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One of my “5 Wishes for Securities Litigation Defense” (April 30, 2016 post) is to require an interview process for the selection of defense counsel in all cases.

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.

On March 24, 2015, the U.S. Supreme Court issued its opinion in Omnicare, Inc. v. Laborers Dist. Council Const. Industry Pension Fund, 135 S. Ct. 1318 (2015).  My partner Claire Davis and I are publishing a forthcoming one-year anniversary article on Omnicare.  In addition to discussing the lower courts’ application of the decision, we take apart the fallacy that Omnicare is “plaintiff-friendly” – a proposition that led to my June 2015 rant “Hey There Fellow Securities Defense Lawyers: Omnicare is GOOD for Us!”  We will post a link to the anniversary article when it’s out.  For now, I want to further explain why I care so much about Omnicare.

As a reminder, Omnicare holds that a statement of opinion is only false if the speaker does not genuinely believe it, and that it is only misleading if – as with any other statement – it omits facts that make it misleading when viewed in its full context.  The Court’s ruling on what is necessary for an opinion to be false establishes a uniform standard that resolves two decades of confusing and conflicting case law.  And the Court’s ruling regarding how an opinion may be misleading emphasizes that courts must evaluate the fairness of challenged statements (both opinions and other statements) within a broad factual context, eliminating the short-shrift that many courts have given the misleading-statement analysis.

In my tax law class in law school, my professor said that he could teach all of tax law through the U.S. Supreme Court case Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929).  Similarly, Omnicare provides the foundation for multiple legal and strategic elements of a strong defense of a securities class action.  It is truly a case study in how to defend a securities case.  Below, I address three of those components. 

1. Omnicare’s directive that courts consider context better allows defense lawyers to show the defendants said nothing false.

Our North Star in defending any securities class action is to explain that the defendants said nothing false.  At the core of every securities class action is a person who is alleged to have lied.  Clients generally feel strongly that they did their best and told the truth.  The reasons for their belief are always the right place to start constructing the defense, and usually remain the gist of the defense after categorizing the facts under the relevant legal standards.

Sticking up for the truth of what our clients said also gives them a voice during the long initial stages of the motion-to-dismiss process.  Although the Reform Act’s prolonged introductory stages were designed to help defendants, they don’t allow defendants to tell their side of the story – which is frustrating and often harmful to the reputations of real people.

But the Reform Act, and now Omnicare’s context standard, leave securities defense lawyers with broad latitude to support the truth of what their clients said, and to attack allegations of falsity, as to both statements of fact and statements of opinion.  A proper falsity analysis always starts by examining each challenged statement individually, and matching it up with the facts that plaintiffs allege illustrate its falsity.  From there, the truth of what the defendants said can be supported in numerous ways that are still within the proper scope of the motion-to-dismiss standard:  showing that the facts alleged do not actually undermine the challenged statements, because of mismatch of timing or substance; pointing out gaps, inconsistencies, and contradictions in plaintiffs’ allegations; demonstrating that the facts that plaintiffs assert are insufficiently detailed under the Reform Act; attacking allegations that plaintiffs claim to be facts, but which are really opinions, speculation, and unsupported conclusions; putting defendants’ allegedly false or misleading statements in their full context to show that they were not misleading; and pointing to judicially noticeable facts that contradict plaintiffs’ theory.

A good motion to dismiss has always analyzed a challenged statement (of fact or opinion) in its broader factual context to explain why it’s not false or misleading.  But many defense lawyers unfortunately leave out the broader context, and courts have sometimes taken a narrower view.  Now, this type of superior, full-context analysis is clearly required by Omnicare.  And combined with the Supreme Court’s directive in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), that courts consider scienter inferences based not only on the complaint’s allegations, but also on documents on which the complaint relies or that are subject to judicial notice, courts clearly must now consider the full array of probative facts in deciding both whether a statement was false or misleading and, if so, whether it was made with scienter.  Plaintiffs can’t cherry-pick what the court considers anymore. 

2. Omnicare’s subjective falsity holding allows us to stick up for the truth of all of our clients’ statements.  

Opinions are ubiquitous in corporate communications.  Corporations and their officers routinely share subjective judgments on issues as diverse as asset valuations, strength of current performance, risk assessments, product quality, loss reserves, earnings forecasts, and progress toward corporate goals.  Indeed, I would guess that more than 75% of all securities class actions involve one or more statements of opinion as a core allegation.

Yet for decades before Omnicare, it was difficult to defend the truth of an opinion.  The law was hopelessly muddled.  For a full discussion, I invite you to review pages 13-19 of our Omnicare amicus brief on behalf of Washington Legal Foundation.  To argue the truth of statements of opinion, we would provide the best possible statement of the legal standard under the law of the circuit we were in, try to convince the court that the real standard should be the standard that is now the Omnicare standard, and then argue that the opinion was true and not misleading under the standard we advanced.  Now, under Omnicare, we can stick up for the truth of all of our clients’ statements, both fact and opinion, without having to first engage in a mini-argument of the law governing opinions.

3. Omnicare allows judges wider latitude to rule in defendants’ favor.

Judges want to figure out if the defendants tried to tell the truth.  The law provides wide latitude for judges to dismiss claims, and we want to give them every reason to do so.  If the judge accepts that the defendants did their best to be fair and candid in their public statements, he or she will be more inclined to accept other arguments.

So the argument against falsity, utilizing the tools Omnicare has provided, is the right place to start, even if there are stronger alternative arguments.  For example, in an earnings forecast case, the best approach is to first defend the truth of the forecast – a statement of opinion – and then use the Reform Act’s Safe Harbor as a fallback argument.  Likewise, a strong argument against scienter is best set up by a strong argument against falsity.  The element of scienter requires plaintiffs to demonstrate that the defendants said something knowingly or recklessly false – in order to do this, plaintiffs must tie their scienter allegations to each particular challenged statement.  A scienter argument that doesn’t build on a strong falsity argument is a strategic mistake.

I hope that this short guide to how to use the powerful tool the Court gave us in Omnicare is helpful.  If we in the defense bar use the decision correctly, companies and their directors and officers will have greater freedom to speak without undue fear of liability, and we will win more cases in which their opinions are challenged.

In 2015, the Private Securities Litigation Reform Act* turned twenty years old.

Over my career as a securities litigator, I’ve seen both sides of the securities-litigation divide that the Reform Act created.  In the first part of my career, I witnessed the figurative skid marks in front of courthouses, as lawyers raced to the courthouse to file claims before knowing if there really was a claim to be filed – the emblem of the problems Congress sought to correct.  And in the 20 years since, I’ve seen the Reform Act both succeed and fail to achieve the results Congress intended.

In this blog post, I assign grades to each of the Reform Act’s key provisions, and an overall grade.  The Reform Act’s successes and failures derive from an amalgam of factors, ranging from Congressional insight and oversight, to good and bad lawyering by plaintiffs’ and defense lawyers alike, to good and bad judging.  The grades I assign are necessarily based on a defense perspective, and mine at that – but I do try to be fair.

Grading the Reform Act’s Key Provisions

The Reform Act was passed by the Contract-with-America Congress to address its perception that securities class actions were reflexive, lawyer-driven litigation that often asserted weak claims based on little more than a stock drop, and relied on post-litigation discovery, rather than pre-litigation investigation, to sort out the validity of the claims.  The Reform Act, among other things:

  • Imposed strict pleading standards for showing both falsity and scienter, to curtail frivolous claims by increasing the likelihood that they would be dismissed;
  • Created a Safe Harbor for forward-looking statements, to encourage companies to make forecasts and other predictions without undue fear of liability;
  • Imposed a stay of discovery until the motion-to-dismiss process is resolved, to prevent discovery fishing expeditions and to eliminate the burden of discovery for claims that do not meet the enhanced pleading standards; and
  • Created procedures for selecting a lead plaintiff with a substantial financial stake in the litigation, to discourage lawyer-driven actions and the “race to the courthouse.”

Following are my grades for each of these provisions:

Falsity Pleading Standard – Grade: D

The Reform Act requires a plaintiff to plead the element of a false or misleading statement with particularity.  Indeed, the statute says that “if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.” 15 U.S.C. § 78u-4(b)(1) (emphasis added).

