D&O Discourse is a forum for discussion of key issues in securities and governance litigation, to help improve litigation outcomes for public companies and their directors and officers, and D&O insurers and brokers, in specific cases and overall.
This post discusses a fundamental, structural, and deepening problem with securities class action defense: the lack of actual litigation past the motion to dismiss process. In other words, there is virtually no “litigation” in securities and governance litigation. Why is that so, and what can we do about it? After diagnosing the problem and discussing the harm it is causing, I’ll discuss the solutions and how we can implement them.
I have defended securities litigation full time for almost 25 years. For the first 15 of those years, securities class actions that were not dismissed would head into litigation, where we would test class certification, map out our summary judgment motion, and engage in fact discovery designed to establish the facts we needed to prevail on the merits. A great many cases were dismissed on summary judgment or were settled while the summary judgment motion was pending.
But something happened about 10 years ago: securities class actions that survived a motion to dismiss increasingly started to settle shortly thereafter, before significant fact or expert discovery. Premature settlement leaves defendants with only one of the three possible pretrial escape hatches, the motion to dismiss, and leaves unused the two other escape hatches, class certification and summary judgment. And premature settlement means that defendants don’t develop damages defenses, making settlement more expensive than the facts and economics often warrant.
What a shame. Class certification offers tremendous opportunities for defendants to defeat or greatly reduce class-claim exposure – indeed, the Supreme Court’s decision in Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014), had the potential to be revolutionary but is rarely used. Summary judgment was once a central strategic tool and presented a real opportunity to win, but very few cases are litigated to summary judgment. The Supreme Court’s decision in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005), requiring a causal connection between challenged statements and the corrective disclosure, has failed to limit damages in the way we anticipated – because defendants rarely do true defense-style damages analysis anymore. And trial isn’t even a consideration. Imagine that: a lawsuit that the defendants can’t even take to trial. That isn’t how litigation is supposed to work, and it doesn’t serve defendants’ interests.
The only winner in this system is plaintiffs’ counsel. Because plaintiffs’ counsel knows defendants can’t rationally litigate a case all the way through, settlement values are based on the lowest amount they are willing to take. Settlement values have little or nothing to do with the value of the case – the merit or lack of merit of the litigation is nearly irrelevant.
Three factors have converged over the past 10 years to create this problem:
First, hourly billing rates and profitability targets at typical securities class action defense firms have skyrocketed – yielding defense-cost increases that vastly exceed the rate of inflation.
Second, the defense bar has become un-specialized. Although there remains a small group of full-time securities defense lawyers, the so-called defense bar comprises an increasing number of general commercial litigators. As a result, there are far more law firm partners pursuing securities litigation than there is securities litigation work to go around. The result is a decline in specialization and an increase in inefficiency, as lawyers hoard the scarce work they win. The heyday of securities litigation defense – think Silicon Valley in the 1990s – is dead.
Third, over the same period, the securities plaintiffs’ bar has expanded to include a set of firms who sue smaller companies. These firms, sometimes called “emerging firms,” have now emerged – indeed, those firms now collectively initiate most securities class actions. These firms tend to focus on cases against smaller companies. As a result of the now-emerged firms’ approach, the median market capitalization of a securities class action defendant is about $1 billion, and two-thirds of all securities class actions are against companies with a market cap of $2 billion or less.
The economics of securities class actions against these smaller public companies are typically modest – for example, most such companies typically carry D&O insurance limits of $15 – $40 million. A great many defense firms literally can’t vigorously defend a case against such a company without swamping a typical D&O insurance tower. Although some might say “they should just buy more insurance,” most of these companies can’t or won’t – and why should they, just to transfer more money to their lawyers? For them, every penny counts – the difference between breaking even, or not; between meeting their loan covenants, or not; between meeting Wall Street expectations, or not.
