Securities Class Action Statistics

By Doug Greene, Genevieve York-Erwin and Michael Tomasulo

I. Introduction

Small, development stage biotech companies are widely considered to be attractive targets for securities actions given the inherent risks of the industry and the volatility of their stock prices.  As a result, many of these companies have relatively limited D&O insurance options.  But are the assumptions that act to limit their options correct?  Do biotech startups actually pose greater securities class action risk than other companies?

As described below, we surveyed all biotech securities class actions in the past decade to better understand how they have fared in the federal courts, and found that they were actually more likely than other types of cases to be dismissed early in the litigation, saving defendants (and insurers) from the bulk of potential legal costs.  This turns the conventional wisdom on its head and suggests a number of important insights that can help biotech companies avoid and successfully defend against securities suits, and help insurers make better coverage decisions regarding these companies.

In short, biotech cases are manageable risks if they are defended correctly, especially if biotech management takes proactive steps to manage its disclosures in a way that will further limit its risks.  Below, we describe the study we undertook and its results, in light of which we then identify four of the biggest myths surrounding biotech securities cases and explain why each is unfounded.  Finally, we describe and analyze the real driving forces behind these decisions, and we explain how biotech companies, their attorneys, and insurers can use these insights to greatest advantage.

II. Study Methodology and Results

We searched for and reviewed all of the district court decisions on motions to dismiss biotech securities cases within the past eleven years in order to identify the subset of cases that concern development-stage biotech companies’ efforts to bring their first drug or device to market.[i]  Only decisions that met all of the following criteria were included in our study set: final district court decisions[ii] on motions to dismiss federal securities claims where the biotech company did not already have a drug or device on the market and its alleged false or misleading statements concerned clinical trials or the FDA approval process for its primary drug or device candidate.[iii]

Of the 61 decisions in our study set that met these criteria, 69% resulted in complete dismissals.  Moreover, the dismissal rate appears to have increased in recent years: 78% of the decisions in the study set from 2012-2016 resulted in complete dismissals, compared with only 56% of decisions from 2005-2011.  Interestingly, this shift seems to have occurred even as more securities class actions were being filed against small biotech companies: 36 decisions in the study set came from the most recent five years, versus only 25 decisions from the previous seven years.  Contrary to conventional wisdom, this analysis indicates that federal securities claims brought against biotech companies regarding the regulatory approval process actually are dismissed more frequently than average at an early stage in the litigation.[iv]

III. Four Myths about Biotech Securities Cases

These findings overturn several important assumptions that currently guide biotech management and are baked into the insurance market for young biotech companies:

Myth #1: Cases against biotech companies for failed clinical trials or products that are not approved by the FDA are risky and expensive.          

FACT: Our analysis shows that about two-thirds of these cases are dismissed in full, and with self-insured retentions that average a million dollars or more most such cases will not even exhaust the company’s retention.  A well-managed motion to dismiss process for a young biotech should cost no more than $500,000 – $750,000, and often far less, and is highly likely to result in a favorable early outcome for defendants in these actions.

Myth #2: Management puts the company at risk if it speaks too positively regarding its expectations of clinical trial results, FDA approval, or product commercialization.

FACT: As discussed in more detail below, statements of opinion will be protected under Omnicare,[v] so long as they are genuinely held and not misleading when considered in their full context.  Optimistic forward-looking statements will also generally be protected by the Private Securities Litigation Reform Act’s (“Reform Act”) safe harbor for forward-looking statements, provided they are accompanied by sufficiently specific cautionary language.[vi] Courts recognize the inherent uncertainty in the FDA approval process and understand that predictions sometimes will prove wrong; the important thing is for companies to make a meaningful effort to help investors understand these risks.  Effective legal counsel can help companies manage their disclosures in a way that allows for optimistic statements while protecting against future litigation.

Myth #3: Once negative results become public, any positive spin given by management will be viewed as misleading.

