I am committed to helping shape a system for securities litigation defense that helps directors and officers get through securities litigation safely and efficiently, without losing their serenity or dignity, and without facing any real risk of paying any personal funds.

But we are actually moving in the opposite direction of this goal, and unless some changes are made, securities litigation will pose greater and greater risk to individual directors and officers.  It is time for the “repeat players” in securities litigation defense – D&O insurers and brokers, defense lawyers, and economists – to make some fundamental changes to how we do things.  Although most cases still seem to turn out fine for the individual defendants, resolved by a dismissal or a settlement that is fully funded by D&O insurance, the bigger picture is not pretty.  The law firms that have defended the lion’s share of cases since securities class actions gained footing through Basic v. Levinson – primarily “biglaw” firms based in the country’s several largest cities – are no longer suitable for many, or even most, securities class actions.  Fueled by high billing rates and profit-focused staffing, those firms’ skyrocketing defense costs threaten to exhaust most or all of the D&O insurance towers in cases that are not dismissed on a motion to dismiss.  Rarely can such firms defend cases vigorously through summary judgment and toward trial anymore.

Worse, these high prices too often do not yield strategic benefits.  A strong motion to dismiss focuses on the truth of what the defendants said, with support from the context of the statements, as directed by the U.S. Supreme Court in Tellabs and Omnicare.  Yet far too often, the motion-to-dismiss briefs that come out of these large firms are little more than cookie-cutter arguments based on the structure of the Reform Act.  And if a motion is lost, settlements are higher than necessary because the defendants often have no option but to settle in order to avoid an avalanche of defense costs that would exhaust their D&O insurance limits.  On the other hand, if settlement occurs later, it can be difficult to keep settlement within D&O insurance limits – and defense counsel’s analysis of a “reasonable” settlement can be influenced by a desire to justify the amount they have billed.

At the same time that defense costs are continuing to rise exponentially, securities class actions are becoming smaller and smaller, with two-thirds of cases brought against companies with market caps less than $2 billion, and almost half under $750 million.  Although catawampus securities litigation economics is a systemic problem, impacting cases of all sizes, the problem is especially acute in the smallest half of cases.  Some of those cases simply cannot be defended both well and economically by typical defense firms.  Either defense costs become ridiculously large for the size of the case and the amount of the D&O insurance limits, or firms try to reduce costs by cutting corners on staffing and projects – or both.  We see large law firms routinely chase smaller and smaller cases.  From a market perspective, it makes no sense at all.

So how do we achieve a better securities litigation system?  Five changes would have a profound impact:

  1. Require an interview process for the selection of defense counsel, to allow the defendants to understand their options; to evaluate conflicts of interest and the advantages and disadvantages of using their corporate firm to defend the litigation; and to achieve cost concessions that only a competitive interview process can yield.
  2. Increase the involvement of D&O insurers in defense-counsel selection and in other strategic defense decisions, to put those who have the greatest overall experience and economic stake in securities class action defense in a position to provide meaningful input.
  3. Make the Supreme Court’s Omnicare decision a primary tool in the defense of securities class actions.  Obviously, Omnicare should be used to defend against challenges to all forms of opinions, including statements regarded as “puffery” and forward-looking statements protected by the Reform Act’s Safe Harbor for forward-looking statements.  But defense counsel should also take advantage of the Supreme Court’s direction in Omnicare that courts evaluate challenged statements in their full factual context.  Omnicare supplements the Court’s previous direction in Tellabs that courts evaluate scienter by considering not just the complaint’s allegations, but also documents incorporated by reference and documents subject to judicial notice.  Together, Omnicare and Tellabs allow defense counsel to defend their clients’ honesty with a robust factual record at the motion to dismiss stage.
  4. Increase the involvement of boards of directors in decisions concerning D&O insurance and the defense of securities litigation, including counsel selection, to ensure their personal protection and good oversight of the defense of the company and themselves.
  5. Move damages expert reports and discovery ahead of fact discovery, to allow the defendants and their D&O insurers to understand the real economics of cases that survive a motion to dismiss, and to make more informed litigation and settlement decisions.

These five changes are among the top wishes I have to improve securities litigation defense, and to preserve the protections of directors and officers who face securities litigation.  Over the next several months, I will post about each one.  Here are links to the posts in the series so far:

Wish #1:  5 Wishes for Securities Litigation Defense: A Defense-Counsel Interview Process in All Cases

Wish #2:  5 Wishes for Securities Litigation Defense: Greater Insurer Involvement in Defense-Counsel Selection and Strategy

Wish #3:  5 Wishes for Securities Litigation Defense: Effective Use of the Supreme Court’s Omnicare Decision

Wish #4:  5 Wishes for Securities Litigation Defense: Greater Director Involvement in Securities Litigation Defense and D&O Insurance

Wish #5:  5 Wishes for Securities Litigation Defense: Early Damages Analysis and Discovery

When a public company purchases a significant good or service, it typically seeks competitive proposals.  From coffee machines to architects, companies invite multiple vendors to bid, evaluate their proposals, and choose one based on a combination of quality and cost.  Yet companies named in a securities class action frequently fail to engage in a competitive interview process for their defense counsel, and instead simply retain litigation lawyers at the firm they use for their corporate work.

To be sure, it is difficult for company management to tell their outside corporate lawyers that they are going to consider hiring another firm to defend a significant litigation matter.  The corporate lawyers are trusted advisors, often former colleagues of the in-house counsel, and have usually made sacrifices for the client that make the corporate lawyers expect to be repaid through engagement to defend whatever litigation might arise.  A big litigation matter is what makes all of the miscellaneous loss-leader work worth it.  “You owe me,” is the unspoken, and sometimes spoken, message.

Corporate lawyers also make the pitch that it will be more efficient for their litigation colleagues to defend the litigation since the corporate lawyers know the facts and can more efficiently work with the firm’s litigators.  Meanwhile, they tell the client that there is no conflict – even if their work on the company’s disclosures is at issue, they assure the company that they will all be on the same side in defending the disclosures, and if they have to be witnesses, the lawyer-as-witness rules will allow them to work around the issue.

All of these assertions are flawed.  It is always – without exception – in the interests of the defendants to take a day to interview several defense firms of different types and perspectives.  And it is never – without exception – in the interests of the defendants to simply hand the case off to the litigators of the company’s corporate firm.  Even if the defendants hire the company’s corporate firm at the end of the interview process, they will have gained highly valuable strategic insights from multiple perspectives; cost concessions that only a competitive interview process will yield; better relationships with their insurers, who will be more comfortable with more thoughtful counsel selection; greater comfort with the corporate firm’s litigators, whom the defendants sometimes have never even met; and better service from the corporate firm.

Problems with Using Corporate Counsel

A Section 10(b) claim involves litigation of whether the defendants:  (1) made a false statement, or failed to disclose a fact that made what they said misleading in context; and (2) made any such false or misleading statements with intent to defraud (i.e. scienter).

Corporate counsel is very often an important fact witness for the defendants on both of these issues.  For example, in a great many cases, corporate counsel has:

  • Drafted the disclosures that plaintiffs challenge, so that the answer to the question “why did you say that?” is “our lawyers wrote it for us.”
  • Advised that omitted information wasn’t required to be disclosed, so that the answer to the question “why didn’t you disclose that” is “our lawyers told us we didn’t have to.”
  • Reviewed disclosures without questioning anything, or not questioning the challenged portion.
  • Drafted the risk factors that are the potential basis of the protection of the Reform Act’s Safe Harbor for forward-looking statements.
  • Not revised the risk factors that are the potential basis of Safe Harbor protection.
  • Advised on the ability of directors and officers to enter into 10b5-1 plans and when to do so, and on the ability of directors and officers to sell stock at certain times, given the presence or absence of material nonpublic information.
  • Advised on individual stock purchases.

The fact that the lawyer has given such advice, or not given such advice, can win the case for the defendants.  For example, for any case turning on a statement of opinion, the lawyer’s advice that the opinion had a reasonable basis virtually guarantees that the defendants won’t be liable.  Likewise, a lawyer’s drafting, revising, or advising on disclosures virtually guarantees that the defendants didn’t make the misrepresentation with scienter, and a lawyer’s advice on the timing of entering into 10b5-1 plans or selling stock makes the sales benign for scienter purposes.

