Following is an article we wrote for Law360, which gave us permission to republish it here:
The coming year promises to be a pivotal one in the world of securities and corporate governance litigation. In particular, there are five developing issues we are watching that have the greatest potential to significantly increase or decrease the exposure of public companies and their directors, officers, and insurers.
1. How Will Lower Courts Apply the Supreme Court’s Decision in Omnicare, Inc. v. Laborers Dist. Council Const. Industry Pension Fund?
If it is correctly understood and applied by defendants and the courts, we believe Omnicare will stand alongside Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), as one of the two most important securities litigation decisions since the Private Securities Litigation Reform Act of 1995.
In Omnicare, 135 S. Ct. 1318 (2015), the Supreme Court held that a statement of opinion is only false if the speaker does not genuinely believe it, and that it is only misleading if – as with any other statement – it omits facts that make it misleading when viewed in its full context. The Court’s ruling on what is necessary for an opinion to be false establishes a uniform standard that resolves two decades of confusing and conflicting case law, which often resulted in meritless securities cases surviving dismissal motions. And the Court’s ruling regarding how an opinion may be misleading emphasizes that courts must evaluate the fairness of challenged statements (both opinions and other statements) within a broad factual context, eliminating the short-shrift that many courts have given the misleading-statement analysis.
These are tremendous improvements in the law, and should help defendants win more cases involving statements of opinion, not only under Section 11, the statute at issue in Omnicare, but also under Section 10(b), since Omnicare’s holding applies to the “false or misleading statement” element common to both statutes. The standards the Court set should also add to the Reform Act’s Safe Harbor, and expand the tools that defendants have to defend against challenges to earnings forecasts and other forward-looking statements, which are quintessential opinions.
Indeed, if used correctly, Omnicare should also help defendants gain dismissal of claims brought based on challenged statements of fact, because of its emphasis on the importance of considering the entire context of a statement when determining whether it was misleading. For example, the Court emphasized that whether a statement is misleading “always depends on context,” so a statement must be understood in its “broader frame,” including “in light of all its surrounding text, including hedges, disclaimers, and apparently conflicting information,” and the “customs and practices of the relevant industry.”
A good motion to dismiss has always analyzed a challenged statement (of fact or opinion) in its broader factual context to explain why it was not misleading. But many defense lawyers unfortunately choose to leave out this broader context, and as a result of this narrow record, courts sometimes take a narrower view. With Omnicare, this superior method of analysis is now explicitly required. This will be a powerful tool, especially when combined with Tellabs’s directive that courts must weigh scienter inferences based not only on the complaint’s allegations, but also on documents on which the complaint relies or that are subject to judicial notice.
Omnicare bolsters the array of weapons available to defendants to effectively defend allegations of falsity, and to set up and support the Safe Harbor defense and arguments against scienter. Because of its importance, we plan to write a piece critiquing the cases applying Omnicare after its one-year anniversary in March.
2. Will Courts Continue to Curtail the Use of 10b5-1 Plans as a Way to Undermine Scienter Allegations?
All successful securities fraud complaints must persuade the court that the difference between the challenged statements and the “corrective” disclosure was the result of fraud, and not due to a business reversal or some other non-fraudulent cause. Because few securities class action complaints contain direct evidence of fraud, such as specific information that a speaker knew his statements were false, most successful complaints include allegations that the defendants somehow profited from the alleged fraud, such as through unusual and suspicious stock sales.
Thus, stock-sale allegations are a key battleground in most securities actions. An important defensive tactic has been to point out that the challenged stock sales were made under stock-sale plans under SEC Rule 10b5-1, which provides an affirmative defense to insider-trading claims, if the plan was established in good faith at a time when they were unaware of material non-public information. Although Rule 10b5-1 is designed to be an affirmative defense in insider-trading cases, securities class action defendants also use it to undermine stock-sale allegations, if the plan has been publicly disclosed and thus subject to judicial notice, since it shows that the defendant did not have control over the allegedly unusual and suspicious stock sales.