Yet this powerful tool is now almost a museum piece.  I don’t just mean the “all facts” part – an issue plaintiffs and defendants heavily litigated for years,  before courts converged around the proposition that plaintiffs only need to include enough detail to adequately plead the claim.  Rather, I mean that most defense firms now merely go through the motions of attacking and analyzing plaintiffs’ falsity allegations.

How could that have happened?  To be blunt, it’s mostly through bad lawyering by defense lawyers, who got sidetracked by the Safe Harbor and the scienter pleading standard (see below), and by self-indulgent statutory analysis, such as what Congress meant by the term “all facts.”  In doing so, they overlooked the more basic but powerful point: the Reform Act’s falsity standard must be a higher and different hurdle than Rule 9(b), requiring a robust analysis of the falsity allegations.  And when they got distracted, defense counsel took their eye off their main job: to stick up for their clients’ honesty.

Indeed, the core argument of virtually every motion to dismiss should be that the defendants told the truth and said nothing false.  The Reform Act, and now the Supreme Court’s decision in Omnicare, Inc. v. Laborers Dist. Council Const. Industry Pension Fund, 135 S. Ct. 1318 (2015), leave securities defense lawyers with broad latitude to attack falsity.  A proper falsity analysis always starts by examining each challenged statement individually, and matching it up with the facts that plaintiffs allege illustrate its falsity.  From there, the truth of what the defendants said can be supported in numerous ways that are still within the proper scope of the motion-to-dismiss standard:  showing that the facts alleged do not actually undermine the challenged statements, because of mismatch of timing or substance; pointing out gaps, inconsistencies, and contradictions in plaintiffs’ allegations; demonstrating that the facts that plaintiffs assert are insufficiently detailed under the Reform Act; attacking allegations that plaintiffs claim to be facts, but which are really opinions, speculation, and unsupported conclusions; putting defendants’ allegedly false or misleading statements in their full context to show that they were not misleading; and pointing to judicially noticeable facts that contradict plaintiffs’ theory.

These arguments must be supplemented by a robust understanding of the relevant factual background, which defines and frames the direction of any argument based on the complaint and judicially noticeable facts.  Yet most motions to dismiss do not make a forceful argument against falsity that is supported with a specific challenge to the facts alleged by the plaintiffs.  Some motions superficially assert that the allegations are too vague to satisfy the pleading standard, but do not engage in a detailed defense of the challenged statements.  Others simply attack the credibility of “confidential witnesses” without addressing in sufficient detail the content of the information the complaint attributes to them.  And others fall back on the doctrine of “puffery,” essentially conceding that the statements may have been lies, but contending that they were not specific or important enough to be taken seriously.  By focusing on these and similar approaches, a brief may leave the judge with the impression that defendants concede falsity, and that the real defense is that the false statements were not made with scienter.  Not only is this an argument not available for Section 11 and 12 claims, but defense counsel’s failure to attack falsity allegations in detail actually undermines the argument that defendants did not have scienter.

The Reform Act’s falsity pleading standard was an enormous gift for defense attorneys, which enables them to mount a strong and vibrant defense on a motion to dismiss if it is used correctly.  But because it has not been used to its potential, I give it a D.

Scienter Pleading Standard – Grade: C

The Reform Act says that “with respect to each act or omission alleged to violate this chapter, [plaintiffs must] state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind,” i.e., scienter. 15 U.S.C. § 78u-4(b)(2).

Defense lawyers have billed billions of dollars analyzing and briefing what these simple words mean.  We argued for years about the meaning of “the required state of mind” – did it mean actual intent, recklessness, or a hybrid?  We litigated how courts must consider whether plaintiffs have pleaded a “strong inference” of that state of mind, an issue ultimately decided by the Supreme Court in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), which held that courts must weigh inferences of scienter to decide whether the alleged inference of fraud is stronger than opposing innocent inferences.  We then argued over whether Tellabs did away with the various “rules” courts had established, such as the amount or percentage of stock holdings a defendant had to sell before his or her sales suggested scienter, and whether looking at stock sales, or any other type of scienter allegation, in isolation was even allowed.  And we have argued over the degree of particularity Congress intended to require, and engaged in thousands of “did so, did not” spats over whether the allegations met the standard for which we were arguing.

For defendants, the overall outcome of all of this is decent.  The dismissal rate is pretty good, and the vast majority of dismissals are based on plaintiffs’ failure to plead scienter.  But the defense counsel community’s intense focus on improving the defendant-friendly scienter standard contributed to the distraction that sidetracked good falsity analysis.  And to what end?  I would bet a great deal that the difference between plain old “recklessness” and a slightly higher degree of recklessness has made no real difference in the dismissal rate.  A judge who believes that a defendant didn’t mean to say something false would not deny a motion to dismiss simply over a slightly different formulation of the legal standard.

But defendants have achieved this decent dismissal rate without their defense counsel making the best possible arguments for them.  As with falsity, the primary flaw in most defense arguments against scienter is with defense counsel’s failure to engage in a fact-specific analysis of the complaint’s allegations about what the defendants knew in regard to each specific challenged statement.  All too often, defendants allow themselves to be sidetracked by technicalities, or even worse, drawn to the plaintiffs’ preferred ground of battle, focusing on arguing about the sufficiency of the circumstantial evidence that plaintiffs use to create the impression that the defendants must have done something wrong.

Both of these flaws are found in defense counsel’s typical approach to plaintiffs’ arguments under the “core operations” inference of scienter and the “corporate scienter” doctrine.  Each of these theories allows a plaintiff to avoid pleading specific facts establishing the speaker’s scienter.  For example, the core operations inference posits that scienter can be inferred where it would be “absurd to suggest” that a senior executive doesn’t know facts about the company’s “core operations.”  Many motions to dismiss set up some formulation of this statement as a legal rule and then use it to make a simplistic syllogistic argument.  Such arguments devolve into “did not, did so” debates, and thus play into plaintiffs’ hands because they are detached from knowledge of falsity.  Instead, the right approach to the core operations inference is to understand that it requires a falsity so blatant that we can strongly infer that the executive had knowledge of the exact facts that made the statement false – not just the subject matter of the facts.  The most effective defense against the core operations inference thus focuses on falsity first, to show that even if a statement is false, it is at least a close call – making it hard for plaintiffs to contend that defendants must have known of this falsity.  But this can’t be done effectively if the argument against falsity does not vigorously attack the falsity allegations.

For these reasons, I give defense counsel’s use of the scienter pleading standard an overall grade of C: a B for the results and a D for how we got there.

Safe Harbor – Grade: D

The Safe Harbor for forward-looking statements was a centerpiece of the Reform Act.  Companies were being sued following announcements of missed earnings forecasts, which deterred companies from giving valuable earnings guidance.  Congress sought to encourage companies to give guidance and make other forward-looking statements by shielding such statements from liability if they are accompanied by “meaningful cautionary statements” or made without “actual knowledge” that they were false.  15 U.S.C. § 77z-2(c)(1); 15 U.S.C. § 78u-5(c)(1).

Yet the Safe Harbor is anything but safe.  In the 20 years of the Reform Act, surprisingly few dismissals are based solely the Safe Harbor; instead, courts either use it as  fallback grounds for dismissal, or just sidestep it – which has resulted in some significant legal errors.  The most notorious erroneous Safe Harbor decision was written by one of the country’s most renowned judges, Judge Frank Easterbrook, in Asher v. Baxter, 377 F.3d 727 (7th Cir. 2004).  Judge Easterbrook read into the Safe Harbor the word “the” before “important” in the phrase “identifying important factors,” to then hold that discovery was required to determine whether the company’s cautionary language contained “the (or any of the) ‘important sources of variance’” between the forecast and the actual results.  Id. at 734.