To the defendants, it doesn’t matter if the lawyer was right or wrong.  As long as the advice wasn’t so obviously wrong that the client could not have followed it in good faith, the lawyer’s advice protects the defendants.  But to the lawyer, it matters a great deal for purposes of professional reputation and liability.  Deepening the conflict is the specter of the law firm defending its advice on the basis that the client didn’t tell them everything.  The interests of the lawyer and defendant client thus can diverge significantly.

That this information may be privileged doesn’t change this analysis.  Of course, the privilege belongs to the client, who can decide whether to use the information in his or her defense, or not.  But with corporate counsel’s litigation colleagues guiding the development of the facts, privileged information is rarely analyzed, much less discussed with the client.  The reality is that most privileged information isn’t truly sensitive to the client, but instead reflects a client seeking advice – and seeking the liability protection the lawyer’s advice provides.  But from the lawyer’s perspective, there can be much to protect.  Privileged communications may reflect poor legal advice, and internal files may contain candid discussions about the client and the client’s issues that would result in embarrassment to the firm, and possible termination, if produced.

Perhaps even more importantly, regular corporate counsel’s litigation colleagues may often fail to assess the case objectively, in part because it implicates the work of their corporate colleagues, and in part because of a desire not to ask hard questions that could strain the law firm’s relationship with the client.  Sometimes the problem arises from a deliberate attempt by the lawyers to protect a particular person who may have made an error leading to the litigation, such as the General Counsel (often is a former colleague), the CFO, or the CEO – all of whom are important to the client relationship.  Sometimes, though, the failure to thoughtfully analyze a case is due to a more generalized alliance with the people with whom the law firm works regularly.  It’s hard for a lawyer to scrutinize someone who will be in the firm’s luxury box at the baseball game that night, much less report a serious problem with him or her to the board.

Yet the defendants, including the board of the corporate client, need candid advice about the litigation to protect their interests.  For example, some problematic cases should be settled early, before the insurance limits are significantly eroded by defense costs and documents are produced that that will make the case even more difficult, and could even spawn other litigation or government investigations.  Defendants and corporate boards need to know this.

Corporate firms might counter that their litigation colleagues will give sound and independent advice, because they are a separate department and will face no economic or other pressure from the corporate department.  But that undermines one of the main reasons corporate lawyers urge that their litigation colleagues be hired: that it is more efficient to use the firm’s litigators since they work closely with the corporate lawyers, if not the company itself.  The corporate firm can’t have it both ways: either the litigators are close to the corporate lawyers and the company, and suffer from the problems outlined above, or they are independent, and their involvement yields little or no benefit in efficiency.  Indeed, it is most likely that the corporate firm’s litigators will be hindered by conflict, while nevertheless failing to create greater efficiency.  Just because lawyers are in a same firm doesn’t mean that they can read each other’s minds.  They still have to talk to one another, just as litigators from an outside firm would have to do.

So Why is Corporate Counsel Used So Often?

I doubt many directors or officers would disagree with the analysis above.  So why do so many companies turn to their corporate counsel without conducting an audition process?  Several practical factors impede the proper analysis of counsel selection in the initial days of a securities class action.

The single most important factor is probably that the corporate firm is first on the scene. Many companies reflexively hire their corporate firm immediately after the initial complaint is filed, or even after the stock drop, before a complaint is even filed.  By the time the defendants start to hear from other securities defense practices, they often have retained counsel.  And then it’s very difficult from a personal and practical perspective to walk the decision back.

This decision, moreover, is often made by the legal department, sometimes in consultation with the CEO and CFO.  The board is often not involved.  Instead, the board is merely presented with the decision, which can seem natural because the firm hired is familiar to them.  The directors often aren’t personally named in the initial complaint, so they might not pay as much attention as they would if they understood if they were likely to become defendants later – either in the main securities action, especially if the case involves a potential Section 11 claim, or in a tag-along shareholder derivative action.

Initial complaints can also mislead the company as to the real issues at stake.  Regular corporate counsel and the defendants may review the first complaint and incorrectly conclude that the allegations don’t implicate the lawyer’s work.  But these initial complaints are merely placeholders, because the Reform Act specifies that the lead plaintiff appointed by the court can later file an amended complaint.  Initial filers have little incentive to invest the time or effort into making detailed allegations in the initial complaint, because they may be beaten out for the lead plaintiff role.  The lead plaintiff’s amended complaint thus typically greatly expands the case to include new alleged false and misleading statements, more specific reasons why the challenged statements were false or misleading, and more detailed scienter allegations, including stock-sale and confidential-witness allegations that most initial complaints lack.  If a conflict becomes apparent at that point, however, it can be very difficult and even prejudicial to the defendants for corporate counsel to bow out.

Regular corporate counsel will often advise their clients that there is no issue with them defending the litigation, or even that doing so makes sense because they advised on the underlying disclosures.  But even if the corporate firm is trying to be candid and look out for its client’s interests, it may have blind spots in seeing its potential conflicts – especially when the corporate lawyers are facing pressure from their firm management to “hold the client.”

The pressures that lead a company to hire its corporate firm to defend the securities litigation are very real, and sometimes this decision is ultimately fine.  But I strongly believe that it is never in a client’s interest to take its corporate counsel’s advice on these issues without obtaining analysis from other securities practices as part of a competitive interview process.

The Benefits of a Competitive Process

In addition to obtaining important perspectives about potential problems with corporate counsel’s defense of the securities class action, an interview process involves myriad benefits – including tens of thousands of dollars of free legal advice.  The only cost to the company is a few hours to select the 3-5 firms that it wants to interview, and a day spent hearing presentations from those firms and discussing their analysis and approach with them.

An interview process gives defendants the opportunity to hear from several experienced securities litigators, who will offer a range of analyses and strategies on how best to defend the case.  It also allows defendants to evaluate professional credentials and personal compatibility, which are both important criteria.  It is difficult, if not impossible, for a company to evaluate how their corporate counsel’s litigators stack up against other litigators in this specialized and national practice area, without first hearing from some other firms.  Sometimes, a company will not even meet its corporate firm’s securities litigators in person before engaging them, which obviously makes it impossible for them to make judgments about personal compatibility and trust.

An interview process, if properly structured, is highly substantive.  The firms that fare best in a new-case interview typically prepare thorough discussions of the issues, and come prepared to analyze the case in great detail.  And the best ones look beyond the issues in the initial complaint to the issues that might emerge in the amended complaint, analyzing the full range of the company’s disclosures, to forecast future disclosure and scienter allegations, and evaluating the defenses that will remain even after allegations are added.

An interview process also helps the company to achieve a better deal on billing rates, staffing, and alternative fee arrangements.  Without an interview process, a law firm is much more likely to charge rack rates and do its work in the way it sees fit – which defendants are rarely in a position to challenge without having done some comparison shopping.  Even though securities class action defense costs are covered by D&O insurance, price matters in defense-counsel selection.  It is a mistake to treat D&O insurance proceeds as “free money.”  Without appropriate cost control, defendants run the risk of not having enough insurance proceeds to defend and resolve the case.  Appropriate cost control can help the litigation from resulting in a difficult or expensive D&O insurance renewal, and can allow the company to save money if the fees are less than the deductible.

An interview process also helps get the defendants off to a better start with its D&O insurers.  In addition to appreciating the cost control that an interview process yields, insurers also appreciate the defendants making a thoughtful decision on defense counsel, including vetting the potential problems with use of the company’s corporate firm.  D&O insurers and brokers are “repeat players” in securities litigation, and know the qualifications of defense counsel better than anyone else – a seasoned D&O insurance claims professional has overseen hundreds of securities class actions.  Asking insurers and brokers to help identify defense counsel to interview may therefore not only yield helpful suggestions, but may also make it easier to develop a relationship of strategic trust with the insurers – which will make it easier to obtain consent to settle early if appropriate, and if not, to defend the case through summary judgment or to trial.

Perhaps most importantly, an interview process results in a closer relationship between the defendants and their lawyers, whoever they end up being.  Most securities class action defendants are troubled by being sued, and need lawyers that they can trust to walk them through the process.  An interview process is the best way to find the lawyers who have the right combination of relevant characteristics – including skills, strategy, and bedside manner – that will best fit the needs of the defendants.

