The history of securities and corporate governance litigation is full of wishes about the law that we later regret (or will), or are happy were not granted. Many of these are not obvious—and some will surprise people. From certain case-by-case tactical decisions such as establishment of special litigation committees, to the (failed) attempt to abolish the fraud-on-the-market doctrine, to the very high standard for director liability for oversight failures, not everything that seems helpful to companies really is.
I will publish a series of blog posts on this topic over the coming months. This month’s post discusses the Private Securities Litigation Reform Act, with a focus on two provisions: the safe harbor for forward-looking statements (“Safe Harbor”), and lead plaintiff procedures.
Overview of the Reform Act
The Reform Act was passed by the Contract-with-America Congress to address its perception that securities class actions were reflexive, lawyer-driven litigation that often asserted weak claims based on little more than a stock drop, and relied on post-litigation discovery, rather than pre-litigation investigation, to sort out the validity of the claims. The Reform Act, among other things:
- Imposed strict pleading standards for showing both falsity and scienter, to curtail frivolous claims by increasing the likelihood that they would be dismissed.
- Created the Safe Harbor, to encourage companies to make forecasts and other predictions without undue fear of liability.
- Imposed a stay of discovery until the motion-to-dismiss process is resolved, to prevent discovery fishing expeditions and to eliminate the burden of discovery for claims that do not meet the enhanced pleading standards.
- Created procedures for selecting a lead plaintiff with a substantial financial stake in the litigation, to discourage lawyer-driven actions and the “race to the courthouse.”
Over my career as a securities litigator, I’ve seen both sides of the securities-litigation divide that the Reform Act created. In the first part of my career, I witnessed the figurative skid marks in front of courthouses, as lawyers raced to the courthouse to file claims before knowing if there really was a claim to be filed—the emblem of the problems Congress sought to correct. And in the 21 years since, I’ve seen the Reform Act both succeed and fail to achieve the results Congress intended.
Having lived the before and after, I would not argue that the Reform Act has not helped companies and their directors and officers. It certainly has. But it is a mixed bag. Indeed, I can argue that even the heightened falsity and scienter pleading standards have caused harm. For example, the pleading standards lead even the most prominent defense lawyers to rely heavily on the lack of words in a complaint—the securities litigation equivalent of “neener neener neener”—instead of using the complaint and judicially noticeable facts to cogently explain why the defendants didn’t say anything false, much less on purpose.
Over-reliance on the pleading standards is a strategic mistake. The Reform Act’s standards give judges enormous discretion; they can dismiss most complaints, or not, with little room to challenge their decisions upon appeal. Winning motions recognize the human element to this discretion. Even if a complaint is technically deficient, judges are less likely to dismiss it (certainly less likely to dismiss it with prejudice) if they nevertheless get the feeling that the defendants committed fraud. Effective motions use the leeway given to defendants by the Reform Act, and now the Supreme Court’s decisions in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318 (2015), and Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), to build a robust factual record that gives judges a sense of comfort that they are not only following the law, but that by strictly applying the Reform Act’s protections, they are also serving justice. And even if the judge doesn’t dismiss the case, he or she will leave the motion to dismiss process with a better feeling about the case going forward. But the pleading standards can be an attractive nuisance, distracting defense lawyers from the best way to defend their clients.
The pleading standards have also spawned a sideshow of “confidential witnesses,” primarily former employees who provide plaintiffs’ lawyers with internal corporate information to help them meet the pleading standards. In addition to raising whistleblower issues, causing fights over misuse of confidential information, and airing dirty laundry, the use of confidential witnesses has resulted in fights between plaintiffs’ lawyers and recanting witnesses requiring judicial intervention.
In one especially contentious dispute, Judge Rakoff spent a day taking testimony from recanting witnesses and a plaintiffs’ investigator, and took additional time to write an opinion commenting on this issue after the parties had settled the litigation. He concluded his nine-page opinion as follows:
The sole purpose of this Memorandum … is to focus attention on the way in which the PSLRA and decisions like Tellabs have led plaintiffs’ counsel to rely heavily on private inquiries of confidential witnesses, and the problems this approach tends to generate for both plaintiffs and defendants. It seems highly unlikely that Congress or the Supreme Court, in demanding a fair amount of evidentiary detail in securities class action complaints, intended to turn plaintiffs’ counsel into corporate “private eyes” who would entice naïve or disgruntled employees into gossip sessions that might support a federal lawsuit. Nor did they likely intend to place such employees in the unenviable position of having to account to their employers for such indiscretions, whether or not their statements were accurate. But, as it is, the combined effect of the PSLRA and cases like Tellabs are likely to make such problems endemic.
We may well see this problem as one of the underpinnings of a legislative attempt to reform the Reform Act one day.