The reason for this judicial antipathy was best articulated by Bill Lerach, who famously said that the Safe Harbor would give executives a “license to lie.”  Judges have tended to agree with this conclusion.  Some have been quite explicit about it.  For example, in In re Stone & Webster, Inc. Securities Litigation, the First Circuit called the Safe Harbor a “curious statute, which grants (within limits) a license to defraud.”  414 F.3d 187, 212 (1st Cir. 2005).  And the Second Circuit, in its first decision analyzing the Safe Harbor – 15 years after the Reform Act was enacted, illustrating the degree of judicial avoidance – correctly interpreted “or” to mean “or,” but stated that “Congress may wish to give further direction on …. the reference point by which we should judge whether an issuer has identified the factors that realistically could cause results to differ from projections.  May an issuer be protected by the meaningful cautionary language prong of the safe harbor even where his cautionary statement omitted a major risk that he knew about at the time he made the statement?”  Slayton v. American Express Co., 604 F.3d 758, 772 (2d Cir. 2010).  Probably for this reason, the Safe Harbor has not deterred plaintiffs’ counsel from continuing to bring false forecast cases.  Twenty years later, a great many securities class actions still focus on earnings forecasts and other forward-looking statements.

We as a defense community have worsened the judicial antipathy and reluctance to issue rulings on Safe Harbor grounds, by making hyper-technical arguments that are detached from any notion that the challenged forward-looking statements aren’t false in the first place.  Most challenged forward-looking statements are true statements of opinion, and don’t even need the Safe Harbor’s protection.  But by bypassing the falsity argument, and falling back on the Safe Harbor, defense counsel plays right into plaintiffs’ hands.  Many defense lawyers try to overcome this problem by emphasizing that Congress intended to immunize even unfair forward-looking statements, if they are accompanied by appropriate warnings.  But this species of the disfavored defense of caveat emptor rings hollow.  Judges don’t like caveat emptor, and they don’t like liars – regardless of Congressional intent.  A much better way to defend forward-looking statements is to show that they were true statements of opinion, and then use the Reform Act as a fallback argument.  It makes the judge feel comfortable dismissing in either or both of two ways.  But few defense lawyers take that approach.

Finally, companies and their outside corporate counsel have contributed to the Safe Harbor’s lack of safety by failing to describe their risks in a fresh and detailed way each quarter.  When I evaluate a securities class action that challenges forward-looking statements and other statements of opinion (which comprise nearly all securities cases), one of the first things I look for is the progression of the risk factors each quarter.  I have a chart made, and I read them start to finish, as the judge will when we create the context for our arguments against falsity and to support the application of the Safe Harbor.  Are the risk factors specific or generic?  Do they change over time or are they static?  Do the changes in the risk factors track disclosed changes in business conditions?  Etc.  But companies and their outside corporate counsel frequently devolve to boilerplate, and fail to draft careful disclosures that make a judge feel comfortable that they were trying to disclose their real risks each quarter.

So, I give the Safe Harbor a D.

Lead Plaintiff Procedures – Grade C

The symbol of the pre-Reform Act era is the race to the courthouse among plaintiffs’ lawyers to file a complaint first and thus win the lead counsel role.  Congress intended the heightened pleading standards and the Safe Harbor to play a role in fixing that problem, because they are meant to incentivize plaintiffs to do more pre-filing investigation.  However, the Reform Act’s lead plaintiff provisions – which require the court to choose a lead plaintiff and lead plaintiff’s counsel after a beauty contest – undermine that goal, since only the lead plaintiff has an economic incentive to invest much time and money in an investigation.  So although the initial filer no longer has a competitive advantage by being the first plaintiff to file, the initial complaint is still routinely filed without any real investigation or worry about satisfying the pleading standards.

The lead plaintiff procedures were also designed to prevent lawyer-driven litigation, by providing that the lead plaintiff is presumptively the plaintiff with the largest financial loss – i.e., a plaintiff with “skin in the game.”  While that goal is salutary, it has spawned complex and mixed results.  The Reform Act’s lead plaintiff process incentivized plaintiffs’ firms to recruit institutional investors to serve as plaintiffs.  For the most part, institutional investors, whether smaller unions or large funds, retained the more prominent plaintiffs’ firms, and smaller plaintiffs’ firms were left with individual 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 these cases, as the larger firms were swamped with credit-crisis cases and likely were deterred by the relatively small damages, potentially high discovery costs, and uncertain insurance and company financial resources.  Moreover, these cases fit smaller firms’ capabilities well; nearly all of the cases had “lawsuit blueprints” such as auditor resignations and/or short-seller reports, thereby reducing the smaller firms’ investigative costs and increasing their likelihood of surviving a motion to dismiss.  The dismissal rate 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.  The result is now two classes of plaintiffs and plaintiffs’ firms:  larger firms with institutional investor clients, as Congress intended, and smaller plaintiffs’ firms with smaller individual clients, which Congress sought to displace.   In a sense, we’re back to where we started, but now with more aggressive institutional investors to boot.

As a result, from the defense perspective, I give the lead plaintiff procedures a C.

Discovery Stay – Grade: A

The Reform Act’s automatic stay of discovery was also meant to prevent plaintiffs from filing a lawsuit without adequate investigation, and conducting formal discovery to fish for facts to support it.  The discovery stay has saved defendants and their insurers many billions of dollars in discovery costs, and prevented millions of hours of unnecessary distraction by employees who have been able to focus on their jobs instead of helping their lawyers and electronic discovery consultants collect documents.  Although the statute contains several exceptions, there has been relatively little litigation over their application, especially over the last decade; the plaintiffs’ bar has shown restraint and efficiency in not over-litigating the discovery stay.  The discovery stay has worked well.

Conclusion:  The Reform Act’s Overall Grade

Grade: C+

In outlining this post, I originally organized my thoughts around this question: Are companies and their directors and officers really better off than they were 20 years ago?  Although it may seem absurd that a defense lawyer could even think about answering that question “no,” it really is a fair question.  I could make the case that the Reform Act’s tools have actually hindered the overall effectiveness of securities litigation defense by distracting from its core purpose: to convince a judge or jury that the defendants didn’t say anything false.  That is best done by thinking about the defense of the litigation overall, through trial – which not only sets the case up for a better defense on the merits, but results in better motion-to-dismiss results, for the reasons I’ve described.  But instead, the Reform Act tempts defense counsel to rely on technicalities, which can result in a mediocre defense, and an increased liability and economic exposure that overall are harmful to public companies, their directors and officers, and insurers.

 

* I never call the Reform Act the “PSLRA.”  The Reform Act was meant to reform securities litigation, not PSLRA-ize it.

Does Item 303 of Regulation S-K matter in private securities litigation?  In Stratte-McClure v. Morgan Stanley, 776 F.3d 94 (2nd Cir. 2015), the Second Circuit held that Item 303 imposes a duty to disclose for purposes of Section 10(b), meaning that the omission of information required by Item 303 can provide the basis for a Section 10(b) claim.  This ruling is at odds with the Ninth Circuit’s opinion in In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046 (9th Cir. 2014), in which the court held that Item 303 does not establish such a duty.  The U.S. Supreme Court declined a cert petition in NVIDIA.

I’m glad the Supreme Court didn’t take the case, because while this issue seems important, it really isn’t – as a practical matter, a claim under Item 303 doesn’t add much, if anything, to a plain vanilla claim alleging that a statement was misleading for omitting the same information.

Evolution of the Legal Issue

SEC forms, under both the Securities Act and the Exchange Act, require the disclosure of various items described in SEC Regulation S-K.  Some of the most important disclosures are found in S-K Item 303(a), which includes “management’s discussion and analysis” (MD&A) of the company’s “financial condition, changes in financial condition and results of operations.”  And Item 303(a)(3)(ii) indicates that the MD&A must include a description of “any known trends or uncertainties that have had or that the [company] reasonably expects will have a material … unfavorable impact on net sales or revenues or income from continuing operations.”  This is a high hurdle for a plaintiff to clear: a company must actually know: (1) the facts underlying the trend or uncertainty, (2) those known facts yield a trend or uncertainty, and (3) the trend or uncertainty will have a negative and material impact.

The key liability provisions of the federal securities laws, Section 10(b) of the Securities Exchange Act of 1934 and Section 11 of the Securities Act of 1933, prohibit a false statement or omission of a fact that causes a statement to be misleading.  In addition, the text of Section 11 allows a claim to be based on the issuer’s failure to disclose “a material fact required to be stated” in a registration statement. 15 U.S.C. § 77k(a) (emphasis added).  One such requirement is Item 303.  Panther Partners Inc. v. Ikanos Communications, Inc., 681 F.3d 114, 120 (2nd Cir. 2012).  Based on this statutory language – which is unique to Section 11 – Section 11 claims thus appropriately can include claims based on Item 303.