In my last D&O Discourse post, “The Future of Securities Class Action Litigation,” I discussed why changes to the securities litigation defense bar are inevitable: in a nutshell, the economic structures of the typical securities defense firms – mostly national law firms – result in defense costs that significantly exceed what is rational to spend in a typical securities class action.  As I explained, the solution needs to come from outside the biglaw paradigm; when biglaw firms try to reduce the cost of one case without changing their fundamental billing and staffing structure, they end up cutting corners by foregoing important tasks or settling prematurely for an unnecessarily high amount.  That is obviously unacceptable.

The solution thus requires us to approach securities class action defense in a new way, by creating a specialized bar of securities defense lawyers from two groups: lawyers from national firms who change their staffing structure and lower their billing rates, and experienced securities litigators from regional firms with economic structures that are naturally more rational.

But litigation venues are regional.  We have state courts and federal courts organized by states and areas within states.  Since lawyers need to go to the courthouse to file pleadings, attend court hearings, and meet with clients in that location, the lawyer handling a case needs to live where the judge and clients live.

Right?

Not anymore.

Although the attitude that a case needs a local lawyer persists, that is no longer how litigation works.  We don’t file pleadings at the courthouse.  We file them on the internet from anywhere – even from an airplane.  There are just a handful of in-person court hearings in most cases.  And the reality is that most clients don’t want their lawyers hanging around in person at their offices – email, phone calls, and Skype suffice.  Even document collection can be done mostly electronically and remotely.  And with increasingly strict deposition limits, and witnesses located around the country and world, depositions don’t require much time in the forum city either.

In a typical Reform Act case, where discovery is stayed through the motion-to-dismiss process, the amount of time a lawyer needs to spend in the forum city is especially modest.  If a case is dismissed on a motion to dismiss, the case activities in the forum city in a typical case amount only to (1) a short visit to the clients’ offices to learn the facts necessary to assess the case and prepare the motion to dismiss, and (2) the motion-to-dismiss argument, if there is one.  Indeed, assuming that a typical securities case requires a total of 1,000 hours of lawyer time through an initial motion to dismiss, fewer than 50 of those hours – one-half of one percent – need to be spent in the forum city.  The other 99.5% can be spent anywhere.

Discovery doesn’t change these percentages much.  Assume that it takes another 10,000 hours of attorney time to litigate a case through a summary judgment motion, or 11,000 total hours.  Four lawyers/paralegals spending four weeks in the forum city for document collection and depositions (a generous allotment) yields only another 640 hours.  So in my hypothetical, only 0.63% of the defense of the case requires a lawyer to be in the forum city.  The other 99.37% of the work can be done anywhere.  Because a biglaw firm would litigate a securities class action with a larger team, the total number of hours in a typical biglaw case would be much higher – both the total defense hours and the total number of hours spent in the forum city – but the percentages would be similar.

Nor does the cost of travel move the economic needle.  Of course, if a firm is willing not to charge for travel time and travel costs to the forum city, there is no economic issue.  My firm is willing to make this concession, and I would bet others are as well.  Even if a firm does charge for travel cost and travel time, the cost is miniscule in relationship to total defense costs.  For example, my total travel costs for a five-night trip to New York City – both airfare and lodging – are typically less than the cost of two biglaw partner hours.

Of course, there are some purposes for which local counsel is necessary, or at least ideal – someone who knows the local rules, is familiar with the local judges, and is admitted in the forum state.  But the need to utilize local counsel for a limited number of tasks doesn’t present any economic or strategic issue either, if the lawyers’ roles are clearly defined.  Depending on the circumstances, I like to work either with a local lawyer in a litigation boutique that was formed by former large-firm lawyers with strong local connections, or with a lawyer from a strong regional firm.  I just finished a case in which the local firm was a boutique, and a case in which the local firm was another regional firm.  In both cases, the local firms charged de minimis amounts.  In some cases, the local firm can and should play a larger role, but whatever the type of firm and its role, the lead and local lawyers can develop the right staffing for the case and work together essentially as one firm – if they want to.

All of these considerations show that securities litigation defense can and should be a nationwide practice.  It is no longer local.  We need look no farther than the other side of the “v” for a good example.  Our adversaries in the plaintiffs’ bar have long litigated cases around the country, often teaming up with local lawyers from different firms.  Like securities defense, plaintiffs’ securities work requires a full-time focus that has led to a relatively small number of qualified firms.  The qualified firms litigate cases around the country, not just in their hometowns or even where their firms have lawyers.

This all seems relatively simple, but it requires us all to abandon old assumptions about the practice of law that are no longer applicable, and embrace a new mindset.  Biglaw defense lawyers need to obtain more economic freedom within their firms to reduce their rates and staffing for typical securities cases, or they must face the reality that their firms perhaps are well suited only for the largest cases.  Regional firms must recruit more full-time securities litigation partners and be willing not to charge for travel time and costs.  And companies and insurers must appreciate that securities litigation defense will improve – through better substantive and economic results in both individual cases and overall – if they recognize that a good regional firm with dedicated securities litigators can defend a securities class action anywhere in the country, and can usually do so more effectively and efficiently than a biglaw firm.

Securities litigation has a culture defined by multiple elements: the types of cases filed, the plaintiffs’ lawyers who file them, the defense counsel who defend them, the characteristics of the insurance that covers them, the way insurance representatives approach coverage, the government’s investigative policies – and, of course, the attitude of public companies and their directors and officers toward disclosure and governance.

This culture has been largely stable over the nearly 20 years I’ve defended securities litigation matters full time.  The array of private securities litigation matters (in the way I define securities litigation) remains the same – in order of virulence: securities class actions, shareholder derivative litigation matters (derivative actions, board demands, and books-and-records inspections), and shareholder challenges to mergers.  The world of disclosure-related SEC enforcement and internal corporate investigations is basically unchanged as well.  And the art of managing a disclosure crisis, involving the convergence of shareholder litigation, SEC enforcement, and an internal investigation, involves the same basic skills and instincts.

But I’ve noted significant changes to other characteristics of securities-litigation culture recently, which portend a paradigm shift.  Over the past few years, smaller plaintiffs’ firms have initiated more securities class actions on behalf of individual, retail investors, largely against smaller companies that have suffered what I call “lawsuit blueprint” problems such as auditor resignations and short-seller reports.  This trend – which has now become ingrained into the securities-litigation culture – will significantly influence the way securities cases are defended and by whom, and change the way that D&O insurance coverage and claims need to be handled.

Changes in the Plaintiffs’ Bar

Discussion of the history of securities plaintiffs’ counsel usually focuses on the impact of the departures of former giants Bill Lerach and Mel Weiss.  But although the two of them did indeed cut a wide swath, the plaintiffs’ bar survived their departures just fine.  Lerach’s former firm is thriving, and there are strong leaders there and at other prominent plaintiffs’ firms.

The more fundamental shifts in the plaintiffs’ bar concern changes to filing trends.  Securities class action filings are down significantly over the past several years, but as I have written, I’m confident they will remain the mainstay of securities litigation, and won’t be replaced by merger cases or derivative actions.  There is a large group of plaintiffs’ lawyers who specialize in securities class actions, and there are plenty of stock drops that give them good opportunities to file cases. Securities class action filings tend to come in waves, both in the number of cases and type.  Filings have been down over the last several years for multiple reasons, including the lack of plaintiff-firm resources to file new cases as they continue to litigate stubborn and labor-intensive credit-crisis cases, the rising stock market, and the lack of significant financial-statement restatements.

While I don’t think the downturn in filings is, in and of itself, very meaningful, it has created the opportunity for smaller plaintiffs’ firms to file more securities class actions.  As D&O Discourse readers know, 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, 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 issuers in 2010.  Smaller plaintiffs’ firms initiated the lion’s share of them, 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.

The smaller plaintiffs’ firms thus built up a head of steam that has kept them going, even after the wave of China cases subsided.  For the last year or two, 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 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.

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.