In any event, and regardless of one’s views of the pleading standards’ overall benefits, two other Reform Act provisions certainly have grown to be problematic for public companies: the Safe Harbor, and the lead plaintiff provisions.
The Safe Harbor for Forward-Looking Statements
The Safe Harbor was a centerpiece of the Reform Act. Lawsuits prompted by announcements of missed earnings forecasts deterred companies from giving valuable earnings guidance. Congress sought to encourage guidance and other forward-looking statements by precluding liability if the statements were accompanied by “meaningful cautionary statements” or made without “actual knowledge” that they were false. 15 U.S.C. § 77z-2(c)(1); 15 U.S.C. § 78u-5(c)(1).
Yet the Safe Harbor is anything but safe. In the 21 years of the Reform Act, surprisingly few dismissals are based solely the Safe Harbor; instead, courts either use it as fallback grounds for dismissal, or just sidestep it—which has resulted in some significant legal errors. The most notorious erroneous Safe Harbor decision was written by one of the country’s most renowned judges, Judge Frank Easterbrook, in Asher v. Baxter, 377 F.3d 727 (7th Cir. 2004). Judge Easterbrook read into the Safe Harbor the word “the” before “important” in the phrase “identifying important factors,” to then hold that discovery was required to determine whether the company’s cautionary language contained “the (or any of the) ‘important sources of variance’” between the forecast and the actual results. Id. at 734.
The reason for this judicial antipathy was best articulated by Bill Lerach, who famously said that the Safe Harbor would give executives a “license to lie.” Judges have tended to agree with his conclusion. Some have been quite explicit about it. For example, in In re Stone & Webster, Inc. Securities Litigation, the First Circuit called the Safe Harbor a “curious statute, which grants (within limits) a license to defraud.” 414 F.3d 187, 212 (1st Cir. 2005). And the Second Circuit, in its first decision analyzing the Safe Harbor—15 years after the Reform Act was enacted, illustrating the degree of judicial avoidance—correctly interpreted “or” to mean “or,” but stated that “Congress may wish to give further direction on …. the reference point by which we should judge whether an issuer has identified the factors that realistically could cause results to differ from projections. May an issuer be protected by the meaningful cautionary language prong of the Safe Harbor even where his cautionary statement omitted a major risk that he knew about at the time he made the statement?” Slayton v. American Express Co., 604 F.3d 758, 772 (2d Cir. 2010). Probably for this reason, the Safe Harbor has not deterred plaintiffs’ counsel from continuing to bring false forecast cases. Twenty-one years later, a great many securities class actions still focus on earnings forecasts and other forward-looking statements.
Much of this problem is self-inflicted. We defense lawyers have worsened the judicial antipathy and reluctance to issue rulings on Safe Harbor grounds by making hyper-technical arguments that are detached from any notion that the challenged forward-looking statements aren’t false in the first place. Most challenged forward-looking statements are true statements of opinion—an especially strong argument under the Supreme Court’s Omnicare decision—and don’t even need the Safe Harbor’s protection. But by bypassing the falsity argument, and falling back on the Safe Harbor, defense counsel plays right into plaintiffs’ hands. Many defense lawyers try to overcome this problem by emphasizing that Congress intended to immunize even unfair forward-looking statements, if they are accompanied by appropriate warnings. But judges don’t like caveat emptor, and they don’t like liars—regardless of Congressional intent. A much better way to defend forward-looking statements is to show that they were true statements of opinion and then use the Safe Harbor as a fallback argument. It makes the judge feel comfortable dismissing the claim in either or both ways. But few defense lawyers take that approach.
Finally, companies and their outside corporate counsel have contributed to the Safe Harbor’s lack of safety by failing to describe their risks in a fresh and detailed way each quarter. When I evaluate a securities class action complaint that challenges forward-looking statements and other statements of opinion (which comprise nearly all securities cases), one of the first things I look for is the progression of the risk factors each quarter. Using a chart, I read them from start to finish, just as the judge will when we create the context for our arguments against falsity and to support the application of the Safe Harbor. Are the risk factors specific or generic? Do they change over time or are they static? Do the changes in the risk factors track disclosed changes in business conditions? Etc. But companies and their outside corporate counsel frequently devolve to boilerplate, and fail to draft careful disclosures that make a judge feel comfortable that they were trying to disclose their real risks each quarter.
Lead Plaintiff Procedures
The symbol of the pre-Reform Act era is the race to the courthouse among plaintiffs’ lawyers to file a complaint first and thus win the lead counsel role. Congress intended the heightened pleading standards and the Safe Harbor to play a role in fixing that problem, because they are meant to incentivize plaintiffs to do more pre-filing investigation. However, the Reform Act’s lead plaintiff provisions—which require the court to choose a lead plaintiff and lead plaintiff’s counsel after a beauty contest—undermine that goal, since only the lead plaintiff has an economic incentive to invest much time and money in an investigation. So although the initial filer no longer has a competitive advantage by being the first plaintiff to file, the initial complaint is still routinely filed without any real investigation or worry about satisfying the pleading standards.