Plaintiffs’ argument in response to a 10b5-1 plan defense has always been that any plan adopted during the class period is just a large insider sale designed to take advantage of the artificial inflation in the stock price. Plaintiffs claim that by definition, the class period is a time during which the defendants had material nonpublic information – although they often manipulate the class period in order to encompass stock sales and the establishment of 10b5-1 plans.
There have been surprisingly few key court decisions on this pivotal issue, but on July 24, 2015, the Second Circuit held that “[w]hen executives enter into a trading plan during the Class Period and the Complaint sufficiently alleges that the purpose of the plan was to take advantage of an inflated stock price, the plan provides no defense to scienter allegations.” Employees’ Ret. Sys. of Gov’t of the Virgin Island v. Blanford, 794 F.3d 297, 309 (2d Cir. 2015).
Plaintiffs’ ability to plead scienter will take a huge step forward if Blanford, decided by an important appellate court, starts a wave of similar holdings in other circuits.
3. Will Delaware’s Endorsement of Forum Selection Bylaws and Rejection of Disclosure-Only Settlements Reduce Shareholder Challenges to Mergers?
For the past several years, there has been great focus on amending corporate bylaws to try to corral and curtail shareholder corporate-governance claims, principally shareholder challenges to mergers. Meritless merger litigation is indeed a big problem. It is a slap in the face to careful directors who have worked hard to understand and approve a merger, and to CEOs who have worked long hours to find and negotiate a transaction that is in the shareholders’ best interests. It is cold comfort to know that nearly all mergers draw shareholder litigation, and that nearly all of those cases will settle before the transaction closes without any payment by the directors or officers personally. It is proof that the system is broken when it routinely allows meritless suits to result in significant recoveries for plaintiffs’ lawyers, with virtually nothing gained by companies or their shareholders.
In 2015, the Delaware legislature and courts took significant steps to curb meritless merger litigation.
First, the legislature added new Section 115 to the Delaware General Corporation Law (“DGCL”), which provides:
The certificate of incorporation or the bylaws may require, consistent with applicable jurisdictional requirements, that any or all internal corporate claims shall be brought solely and exclusively in any or all of the courts in this State.
This provision essentially codified the holding in Boilermakers Local 154 Ret. Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013), in which the Delaware Court of Chancery upheld the validity of bylaws requiring that corporate governance litigation be brought only in Delaware state and federal courts. The Delaware legislature also amended the DGCL to ban bylaws that purport to shift fees. In new subsection (f) to Section 102, the certificate of incorporation “may not contain any provision that would impose liability on a stockholder for the attorneys’ fees or expenses of the corporation or any other party in connection with an internal corporate claim.” See also DGCL Section 109(b) (similar).
Second, in a series of decisions in 2015, the Delaware Court of Chancery rejected or criticized so-called disclosure-only settlements, under which the target company supplements its proxy-statement disclosures in exchange for a payment to the plaintiffs’ lawyers. See Acevedo v. Aeroflex Holding Corp., et al., C.A. No. 7930-VCL (Del. Ch. July 8, 2015) (TRANSCRIPT) (rejecting disclosure-only settlement); In re Aruba Networks S’holder Litig., C.A. No. 10765-VCL (Del. Ch. Oct. 9, 2015) (TRANSCRIPT) (same); In re Riverbed Tech., Inc., S’holder Litig., 2015 WL 5458041, C.A. No. 10484-VCG (Del. Ch. Sept. 17, 2015) (approving disclosure-only settlement with broad release, but suggesting that approval of such settlements “will be diminished or eliminated going forward”); In re Intermune, Inc., S’holder Litig., C.A. No. 10086–VCN (Del. Ch. July 8, 2015) (TRANSCRIPT) (noting concern regarding global release in disclosure-only settlement).