These dynamics are confirmed by recent securities litigation filing statistics.  Cornerstone Research’s “Securities Class Action Filings: 2014 Year in Review,” concludes that (1) aggregate market capitalization loss of sued companies was at its lowest level since 1997, and (2) the percentage of S&P 500 companies sued in securities class actions “was the lowest on record.”  Cornerstone’s “Securities Class Action Filings: 2015 Midyear Assessment” reports that two key measures of the size of cases filed in the first half of 2015 were 43% and 65% lower than the 1997-2014 semiannual historical averages.  NERA Economic Consulting’s “Recent Trends in Securities Class Action Litigation:  2014 Full-Year Review” reports that 2013 and 2014 “aggregate investor losses” were far lower than in any of the prior eight years.  And PricewaterhouseCoopers’ “Coming into Focus: 2014 Securities Litigation Study” reflects that in 2013 and 2014, two-thirds of securities class actions were against small-cap companies (market capitalization less than $2 billion), and one-quarter were against micro-cap companies (market capitalization less than $300 million).*  These numbers confirm the trend toward filing smaller cases against smaller companies, so that now, most securities class actions are relatively small cases.

Consequences for Securities Litigation Defense

Securities litigation defense must adjust to this change.  Smaller securities class actions are still important and labor-intensive matters – a “small” securities class action is still a big deal for a small company and the individuals accused of fraud, and the number of hours of legal work to defend a small case is still significant.  This is especially so for the “lawsuit blueprint” cases, which typically involve a difficult set of facts.

Yet most securities defense practices are in firms with high billing rates and high associate-to-partner ratios, which make it uneconomical for them to defend smaller litigation matters.  It obviously makes no sense for a firm to charge $6 million to defend a case that can settle for $6 million.  It is even worse for that same firm to attempt to defend the case for $3 million instead of $6 million by cutting corners – whether by under-staffing, over-delegation to junior lawyers, or avoiding important tasks.  It is worse still for a firm to charge $2 million through the motion to dismiss briefing and then, if they lose, to settle for more than $6 million just because they can’t defend the case economically past that point.  And it is a strategic and ethical minefield for a firm to charge $6 million and then settle for a larger amount than necessary so that the fees appear to be in line with the size of the case.  .

Nor is the answer to hire general commercial litigators at lower rates.  Securities class actions are specialized matters that demand expertise, consisting not just of knowledge of the law, but of relationships with plaintiffs’ counsel, defense counsel, economists, mediators, and D&O brokers and insurers.

Rather, what is necessary is genuine reform of the economics of securities litigation defense through the creation of a class of experienced securities litigators who charge lower rates and exhibit tighter economic control.  Undoubtedly, that will be difficult to achieve for most securities defense lawyers, who practice at firms with supercharged economics.  The lawyers who wish to remain securities litigation specialists will thus face a choice:

  1. Accept that the volume of their case load will be reduced, as they forego smaller matters and focus on the largest matters (which Biglaw firms are uniquely situated to handle well, on the whole);
  2. Reign in the economics of their practices, by lowering billing rates of all lawyers on securities litigation matters, and by reducing staffing and associate-to-partner ratios; and/or
  3. Move their practices to smaller, regional defense firms that naturally have more reasonable economics.

I’ve taken the third path, and I hope that a number of other securities litigation defense lawyers will also make that shift toward regional defense firms.  A regional practice can handle cases around the country, because litigation matters can be effectively and efficiently handled by a firm based outside of the forum city.  And they can be handled especially efficiently by regional firms outside of larger cities, which can offer a better quality of life for their associates, and a more reasonable economic model for their clients.

Consequences for D&O Insurance

D&O insurance needs to change as well.  For public companies, D&O insurance is indemnity insurance, and the insurer doesn’t have the duty or right to defend the litigation.  Thus, the insured selects counsel and the insurer has a right to consent to the insured’s selection, but such consent can’t be unreasonably withheld.  D&O insurers are in a bad spot in a great many cases.  Since most experienced securities defense lawyers are from expensive firms, most insureds select an expensive firm.  But in many cases, that spells a highly uneconomical or prejudicial result, through higher than necessary defense costs and/or an early settlement that doesn’t reflect the merits, but which is necessary to avoid using most or all of the policy limits on defense costs.

Given the economics, it certainly seems reasonable for an insurer to at least require an insured to look at less expensive (but just as experienced) defense counsel before consenting to their choice of counsel – if not outright withholding consent to a choice that does not make economic sense for a particular case.  If that isn’t practical from an insurance law or commercial standpoint, insurers may well need to look at enhancing their contractual right to refuse consent, or even to offer a set of experienced but lower-cost securities defense practices in exchange for a lower premium.  It is my strong belief that a great many public company CFOs would choose a lower D&O insurance premium over an unfettered right to choose their own defense lawyers.

Since I’m not a D&O insurance lawyer, I obviously can’t say what is right for D&O insurers from a commercial or legal perspective.  But it seems obvious to me that the economics of securities litigation must change, both in terms of defense costs and defense-counsel selection, to avoid increasingly irrational economic results.

 

* Median settlement values are falling as well.  In 2014, the median settlement was just $6.5 million according to NERA and $6.0 million according to Cornerstone.  NERA found that “[o]n an inflation-adjusted basis, 2014 median settlement was the third-lowest since the passage of the PSLRA: only in 1996 and in 2001 were median settlement amounts lower on an inflation-adjusted basis.”  Cornerstone reports that 62% of settlements in 2014 were $10 million or less, compared to an average of 53% over 2005-13.  Since settlements in 2014 were of cases filed in earlier years, when the size of cases was larger, it stands to reason that median settlements should remain small or decrease further in future years.

Securities litigation headlines are dominated by mega-cases. But the majority of securities class actions are brought against smaller companies. And it appears that plaintiffs’ lawyers are filing an increasingly large number of cases against smaller companies: in Cornerstone Research’s “Securities Class Action Filings: 2014 Year in Review,” the firm concludes, among other things, that (1) aggregate market capitalization loss of sued companies was at its lowest level since 1997, and (2) the percentage of S&P 500 companies sued in securities class actions “was the lowest on record.”

While the majority of securities class actions are against smaller companies, the predominate type of defense firm in all types of cases, big and small, is biglaw firms. Fees at such firms have skyrocketed since 1997. Billing rates have increased dramatically, with first-year associates now charging more per hour than senior partners did in 1997. Profits per partner at the most prominent securities litigation defense firms have at least tripled since 1997, with the “smallest” profits per partner at such firms now exceeding $1.5 million, and the largest totaling $3 million or more.

Biglaw firms are uniquely equipped to handle many types of matters. But they are not the only firms that can defend securities class actions effectively. And they aren’t well-equipped to defend smaller securities class actions efficiently; their fees have catapulted beyond what makes sense for a typical smaller securities class action. As I’ve written previously, catawampus economics can also cause problems with the effectiveness of the defense.

To illustrate the economic problem, consider hypothetical securities class actions against two smaller companies: 1997 Co., which carries $15 million in D&O insurance limits, and 2015 Co., which carries limits of $25 million. (Smaller company D&O insurance limits have increased some since 1997, but not markedly.) Assume settlements of $7.5 million in 1997, and $12.5 million in 2015.  Assume that defense costs through summary judgment were $5 million in 1997 (cases against smaller companies are nevertheless often as labor-intensive as cases against larger companies), and today are $15 million, or triple the 1997 figure, corresponding to the tripling (or more) of biglaw economics.

– Biglaw defense of 1997 Co. makes some economic sense: $5 million in defense costs, plus $7.5 million to settle, equals $12.5 million – or $2.5 million less than the D&O insurance limits.

– Biglaw defense of 2015 Co. does not make economic sense: $15 million in defense costs, plus $12.5 million to settle, equals $27.5 million – or $2.5 million more than the D&O insurance limits.

This is a problem without a good near-term global solution. Few firms outside of biglaw have the experience and expertise to defend cases effectively or efficiently, much less both effectively and efficiently. Perhaps what the securities defense bar needs is a new set of defense firms that have a combination of experience and economics similar to the 1997 versions of the technology and life sciences firms that historically have dominated securities class action defense. Such a development likely would require other biglaw lawyers to follow my lead and join excellent non-biglaw firms.  Until then, a company that is sued should engage in an especially thorough counsel-selection process, comprising three important steps:

  1. Ask its D&O broker and insurers to help sort through the possible candidates. Insurers and brokers are “repeat players” in securities litigation and usually have good insights on defense counsel.
  2. Choose several firms to interview, including firms of different types and with different strategies. The interview list should include firms other than regular outside counsel, which can be the wrong firm to defend the litigation. Conducting an interview process will not only ensure that the defendants end up with the right defense counsel, but also give them the advantages that come from engaging in a competitive hiring process.
  3. Involve the board in the hiring process.