The lead plaintiff procedures were also designed to prevent lawyer-driven litigation, by providing that the lead plaintiff is presumptively the plaintiff with the largest financial loss—i.e., a plaintiff with “skin in the game.” While that goal is salutary, it has spawned complex and mixed results. The 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, retained the more prominent plaintiffs’ firms, and smaller plaintiffs’ firms were left with individual retail 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.
But nature abhors a vacuum—here, a securities litigation system that leaves out retail investors and smaller plaintiffs’ firms. So, it was inevitable that these alienated groups would find a way to bring securities class actions. As I’ve chronicled previously, this void started to be filled with the wave of cases against Chinese issuers in 2010. Smaller plaintiffs’ firms initiated the lion’s share of these cases, primarily on behalf of retail investors, 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 has indeed been 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.
With these gains in efficiency, market share, and money, these smaller plaintiffs’ firms have continued to file a large number of securities class actions on behalf of retail investors. Like the China cases, these 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 that reduce the plaintiffs’ firms’ investigative costs—for which they can win the lead plaintiff role and that they can prosecute at a sufficient profit margin.
We now have two classes of prominent plaintiffs and plaintiffs’ firms: larger firms with institutional investor clients, as Congress intended, and smaller plaintiffs’ firms with smaller individual clients, which Congress sought to displace. In a sense, we’re back to where we started, but now with more aggressive institutional investors to boot.
Smaller plaintiffs’ firms’ permanent arrival on the scene has led to two sets of additional problems.
First, smaller plaintiffs’ firms have ratcheted up the number of press releases by plaintiffs’ firms seeking plaintiffs to file a securities class action. There have always been plaintiff law firm “investigations” to try to find plaintiffs to file lawsuits, but there has been nothing short of an avalanche in recent years. This is so for a number of reasons. Unlike larger plaintiffs’ firms that have spent 21 years cultivating institutional investor clients as the Reform Act envisioned, smaller plaintiffs’ firms generally don’t have existing attorney-client relationships with potential plaintiffs who own a wide range of securities—so they need to recruit plaintiffs for particular cases. Smaller plaintiffs’ firm successes are drawing more smaller firms into the securities class action business. This competition is resulting in an “investigation” following nearly every negative corporate announcement. Increasingly, this is so even if the stock price drop is relatively small—indeed, I’ve seen more investigations and subsequent securities class actions follow single-digit stock drops than ever before, likely because the of the number of smaller-firm players and the reality that a small case is better than none. The press release process is repeated after a lawsuit is filed. As the Reform Act requires, the first filer publishes a press release announcing the filing. Other smaller plaintiffs’ firms then publish their own announcements that a lawsuit has been filed in order to find a good lead plaintiff contestant. Each firm publishes their own notice, and the firms then publish reminders leading up to the lead plaintiff filing deadline 60 days later.
To put it mildly, this process is a real nuisance, especially for smaller companies. Investors, employees, and other stakeholders who don’t understand this process sometimes perceive that the company is falling apart. Dealing with their concerns can cause officers and directors to become distracted. The result can be further deterioration of the company’s business and financial condition, and an unwarranted sell-off of the company’s stock. This can be about more than money—for example, development of life-saving drugs can be slowed or even derailed. Obviously, none of that is good. I doubt the plaintiffs’ lawyers themselves would disagree, but instead would say that they’re simply working under the Reform Act’s lead plaintiff procedures.
Second, the fervent competition among smaller plaintiffs’ firms is affecting the types of cases filed and settlement dynamics. Although the smaller plaintiffs’ firms’ bread-and-butter are “lawsuit blueprint” cases that often have difficult facts, they are also filing many low-merit cases, such as challenges to earnings guidance. At the same time, the intense competition sometimes results in more difficult and protracted litigation, meritorious or not. There are usually other smaller plaintiffs’ firms on the scene through tag-along derivative suits or as co-lead securities class action counsel, and none of the firms wants the others to see it as a pushover for wanting to settle for an amount they’d otherwise gladly take. That said, it’s also true that smaller plaintiffs’ firms are defeating an increasing number of motions to dismiss and can be formidable adversaries—which of course gives them greater leverage and leads to more difficult litigation to defend and resolve.
Although these issues won’t make the legislative agenda anytime soon, we defense lawyers can make a difference. We can:
- Emphasize the truth of the challenged statements through the tools the Reform Act and Supreme Court have provided, and avoid over-reliance on the Safe Harbor and pleading standards.
- Ask courts to impose clear leadership and coordination between and among securities class action and derivative plaintiffs’ counsel.
- Educate companies about the reasons for the frustrating flurry of press releases.