on historical settlement information and their judgment.
Historically, settlement amounts were driven by an accurate understanding of the merits of the litigation and damages exposure. Cases that weren’t dismissed on a motion to dismiss were often defended through at least the filing of a summary judgment motion and the completion of damages discovery. This kind of vigorous defense is no longer economically rational in the lion’s share of cases, because of the high billing rates and profit-focused staffing of the typical defense firms—primarily firms with marquee names. 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 fact and expert discovery and summary judgment anymore.
The reality of these economics is increasingly leading to mediations and settlements very early in the litigation, if a case isn’t dismissed. But, though rational, this comes at a high price. Early settlements are, by definition, less informed than later settlements. Plaintiffs’ lawyers must push for a higher settlement payment to compensate for the risk that they are settling a meritorious case for too little, and to increase the baseline for a smaller percentage fee due to a lower lodestar. Defendants and their insurers tend to be willing to overpay because they are saving on defense costs by not litigating further, and because there may be some downward pressure on the settlement amount since the plaintiffs’ lawyers will be doing less work too.
Damages considerations also loom large. At an early mediation, before damages expert discovery, the parties typically come to the mediation only with a preliminary damages estimate that neither side has thoroughly analyzed, much less tested through intensive work with the experts and expert discovery. Rigorous expert work often significantly reduces realistic damages exposure. For example, stock drops that lead to a securities class action are often the result of multiple negative news items. A rigorous damages analysis parses each item from the total stock drop to isolate the portion caused by the revelation of the allegedly hidden truth that made the challenged statements false or misleading. A defense firm that is motivated to settle the litigation sometimes does not want to do this work, so that it can use the large bet-the-company damages figure to pressure the insurer into settling for an amount that the plaintiffs will take. A defense lawyer might say, “Our economist says that damages are $1 billion, so the $30 million the plaintiffs are demanding is a reasonable settlement.” But expert analysis and discovery may well push the $1 billion number down to a much lower number, which in turn would dramatically reduce a reasonable settlement amount. Worsening this problem is the increasing unwillingness of mediators and plaintiffs’ lawyers to base settlement amounts on historical data—which places the preliminary damages analysis at the center of the negotiations.
This problem leads to my fifth wish: expert damages analysis and discovery should be the first thing we do after a motion to dismiss is denied. This will help us know if the case is really a big case, or is a small case that just seems big. Everyone would benefit. Plaintiffs and defendants would be able to reach a settlement more easily, based on true risk and reward. Insurers would know that they are funding a settlement that reflects the real risk, in terms of damages exposure. And courts would feel more comfortable that they are approving (or rejecting) settlements based on a litigated assessment of damages. Indeed, placing damages expert work first would help serve the core policy of our system of litigation: “to secure the just, speedy, and inexpensive determination of every action and proceeding.” Federal Rule of Civil Procedure 1.
Although the logic of my wish would lead to full fact discovery before mediation as well, so that settlements can be fully informed, I favor a continued stay of fact discovery during early expert discovery. Early expert discovery can be accomplished relatively quickly and efficiently, whereas fact discovery can be immediately and wildly expensive—which is primarily what drives very early settlements. And although plaintiffs and defendants often disagree about the relevance of fact discovery on damages, the absence of fact discovery for consideration in damages analysis is a factor the parties can weigh in evaluating the damages experts’ opinions. Unless and until the cost of discovery becomes more manageable, continuing the fact-discovery stay while expert damages discovery proceeds would strike the right balance.
Accelerating the timing of damages expert discovery would align it with the work required by damages experts to analyze price-impact issues under the Supreme Court’s 2014 decision in Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014) (“Halliburton II“). In Halliburton II, the Supreme Court held that defendants may seek to rebut the fraud-on-the-market presumption of reliance, and thus defeat class certification, through evidence that the alleged false and misleading statements did not impact the market price of the stock. Unifying these two overlapping economic expert projects would create efficiencies for the lawyers and economists. Completing both of them before fact discovery starts would avoid unnecessary discovery costs if the Halliburton II opposition defeated or limited class certification, or if the damages analysis facilitated early settlement.
I’m sure it is not lost on readers that I just argued for a fundamental reform in the procedure for securities class action litigation to fix a problem that is primarily caused by the inability of typical defense firms to efficiently and effectively defend a securities class action even through summary judgment. To say the least, a system of litigation that can’t accommodate actual litigation is broken. Significant change in securities litigation defense is inevitable.
I hope that this series has provoked thought and discussion about ways to re-focus our system of securities litigation defense on its mission: to help directors and officers through litigation safely and efficiently, without losing their serenity or dignity, and without facing any real risk of paying any personal funds. Here, again, are my five wishes:
- 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. (5 Wishes for Securities Litigation Defense: A Defense-Counsel Interview Process in All Cases)
- 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. (5 Wishes for Securities Litigation Defense: Greater Insurer Involvement in Defense-Counsel Selection and Strategy)
- 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. (5 Wishes for Securities Litigation Defense: Effective Use of the Supreme Court’s Omnicare Decision)
- 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 Wishes for Securities Litigation Defense: Greater Director Involvement in Securities Litigation Defense and D&O Insurance)
- 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.
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 Courts, Critical Legal Issues Working Paper Series, Washington Legal Foundation (No. 195, June 2016).