 

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.

 

Shareholder litigation comes in waves.  There is a widespread belief that the next big wave will be shareholder derivative litigation – a shareholder’s assertion of a claim belonging to the corporation, typically brought against directors and officers, alleging corporate harm for a board’s failure to prevent corporate problems.

Derivative cases filed as tag-alongs to securities class actions have long been commonplace, and frequently are little more than a nuisance.  Over the years, there have been sporadic large derivative actions concerning other areas of legal compliance – typically over a very large corporate problem.   Non-disclosure derivative litigation filings recently have seemed more frequent, and there have been some large settlements that have come as a result.  And the specter of cyber liability derivative suits looms large – not surprisingly, Target shareholders just filed derivative litigation related to the recent customer data breach.  Whether the forecasted non-disclosure derivative-litigation wave materializes, or remains a sporadic occurrence in the larger world of D&O litigation, is one of the issues I’m watching closely in 2014 and beyond.

This potential wave raises issues that are unique to derivative litigation.  One key issue that has not been analyzed enough is representation: which lawyers can and should represent the company and the individual defendants in derivative litigation?

Because a derivative litigation claim belongs to the corporation, it puts the corporation in an odd spot.  A shareholder, as one of the corporation’s “owners” (usually a really, really small owner – but an owner nevertheless), is trying to force the company to bring a claim against the people who run the company.  The law says, however, that those people, the directors, get to decide whether the company should sue someone – including themselves – unless a shareholder can show that they couldn’t make a disinterested and independent decision.   Thus, to bring a derivative action, a shareholder must allege that it would have been futile to demand that the board take action, and defendants will typically challenge the lawsuit with a motion to dismiss for failure to make a demand (“demand motion”) on the basis that the demand-futility allegations aren’t sufficiently probative or particularized.

It is often said that the interests of the company and defendants are aligned through the demand motion, because they all have an interest in making sure that the shareholder follows proper governance procedures – namely, making a pre-suit demand on the board.  But this sort of statement prejudges the demand-futility allegations; it assumes that the allegations of futility are insufficient.  In Delaware and states that follow its demand law, proper corporate governance procedures require a shareholder either to make a demand or to plead demand-futility.  Only if and when the court rules that demand was required can we truly say that the interests of the company and defendants on the demand issue were aligned.  However, I don’t think this means that legal ethics require the company to be separately represented from the inception of a derivative action in all cases; the shared-interest view is arguable.   So if there are good practical reasons for joint representation from inception, and it causes no harm, so be it.  (That the primary lawyers are expensive relative to the D&O insurance limits isn’t a good reason for joint representation – it’s a good reason why those lawyers were the wrong lawyers for the matter.  But I digress.)

There’s also a compelling strategic reason to separate the representation from the beginning of the case.  A demand motion asks the court to allow the defendants to be the judge – to require the plaintiff to ask the directors to evaluate and bring claims against themselves and senior officers.  Thus, the company must overcome a judge’s skepticism that such an evaluation presents a “fox-guarding-the-chicken-coop” problem.  This is far easier to do if the company is separately represented and makes the demand motion.  It is true that courts frequently grant demand motions made during joint representation of the company and defendants.  But it is also true that joint representation always carries strategic risk, and the more serious the derivative litigation, the more unwise it is to take the risk.  Rather than make judgments in advance about which derivative litigation is serious, warranting a split, and which isn’t, allowing joint representation, I advocate splitting the representation from the outset – since the representation must be split up if demand is excused, splitting it from the outset imposes relatively little additional cost burden, if there’s appropriate coordination.

Representation between and among the defendants has strategic components, in addition to ethical considerations.  It can be strategically advantageous for individuals who aren’t accused of active wrongdoing to be separately represented from those who are.  That typically means officers and outside directors are represented separately in groups.  With this division, the court can see that the directors who would evaluate a demand don’t have the same lawyers as the people who allegedly engaged in active wrongdoing.  However, I don’t think that’s as strategically important for purposes of the demand motion as splitting up the company and defendants.  In evaluating a demand, the directors, acting as directors and not director-defendants, should be represented by counsel other than their litigation defense counsel.  Moreover, demand futility is judged at the time the suit is filed, not when the court decides the demand motion.  Thus, it isn’t technically necessary or legally accurate to send a “signal” of independence to the court through splitting up the representation further.  That said, in a very significant derivative case, and/or one in which the judge is new to derivative litigation, such an approach could be strategically advantageous.

It can sometimes be appropriate to consider even more divisions – for example, splitting the outside directors into audit-committee and non-audit-committee groups where audit-committee oversight is the main oversight allegation.  Such divisions may be ethically prudent or necessary later, but for purposes of the demand motion, they often don’t add much, if anything, since the demand motion is about the ability of a majority of the full board to consider a demand.

So, a typical case needs at least two lawyers from the outset – one for the company, and another for the individual defendants.  The type of derivative litigation we’re discussing often arises in the context of an underlying legal problem for which the company has lawyers – in a disclosure-related matter for a related securities class action, and in non-disclosure matters for other types of underlying matters (FCPA, antitrust, privacy, etc.).   To what extent should the lawyers defending the underlying matters be involved in the derivative action?

In general, I believe that the lawyers defending the underlying proceedings that created the corporate liability or harm (actual or potential) at issue in the derivative case should not defend the derivative case.  The reasons are similar to those I have written about in the context of using corporate counsel to defend a securities class action that may involve corporate counsel’s advice – there are tricky and hidden conflict issues, and the lawyers can be of better service to their clients as witnesses.

In derivative litigation, the problem can be even worse.  Corporate counsel typically advises on relevant corporate governance issues, such as compliance programs, the severity of legal risks that ultimately trigger the derivative litigation, board review of various risks, and preparation or review of board minutes.  Some companies are heavily guided in these areas by their corporate counsel, either directly in the boardroom or indirectly through advice to in-house counsel.   It is in the interests of the company and the board to be able to testify that they took a course of action, or didn’t do so, because of their lawyers’ advice.  The problem is greater than that of lawyer-as-witness – defense counsel should not be in the position of making judgments or recommendations that might be influenced by the law firm’s concerns about the public airing of its corporate work.

In derivative cases based on a disclosure problem, another representation issue arises:  whom should the securities class action defense counsel represent – the company or the defendants?   Securities class action defense counsel take different approaches to dividing derivative litigation representation.  Some will represent the company only, and have their securities class action individual defendant clients be represented by a different firm.  Others represent the individual defendants in the derivative action, and have the company represented by a different firm.   The right approach is a judgment call, but I prefer to have the securities class action defense counsel represent the individual defendants in the derivative action and have another firm represent the company.  That approach allows the lawyers in defense mode to fully remain in defense mode – they can defend the lack of merit to the charges of wrongdoing in all proceedings.   It also allows the defending lawyers to avoid the tension involved in simultaneously defending individuals in the securities class action and representing the potentially adverse company in the related derivative action.  This approach is possible with the right waivers, but I prefer the pure-defense approach.

Once the right lawyers are in place, how can and should the lawyers interact to prepare motions to dismiss and conduct other preliminary projects effectively – and cost-effectively?  The gating question is who should make the demand motion – the company or the defendants?  The company is really the right movant.  The demand motion is about the company’s corporate governance procedures, and the directors are involved not as directors but as individual defendants, so the purest approach is for the company to make the demand motion.