FACT: Even in the face of bad news, positive statements of opinion will not be viewed as false or misleading if they are honestly held and are made within the proper context, especially where the company accurately discloses the underlying facts.  Courts do not require companies to be pessimistic in assessing arguably negative results; they merely require that companies be honest in their statements and forthcoming with the relevant underlying facts.  See, e.g., Sarafin v. BioMimetic Therapeutics, Inc., 2013 WL 139521, at *13-14 (M.D. Tenn. Jan. 10, 2013) (dismissing where defendant characterized clinical trial results positively even though FDA had expressed concerns and contemporaneous news reports described the results as disappointing).

Myth #4: Cases will not get dismissed if the company raises capital or insiders sell stock during the class period.

FACT: These facts may contribute to an inference of scienter in some circumstances, but they are not determinative.  Far more important is the overall story, and whether the alleged motivation to commit fraud makes sense in the context of this larger narrative.  When courts are convinced that the defendants were trying their best for the company and were honest and forthright in their public statements, they tend not to be concerned about capital raising or insider sales during the class period.  See, e.g., Brennan v. Zafgen, Inc., 2016 WL 4203413, at *2 (D. Mass. Aug. 9, 2016) (“[T]he complaint’s circumstantial allegations concerning scienter—a patchwork of scientific literature and unsuspicious insider sales—are insufficient to support a strong inference of defendants’ conscious intent to defraud or high degree of recklessness.” (internal quotation marks omitted)); In re MELA Sciences, Inc. Sec. Lit., 2012 WL 4466604, at *5 (S.D.N.Y. Sep. 19, 2012) (“To the extent the [proposed amended complaint] relies on MELA’s capital raised during the Class Period, the court finds this inadequate to support an allegation of intent to commit fraud.”).  But see Gargiulo v. Isolagen, Inc., 527 F. Supp. 2d 384, 390 (E.D. Pa. 2007) (scienter was sufficiently pleaded based on several factors, including that defendants allegedly sold their respective securities at the time for “considerable gain”).

IV. Case Trends and Practice Tips

Careful review of the decisions in the study set not only upends the myths described above, but also reveals important insights into how courts actually decide these cases and what companies and legal counsel can do to head off and defend against these suits.

A. Decisions are often driven by the court’s overall feeling about whether or not the company was being forthright and dealing honestly.

District court judges, like anyone else, are influenced by their overall impressions of the parties and the facts, even at the earliest stages in litigation.  Motions to dismiss frequently turn on how the court chooses to characterize the pleadings, which leaves significant room for outcome-driven analysis.  This may seem obvious, but has important practice implications, as discussed below.

Decisions in our study set—both those that dismissed and those that did not—showed again and again that in applying the pleading standard and securities laws to young biotech companies, judges appeared to be swayed by their overall sense of whether or not company management had honestly been doing its best to bring a product to market and inform investors of significant developments in a timely manner.  Where courts saw little indication of good faith, they rarely dismissed.  As one court put it:

“[N]otwithstanding the defendants’ contentions to the contrary, their allegedly misleading statements bear no hallmarks of good faith error.  The defendants are sophisticated scientists running a regulated, publicly traded corporation; they are alleged to have misrepresented their regulator’s feedback, misrepresented the legal context in which they operated, heralded scientific results which they knew to be the product of empirically faulty procedures and manipulated statistical analysis, and claimed a level of external review that simply did not exist.  If the defendants have good faith explanations for these misstatements…they do not emerge from the complaint.”

Frater v. Hemispherx Bipharma, Inc., et al., 996 F. Supp.2d 335, 350 (E.D. Pa. 2014).  See also, e.g., KB Partners I, L.P. v. Pain Therapeutics, Inc., 2015 WL 7760201, at *1 (W.D. Tex. Dec. 1, 2015) (refusing to dismiss where complaint plausibly alleged defendants intentionally concealed the nature and extent of problems with their drug candidate after its first NDA was rejected, and did so while lining their own pockets with “unjustifiable compensation packages”).