We will be closely watching the impact of these developments, with the hope that they will deter plaintiffs from reflexively filing meritless merger cases. Delaware exclusive-forum bylaws will force plaintiffs to face the scrutiny of Delaware courts, and the Court of Chancery has indicated that it may no longer allow an easy exit from these cases through a disclosure-only settlement. And with cases in a single forum, defendants will now be able to coordinate them for early motions to dismiss. Thus, the number of mergers subject to a shareholder lawsuit should decline – and the early returns suggest that this may already be happening.
Yet defendants should brace for negative consequences. Plaintiffs’ lawyers will doubtless bring more cases outside of Delaware against non-Delaware corporations, or against companies that haven’t adopted a Delaware exclusive-forum bylaw. And within Delaware, plaintiffs’ lawyers will tend to bring more meritorious cases that present greater risk, exposure, and stigma – and while Delaware is a defendant-friendly forum for good transactions, it is a decidedly unfriendly one for bad ones. If disclosure-only settlements are no longer allowed, defendants will no longer have the option of escaping these cases easily and cheaply. This means that those cases that are filed will doubtless require more expensive litigation, and result in more significant settlements and judgments. Thus, although the current system is undoubtedly badly flawed, many companies may well look back on the days of this broken system with nostalgia, and conclude that they were better off before it was “fixed.”
4. Will Item 303 Claims Make a Difference in Securities Class Actions?
The key liability provisions of the federal securities laws, Section 10(b) of the Securities Exchange Act of 1934 and Section 11 of the Securities Act of 1933, both require that plaintiffs establish a false statement, or a statement that is rendered misleading by the omission of facts. Over the last several years, plaintiffs’ lawyers have increasingly tried to bypass this element by asserting claims for pure omissions, detached from any challenged statement.
Plaintiffs base these claims on Item 303 of SEC Regulation S-K, which requires companies to provide a “management’s discussion and analysis” (MD&A) of the company’s “financial condition, changes in financial condition and results of operations.” Item 303(a)(3)(ii) indicates that the MD&A must include a description of “any known trends or uncertainties that have had or that the [company] reasonably expects will have a material … unfavorable impact on net sales or revenues or income from continuing operations.”
Both Section 10(b) and Section 11 prohibit a false statement or omission of a fact that causes a statement to be misleading, while Section 11 also allows a claim based on an issuer’s failure to disclose “a material fact required to be stated” in a registration statement. 15 U.S.C. § 77k(a) (emphasis added). Item 303 is one regulation that lists such “material fact(s) required to be stated.” Panther Partners Inc. v. Ikanos Communications, Inc., 681 F.3d 114, 120 (2d Cir. 2012). Based on this unique statutory language, Section 11 claims thus appropriately can include claims based on Item 303.
Last year, in Stratte-McClure v. Morgan Stanley, 776 F.3d 94 (2d Cir. 2015), the Second Circuit held that Item 303 also imposes a duty to disclose for purposes of Section 10(b), meaning that the omission of information required by Item 303 can provide the basis for a Section 10(b) claim. This ruling is at odds with the Ninth Circuit’s opinion in In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046 (9th Cir. 2014), in which the court held that Item 303 does not establish such a duty. The U.S. Supreme Court declined a cert petition in NVIDIA.
Claims based on Item 303 seem innocuous enough, and even against plaintiffs’ interest. Plaintiffs face a high hurdle in showing that information was wrongfully excluded under Item 303, since they must show that a company actually knew: (1) the facts underlying the trend or uncertainty, (2) those known facts yield a trend or uncertainty, and (3) the trend or uncertainty will have a negative and material impact. In virtually all cases, these sorts of omitted facts would also render one or more of defendants’ affirmative statements misleading, and thus be subject to challenge regardless. Moreover, in Section 11 cases, Item 303 injects knowledge and causation requirements in a statute that normally doesn’t require scienter and only includes causation as an affirmative defense.