Panther Partners is the decision that has fueled plaintiffs’ counsel’s use of Item 303. In Panther Partners, the Second Circuit held that Item 303 required the issuer, Ikanos Communications, to disclose information about a high product defect rate, and that the omission of this information from a registration statement gave rise to a cause of action under Section 11.  There are two important facets of the decision that have largely been forgotten.  First, the court emphasized Section 11’s language, which isn’t present in the statute or decisions under Section 10(b), that an issuer must disclose “a material fact required to be stated” in a registration statement.  Second, the court was troubled by the fact that the company’s risk factor about product defects suggested there were no defects when, in fact, there were:

In light of these allegations, the Registration Statement’s generic cautionary language that “[h]ighly complex products such as those that [Ikanos] offer[s] frequently contain defects and bugs” was incomplete and, consequently, did not fulfill Ikanos’s duty to inform the investing public of the particular, factually-based uncertainties of which it was aware in the weeks leading up to the Secondary Offering.

Id.at 122.  I could make a strong argument that the driver of the court’s decision was a false or misleading risk factor, and Item 303 was just the way the court articulated its conclusion.  As I’ve written, courts are often troubled by boilerplate risk factors, especially those that cast as hypothetical risks that have materialized.

In NVIDIA, plaintiffs alleged that several of NVIDIA’s SEC filings contained materially false and misleading statements because they omitted information relating to a defect in NVIDIA’s graphics processing unit (“GPU”) chips.  Plaintiffs also argued that certain omissions in filing statements were actionable under Section 10(b) because the chip defects constituted a “known trend” under Item 303 – but did not present this theory in the complaint itself.

The district court found that plaintiffs had pled “at least one” material misrepresentation – a risk factor saying that defects “might occur,” which falsely suggested that NVIDIA was not already aware of the same defect in other products.  The district court did not inquire into whether any of the other specific statements were also materially misleading.  Nonetheless, the district court dismissed the complaint on the ground that plaintiffs had failed to plead scienter.  The district court opinion only mentioned Item 303 briefly, as it was not (yet) a centerpiece of plaintiffs’ theory.

Before the Ninth Circuit, plaintiffs argued that the district court should have considered scienter in the context of Item 303, focusing on whether defendants had acted with scienter in violating that rule.  The Ninth Circuit rejected this line of argument on the ground that Item 303 does not establish an independent duty of disclosure for the purposes of Section 10(b).  The Ninth Circuit did not consider whether plaintiffs had successfully pled a material misrepresentation (as the district court had found), focusing instead on scienter, and affirming the district court’s judgment on this ground.

Shortly thereafter, the Second Circuit, in Stratte-McClure, held that Item 303 does establish an independent duty of disclosure for purposes of Section 10(b).  The court began with the cardinal rule that silence, absent a duty to disclose, is not actionable, and such a duty is created when a company omits facts that make a statement misleading.  768 F.3d at 101-02.  The court then grappled with whether omission of facts required to be disclosed under Item 303 creates a duty of disclosure for purposes of Section 10(b).  In analyzing this issue, the court relied on the Panther Partners holding, though the court compared Section 10(b)’s requirements to Section 12(a)(2) of the 1933 Act, which does not contain Section 11’s unique statutory language, i.e., Section 11 makes actionable not just a false or misleading statement, but also a failure to disclose “a material fact required to be stated” in a registration statement.

The court’s comparison of Section 10(b) to Section 12(a)(2) instead of to Section 11 resulted in a large legal leap.  The court in Panther Partners stated that “[o]ne of the potential bases for liability under §§ 11 and 12(a)(2) is an omission in contravention of an affirmative legal disclosure obligation” (i.e. making actionable the omission of “a material fact required to be stated” in a registration statement).  681 F.3d at 120.  But, in fact, only Section 11, and not Section 12(a)(2), contains that provision.  Instead, Section 12(a)(2), like Section 10(b), imposes liability for a false or misleading statement, and doesn’t contain the alternative basis of liability for a failure to disclose “a material fact required to be stated ….”  As a result, Stratte-McClure doesn’t fairly portray the rationale for the holding in Panther Partners.

Nevertheless, the court in Stratte-McClure supplied a separate basis, grounded in Section 10(b)’s requirement of a false or misleading statement, for concluding that Item 303 supplies a duty to disclose that can be actionable under Section 10(b):

Due to the obligatory nature of [Item 303], a reasonable investor would interpret the absence of an Item 303 disclosure to imply the nonexistence of “known trends or uncertainties … that the registrant reasonably expects will have a material … unfavorable impact on … revenues or income from continuing operations.” …  It follows that Item 303 imposes the type of duty to speak that can, in appropriate cases, give rise to liability under Section 10(b).

776 F.3d at 102 (citations omitted).  In other words, a company that fails to disclose information required to be disclosed by Item 303 has misled investors by creating an impression of a state of affairs (that there are no materially negative trends or uncertainties) that differs from the one that actually exists (that there are such trends or uncertainties).  Thus, what the court implicitly held is that an Item 303 omission makes the whole set of the company’s affirmative statements misleading.

Item 303’s Lack of Practical Impact

The Item 303 issue is certainly interesting.  My colleagues and I have had lively discussions about the questions it raises.  But we keep concluding that it doesn’t really add anything.

We first reached this conclusion in a roundabout way in a case a few years ago.  There were two offerings at issue, and just after Panther Partners, plaintiffs’ counsel featured the Item 303 allegations.  We drafted a detailed motion to dismiss section on the Item 303 issue.  As we evaluated our arguments in light of the page limit, we kept shortening the Item 303 argument.  In the end, we decided that the Item 303 claim was redundant: the court wasn’t going to deny the motion to dismiss under Item 303 without also finding that the plaintiffs had sufficiently pleaded a false statement and scienter, because the plaintiffs challenged many statements and pleaded scienter using the same allegations that formed the basis of the Item 303 claim.  So in the filed version of the motion, the argument became a fraction of the size of the original one.  And in the reply brief, the Item 303 argument was in a short footnote.

Since then, the plaintiffs’ bar’s focus on the issue, and various court decisions, and even a cert petition, have kept me re-thinking the importance of Item 303 to securities claims.  But I haven’t changed my view that Item 303 is redundant: very rarely, if ever, would there be an omitted fact that gives rise to an Item 303 claim without also rendering false or misleading one or more challenged statements; and the knowledge required under Item 303 is at least as great as is necessary to establish scienter.  Even under Section 11, where the unique statutory language allows for a claim, Item 303’s multiple knowledge requirements, if appropriately applied, make the claim difficult to plead and prove.

The NVIDIA case provides a good illustration.  Recall that the plaintiffs alleged that NVIDIA made false statements related to a defect in its GPU chips, and argued that the chip defects constituted a known trend under Item 303.  The complaint challenged many statements, and the district court concluded that “at least one” was misleading as a result of the defects:

*          “Our core businesses are continuing to grow as the GPU becomes increasingly central to today’s computing experience in both the consumer and professional market segments.”

*          “Fiscal 2008 was another outstanding and record year for us. Strong demand for GPUs in all market segments drove our growth. Relative to Q4 one year ago, our discrete GPU business grew 80%.”

*          “As we have in the past, we intend to use this [R&D] strategy to achieve new levels of graphics, networking and communications features and performance and ultra-low power designs, enabling our customers to achieve superior performance in their products.”

*          “[W]e believe that close relationships with OEMs, ODMs and major system builders will allow us to better anticipate and address customer needs with future generations of our products.”

*          “The growth of GPUs continues to outpace the PC market. We shipped 42 percent more GPUs this quarter compared to the same period a year ago, resulting in our best first quarter ever. … We expect this positive feedback loop to continue to drive our growth.”

*          “In the past, we have discovered defects and incompatibilities with customers’ hardware in some of our products. Similar issues in the future may result in delays or loss of revenue to correct any defects or incompatibilities.”