Because of this dynamic, plaintiffs’ firms hold all the cards at mediation: defendants have just lost the motion to dismiss and have not developed the facts necessary to say with confidence that they will prevail, and they haven’t engaged in enough economic analysis to persuasively argue that plaintiffs can’t obtain class certification or prove significant damages. And, in most cases, the defendants can’t credibly threaten to take the case to trial because the plaintiffs know further litigation would threaten to exhaust the insurance proceeds. Because plaintiffs’ counsel knows defendants can’t rationally litigate a case all the way through, settlement values are based on the lowest amount plaintiffs’ counsel are willing to take. As a result, settlement values have little or nothing to do with the value of the case – the merit or lack of merit of the litigation is nearly irrelevant. This problem significantly impacts cases against larger companies as well. As settlement values increase in smaller cases because they aren’t defended, plaintiffs’ lawyers in larger cases expect higher settlement percentages too.
There are two main solutions to these problems: (1) in the medium and longer term, we need to improve the efficiency and effectiveness of securities class action defense by retooling the D&O insurance product and the defense bar; and (2) in the short term, we need to move economic analysis up front, so that defendants come to early mediations at least with class certification and damages arguments.
Securities Defense Reform
We need to create an efficient defense-counsel market, especially for the two-thirds of securities class actions against companies with market caps of $2 billion or less. Imagine a hypothetical single purchaser of all securities litigation defense services. That buyer may well hire Dewey Cheatham & Howe to defend cases against the largest companies. Even sky-high defense costs fit within the large D&O towers large companies typically purchase.
But that hypothetical rational buyer would never – ever – hire Dewey Cheatham & Howe to defend small and medium-sized cases. The median securities class action settlement hovers around $7 million. If Dewey Cheatham & Howe defended such a case naturally, with high billing rates and high associate-to-partner ratios, it would charge at least twice the settlement value to defend the case through trial. Obviously, it makes no sense to spend $14 million to defend a case that can be settled for $7 million.
Thus, our hypothetical purchaser would put the defense counsel work on cases against small and medium-sized companies out for bid, to be awarded to firms that could and would agree to defend the case through trial for an amount commensurate with the value of the case. Firms that could not or would not do the work for the right amount would not try for the work or wouldn’t get it. In securities class actions, many typical defense firms could not or would not defend small and medium-sized cases for a rational price.
But a number of the relatively small group of full-time securities class action lawyers would find a way to scale their practices to defend securities class action litigation against small and medium-sized companies. We find the current system frustrating – especially the engagement of non-specialists to defend these specialized cases – and want to revive the effectiveness and efficiency of securities litigation defense. Doing so would benefit us too, by lowering our cost of sales and restoring a system that provides defendants a real defense. I’d bet that none of the 20+ year full-time securities defense lawyers set out to have a motion to dismiss and mediation practice. I certainly didn’t. Rather, we want to win, and know that we can win most cases on class certification, summary judgment, or even trial, even if we didn’t win the motion to dismiss.
This small group of lawyers can form a pool from which insurers and brokers can establish small, focused, and collegial panels – formal or informal – to defend securities class actions against small and medium-sized companies. Under such a system, insurers and brokers can help defendants achieve a superior defense for amounts that allow defendants to actually defend securities class actions, while leaving plenty of policy proceeds to resolve claims. For example, if defense counsel agrees to a defense-costs cap for tasks that total $3.5 million through summary judgment, the defendants and insurers would know that there will be $7 million (the median settlement value) of primary policy proceeds remaining for settlement, assuming a $10 million primary policy and $1 million self-insured retention. Of course, a fair number of cases defended through class certification and summary judgment will be dismissed, eliminating the need to settle at all, or will be limited, reducing the settlement value.
This would transform securities litigation dynamics. Cases can and should be defended through the motion to dismiss within the self-insured retention. A collegial group of full-time securities defense lawyers could and would work more collegially with insurers and brokers and the defendants up front to make a plan up front to defend certain cases on the merits. This would put pressure on plaintiffs’ lawyers, some of whom operate on a volume model and literally don’t have the ability to litigate their inventory of cases.
Beyond taking advantage of plaintiff-firm staffing and economics, there are myriad benefits to more actual litigation. First and foremost, the defendants and their insurers and brokers would be able to understand the merits and settle based on a real litigation risk analysis – what the case is actually worth. Although no one can know for sure, I believe that settlement values are at least 30% higher than they would be if defendants and their insurers were comfortable defending cases through class certification and summary judgment. Imagine the reduction in severity. Frequency will begin to be reduced as well – they will begin to forego filing dubious cases, and they will be forced to spend more time on litigation and less time on case origination.