Why, then, have plaintiffs’ counsel pushed Item 303 claims so hard? We believe they’ve done so to combat the cardinal rule that silence, absent a duty to disclose, is not misleading. Companies omit thousands of facts every time they speak, and it is relatively easy for a plaintiff to identify omitted facts – but much more difficult to explain how those omissions rendered an affirmative statement misleading. Plaintiffs likely initially saw these claims as a way to maintain class actions in the event the Supreme Court overruled Basic v. Levinson as a result of attacks in the Amgen and Halliburton cases. And even though the Supreme Court declined to overrule Basic in Halliburton II, the Court’s price-impact rule presents problems for plaintiffs in some cases. As a result, plaintiffs may believe it is in their strategic interests to assert Item 303 claims, which plaintiffs have contended fall under the Affiliated Ute presumption of reliance, rather than under Basic.
But whatever plaintiffs’ rationale, Item 303 is largely a red herring. Although it shouldn’t matter to securities litigation, it will matter, as long as plaintiffs continue to bring such claims. And they probably will continue to bring them, given the current strategic considerations, and the legal footing they have been given by key appellate rulings in Panther Partners and Stratte-McClure. Defense attorneys will have to pay close attention to these trends and mount sophisticated defenses to these claims, to ensure that Item 303 claims do not take on a life of their own.
5. Cyber Security Securities and Derivative Litigation: Will There Be a Wave or Trickle?
One of the foremost uncertainties in securities and corporate governance litigation is the extent to which cyber security will become a significant D&O liability issue. Although many practitioners have been bracing for a wave of cyber security D&O matters, to date there has been only a trickle.
We remain convinced that a wave is coming, perhaps a tidal wave, and that it will include not just derivative litigation, but securities class actions and SEC enforcement matters as well. To date, plaintiffs generally haven’t filed cyber security securities class actions because stock prices have not significantly dropped when companies have disclosed breaches. That is bound to change as the market begins to distinguish companies on the basis of cyber security. There have been a number of shareholder derivative actions asserting that boards failed to properly oversee their companies’ cyber security. Those actions will continue, and likely increase, whether or not plaintiffs file cyber security securities class actions, but they will increase exponentially if securities class action filings pick up.
While the frequency of cyber security shareholder litigation will inevitably increase, we are more worried about its severity, because of the notorious statistics concerning a lack of attention by companies and boards to cyber security oversight and disclosure. Indeed, the shareholder litigation may well be ugly: The more directors and officers are on notice about the severity of cyber security problems, and the less action they take while on notice, the easier it will be for plaintiffs to prove their claims.
We also worry about SEC enforcement actions concerning cyber security. The SEC has been struggling to refine its guidance to companies on cyber security disclosure, trying to balance the concern of disclosing too much and thus providing hackers with a roadmap, with the need to disclose enough to allow investors to evaluate companies’ cyber security risk. But directors and officers should not assume that the SEC will announce new guidance or issue new rules before it begins new enforcement activity in this area. All it takes to trigger an investigation of a particular company is some information that the company’s disclosures were rendered false or misleading by inadequate cyber security. And all it takes to trigger broader enforcement activity is a perception that companies are not taking cyber security disclosure seriously. As in all areas of legal compliance, companies need to be concerned about whistleblowers, including overworked and underpaid IT personnel, lured by the SEC’s whistleblower bounty program, and about auditors, who will soon be asking more frequent and difficult questions about cyber security.
Of course, there are a number of other important issues that deserve to be on watch lists. But given the line we’ve drawn – issues that will cause the most volatility in securities litigation liability exposure – we regard the issues we’ve discussed as the top five.
And the top one – whether lower courts will properly apply Omnicare – is a rare game-changer. If defense counsel understands and uses Omnicare correctly, and if lower courts apply it as the Supreme Court intended, securities litigation decisions will be based on reality, and therefore far fairer and more just. But if either defense counsel or lower courts get it wrong, companies and their directors and officers will suffer outcomes that are less predictable, more arbitrary, and often wrong.