*          “If our products contain significant defects our financial results could be negatively impacted, our reputation could be damaged and we could lose market share.”

*          In a statement disclosing the defects: “We are evaluating the potential scope of this situation, including the nature and cause of the alleged defect and the merits of the customer’s claim, and to what extent the alleged defect might occur with other of our products.”

This list of challenged statements illustrates that companies affirmatively say many things on the subject matter of an omission sufficient to yield an Item 303 claim.  Indeed, it’s hard to imagine a case in which an issue is so major as to require Item 303 disclosure but isn’t something about which the company has spoken.

And given that is the case, and Item 303’s disclosure requirements are infused with knowledge requirements, it also would be an anomalous case in which there is an Item 303 violation but not scienter.  For example, if a company violates Item 303 by not disclosing that its biggest customer is switching suppliers next quarter, and proceeds to say things about its business and financial outlook as it of course would, it has made misleading statements with intent to defraud.  The Item 303 claim adds nothing.  Stratte-McClure, on its face, is an anomalous case.  After concluding that Morgan Stanley had a duty to disclose certain facts about subprime lending that were likely to cause material trading losses, the court concluded that the failure to disclose those facts wasn’t done with scienter.  The analysis is fact-specific and technical.  Suffice it to say that I could easily re-write the opinion, using the court’s own scienter analysis, to conclude that no disclosure was required under Item 303 in the first place – it’s really a matter of six of one, half a dozen of another.

Why, then, have plaintiffs’ counsel pushed Item 303 claims so hard?  I believe it’s mostly to combat the cardinal rule that silence, absent a duty to disclose, is not misleading. Companies omit thousands of facts every time they speak, and it’s relatively easy for a plaintiff to identify omitted facts – but it’s analytically difficult work, and often unsuccessful, to challenge affirmative statements.

Another important reason is defendants’ attack on the fraud on the market presumption of reliance over the past several years – first to the legitimacy of Basic v. Levinson, which gave rise to securities class actions, and now to its viability in specific cases under the price-impact rule of Halliburton II.  Claims of pure omission under Item 303 arguably would fall under the Affiliated Ute presumption of reliance, rather than under Basic, which would make class certification easier and more certain.  But the court’s reasoning in Stratte-McClure that an Item 303 violation makes what the company said misleading would make the claim a statement-based claim that would be evaluated under Basic, not Affiliated Ute.

Whatever the reason, I hope parties and courts don’t waste time litigating over Item 303 further.  It just doesn’t matter.

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.

In the world of securities and corporate governance litigation, we are always in the middle of a reform discussion of some variety.  For the past several years, there has been great focus on amendment of corporate bylaws to corral and curtail shareholder corporate-governance claims, principally shareholder challenges to mergers.*  Meritless merger litigation is indeed a big problem.  It is a slap in the face to careful directors who have worked hard to understand and approve a merger, or to CEOs who have spent many months or years working long hours to locate and negotiate a transaction in the shareholders’ best interest.  It is cold comfort to know that nearly all mergers draw shareholder litigation, and that nearly all of those cases will settle before the transaction closes without any payment by the directors or officers personally.  And we know the system is broken when it routinely allows meritless suits to result in significant recoveries for plaintiffs’ lawyers, with virtually nothing gained by companies or their shareholders.

There are three main solutions afoot, at different stages of maturity, involving amendments to corporate bylaws to require that: (1) there be an exclusive forum, chiefly Delaware, for shareholder litigation; (2) a losing shareholder pay for the litigation defense costs; and (3) a shareholder stake hold a minimum amount of stock to have standing to sue.  I refer readers to the blogs published by Kevin LaCroix, Alison Frankel, and Francis Pileggi for good discussions of these types of bylaws.  The purpose of this blog post is not to specifically chronicle each initiative, but to caution that they will cause unintended consequences that will leave us with a different set of problems than the ones they solved.

Exclusive-forum bylaws offer the most targeted solution, albeit with some negative consequences.

Exclusive-forum bylaws best address the fundamental problem with merger litigation: the inability to coordinate cases for an effective motion to dismiss before the plaintiffs and defendants must begin negotiations to achieve settlement before the merger closes.  Although the merger-litigation problem is virtually always framed in terms of the oppressive cost and hassle of multi-forum litigation, good defense counsel can usually manage the cost and logistics.  Instead, the bigger problem, and the problem that causes meritless merger litigation to exist, is the inability to obtain dismissals.  This is primarily so because actions filed in multiple forums can’t all be subjected to a timely motion to dismiss, and a dismissal in one forum that can’t timely be used in another forum is a hollow victory.  Exclusive litigation in Delaware for Delaware corporations is preferable, because of Delaware’s greater experience with merger litigation and likely willingness to weed out meritless cases at a higher rate.  But the key to eradicating meritless merger litigation is consolidation in some single forum, and not every Delaware corporation wishes to litigate in Delaware.

The closest historical analogy to such bylaws is the Securities Litigation Uniform Standards Act’s provision requiring that covered class actions be brought in federal court and litigated under federal law to ensure that the least meritorious cases are weeded out early, as Congress intended through the Reform Act.  The Reform Act’s emphasis on early dismissal of cases that lack merit has been its best feature, and requiring litigation in federal court helped achieved it.

So too would litigation in an exclusive forum, because it would yield a more meaningful motion to dismiss process, which would weed out less-meritorious cases early, which in turn would deter plaintiffs’ lawyers from bringing as many meritless cases.  The solution is that simple.  There will be consequences, though.  Plaintiffs’ lawyers, of course, will tend to bring more meritorious cases that present greater risk, exposure, and stigma, and will bring more in Delaware, which is a defendant-friendly forum for good transactions but a decidedly unfriendly one for bad transactions.  So while it certainly isn’t good that there are shareholder challenges to 95% of all mergers, the current system reduces the stigma of being sued and tends to result in fairly easy and cheap resolutions.  In contrast, cases that focus on the worst deals and target defendants that the plaintiffs’ lawyers regard as the biggest offenders will require more expensive litigation and significant settlements and judgments.

Fee-shifting and minimum-stake bylaws are overly broad and will cause a different set of problems.

So exclusive-forum bylaws attack the merger-litigation problem in a focused and effective fashion, albeit with downside risk.  In contrast, fee-shifting bylaws and minimum-stake bylaws attack the merger-litigation problem, but do so in an overly broad fashion, and will cause significant adverse consequences.

Fee-shifting bylaws, of course, attempt to curtail the number of cases by forcing plaintiffs who bring bad cases to pay defendants’ fees.  I find troubling the problem of deterring plaintiffs’ lawyers from bringing meritorious cases as well, since many plaintiffs’ lawyers would be very conservative and thus refuse to bring any case that might not succeed, even if strong.  That concern probably will cause the downfall of fee-shifting bylaws, where the Delaware Senate just passed a bill that would outlaw fee-shifting bylaws, and the issue now goes to the Delaware House.  (The same bill authorizes bylaws designating Delaware as the exclusive forum for shareholder litigation.)  But to me, the bigger problem is an inevitable new category of super-virulent cases, involving tremendous reputational harm (e.g. the plaintiffs’ firm decided to risk paying tens of millions of dollars in defense fees because they decided those defendants are that guilty) and intractable litigation that quite often would head to trial – at great cost not just financially, but to the law as well because it is indeed true that bad facts make bad law.

The Reform Act’s pleading standards have created analogous negative consequences, but much less severe and costly.  The pleading standards (and the Rule 11 provision) weed out bad cases early on, but almost never is there a financial penalty to a plaintiff for bringing a bad case.  Instead, the bigger plaintiffs’ firms have tended to be more selective in the cases they bring, which has yielded a pretty good system overall – even though they sometimes still bring meritless cases, and meritless cases sometimes get past motions to dismiss.  The bigger and still-unsolved problem with pleading standards is the overly zealous and necessarily imperfect confidential-witness investigations they cause, to attempt to satisfy the statute’s elevated pleading requirements.  The fee-shifting bylaws would occasion those sorts of problems as well, in addition to the virulent-case problem I’ve described.