But when defendants presented a credible narrative evidencing good-faith, courts seemed inclined to run with it, absent specific, compelling allegations to the contrary.  See In re Axonyx Sec. Lit., 2009 WL 812244, at *3 (S.D.N.Y. Mar. 27, 2009) (dismissing and noting that “[t]he idea that this company, highly dependent on the success of the new drug, would knowingly or recklessly carry on a defective trial—so that any defects were not remedied—virtually defies reason, unless the company was bent on defrauding the FDA and the suffering people who might use the drug.  Nothing of that sort is even suggested in the complaint.”); see also, e.g., Kovtun v. VIVUS, Inc., 2012 WL 4477647, at *3, 10 (N.D. Cal. Sep. 27, 2012) (dismissal appears partly influenced by fact that drug was ultimately approved after the class period, making alleged intentional misrepresentations re approvability improbable).

This seeming inclination to dismiss when presented with a convincing defense narrative appears to reflect two underlying beliefs that favor biotech defendants and may help drive the high dismissal rate in these cases: (1) that the research and development of new drugs and medical devices constitutes an important public good, and (2) that investment in development-stage companies, which have no existing revenue stream, is inherently particularly risky.  As courts explicitly have noted:

“There is a significant public interest in the development of life-saving drugs.  For every drug that succeeds, others do not.  Clinical trials are phased into stages: some drugs never make it past the first stage, others never make it past the second stage, and so on.  The costs of failure are high, but the rewards for success are also high.  The relationship and ratio between the two determines whether, as a matter of economics, the costs of experimentation are worth it.  Publicly traded pharmaceutical companies have the same obligations as other publicly traded companies to comply with the securities laws, but they take on no special obligations by virtue of their commercial sector.  It would indeed be unjust—and could lead to unfortunate consequences beyond a single lawsuit—if the securities laws become a tool to second guess how clinical trials are designed and managed.  The law prevents such a result; the Court applies that law here, and thus dismisses these actions.”  In re Keryx Biopharmas., Inc., Sec. Lit., 2014 WL 585658, at *1 (S.D.N.Y. 2014).

“Ultimately, investments in experimental drugs are inherently speculative.  Investors cannot, after failing in this risky endeavor, hedge their investment by initiating litigation attacking perfectly reasonable-if overly optimistic statements proved wrong only in hindsight.”  In re Vical Inc. Sec. Lit., 2015 WL 1013827, at *8 (S.D. Cal. Mar. 9, 2015).

“[I]nvesting in a start-up pharmaceutical company like Adolor involves a certain amount of risk on the part of investors.   No matter how safe that risk may seem at the time, there are no guarantees, and Defendants never suggested otherwise.  The fact that Plaintiffs now suffer from buyer’s remorse does not entitle them to relief under Rule 10b-5.” In re Adolor Corp. Sec. Lit., 616 F. Supp. 2d 551, 570 (E.D. Pa. 2009).

Against this backdrop, biotech defendants are well-positioned to secure early dismissals if they simply tell their stories and frame the facts in a manner that demonstrates their good faith.  On the front end, this means companies will benefit from getting legal counseling on their disclosures, so that if trouble arises the disclosures will show a pattern of being honest and forthright and avoid indications of fraud in the context of the company’s particular situation (i.e., the state of its communications with the FDA, financing, stock sales, etc.).

Once biotech defendants have been sued, however, they should focus on selecting counsel who will tell their overall story in a way that emphasizes their honestly and does not just focus on a technical defense.  Too many defense attorneys feel constrained to make narrow, technical arguments at the motion to dismiss stage—when plaintiff’s factual pleadings are to be taken as true—rather than mounting a normative defense of their clients’ conduct.  As the decisions (and results) in our study set show, this is a missed opportunity.  The decision in Omnicare expressly allows and even encourages defendants to tell their versions of the story by declaring that whether a statement of opinion (or, by clear implication, a statement of fact) was misleading “always depends on context.” 135 S. Ct. at 1330.  Under this standard, courts are required to consider not only the challenged statements and the immediate contexts in which they were made, but also other statements made by the company and other publicly available information, including the customs and practices of the industry.