In addition to allowing us to actually litigate again, reforming the defense bar would improve the quality of the defense bar. Defense lawyers would be incentivized to devote more time and energy to shaping the law both in specific cases and through thought leadership. We as a defense bar have generally failed to shape the law in recent years the way we did in the first 15 years after the Reform Act – a shortcoming I believe owes to a deterioration in specialization. Specialized lawyers can also more persuasively promote legislative changes of the type Chubb proposed in its June 2019 white paper, “From Nuisance to Menace: The Rising Tide of Securities Class Action Litigation.”
Early Damages Analysis
My friend John McCarrick has been outspoken about the problems caused by the lack of defense-style damages in the premature settlement system. We wrote an article about this issue: “Improving Securities Class Action Outcomes through Early Damages Analysis.”
In an early mediation, the parties typically come to the mediation only with a preliminary damages estimate that neither side has thoroughly analyzed, much less tested through intensive work with the experts and expert discovery. Defense counsel uses a basic, plaintiffs-style damages analysis yielding large bet-the-company damages figures. Rigorous expert work often significantly reduces realistic damages exposure. For example, stock drops that lead to a securities class action are often the result of multiple negative news items. A rigorous damages analysis parses each item from the total stock drop to isolate the portion caused by the revelation of the allegedly hidden truth that made the challenged statements false or misleading. A defense lawyer might say, “Our economist says that damages are $500 million, so the $35 million the plaintiffs are demanding is a reasonable settlement.” But expert analysis and discovery may well push the $500 million number much lower, which in turn would dramatically reduce a reasonable settlement amount.
To allow us to better calibrate what is actually at stake in each case, John and I have proposed moving securities class action damages expert reports and discovery ahead of fact discovery. Expert damages analysis and discovery really should be the first things we do after a motion to dismiss is denied. This will help us know whether the case is really a big case, or is a small case that just seems big – an insight that would yield tremendous benefits for defendants. Plaintiffs and defendants would be able to reach a settlement, one based on true risk and reward, more easily. Defendants would not settle for bloated amounts that create a perception that they did something wrong. Insurers would know that they are funding a settlement that reflects the real risk in terms of damages exposure. And courts would feel more comfortable that they are approving (or rejecting) settlements based on a litigated assessment of damages. Indeed, placing damages expert work first would help serve the core policy of our system of litigation: “to secure the just, speedy, and inexpensive determination of every action and proceeding.”
There is no rule or procedural reason why parties cannot accomplish damages discovery ahead of fact discovery. Courts should be willing to stay fact discovery for a limited period of time, to allow the parties to better understand the realistic size of the case from a damages standpoint. Moreover, early expert discovery can be accomplished relatively quickly and efficiently, whereas fact discovery can be immediately and wildly expensive — which is primarily what drives very early settlements. And although plaintiffs and defendants often disagree about the relevance of fact discovery to damages, the absence of fact discovery for consideration in damages analysis is a factor the parties can weigh in evaluating the damages experts’ opinions.
Unless and until the securities defense system changes, continuing the fact discovery stay while expert damages discovery proceeds would strike the right balance. Even if fact discovery blows up from time to time, or defendants need to acquiesce to limited fact discovery that the plaintiffs persuasively argue is relevant to damages, everyone would be better off with a system that emphasizes early damages discovery and does not default to full fact discovery first. Accelerating the timing of damages expert discovery would align it with the work required by damages experts to analyze price-impact issues under Halliburton II. Unifying these two overlapping economic expert projects would create efficiencies for the lawyers and economists. Completing both of them before fact discovery starts would avoid unnecessary discovery costs if the Halliburton II opposition defeated or limited class certification, or if the damages analysis facilitated early settlement.
The securities litigation system is broken. But these two solutions, one near term and the other longer term, will not just fix the current problems but will also result in a better and more sustainable system for defendants, their insurers and brokers, and sophisticated securities litigation defense counsel.