Fee-shifting bylaws advocates’ push for ultra-meritorious lawsuits strikes me as an extreme case of “be careful what you wish for.”  But it brings to mind a more mainstream situation that has worried me for many years: aggressive arguments in demand motions for pre-litigation board demands and shareholder inspections of books and records.  In arguing that a shareholder derivative lawsuit should be dismissed for failure to make a demand on the board, defendants have long asserted that a shareholder failed to even ask the company for records under Section 220 of the Delaware General Corporation Law or similar state laws, to attempt to investigate the corporate claims he or she is pressing.  Delaware courts, in turn, have chastised shareholders for failing to utilize 220, though thus far have stopped short of requiring it.  Likewise, defendants, sometimes with great disdain, have criticized shareholders for not making a pre-suit demand on the board.

Although these are correct and appropriate litigation arguments, I have observed that, over time, they have succeeded in spawning more 220 inspection demands and pre-suit demands on boards, which over time will create more costly and virulent derivative cases than plain vanilla demand-excused cases brought without the aid of books and records.  The solution is to just get those highly dismiss-able cases dismissed, without trying to shame the derivative plaintiffs into making a 220 or demand on the board next time.

Minimum-stake bylaws are problematic as well.  They have as their premise that shareholders with some “skin in the game” will evaluate cases better, and will help prevent lawyer-driven litigation.  Like fee-shifting bylaws, they will prevent shareholders from brining meritless lawsuits, and likewise tend to yield more expensive and difficult cases to defend and resolve.  But they also will create a more difficult type of plaintiff to deal with, much the same way as the Reform Act’s lead-plaintiff provisions have created a class of plaintiffs that sometimes make us yearn for the days when the plaintiffs’ lawyers had more control.  More invested plaintiffs increase litigation cost, duration, and difficulty, and increase the caliber and intensity of plaintiffs’ lawyering.

And I have no doubt that, despite the bylaws, smaller shareholders and plaintiffs’ firms will find a way back into the action, much as we’re seeing recently with retail investors and smaller plaintiffs’ firms brining more and smaller securities class actions that institutional investors and the larger plaintiffs’ firms with institutional-investor clients don’t find worth their time and money to bring.  So with securities class actions, I think a two-headed monster is emerging: a relatively small group of larger and virulent cases, and a growing group of smaller cases.  That, too, likely would happen, somehow, with minimum-stake bylaws.

What’s the harm with taking a shot at as many fixes as possible?

Even if someone could see the big picture well enough to judge that these problems aren’t sufficient to outweigh the benefits of fee-shifting and minimum-stake bylaws, I would still hesitate to advocate their widespread adoption, because governments and shareholder advocacy groups would step in to regulate under-regulation caused by reduced shareholder litigation.  That would create an uncertain governance environment, and quite probably a worse one for companies.  Fear of an inferior alternative was my basic concern about the prospect that the Supreme Court in Halliburton Co. v. Erica P. John Fund, Inc. would overrule Basic v. Levinson and effectively abolish securities class actions.

Beyond the concern about an inferior replacement system, I worry about doing away with the benefits shareholders and plaintiffs’ lawyers provide, albeit at a cost.  Shareholders and plaintiffs’ lawyers are mostly-rational economic actors who play key roles in our system of disclosure and governance; the threat of liability, or even the hassle of being sued, promotes good disclosure and governance decisions.  Even notorious officer and director liability decisions, such as the landmark 1985 Delaware Supreme Court decision in Smith v. Van Gorkom, are unfortunate for the defendants involved but do improve governance and disclosure.

One final thought.  Shareholder litigation’s positive impact on governance and disclosure makes me wonder: will the quality of board oversight of cybersecurity, and corporate disclosure of cybersecurity issues, improve without the shock of a significant litigation development?

 

* Although indiscriminate merger litigation is the primary target of bylaw amendments, other types of securities and corporate-governance lawsuits, such as securities class actions and non-merger derivative litigation, are sometimes part of the discussion.  Those types of cases, however, do not pose the same problems as merger litigation.  And it is doubtful whether a company’s bylaws could regulate securities class actions, which are not an intra-corporate dispute between a current shareholder and the company, but instead direct class-period claims brought by purchasers or sellers, who do not need to be, and often are not, current shareholders.

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.

 

In 1995, public companies and their directors and officers received one of the greatest statutory gifts in the history of American corporate law:  the Private Securities Litigation Reform Act.  The Reform Act established heightened standards for pleading falsity and scienter, among other protections, to allow for dismissal before discovery in a fair percentage of cases.  That was a tremendous change from the pre-Reform Act world, in which dismissals were infrequent and expensive discovery was the norm.

The provisions of the Reform Act make motions to dismiss in securities cases different from those in any other area of law, and guide our strategy in every case that we litigate.  As a full-time securities litigation defense lawyer, I feel a responsibility to understand the Reform Act and the cases applying it with as much sophistication as possible.  I have a sense of pride in my Reform Act analysis.  It may sound hokey, but I consider myself a craftsman, and I know that some of the most effective full-time securities litigators tend to feel the same.

I was recently asked about the biggest threats to the Reform Act’s protections, and have since been giving that question a lot of thought.  To be blunt, the biggest threat is the failure by many defense firms to make rigorous arguments on motions to dismiss that hold plaintiffs to the strict pleading standards of the Reform Act, allowing for court decisions that likewise lack rigor and fail to enforce the Act’s high pleading burdens.

This lack of technical rigor has many causes.  One factor is the dwindling number of securities litigation defense specialists, caused by the downturn in classic securities litigation cases calling for straightforward Reform Act motions to dismiss.  Beginning in 2006, securities litigation defense has mostly consisted of stock-option backdating derivative cases, large credit-crisis cases, and merger objection cases.  Through these waves, very few securities litigators remained dedicated to studying Reform Act developments and devising better arguments that take advantage of its provisions.  As a result, today there are relatively few practitioners whose practices are devoted to securities litigation defense – defense lawyers who sweat over subtleties in the law that in isolation may seem trivial, but which collectively make a big difference in the development of the law.

Another factor is the biglaw approach to writing motions to dismiss “by committee.”  Biglaw firms tend to write motions with large teams composed of new associates, mid-level associates, senior associates, and partners.  Writing by committee doesn’t work.  It is not only expensive, it is ultimately far less effective.  If the first draft of a motion is written without sufficient intellectual rigor and sophisticated understanding of the law and practice of securities litigation, it is difficult to reach an end result that will compensate for these deficiencies.  To draft the best motion to dismiss possible, Reform Act “craftsmen” should be involved in the process from the beginning, the entire drafting team needs to coordinate closely on the strategic objectives of the motion, and all the attorneys need to be well trained to appreciate the subtleties of the law.

Whatever the cause, the declining quality of many motions to dismiss is leading to a deterioration of the law that is eroding the Reform Act’s protections.  The rate of dismissals remains relatively high, but I predict that the dismissal rate will decrease, perhaps dramatically, over time as the law becomes more lax.

Below, I discuss the building blocks of a strong motion to dismiss and then address flaws found in many that I have seen filed lately – both by practitioners who do not specialize in the field, and by some “go to” biglaw firms with departments that specialize in securities litigation.

Constructing a Strong Motion to Dismiss

The Reform Act erected high hurdles for plaintiffs to clear before requiring a company to be put through the burdens of discovery:

  • To plead the falsity of a challenged statement of fact, plaintiffs must plead inconsistent contemporaneous facts.
  • To plead a false statement of opinion, in most circuits plaintiffs must plead that the statement was both objectively false and subjectively false, meaning they must show the speaker did not genuinely believe the opinion expressed.
  • To plead that the defendant made a false statement with intent to defraud, plaintiffs must plead facts demonstrating a strong inference that the defendant either knew the statement was false or was extremely and deliberately reckless in choosing not to find out whether it was true or false.
  • Even if plaintiffs plead facts demonstrating it was false, a forward-looking statement is not actionable under the Safe Harbor provisions of the Reform Act if either: (1) the statement was accompanied by meaningful cautionary statements, or (2) plaintiffs fail to plead that the speaker had actual knowledge of the statement’s falsity.