Evaluating challenged statements in this broader context nearly always benefits defendants, since it helps courts better understand the statements and makes them seem fairer than they might on their own.  Moreover, in combination with the Supreme Court’s directive in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), to assess scienter based on not only the complaint’s allegations but also documents on which it relies or that are subject to judicial notice, Omnicare now clearly requires courts to consider a broad set of probative facts each time they decide a motion to dismiss federal securities claims.  Effective defense counsel will take advantage of this mandate and continue to use the motion to dismiss to tell their client’s story in a way that frames the facts and issues favorably and helps the court feel comfortable dismissing the suit.

B. Statements of opinion and forward-looking statements are generally safe, even more so after Omnicare.

The sorts of forward-looking statements of opinion that biotech companies often most want to make about their flagship products are not actually likely to get them into trouble, so long as the statements are honestly believed and are accompanied by disclosures that acknowledge specific, relevant uncertainties.

1. Claims challenging statements of opinion—including optimistic predictions—are likely to be dismissed under the Omnicare

Even before the Supreme Court’s recent decision in Omnicare, courts tended to find statements of opinion to be non-actionable on a variety of different theories (e.g., puffery, lack of falseness, immateriality, etc.).  After all, “[p]unishing a corporation and its officers for expressing incorrect opinions does not comport with Rule 10b-5’s goals.”  In re Vical Inc. Secs. Lit., 2015 WL 1013827, at *8 (S.D. Cal. Mar. 9, 2015).  So, for example, the court in Shah v. GenVec, Inc., 2013 WL 5348133 (D. Md. Sep. 20, 2013), found the defendants’ positive characterizations of interim data to be immaterial “puffery” and, therefore, non-actionable:

“Plaintiffs properly characterize their challenge as Defendants placing ‘an unjustifiably positive spin on the data available at the time of the [first interim analysis] by using terms like “encouraging” and “bullish[.]”’ Such vague and general statements of optimism constitute no more than puffery and are understood by reasonable investors as such.  Accordingly, they are immaterial and not actionable under § 10(b).”

Id. at *15 (internal citations omitted).  See also, e.g., Kovtun v. VIVUS, Inc., 2012 WL 4477647, at *11 (N.D. Cal. Sep. 27, 2012) (“[S]tatements referring to [the drug candidate’s] ’excellent’ or ‘compelling’ risk/benefit profile, or statements to the effect that the trials had shown ‘remarkable’ safety and efficacy, . . . are simply vague assertions of corporate optimism and therefore are not actionable . . . .”); In re MELA Sciences, Inc. Sec. Lit., 2012 WL 4466604, at *13 (S.D.N.Y. Sep. 19, 2012) (characterizing positive statements about clinical results as opinions and dismissing because “Plaintiffs cannot premise a fraud claim upon a mere disagreement with how defendants chose to interpret the results of the clinical trial.”).

The decision in Omnicare, however, as discussed above, established a clear, unified, and even more defendant-friendly standard for assessing statements of opinion in securities cases: an opinion is only false if the speaker does not believe it, and it is only misleading if it omits facts that make it misleading when viewed in its full, broadly understood context.  See id. at 1328-30.  Thus, a company’s statements of opinion—including optimistic projections about clinical results or FDA approval—are not actionable as long as the company actually believed them at the time and they were not misleading in their full context.  For example, applying this standard in Gillis v. QRX Pharma Ltd., 2016 WL 3685095 (S.D.N.Y. July 6, 2016), the court concluded that the defendants’ optimistic statements that it was “encouraged” by FDA feedback and was “confident that [its drug candidate would] receive approval” were opinions, and plaintiffs had failed sufficiently to allege that defendants did not believe them or that they were misleading in context.  Id. at *21-23.  See also, e.g., Corban v. Sarepta, 2015 WL 1505693, at *8 (D. Mass. Sep. 30, 2015) (“[T]he company’s statements that it was encouraged by the feedback and believed its data would be sufficient for a filing constituted an expression of opinion,” which the court found not to be actionable).

