In my last post of 2013, I thought I’d share some thoughts about how public companies can better protect themselves against securities claims – practical steps companies can take to help them avoid suits, mitigate the risk if they are sued, and to defend themselves more effectively and efficiently. I’ll share a few thoughts in this post and expand on some of them in future posts.
How Can Companies Avoid Securities Litigation?
Companies can avoid many suits with what I’ll call “better-feeling” disclosures. Nearly all public companies devote significant resources to accounting that conforms with GAAP, and non-accounting disclosures that comply with the labyrinth of disclosure rules. Despite tremendous efforts in these areas, later events sometimes surprise officers and directors – and the market – and make a company’s previous accounting or non-accounting disclosures appear to have been inaccurate.
But plaintiffs’ lawyers decide to sue only a subset of such companies – a smaller percentage than most people would assume. What makes them sue Company A, but not Company B, when both have suffered a stock price drop due to a development that relates to their earlier disclosures? There are a number of factors, but I believe the driver is whether a company’s disclosures “feel” fair and honest. Without the benefit of discovery, plaintiffs’ lawyers have to draw inferences about whether litigation will reveal fraud or a sufficient degree of recklessness – or show that the discrepancies between the earlier disclosures and later revelations was due to mistake or an unanticipated development.
What can companies do to make their disclosures “feel “more honest?
An easy way for companies to make their disclosures feel more honest and forthright is to improve the quality of their Safe Harbor warnings. Although the Reform Act’s Safe Harbor was designed to protect companies from lawsuits over forward-looking statements, there are still an awful lot of such actions filed. The best way to avoid them is by crafting risk warnings that are current and candid. A plaintiffs’ lawyer who reads two years’ worth of risk factors can tell whether the risk factors are boilerplate, or an honest attempt to describe the company’s risks. The latter deters suits. The former invites them.
Another way for companies to improve their disclosures is through more precision and a greater feel of candor in the comments they make during investor conference calls. Companies sweat over every detail in their written disclosures, but then send their CEO and CFO out to field questions on the very same subjects and improvise their responses. What executives say, and how they say it, often determines whether plaintiffs’ lawyers sue – and, if they do, how difficult the case will be to defend. A majority of the most difficult statements to defend in a securities class action are from investor calls, and plaintiffs’ lawyers listen to these calls and form impressions, positive and negative, about officers’ fairness and honesty.
Companies looking to minimize the risks of litigation should also take steps to prevent their officers and directors from making suspicious-looking stock sales – for obvious reasons, plaintiffs’ lawyers like to file suits that include stock sales. If a company’s officers and directors don’t have 10b5-1 plans, companies should establish and follow an insider trading policy and, when in doubt, seek guidance from outside counsel on issues such as trading windows and the propriety of individual stock sales, both as to the legal ability to sell, and how the sales will appear to plaintiffs’ lawyers. And even if their officers and directors have 10b5-1 plans, companies aren’t immune to the scrutiny of their stock sales – plaintiffs’ lawyers usually aren’t deterred by 10b5-1 plans, contrary to conventional wisdom. So companies should consult with their counsel about establishing and maintaining the plans, to avoid traps for the unwary.
How Can Companies Better Protect Themselves Against Securities Litigation that Does Arise?
Whether a securities class action is a difficult experience or a fairly routine corporate legal matter usually turns on the company’s decisions about directors’ and officers’ indemnification and insurance, its choice of defense counsel, and its management of the defense of the litigation.
Deciding on the right director and officer protections and defense counsel require an understanding of the seriousness of securities class actions. Although securities class actions are a public company’s primary D&O litigation exposure,* most companies don’t understand the degree of risk they pose. Some companies seem to take securities class actions too seriously, while others might not take them seriously enough.
The right level of concern is almost always in the middle. A securities class action is a significant lawsuit. It alleges large theoretical damages and wrongdoing by senior management and often the board. But the risk presented by a securities action is usually very manageable, if the company hires experienced, non-conflicted and efficient counsel, and devotes sufficient time and energy to the litigation. Cases can be settled for a predictable amount, and it is exceedingly rare for directors and officers to write a personal check to defend or settle the case. On the other hand, it can be a costly mistake for a company to take a securities class action too lightly; even meritless cases can go wrong.
The right approach to securities litigation involves several practical steps that are within every company’s control.
Companies should hire the right D&O insurance broker and treat the broker as a trusted advisor. There is a talented and highly specialized community of D&O insurance brokers. Companies should evaluate which is the right broker for them – they should conduct an interview process to decide on the right broker, and seek guidance from knowledgeable sources, including securities litigation defense counsel. Companies should heavily utilize the broker in deciding on the right structure for their D&O insurance program and in selecting the right insurers. And since D&O insurance is ultimately about protecting officers and directors, companies should have the broker speak directly to the board about the D&O insurance program.
Boards should learn more about their D&O insurers. Boards should know their D&O insurers’ financial strength and other objective characteristics. But boards should also consider speaking with the primary insurer’s underwriting executives from time to time, especially if the relationship with the carrier is, or may be, long-term. The quality of any insurance turns on the insurer’s response to a claim. D&O insurance is a relationship business. Insurers want to cover D&O claims, and it is important to them to have a good reputation for doing so. The more the insurer knows the company, the more comfortable the insurer will be about covering even a difficult claim. And the more a board knows the insurer, the more comfortable the board will be that the insurer will cover even a difficult claim.
Boards should oversee the defense-counsel selection process, and make sure the company conducts an interview process and chooses counsel based on value. The most important step for a company to take in defending a securities class action is to conduct an audition process through which the company selects conflict-free defense counsel who can provide a quality defense – at a cost that leaves the company enough room to defend and resolve the litigation within policy limits. Put differently, the biggest threats to an effective defense of a securities class action are the use of either a conflicted defense counsel, defense counsel who will charge an irrational fee for the litigation, or counsel who will cut corners to make the economics appear reasonable.
Errors in counsel-selection most often occur when a company fails to conduct an interview process, or fails to consult with its D&O insurers and brokers, who are “repeat players” in D&O litigation and thus have good insights on the best counsel for a particular case. Although the Reform Act’s 90-day lead plaintiff selection process gives companies plenty of time to evaluate, interview, and select the right defense counsel for the case, many companies quickly hire their corporate counsel’s litigation colleagues, without consulting with brokers and insurers or interviewing other firms.
The right counsel may end up being the company’s normal corporate firm, but a quick hiring decision rarely makes sense under a cost-benefit analysis. The cost of hiring the wrong firm can substantial – the harm includes millions of dollars of unnecessary fees; hundreds of hours of wasted time by the board, officers, and employees; an outcome that is unnecessarily uncertain; and an unnecessarily high settlement – and there’s very little or no upside to the company.
On the other hand, it costs very little to interview several firms for an hour or two each, and the benefit can be substantial – free and specialized strategic advice by several of the handful of lawyers who defend securities litigation full time, and potentially substantial price and other concessions from the firm that is ultimately chosen. The auditioning lawyers can also provide guidance to the company on whether its corporate counsel faces conflicts and, if so, the potential harm to the company and the officers and directors from hiring corporate counsel anyway.
* This discussion focuses on public company securities class actions. I set aside shareholder derivative litigation and shareholder challenges to mergers, which typically involve lesser risk.