A rigorous motion to dismiss uses the Reform Act’s pleading tools in the most advantageous way possible, by really understanding them and maximizing their usefulness.  These tools give defense lawyers the opportunity to delve into factual issues in a manner that is unusual in motion -to-dismiss practice, and which may feel unnatural to attorneys who are not securities litigation specialists or who didn’t become securities litigation specialists during the Reform Act era.  An effective motion to dismiss not only dismantles the complaint with these tools, but capitalizes upon them to tell the judge a compelling story of an honest company that did its best to make straightforward disclosures to the market.

The Reform Act’s standards give judges enormous discretion; they can dismiss most complaints, or not, with very little room to challenge their decisions upon appeal.  Winning motions recognize the human element to  this discretion.  Even if a complaint is technically deficient, judges are less likely to dismiss it (certainly less likely to dismiss it with prejudice) if they nevertheless get the feeling that the defendants committed fraud.  Effective motions use the leeway given to defendants by the Reform Act to give judges a sense of comfort that they are not only following the law, but that by strictly applying the Reform Act’s protections, they are also serving justice.  On the other hand, one of the most common flaws in ineffective motions to dismiss is the use of formulaic and hyper-technical arguments, which fail to take advantage of the Reform Act to dig into the facts of the individual case, expose the flaws of each complaint in detail, and tell the judge a compelling story of the case that negates the inference of scienter.

Flaws Found in Many Motions to Dismiss

Flaws in Arguments against Falsity

The first element of a claim under Rule 10b-5(b) – the classic securities claim – is a false or misleading statement.  As we recently wrote, it is an incorrect statement of law to characterize this element as requiring a “materially false statement or omission.”  An omission is only actionable if it made what the defendant said materially misleading (or he or she otherwise had a duty to disclose it, which is a rare assertion as the main claim in a securities class action).

Yet if I had a dollar for every motion to dismiss that contained this misstatement of law, I would be writing this blog from a vacation home in Hawaii.  This is not a semantic issue; the difference between an “omission” and a “misleading statement” is enormous.  Every disclosure problem involves dozens or even hundreds of omitted facts that seem “material” in the sense that an investor would want to know them, but far fewer involve statements that were materially misleading (it is the statement that must be material, not the omitted fact) as a result of the omission.  I realize that many courts, including the U.S. Supreme Court, use this incorrect terminology.  But that doesn’t mean we need to parrot it – and every time that we do, we weaken the standard that is an explicit part of the Reform Act statute.

Defense lawyers’ loose language is a symptom of a bigger problem:  a lack of focus on falsity.  The allegedly false statements frame the entire case; other defense arguments are derived from the attack on plaintiffs’ falsity claims.  Foremost among the arguments derived from a strong falsity argument is the argument against scienter.  Scienter requires plaintiffs to show that a speaker knew what he or she said was false.  Falsity thus sets the stage for the scienter analysis – if there was no false statement to begin with, there can be no knowledge of that falsity.  On the other hand, the more egregiously false plaintiffs can make a statement appear, the easier it will be for them to show knowledge of falsity.  A strong scienter argument has as its North Star, “scienter as to what?”  That “what” must be a false statement, and a good motion to dismiss will enforce that structure from the beginning.  I cringe when I read a motion to dismiss that addresses scienter before falsity.  That is simply backwards.

The lack of focus on falsity infects the way defense firms tend to argue against falsity.  The Reform Act falsity standard generally requires the plaintiffs to allege contemporaneous facts that are inconsistent with each challenged statement.  That is a high hurdle.

To be sure, it isn’t easy to make a fact-specific argument against falsity; it requires a great command of the complaint and judicially noticeable documents, which isn’t the forte of most litigators.  And it can seem “too factual” to general litigators, or to many senior securities litigators who became securities litigation specialists under the pre-Reform Act regime, where motions to dismiss had to be simple and safe to have any chance of success under lenient pleading standards.  Perhaps for these reasons, in addition to those discussed above, a large number of motions to dismiss bypass this advantageous and fundamental argument, or fail to emphasize it, and instead opt for arguments that lump statements together by type and argue against them as a group in a boilerplate fashion.  In my view, one of the worst arguments of this type is the “puffery” defense – which basically concedes that a statement was false, but contends it was too immaterial to be actionable.  The subtext is cavalier, and unlikely to reassure a dubious judge: “sure the defendant lied, but it doesn’t matter because no one cared.”  Although courts do sometimes accept this argument, whether to do so or not amounts to an unprincipled coin-flip, and it is often made at the expense of better and more definite arguments.  For example, statements constituting “puffery” also generally qualify as statements of opinion, which have a standard for falsity that is protective and can be analyzed specifically.

The Reform Act called out forward-looking statements for special analysis and protection.  As we have previously written, the Safe Harbor is not as safe as Congress intended.  Because they think it goes too far, and can give companies a “license to lie,” many judges go to great lengths to avoid the statute’s plain language.  Many defense lawyers’ arguments not only fail to address this judicial skepticism, but actually reinforce it.  They do this by relying solely on the Safe Harbor’s technical elements, while failing to simultaneously contend that the forward-looking statements in question also had a reasonable basis, and the company’s cautionary language was a good-faith effort to describe specific risks the company faced.  Such arguments based only on the letter of the Safe Harbor ring of “caveat emptor,” which the law has been trying to shake for centuries.

Flaws in Arguments against Scienter

Scienter allegations are of two types:  allegations pleading facts about what the defendant knew, to attempt to plead that he or she knew the challenged statements were false; and, far more prevalent, allegations that the defendant “must have” meant to lie, based on circumstantial considerations such as a defendants’ stock sales, corporate transactions, the temporal proximity of the challenged statement to the disclosure of the “truth,” and the relationship of the subject of the challenged statements to the company’s “core operations.”  As with falsity, the primary flaw in most defense arguments against scienter is with their failure to engage in a fact-specific analysis of the complaint’s allegations about what the defendants knew in regard to each specific challenged statement. All too often, defendants allow themselves to be drawn to the plaintiffs’ preferred ground of battle, focusing just on arguing about the sufficiency of the circumstantial evidence that plaintiffs use to create the impression that the defendants must have done something wrong.

Circumstantial scienter allegations are only ways to try to make an educated guess about what the speaker knew or intended.  But the Reform Act’s scienter standard requires particularized pleading yielding a “strong inference” that the defendant lied on purpose – a very high standard.  So it makes no sense for defense counsel not to approach the issue directly, by making it clear that the speaker did not lie, and holding plaintiffs to the strict standard of showing specific scienter as to each challenged statement.

For this reason, all effective motions to dismiss start by testing the complaint’s allegations that the defendants actually knew, or were intentionally reckless about not knowing, the facts establishing falsity.  This means that, for each statement and each defendant, the motion to dismiss needs to isolate the statement and the reasons that the complaint alleges it was false, and analyze what the complaint alleges each defendant knew about those facts at the time he or she made each challenged statement. Without this focus on each specific challenged statement, the scienter inquiry is vague, and becomes more about whether the defendant seems bad, or had generally bad motives, than whether he lied on purpose.  A good motion to dismiss does not let plaintiffs get away with these kinds of generalized allegations.

The problem is made worse if defense counsel approaches falsity categorically, without careful scrutiny of the reasons the complaint alleges the challenged statements were false.  Without this focus, defense counsel can’t meaningfully answer the central question in the Reform Act analysis – “scienter as to what?” – because there isn’t a sufficient nexus between the challenged statements and contemporaneous facts that made the statements false.  The scienter inquiry thus becomes unmoored from knowledge that specific statements were false.  The result is a lower burden for plaintiffs:  if they are able to plead falsity, and the defendants seemed to know something about the general subject matter, scienter is almost a foregone conclusion.

This problem is even worse under the “core operations” inference of scienter, and the “corporate scienter” doctrine.  Each of these theories allows a plaintiff to avoid pleading specific facts establishing the speaker’s scienter.  For example, the core operations inference posits that scienter can be inferred where it would be “absurd to suggest” that a senior executive doesn’t know facts about the company’s “core operations.”  Many motions to dismiss set up some formulation of this statement as a legal rule and make a simplistic syllogistic argument from it.  Such arguments devolve into “did not, did so” debates, and thus play into plaintiffs’ hands because they are detached from knowledge of falsity.

