Why do the costs of defending securities class actions continue to increase? Because of my writing on the subject (e.g. here and here), I’m asked about the issue a lot. My answer has evolved from blaming biglaw economics – a combination of rates and staffing practices – to something more fundamental. Biglaw economics is a consequence of the problem, not its cause. I believe the root cause is the convergence of two related factors:
- The prevailing view, fueled by defense lawyers, that securities class actions are “bet the company” cases and threaten the personal financial security of director and officer defendants; and
- As a result of these perceived threats, the reflexive hiring of biglaw firms, which companies and their directors and officers feel are uniquely equipped to defend them – in other words, they go to what they perceive to be the “Mayo Clinic” of defense firms.
But it simply isn’t necessary, and is often even strategically unwise, to turn to a biglaw firm for most securities class actions.
To be sure, securities class actions are serious matters that assert large theoretical damages. But the vast majority of cases, if defended effectively and efficiently by securities litigation specialists, are easily managed and settled within D&O insurance limits, with no real risk of any out-of-pocket payment by a company’s directors and officers.
The Vast Majority of Securities Litigation Is Manageable
Companies and their directors and officers understandably feel threatened by securities class actions. Plaintiffs asserting 10b-5 claims allege that the defendants lied on purpose, and claim theoretical damages in the hundreds of millions or billions of dollars in the lion’s share of cases. Plaintiffs asserting Section 11 claims have relaxed standards of pleading and proof – the company’s liability is strict, and individuals have the burden of showing their due diligence. Section 11 damages are typically lower than 10b-5 damages, but they are still substantial. In the world of complex corporate litigation, securities lawsuits certainly are among the most threatening.
Not surprisingly, many biglaw lawyers exaggerate this threat – so that the obvious and necessary recourse seems to be to hire their firm. In turn, in-house lawyers often reflexively turn to biglaw because “no one ever got fired for hiring _______ [fill in your favorite biglaw firm].” This is especially so if such a “safe” biglaw firm is their regular outside firm. Busy CEOs and CFOs, the typical individual defendants, rely on their in-house lawyers’ recommendation of which firm to hire, or firms to interview. Boards often defer to management’s hiring process and recommendation or decision, even though board members often will become defendants themselves in a related shareholder derivative action shortly after the securities class action is filed.
In reality, however, very few securities class actions pose a real threat to the company or its directors and officers. Most securities class actions are brought by a small group of plaintiffs’ firms, who have a playbook that experienced defense counsel know well. There are few surprises in the vast majority of cases. Indeed, at the outset of a securities class action, most good securities defense lawyers and D&O insurance professionals can accurately estimate the odds of prevailing on a motion to dismiss and, if the case is not dismissed, the settlement value.
Securities class actions follow a highly predictable course. The first step, of course, is a motion to dismiss. Because of the high pleading standards imposed by the Private Securities Litigation Reform Act, the rate of dismissal of 10b-5 cases is high. According to NERA Economic Consulting, approximately 50% of securities class actions filed and resolved from 2000 through 2013 were dismissed on a motion to dismiss.
Of cases that are not dismissed, nearly all are settled short of a trial verdict. According to NERA, of the 4,226 securities class actions filed since the Reform Act, only 20 have gone to trial and only 14 have reached a verdict. Settlements, moreover, are generally relatively modest. For the past five years, the median settlement amount was, in millions (again according to NERA), $8.5, $11.0, $7.5, $12.3, and $9.1 respectively – well within the limits of a typical public company D&O insurance program.
Shareholder derivative litigation and shareholder challenges to M&A transactions likewise pose little real threat to companies and individual defendants as a general rule. Corporate law imposes high hurdles for plaintiffs in the typical shareholder derivative case, which is often dismissed on motions to dismiss. If not dismissed, the vast majority of such cases are settled through corporate governance changes and a six-figure payment to the plaintiffs’ lawyers. Likewise, the vast majority of shareholder challenges to M&A transactions are resolved early in the litigation through proxy statement changes, and sometimes changes to the transaction, and a six-figure payment to the plaintiffs’ lawyers.
These settlements are covered by D&O insurance, with limited exceptions. Major D&O insurers typically handle D&O claims in an insured-friendly and responsive manner, owing in part to the fact that they are insuring the company’s directors and officers. Actual D&O coverage litigation is uncommon. Insurers’ in-house and outside claims professionals are experts in D&O liability litigation, and many of them have handled vastly more D&O claims than even the most experienced securities defense lawyers. Good defense counsel are able to work cooperatively with D&O claims professionals through the litigation, utilize their experience to assist with strategic decisions to improve the defense of the litigation, and if the litigation isn’t dismissed, obtain funding of a reasonable settlement, typically within policy limits and without a contribution from the company – provided defense costs are in line with the settlement value of the litigation.