The same result makes sense from a strategic perspective.  The defendants have 12(b)(6) motions to make, and having them make both motions is awkward.   Although both motions say that the allegations (not the claims) aren’t good enough – the demand motion asserts that the allegations don’t raise a substantial likelihood of liability or other disabling interest sufficient to excuse demand, and the 12(b)(6) motion asserts they are not sufficient to state a claim – having the directors simultaneously assert that they could impartially consider a demand, but that the claims should be dismissed, is slicing the issues pretty finely.   If the defendants don’t make a 12(b)(6) motion, that problem is alleviated.  Many defense lawyers – including me from time to time – opine that the 12(b)(6) motions will fail if the demand motion fails, so defendants should just forego the 12(b)(6) motion entirely and make a 12(c) motion later, if necessary.  However, that foregoes the initial line of defense for the individuals.

It will be interesting to see if there is indeed a wave of more serious derivative litigation coming.  I will be on the look-out, and will write about other derivative-litigation issues that I think are of interest.

In my last post of 2013, I thought I’d share some thoughts about how public companies can better protect themselves against securities claims – practical steps companies can take to help them avoid suits, mitigate the risk if they are sued, and to defend themselves more effectively and efficiently.  I’ll share a few thoughts in this post and expand on some of them in future posts.

How Can Companies Avoid Securities Litigation?

Companies can avoid many suits with what I’ll call “better-feeling” disclosures.  Nearly all public companies devote significant resources to accounting that conforms with GAAP, and non-accounting disclosures that comply with the labyrinth of disclosure rules.  Despite tremendous efforts in these areas, later events sometimes surprise officers and directors – and the market – and make a company’s previous accounting or non-accounting disclosures appear to have been inaccurate.

But plaintiffs’ lawyers decide to sue only a subset of such companies – a smaller percentage than most people would assume.  What makes them sue Company A, but not Company B, when both have suffered a stock price drop due to a development that relates to their earlier disclosures?  There are a number of factors, but I believe the driver is whether a company’s disclosures “feel” fair and honest.  Without the benefit of discovery, plaintiffs’ lawyers have to draw inferences about whether litigation will reveal fraud or a sufficient degree of recklessness – or show that the discrepancies between the earlier disclosures and later revelations was due to mistake or an unanticipated development.

What can companies do to make their disclosures “feel “more honest?

An easy way for companies to make their disclosures feel more honest and forthright is to improve the quality of their Safe Harbor warnings.  Although the Reform Act’s Safe Harbor was designed to protect companies from lawsuits over forward-looking statements, there are still an awful lot of such actions filed.  The best way to avoid them is by crafting risk warnings that are current and candid.  A plaintiffs’ lawyer who reads two years’ worth of risk factors can tell whether the risk factors are boilerplate, or an honest attempt to describe the company’s risks.  The latter deters suits.  The former invites them.

Another way for companies to improve their disclosures is through more precision and a greater feel of candor in the comments they make during investor conference calls.  Companies sweat over every detail in their written disclosures, but then send their CEO and CFO out to field questions on the very same subjects and improvise their responses.  What executives say, and how they say it, often determines whether plaintiffs’ lawyers sue – and, if they do, how difficult the case will be to defend.  A majority of the most difficult statements to defend in a securities class action are from investor calls, and plaintiffs’ lawyers listen to these calls and form impressions, positive and negative, about officers’ fairness and honesty.

Companies looking to minimize the risks of litigation should also take steps to prevent their officers and directors from making suspicious-looking stock sales – for obvious reasons, plaintiffs’ lawyers like to file suits that include stock sales.  If a company’s officers and directors don’t have 10b5-1 plans, companies should establish and follow an insider trading policy and, when in doubt, seek guidance from outside counsel on issues such as trading windows and the propriety of individual stock sales, both as to the legal ability to sell, and how the sales will appear to plaintiffs’ lawyers.  And even if their officers and directors have 10b5-1 plans, companies aren’t immune to the scrutiny of their stock sales – plaintiffs’ lawyers usually aren’t deterred by 10b5-1 plans, contrary to conventional wisdom. So companies should consult with their counsel about establishing and maintaining the plans, to avoid traps for the unwary.

How Can Companies Better Protect Themselves Against Securities Litigation that Does Arise?

Whether a securities class action is a difficult experience or a fairly routine corporate legal matter usually turns on the company’s decisions about directors’ and officers’ indemnification and insurance, its choice of defense counsel, and its management of the defense of the litigation.

Deciding on the right director and officer protections and defense counsel require an understanding of the seriousness of securities class actions.  Although securities class actions are a public company’s primary D&O litigation exposure,* most companies don’t understand the degree of risk they pose.  Some companies seem to take securities class actions too seriously, while others might not take them seriously enough.

The right level of concern is almost always in the middle.  A securities class action is a significant lawsuit.  It alleges large theoretical damages and wrongdoing by senior management and often the board.  But the risk presented by a securities action is usually very manageable, if the company hires experienced, non-conflicted and efficient counsel, and devotes sufficient time and energy to the litigation.  Cases can be settled for a predictable amount, and it is exceedingly rare for directors and officers to write a personal check to defend or settle the case.  On the other hand, it can be a costly mistake for a company to take a securities class action too lightly; even meritless cases can go wrong.

The right approach to securities litigation involves several practical steps that are within every company’s control.

Companies should hire the right D&O insurance broker and treat the broker as a trusted advisor.  There is a talented and highly specialized community of D&O insurance brokers.  Companies should evaluate which is the right broker for them – they should conduct an interview process to decide on the right broker, and seek guidance from knowledgeable sources, including securities litigation defense counsel.  Companies should heavily utilize the broker in deciding on the right structure for their D&O insurance program and in selecting the right insurers.  And since D&O insurance is ultimately about protecting officers and directors, companies should have the broker speak directly to the board about the D&O insurance program.

Boards should learn more about their D&O insurers.  Boards should know their D&O insurers’ financial strength and other objective characteristics.  But boards should also consider speaking with the primary insurer’s underwriting executives from time to time, especially if the relationship with the carrier is, or may be, long-term.  The quality of any insurance turns on the insurer’s response to a claim. D&O insurance is a relationship business.  Insurers want to cover D&O claims, and it is important to them to have a good reputation for doing so.  The more the insurer knows the company, the more comfortable the insurer will be about covering even a difficult claim.  And the more a board knows the insurer, the more comfortable the board will be that the insurer will cover even a difficult claim.

Boards should oversee the defense-counsel selection process, and make sure the company conducts an interview process and chooses counsel based on value.  The most important step for a company to take in defending a securities class action is to conduct an audition process through which the company selects conflict-free defense counsel who can provide a quality defense – at a cost that leaves the company enough room to defend and resolve the litigation within policy limits.  Put differently, the biggest threats to an effective defense of a securities class action are the use of either a conflicted defense counsel, defense counsel who will charge an irrational fee for the litigation, or counsel who will cut corners to make the economics appear reasonable.

Errors in counsel-selection most often occur when a company fails to conduct an interview process, or fails to consult with its D&O insurers and brokers, who are “repeat players” in D&O litigation and thus have good insights on the best counsel for a particular case.  Although the Reform Act’s 90-day lead plaintiff selection process gives companies plenty of time to evaluate, interview, and select the right defense counsel for the case, many companies quickly hire their corporate counsel’s litigation colleagues, without consulting with brokers and insurers or interviewing other firms.

The right counsel may end up being the company’s normal corporate firm, but a quick hiring decision rarely makes sense under a cost-benefit analysis.  The cost of hiring the wrong firm can substantial – the harm includes millions of dollars of unnecessary fees; hundreds of hours of wasted time by the board, officers, and employees; an outcome that is unnecessarily uncertain; and an unnecessarily high settlement – and there’s very little or no upside to the company.

On the other hand, it costs very little to interview several firms for an hour or two each, and the benefit can be substantial – free and specialized strategic advice by several of the handful of lawyers who defend securities litigation full time, and potentially substantial price and other concessions from the firm that is ultimately chosen.  The auditioning lawyers can also provide guidance to the company on whether its corporate counsel faces conflicts and, if so, the potential harm to the company and the officers and directors from hiring corporate counsel anyway.

 

* This discussion focuses on public company securities class actions. I set aside shareholder derivative litigation and shareholder challenges to mergers, which typically involve lesser risk.

When I moved my securities litigation practice to a regional law firm from biglaw, I made a bet.  I bet that public companies and their directors and officers would be willing to hire securities defense counsel on the basis of value, i.e., the right mix of experience, expertise, efficiency, and price – just as they do with virtually all other corporate expenditures – and not simply default to a biglaw firm because it is “safer.”

