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.