Both the district court (before Omnicare) and the Second Circuit (after Omnicare) came to the same conclusion regarding the optimistic predictions at issue in In re Sanofi Securities Litigation.[vii] There, plaintiffs alleged that the defendants’ optimistic statements concerning a drug candidate’s likelihood of approval and its clinical results were misleading where they failed to disclose that the FDA repeatedly had expressed concerns about the company’s use of single-blind studies.  In re Sanofi Sec. Litig., 87 F. Supp. 3d 510, 517 (S.D.N.Y. 2015).  Applying the Second Circuit’s pre-Omnicare standard, the district court concluded that the challenged statements all were statements of opinion, and dismissed because plaintiffs had not established either that the opinions were not honestly held or that they were “objectively false.”  Id. at 531-33.  The Second Circuit affirmed, but took the opportunity to apply the Supreme Court’s then-recent Omnicare standard to the facts at hand, emphasizing in particular the larger context in which the challenged statements were made:

“Plaintiffs are sophisticated investors, no doubt aware that projections provided by issuers are synthesized from a wide variety of information, and that some of the underlying facts may be in tension with the ultimate projection set forth by the issuer. . . . These sophisticated investors, well accustomed to the “customs and practices of the relevant industry,” would fully expect that Defendants and the FDA were engaged in a dialogue, as they were here, about the sufficiency of various aspects of the clinical trials and that inherent in the nature of a dialogue are differing views.”

Tongue v. Sanofi, 816 F.3d 199, 211 (2d Cir. 2016).  As previously discussed, this highly-contextual analysis favors defendants, and makes it even more likely that claims challenging defendants’ statements of opinion—including optimistic predictions concerning FDA approval or interpretations of clinical results—will be dismissed, provided the defendants genuinely held those opinions.

Of course, even statements of opinion can be false if they’re not genuinely believed; making an optimistic projection about FDA approval when a company has specific reason to believe the drug will not in fact be approved is likely to get it into trouble.  So, for example, in In re Pozen Sec. Lit., 386 F. Supp. 2d 641 (M.D. N. Car. 2005), the court refused to dismiss claims regarding optimistic statements by the defendant touting its drug candidates’ effectiveness and implying their approvability, where the company knew at the time that it was applying a statistical analysis different from what it had agreed to with the FDA and knew that the drugs had failed in part to meet a critical clinical measure it had specifically agreed upon with the FDA ahead of time.  Id. at 646-47.  The court noted that the defendants might well have had other reasons to believe their own expressions of optimism at the time—which would make these statements of opinion not false—but it found the allegations sufficient to survive a motion to dismiss.  Id.

2. Predictions of clinical trial success or FDA approval usually are also protected forward-looking statements

Not only are most optimistic projections statements of opinion, subject to Omnicare’s rigorous standard, they also tend to be forward-looking statements protected under the Reform Act’s safe harbor.

Courts in the study set usually found expressions of optimism regarding clinical trial results or the likelihood of FDA approval to be forward-looking statements protected under the Reform Act’s safe harbor where the statements were accompanied by specific cautionary language that warned investors of the most significant risks.  As one court explained:

“Projections about the likelihood of FDA approval are forward-looking statements.  They are assumptions related to the company’s plan for its product, and as such fall under the PSLRA’s safe harbor rule.  Each VIVUS press release or other public statement cited by plaintiff included warnings about the uncertainties of forward-looking statements, and also referred to VIVUS’ SEC filings.  Those filings, in turn, were replete with discussion of risk factors, including potential difficulties with obtaining FDA clearances and approval; the known side-effects of Qnexa’s two components, and the possibility of FDA required labeling restrictions; the risk that the FDA might require additional, expensive trials; and concerns regarding Qnexa’s association with Fen-Phen.”

Kovtun v. VIVUS, Inc. 2012 WL 4477647, at *12 (N.D. Cal. Sep. 27, 2012) (dismissing); see also, e.g., Gillis v. QRX Pharma Ltd., 2016 WL 3685095, at *23 (S.D.N.Y. July 6, 2016) (“QRX’s statement that it was ‘confident that MOXDUO will receive approval,’ SAC ¶ 48, is, separately, shielded by the PSLRA safe harbor.”).