My bet certainly was made less risky by the quality of my new law firm (a 135-year-old renowned firm that has produced past and present federal judges, and is full of superior lawyers); my confirmatory discussions with public company directors, officers, and in-house lawyers; my observations and analyses about the evolving economics of securities litigation defense and settlement; and my knowledge that I could recruit other talented full-time securities litigators to join me in my new practice.  But it was still a bet.

Well, so far, so good – my experience to date has confirmed my belief.  So, too, did a recent article titled, “Why Law Firm Pedigree May Be a Thing of the Past,” on the Harvard Business Review Blog Network (“HBR article”), reporting on scholarship and survey results indicating that public companies are increasingly willing to hire firms outside of biglaw to handle high-stakes matters.

The HBR article frames the issue in colorful terms:

Have you ever heard the saying: “You never get fired for buying IBM”? Every industry loves to co-opt it; for example, in consulting, you’ll hear: “You never get fired for hiring McKinsey.” In law, it’s often: “You never get fired for hiring Cravath”. But one general counsel we spoke with put a twist on the old saying, in a way that reflects the turmoil and change that the legal industry is undergoing. Here’s what he said: “I would absolutely fire anyone on my team who hired Cravath.” While tongue in cheek, and surely subject to exceptions, it reflects the reality that there is a growing body of legal work that simply won’t be sent to the most pedigreed law firms, most typically because general counsel are laser focused on value, namely quality and efficiency.

The HBR article reports that a study of general counsel at 88 major companies found that “GCs are increasingly willing to move high-stakes work away from the most pedigreed law firms (think the Cravaths and Skaddens of the world) … if the value equation is right.  (Firms surveyed included companies like Lenovo, Vanguard, Shell, Google, NIKE, Walgreens, Dell, eBay, RBC, Panasonic, Nestle, Progressive, Starwood, Intel, and Deutsche Bank.)”

The article reports on two survey questions.

The first question asked, “Are you more or less likely to use a good lawyer at a pedigreed firm (e.g. AmLaw  20 or Magic Circle) or a good lawyer at a non-pedigreed firm for high stakes (though not necessarily bet-the-company) work, assuming a 30% difference in overall cost?”

The result: 74% of GCs answered that they are less likely to use a pedigreed firm, and 13% answered the “same.”  Only 13% responded that they are more likely to use a pedigreed firm than other firms.

The second question asked, “On average, and based on your experiences, are lawyers at the most pedigreed, “white shoe” firms more or less responsive than at other firms?”

The result:  57% answered that pedigreed firms are less responsive than other firms, and 33% answered they are the “same.”  Only 11% responded that pedigreed firms are more responsive than other firms.

The survey results ring true, and are reinforced by other recent scholarship and analysis on the issue, including a Wall Street Journal article titled, “Smaller Law Firms Grab Big Slice of Corporate Legal Work” (“WSJ article”), and an article featured on www.law.com Corporate Counsel blog titled, “In-House Counsel Get Real About Outside Firm Value” (“Corporate Counsel article”).  As all three articles emphasize, skyrocketing legal fees are a notorious problem in general.  And corporate executives are increasingly becoming attuned to this issue.  Indeed, during the in-house counsel panel discussed in the Corporate Counsel article, a general counsel noted that in explaining outside counsel costs to the CEO and CFO of his company, “it’s very, very difficult … to say why someone should [bill] over $1,000 per hour . . . It just doesn’t look good.”  The problem is especially acute in securities class action defense, in which the defense is largely dominated by biglaw firms with high billing rates and a highly leveraged structure (i.e. a high associate-to-partner ratio), which tends to result in larger, less-efficient teams.

Now, as the economy has forced companies to be more aware of legal costs, including the fact that using a biglaw firm often results in prohibitively high legal fees, it is unsurprising that companies are increasingly turning to midsize firms.  According to the WSJ article, midsize firms have increased their market share from 22% to 41% in the past three years for matters that generate more than $1 million in legal bills.  Indeed, both Xerox’s general counsel and Blockbuster’s general counsel advocated that companies control legal costs by using counsel in cities with lower overhead costs.

Some companies, and many law firms, see securities class actions as a cost-insensitive type of litigation to defend: the theoretical damages can be very large, they assert claims against the company’s directors and officers, and the defense costs are covered by D&O insurance.

But these considerations rarely, if ever, warrant a cost-insensitive defense.  Securities class actions are typically defended and resolved with D&O insurance.  D&O insurance limits of liability are depleted by defense costs, which means that each dollar spent on defense costs decreases the amount of policy proceeds available to resolve the case.  At the end of a securities class action, a board will very rarely ask, “why didn’t we hire a more expensive law firm?”  Instead, the question will be, “why did we have to write a $10 million check to settle the case?”  Few GCs would want to have to answer:  “because we hired a more expensive law firm than we needed to.”

That takes us to the heart of the HBR article: “do we need to hire an expensive law firm?”  After all, in a securities class action, the theoretical damages can be very large, often characterized as “bet the company,” and the fortunes of the company’s directors and officers are theoretically implicated.  Certainly, when directors and officers are individually named in a lawsuit, their initial gut reaction may be to turn to biglaw firms regardless of price, if they believe that the biglaw brand name will guarantee them a positive result.

Biglaw capitalizes on these fears.  But, of course, hiring a biglaw firm does not guarantee a positive result.  The vast majority of securities class actions are very manageable.  They follow a predictable course of litigation, and can be resolved for a fairly predictable amount, regardless how high the theoretical damages.  And it is exceedingly rare for an individual director or officer to write a check to settle the litigation.  Indeed, the biggest practical personal financial risk to an individual director or officer is exhaustion of D&O policy proceeds due to defense costs that are higher than necessary.

Lurking behind these considerations are two central questions: “aren’t lawyers at biglaw firms better?” and “don’t I need biglaw resources?”

“Aren’t lawyers at biglaw law firms better?”  Not necessarily.  That’s the main point of the GC survey discussed in the HBR article.

To be sure, there are excellent securities litigators at many biglaw firms.  But the blanket notion that biglaw securities litigators are more capable than their non-biglaw counterparts is false.  And it’s not even a probative question when comparing biglaw lawyers to non-biglaw lawyers who came from biglaw.  In the WSJ article, Blockbuster’s general counsel, in explaining why his company often seeks out attorneys from more economical areas of the country, pointed out that many of the attorneys in less expensive firms came from biglaw firms.  Many top law school graduates and former biglaw attorneys practice at non-biglaw firms, not because they were not talented enough to succeed at a biglaw firm, but for personal reasons, including a desire to live in a city other than New York, the Bay Area, or Los Angeles, to find work-life balance, to have the freedom to design a better way of defending cases, or to develop legal skills at a faster pace than is usually available at a biglaw firm.

There obviously is a baseline amount of expertise and experience that is necessary to handle a case well, and there are a number of non-biglaw lawyers in the group of lawyers who meet that standard.  One easy way to judge the quality of firms is by reading recently filed briefs of biglaw and midsize firms.  While this type of analysis takes more time than simply looking up a lawyer or law firm ranking, it will be the best indicator of the type of work product to expect from a firm.  As with all lawyer-hiring decisions, the individual lawyer’s actual abilities, strategic vision for the litigation, and attention to efficiency are key considerations.  A lawyer’s association with a biglaw firm name can be a proxy for quality, but it does not ensure quality.

Indeed, the opposite can be true – by paying for the biglaw expertise and experience of a particularly accomplished senior partner (the partner likely to pitch the business), companies often end up with the majority of the work being done by senior associates and junior partners.  A company should consider the impact of the economic realities of biglaw versus non-biglaw firms.  Senior partners at biglaw firms, with higher associate-to-partner ratios, must have a lot of matters to keep their junior partners and associates busy, and thus necessarily spend less time on each matter – even if they have good intentions to devote personal time to a matter.  Biglaw firms’ largest clients and cases, moreover, often demand much of a senior partner’s time, at the expense of other cases.  And given the reality that partners practice less and less law the more senior they become, it is fair to question whether they are the right people for the job anyway.  In contrast, senior partners at non-biglaw firms typically have fewer people to keep busy, and have lower billing rates – which means that they can spend more time working on their cases, and they spend more time actually practicing law.