Instead, the right approach to the core operations inference is to understand that it requires a falsity so blatant that we can strongly infer that the executive had knowledge of the exact facts that made the statement false – not just the subject matter of the facts.  The most effective defense against the core operations inference thus focuses on falsity first, to show that even if a statement is false, it is at least a close call – making it hard for plaintiffs to contend that defendants must have known of this falsity.  This can’t be done effectively, of course, if the argument against falsity is categorical (i.e., embraces arguments such as “puffery,” rather than discussing the specific statements), or otherwise fails to address the falsity allegations in detail.  Of course, it is impossible to make this argument effectively if the scienter section precedes the falsity section of the brief.

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We plan to address in greater depth some of the technical Reform Act issues in later posts, in hopes that we can improve the craftsmanship of motions to dismiss.  These are important issues to discuss as a defense bar, because each motion to dismiss that fails to maximize the Reform Act’s protections runs the risk of weakening the law for the rest of us.

 

 

Even the most experienced securities defense attorneys regularly summarize Rule 10b-5(b) as creating a cause of action for “false or misleading statements and omissions of material fact.”  Courts –including the Supreme Court – routinely use the same shorthand.   When I was a new securities litigation defense attorney, one of the first things that I learned was the importance of adding the rest of the sentence: “false or misleading statements and omissions of material fact necessary to make statements made not misleading.”

One of the most common misconceptions about the federal securities laws is that Rule 10b-5(b) creates a cause of action for omissions as well as for false or misleading statements.  But by the express terms of the rule, and Supreme Court precedent, omissions are only actionable if they cause an affirmative statement to be false or misleading because of the information that was omitted.  In other words, when a claim is based upon an alleged omission, it is not enough for a plaintiff to demonstrate that something was omitted, or even that the omitted fact was material.  Rather, in order to state a cause of action, the omitted information must have made an affirmative statement materially misleading by creating “an impression of a state of affairs that differs in a material way from the one that actually exists.” See Brody v. Transitional Hosps. Corp., 280 F.3d 997, 1006 (9th Cir. 2002).

It is understandable that plaintiffs’ attorneys would try to obscure this standard.  If all they needed to establish was that material information was omitted, it would be relatively easy to bring a successful claim.  No matter how much is disclosed, you can always find something that was omitted, and the squishy standard for materiality leaves plenty of room to make a case that the omission was material.  But the key to many successful motions to dismiss is to hold plaintiffs to the text of the rule:  whether they are alleging an affirmative lie, or a lie by omission, they must point to a statement that was false or misleading.

In the building frenzy among securities attorneys over the possible consequences of the Supreme Court’s upcoming ruling in Halliburton Co. v. Erica P. John Fund, this key distinction has been widely forgotten.  As attorneys contemplate the possible demise of the fraud-on-the-market presumption laid down in Basic v. Levinson, there is wide speculation about how, in the face of such a ruling, securities class actions might continue. (See Doug Greene’s discussion of the possible impact of Halliburton.)  One theory that has been repeatedly put forward by defense attorneys and legal commentators is that plaintiffs’ attorneys could cast their claims as alleging only material omissions, rather than false or misleading statements.  The theory is that this approach would allow plaintiffs to sidestep the formidable obstacle of proving class-wide reliance in the absence of the fraud-on-the-market presumption, by taking advantage of a Supreme Court ruling that indicated that proof of reliance was not necessary to support a claim based on omissions. See Affiliated Ute Citizens v. United States, 406 U.S. 128 (1972).

Wrote one securities litigation defense firm: if the Halliburton court rejects the fraud-on-the-market presumption, “plaintiffs could turn to the Affiliated Ute presumption, in which a plaintiff can avoid pleading actual reliance in a case framed as a material omission . . .The Affiliated Ute presumption will allow plaintiffs’ lawyers to recast their affirmative misrepresentation claims as pure omission claims, which do not need to rely on the fraud-on-the-market presumption to proceed.. . .Parties will vigorously litigate whether the crux of a case concerns affirmative misstatements, pure omissions, or both.”

But Affiliated Ute does not offer a quick fix to the potential elimination of Basic’s fraud-on-the-market presumption.  Affiliated Ute did not involve public statements or the securities markets, much less a securities class action under Rule 10b-5(b).  Rather, it involved face-to-face transactions among a relatively small group of individuals related to the allocation of Native American mineral rights.  The Affiliated Ute Court found that the defendants had failed to disclose material information to Native Americans as part of a fraudulent scheme to induce them to sell their mineral rights below market value.  The Court found that this created liability under Rule 10b-5(a) and (c), the subsections of the rule that create liability for a fraudulent “device, scheme, or artifice” or “practice or course of business.”  In these circumstances, the Court held that causation was established, and the plaintiffs did not need to prove “reliance” on the material omissions.

The Affiliated Ute ruling is thus based on the existence of a material omission as part of a fraudulent scheme.  But as the Supreme Court pointed out in Basic, and recently reaffirmed in Matrixx: “Silence, absent a duty to disclose, is not misleading under Rule 10b-5.”  Basic, Inc. v. Levinson, 485 U.S. 224, 239 n.17 (1988); Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1322 (2011).  No matter how material it might be, an omission is not actionable unless there is a duty to disclose.  See, e.g., In re Time Warner, Inc. Sec. Litig., 9 F.3d 259, 267 (2d Cir. 1993) (“[A] corporation is not required to disclose a fact merely because a reasonable investor would very much like to know that fact.”).  There are specific circumstances under which such a duty to disclose might arise – for example, when there is a fiduciary relationship between the parties, if an insider is trading stock, or under Items 303 or 503 of Regulation S-K relating to public offerings.

But Rule 10b-5(b), the traditional territory of securities class actions, imposes no such requirement.  For this reason, as several courts have pointed out, the “presumption” of reliance on material omissions that developed from Affiliated Ute does not implicate core securities fraud claims.  See, e.g., Regents of the University of California v. Credit Suisse First Boston, 482 F. 3d 372, (5th Cir. 2007) (clarifying that Affiliated Ute does not apply to actions for misrepresentations under Rule 10b-5(b)). Thus, plaintiffs cannot simply recast their securities fraud allegations as “omissions,” as many commentators have suggested, and cause the parties to have to “litigate whether the crux of a case concerns affirmative misstatements, pure omissions, or both.”  Plaintiffs may only state a claim under 10b-5(b) based on an affirmative misstatement – whether that affirmative statement was misleading because of what it said, or because of what it did not say.

Under Affiliated Ute itself, the presumption of reliance on omissions is only invoked under Rule 10b-5 if there is proof of a fraudulent “course of business” or a “device, scheme or artifice that operated as a fraud” – under the Rule’s little-used subsections (a) and (c).  Do these subsections – which are not necessarily dependent upon affirmative misstatements – create a route for plaintiffs to find a way around the potential rejection of the fraud-on-the-market presumption?  Maybe in some cases, where plaintiffs are able to allege additional facts necessary to show some form of “scheme” liability under these subsections.  See Credit Suisse, 482 F.3d at 384 (“Merely pleading that defendants failed to fulfill [a duty to disclose] by means of a scheme or act, rather than by a misleading statement, does not entitled plaintiffs to employ the Affiliated Ute presumption.”). But that potential “solution” raises more questions than it answers, since the law surrounding these subsections is far less developed that the law of Rule 10b-5(b), and incorporates a number of additional complexities.*

One thing is clear.  Affiliated Ute does not offer a straightforward solution for plaintiffs’ lawyers if the Halliburton Court takes away the fraud-on-the-market presumption.   Whether they phrase their allegations as claims of affirmatively false statements or statements made false by omission, they are still claims based on statements, not omissions, and current law requires that plaintiffs find a way to show class-wide reliance.

 

* For example, the courts have established that Rule 10b-5 imposes a duty to disclose material nonpublic information on a defendant who sells stock.  But this “omission” claim is difficult for plaintiffs’ lawyers to bring, because a plaintiff must be a contemporaneous buyer to have standing – which generally means the plaintiff must have purchased stock in the few days surrounding when the defendant sold.  The standing requirement also restricts damages for such a claim to a class of contemporaneous purchasers – a much smaller group than the typical class in a securities class action arising out of a false or misleading statement, which can include purchasers of stock over a period of several years.