In fact, some courts found optimistic projections to be protected even where the cautionary language was fairly minimal.  For example, in Oppenheim v. Encysive Pharmas., Inc., 2007 WL 2720074 (S.D. Tex. Sep. 18, 2007), the court concluded that statements by the defendant (1) that it had a “good shot” at receiving priority review from the FDA (but where it had clearly acknowledged that it was “an FDA decision of course”), and (2) that it did not expect the FDA to require additional clinical trials (but where it had stated “you never know what’s going to happen when you get into a regulatory process”), were protected under the safe harbor.  Id. at *3.

3. Challenges to clinical methodology and analysis are generally rejected, as long as the defendants do not appear to have been manipulating data.

Courts also routinely dismiss challenges to a company’s clinical methodology or analysis. Statements interpreting clinical trial results often are found to be non-actionable expressions of opinion.  See, e.g., Corban v. Sarepta, 2015 WL 1505693, at *6 (D. Mass. Sep. 30, 2015) (applying pre-Omnicare standard and dismissing claims re statements touting the strength of clinical trial results in part because “many of the challenged statements consist of interpretations of the company’s data,” which the court found to be nonactionable expressions of opinion).

Likewise, courts tend to dismiss suits where plaintiffs’ theory boils down to a mere disagreement with the company’s clinical trial methodology.  See, e.g., Davison v. Ventrus Biosciences, Inc., 2014 WL 1805242, at *7 (S.D.N.Y. May 5, 2014) (dismissing claims that optimistic statements were misleading because they failed to disclose that the small sample size allegedly distorted results, and noting that “[t]he Second Circuit has emphasized that in scrutinizing a Section 10(b) claim, a court does not judge the methodology of a drug trial, but whether a defendant’s statements about that study were false and misleading”); In re Keryx Biopharmas., Inc., 2014 WL 585658, at *10-12 (S.D.N.Y. Feb. 14, 2014) (dismissing claims based on statements re clinical results that plaintiffs allege were misleading due to extensive methodological flaws); Abely v. Aeterna Zentaris, Inc., 2013 WL 2399869, at *6-10 (S.D.N.Y. May 29, 2013) (dismissing claims because plaintiff’s allegations “merely amount to a competing view of how the trial should have been designed” and “[p]ublic statements about clinical studies need not incorporate all potentially relevant information or findings, or even adhere to the highest research standards, provided that its findings and methods are described accurately”).  As long as a biotech company describes its clinical and interpretive methodologies accurately, courts generally will not pass judgment on the soundness of those approaches.  See id. at *6 (“The Second Circuit and other tribunals have concluded that the securities laws do not recognize a fraud claim premised on criticisms of a drug trial’s methodology, so long as the methodology was not misleadingly described to investors.” (emphasis added)).

Where plaintiffs put forth specific, credible allegations indicating that defendants were intentionally misrepresenting or manipulating data, however, courts often allow these cases to go forward.  See, e.g., In re Delcath Systems, Inc. Sec. Lit., 36 F. Supp. 3d 320, 333 (S.D.N.Y. 2014) (dismissing claims re optimistic projections concerning drug approval, but allowing claims re alleged misrepresentations and omissions concerning clinical results because “[t]he allegations here do not involve differing interpretations of disclosed data, but rather data that was not disclosed”); In re Immune Response Sec. Lit., 375 F. Supp. 2d 983, 1018-22 (S.D. Cal. 2005) (refusing to dismiss claims alleging that defendants continuously misrepresented clinical results that they knew were incomplete and flawed, where complaint included specific corroborating details suggesting intentional misconduct); In re Vicuron Pharmas. Inc. Sec. Lit., 2005 WL 2989674, at *6 (E.D. Pa. July 1, 2005) (allowing claims re positive statements about Phase III clinical results to move forward where court seemed convinced by allegations that defendant actually knew clinical results were problematic and approval was unlikely).