Further, for smaller and less significant projects that should be handled by associates, and should not require the higher billing rates of partners, biglaw is similarly unable to offer a cost-effective solution for companies.  Associates at biglaw firms typically have less hands-on experience than their counterparts at mid-sized firms.  In litigation, for example, biglaw associates generally spend their first few years solely on discovery or discrete research projects.  The end result is that many projects that could be handled by a junior or mid-level associate at a mid-sized firm would have to be handled by a senior associate or junior partner at a biglaw firm.  So, even putting aside differences in billing rates between a fifth-year biglaw associate and a fifth-year midsize firm associate, going with a biglaw firm typically means that projects are being assigned to attorneys too senior (and accordingly too costly) to be handling the assignments.

Don’t I need biglaw resources?  There are two primary answers.  First, from both a quality and an efficiency standpoint, securities litigation defense is best handled by a small team through the motion–to-dismiss process.  Prior to a court’s decision on the motion to dismiss, the only key tasks are a focused fact investigation and the briefing on the motion to dismiss.   As to both, fewer lawyers means higher quality.

If a case survives a motion to dismiss, most firms with a strong litigation department will have sufficient resources to handle it capably.  That, of course, is something a company can probe in the hiring process.   There are cases that necessarily will require a larger team than some mid-size firms can provide.  However, such cases are rare, and it is often the case that biglaw firms, in an effort to maintain associate hours at a certain level, will heavily staff associates on discovery projects such as document review.  While the exceptional case will require a team of more than around five associates, for the most part, discovery can and should be handled most efficiently by a team of contract attorneys supervised by a small team of associates – or by utilizing new technologies that allow smaller teams to review documents more efficiently and effectively.

Second, as reflected in the HBR article’s discussion of GCs’ answers to the second question, there isn’t a correlation between a firm’s pedigree and its responsiveness – which is a key facet of law firm resources.  Indeed, responsiveness is a function of effort, and it stands to reason that non-biglaw firms will make the necessary effort to give excellent client service.

The bottom line of all this is simply common sense: within the qualified group of lawyers, a company should look for value – the right mix of experience, expertise, efficiency, and cost – as it does with any significant corporate expenditure.

Last Tuesday, new SEC Chairman Mary Jo White said at The Wall Street Journal’s annual CFO Network Event that the SEC “in certain cases” will seek admissions of liability as part of settlements. The statement made headlines, and for good reason: for decades, the SEC has allowed settling defendants to neither admit nor deny wrongdoing. The policy shift, moreover, comes during the appeal to the Second Circuit of District Judge Jed Rakoff’s rejection of the SEC-Citigroup settlement, where he rejected a no-admit-or-deny settlement based in part on his determination that any consent judgment that is not supported by “proven or acknowledged facts” would not serve the public interest. (Last year, the SEC stopped allowing civil defendants to neither admit nor deny fraud, if they had already pleaded guilty in a parallel criminal case.)

Chairman White’s remarks last Tuesday indicated that a new policy requiring admissions of liability will be applied in cases of “widespread harm to investors” and “egregious intentional misconduct.” An internal SEC email from co-directors of the SEC Enforcement Division to the Enforcement staff, obtained by Alison Frankel of Reuters, and author of the blog On the Case, elaborates on the scope of the policy’s application:

“While the no admit/deny language is a powerful tool, there may be situations where we determine that a different approach is appropriate,” Ceresney and Canellos said in the email, which was provided to me by an SEC representative. “In particular, there may be certain cases where heightened accountability or acceptance of responsibility through the defendant’s admission of misconduct may be appropriate, even if it does not allow us to achieve a prompt resolution. We have been in discussions with Chair White and each of the other commissioners about the types of cases where requiring admissions could be in the public interest. These may include misconduct that harmed large numbers of investors or placed investors or the market at risk of potentially serious harm; where admissions might safeguard against risks posed by the defendant to the investing public, particularly when the defendant engaged in egregious intentional misconduct; or when the defendant engaged in unlawful obstruction of the commission’s investigative processes. In such cases, should we determine that admissions or other acknowledgement of misconduct are critical, we would require such admissions or acknowledgement, or, if the defendants refuse, litigate the case.”

What will this mean in actual SEC enforcement matters and related shareholder cases? Comments from plaintiffs’ lawyers and defense lawyers in Frankel’s blog post provide a useful start to the discussion. Not surprisingly, plaintiffs’ lawyers Max Berger, Gerald Silk and Steve Toll feel the policy will help them by providing them with ammunition to use to bolster their private securities cases. My former partner Boris Feldman of Wilson Sonsini said that the “proof of the sausage is in the making,” and feels the policy won’t change SEC enforcement matters much because the SEC will only insist on an admission when “the defendant is hosed anyway.” Thomas Gohrman of Dorsey & Whitney is worried that, “unless applied on a very sparing basis,” the policy “may well significantly undercut the entire enforcement program” because defendants will refuse to settle and the SEC will expend its resources litigating these cases.

My view lies somewhere in between these. The SEC doesn’t currently have the enforcement resources to litigate a significant additional number of additional cases, so in the near term it really can only apply the policy to particularly gnarly cases, where there is egregious or notorious misconduct, and where they are very confident they would win at trial. This approach won’t impact defendants significantly, because in cases that fall into these categories, the defendants already have significant problems stemming from the underlying facts, and there would be little collateral damage from the admission the SEC seeks.

But, to be sure, the SEC is bound to apply the policy to some close cases as well, because of a misapprehension of the case’s strength, or an overly zealous interpretation of White’s edict by the SEC staff. (There may also be a temptation by the SEC to apply this policy too broadly to high-profile cases of questionable merit, although I believe that tendency will be limited by a concern over suffering too many high-profile defeats.) The defendants will refuse to agree to settlements requiring admissions in most close cases, because of collateral consequences in otherwise defensible cases, thus yielding an increase in the number of cases the SEC litigates. How many more cases will be litigated will depend in large part on the rigor of the SEC’s screening process and on whether the SEC staff facilitates frank and meaningful discussions with defense counsel about the facts of each case.

What we know for sure is that the amount of litigation will increase in proportion to the SEC’s implementation of this new policy. Unless the new policy is interpreted very narrowly, the SEC will very quickly have a decision to make: it will either need to find new resources to finance the additional litigation; divert resources into litigation from investigation and enforcement, resulting in fewer actions being filed in the first place; or pull back on the implementation of the new policy.

I predict that after some initial overreaching, the SEC will re-calibrate its no-admission policy to limit its application to only the gnarliest cases with the worst facts. Otherwise, the government will have to fundamentally rethink the SEC’s funding and/or its enforcement role, in order to accommodate substantially more active litigation. This is possible, of course, but it seems unlikely.

On the other hand, the SEC is in control of the process only up to the point of judicial review of a proposed settlement. The uncertainty surrounding judicial review of no-admit-or-deny settlements is a wild card – increased judicial insistence on admissions likely would prompt the SEC to apply its policy to more cases than it otherwise would. Thus, the Second Circuit’s response to Judge Rakoff in the SEC-Citigroup case remains an important development to watch.

As I previously wrote, increased insistence on admissions, whether by the SEC or courts, would have significant consequences on private litigation and D&O insurance coverage. Obviously, making these admissions would increase the risk of liability in related private litigation, while at the same time creating insurance coverage problems – not to mention the impact they would have on a company’s reputation and directors’ and officers’ careers.

Deciding to litigate with the SEC will create difficult issues as well. Increased litigation will strain D&O insurance policies, not just because it creates another piece of litigation, but because it is inherently expensive litigation, which is likely to go to trial and will frequently require separate representation for each defendant. That will leave less insurance to settle the private cases, which in turn will mean that more private shareholder cases will go to trial as well.

These forces, along with the problem of increasing defense costs (about which I’ve posted here and here), will create a financial problem for many companies and their directors and officers. And, of course, they could create a serious liability problem as well, since the odds are that a decent percentage of the cases that go to trial under these circumstances will result in determinations of liability. Depending upon how these factors play out, it will become even more critical for defense counsel to adopt a more efficient, effective, and trial-focused approach to securities litigation.