Biglaw Securities Defense Tends to Over-Litigate or Under-Litigate
To illustrate the way that biglaw firms tend to over-litigate or under-litigate securities actions, let’s use a hypothetical case. Acme and its CEO and CFO are sued in a securities class action. Acme has $25 million in D&O insurance, which is an appropriate amount based on Acme’s market capitalization, risk profile, and other company and industry considerations. Acme hires a biglaw firm to defend the litigation. Defense counsel’s billing rates range from $1,200 for the senior partner to $600 for a new associate. There are 2 partners and 6 associates at various levels assigned to the case.*
At the outset of the case, Acme’s economist conducts a preliminary “plaintiffs’-style” damages analysis, and estimates that plaintiffs will assert damages of around $500 million. Based on this estimate of asserted damages and analysis of various other factors, Acme’s economist, D&O insurer, and defense counsel suggest that the case should settle in the range of $10–15 million.
Acme makes a motion to dismiss the securities class action, and loses. Acme’s defense counsel’s fees through the motion to dismiss total $1.5 million. Acme’s D&O insurer asks defense counsel for a budget through completion of discovery and summary judgment – i.e., the budget does not include trial. Defense counsel gives the insurer an estimate of $10 million (and, in most matters, the defense budget understates what the actual defense costs will be). Around the same time, an Acme shareholder files a tag-along shareholder derivative action against Acme’s directors and officers. Acme intends to move to dismiss the shareholder derivative action. Depending on the outcome of the motion, defense counsel gives a budget estimate of $1–5 million up to, but not including, trial.
Let’s pause here. At this point, at least $12.5 million of Acme’s $25 million of D&O insurance will be depleted for work up to, but not including, trials in the two matters: $1.5 million incurred, plus $11 million estimated. That amount could grow to $16.5 million if the derivative action survives a motion to dismiss. And the actual cost could be even higher if the biglaw defense firm’s estimates are indeed low. So let’s say a better estimate of total defense costs for the securities and derivative actions, not including trials, would be $20 million. Based on that estimate, Acme would have as much as $12.5 million and as little as $5 million with which to settle the litigation if it were to litigate through summary judgment – which is normal in complex commercial cases, because litigation through summary judgment helps the parties reach a settlement that reflects the actual merits of the litigation. And if the case did not settle at that point, there would not be enough insurance proceeds left to take the case to trial.
What are Acme’s options?
First, it could proceed to defend the litigation through summary judgment. However, absent a denial of plaintiffs’ motion for class certification or dismissal on summary judgment, at most there would remain just enough to settle within insurance limits, and if in fact the defense firm has underestimated defense costs, there probably would not be sufficient proceeds left for settlement – which means that Acme itself would need to write a check to pay for the settlement.
Second, Acme could try to settle the case at this point, before incurring further defense costs. This would allow for a settlement within policy limits. However, early settlements tend to be more expensive than later settlements – i.e., they overpay the plaintiffs. And Acme and its directors and officers feel they did nothing wrong, and would prefer to litigate the case further and try to obtain dismissal at class certification or summary judgment – and perhaps even consider taking the case to trial. (Acme has tried several large commercial and IP cases over the years, and likes to take cases to trial if they can’t be settled reasonably.)
Thus, Acme has two options: (1) it can defend the case past its insurance limits, or (2) it can settle early and probably pay more than the merits say it should. To avoid this dilemma, biglaw firms sometimes employ a third alternative: they under-litigate cases, cutting corners to make their economics fit matters that don’t justify the billing they would generate based on their “normal” rates and staffing practices. The result, of course, is a diminished defense. I suppose with client and insurer permission, deliberate under-litigation and corner-cutting would be a legitimate strategy. But who would knowingly want a diminished defense?
The Solution is Non-Biglaw Alternatives
Some securities cases are well-suited for biglaw securities defense practices, primarily large cases that are relatively cost-insensitive and require large teams. And some biglaw firms and partners do a better job than others defending securities matters within the biglaw system. But, as the Acme hypothetical illustrates, there are many cases for which biglaw economics just don’t work. Public companies and their directors and officers need an alternative to biglaw defense practices in such cases.
Let’s briefly re-analyze the Acme hypothetical assuming incurred fees of $500,000 and a capped defense-cost budget of $5 million for the securities class action and $500,000–$2.5 million for the derivative action. If Acme were to litigate up to trial, it would have $17 to $19 million left with which to settle the litigation – leaving plenty of room under the policy for settlement, as well as potentially for trial.
There are a handful of firms (including mine) that can handle the hypothetical case with those economics while providing the same, or better, quality of defense, and can litigate nationwide. D&O brokers and insurers can help companies find them. But there need to be more. The ideal profile of a biglaw alternative is a team comprising former biglaw lawyers, who can offer the best of both worlds: the sophistication and quality of defense biglaw offers, without the economic difficulties that biglaw can present. I hope that other biglaw partners will consider doing what I did, and move their practice to a strong non-biglaw firm, and build a team that is a good alternative to biglaw in the right cases.
Public companies, their directors and officers, and their D&O insurers would be better served with more of us providing an attractive alternative to the standard defense practice.
* As we have written previously (e.g., here and here), the associate-heavy structure of the team is, in large part, simply a function of biglaw firms’ economic model – high associate-to-partner ratios designed to increase profits-per-partner. That system invites over-litigation and economic inefficiency, including make-work, over-delegation, and inadequate supervision. Even partners acting with the utmost good faith often can’t overcome the pressures biglaw’s economic system imposes.