Thus, it is best for biotech companies accurately to disclose the details of their clinical trial methodology and underlying data along with the company’s interpretation of that data, in order to avoid plausible claims of subterfuge later on.

C. Other than cases where companies appear to have made false statements of fact, the riskiest areas for companies are disclosures made relative to FDA feedback.

One category of statements sticks out in the study set as particularly troublesome for defendants: alleged misrepresentations concerning feedback from or interactions with the FDA.  On the one hand,

“[N]umerous courts have concluded that a defendant pharmaceutical company does not have a duty to reveal interim FDA criticism regarding study design or methodology.  Indeed, such courts frequently reason that interim FDA feedback is not material because dialogue between the FDA and pharmaceutical companies remain ongoing throughout the licensing process, rendering such criticism subject to change and not binding in regards to ultimate licensing approval.”

Vallabhaneni v. Endocyte, Inc., 2016 WL 51260, at *12 (S.D. Ind. Jan. 4, 2016) (dismissing claims that defendant misled investors by touting Phase II results without disclosing that the FDA had questioned how efficacy was determined in the study, because FDA concerns expressed were not so severe as to suggest the drug could not be approved, and the FDA subsequently allowed Phase III to move forward).  See also Tongue v. Sanofi, 815 F.3d 199, 214 (2d Cir. 2016) (affirming dismissal) (“Reasonable investors understand that dialogue with the FDA is an integral part of the drug approval process, and no sophisticated investor familiar with standard FDA practice would expect that every view of the data taken by Defendants was shared by the FDA.”).

On the other hand, claims concerning statements or omissions about interactions with the FDA seem to survive motions to dismiss more often than other types of statements in biotech cases, perhaps because companies too often cherry-pick the FDA feedback they choose to disclose.

In assessing these sorts of claims, courts carefully distinguish between optimistic projections regarding approval, which tend to be protected forward-looking statements, and statements regarding past FDA interactions or feedback, which pertain to verifiable historical facts.  For example, in In re Mannkind Sec. Actions, 835 F. Supp. 2d 797 (C.D. Cal. 2011), the court refused to dismiss claims regarding defendants’ repeated assurances that the FDA had “blessed,” “approved,” “accepted,” and “agreed to” the company’s methodological approach in its clinical trials, when it later became clear that the FDA had done no such thing:

“Courts must of course be careful to distinguish between forward-looking statements later deemed to be unduly optimistic, and statements of historical fact later shown to be false when made…

            … [S]tatements touting the merits of the bioequivalency studies, can be fairly read as misguided opinion or ‘corporate optimism,’ [but] it is harder to escape the conclusion that Defendants’ statements concerning the FDA cross the line from exaggeration and ‘corporate optimism’ into outright misstatement of historical fact.”

Id. at 809-11 (emphasis in original).

Likewise, in In re Cell Therapeutics, Inc. Class Action Lit., 2011 WL 444676 (W.D. Wa. Feb. 4, 2011), the court dismissed claims challenging the defendants’ optimistic statements about the drug candidate’s progress in clinical trials and the company’s hopes for FDA approval because these were forward-looking statements accompanied by sufficient cautionary language.  Id. at *7-8.  At the same time, however, the court allowed claims to move forward regarding defendants’ repeated statements indicating that its Special Protocol Assessment (“SPA”)—an agreement with the FDA that the drug would be approved if the company followed the agreed-upon protocol and the drug proved effective[viii]—was still in effect even after defendants knew that they had invalidated the SPA.  Id.; see also, e.g., Frater v. Hemispherx Biopharma, Inc., 996 F. Supp. 2d 335, 346 (E.D. Pa. 2014) (declining to dismiss claims re statements that allegedly mischaracterized FDA feedback by (1) omitting FDA statements indicating that it probably would not be receptive to company’s intended clinical approach and (2) incorrectly stating that the FDA had withdrawn its request for a new clinical trial as part of a resubmitted New Drug Application).

In light of these cases, how does a company decide what to disclose when it is in constant communications with the FDA?  This is a prime area where a company can mitigate its risk by getting expert disclosure advice.  As a starting point, review of our case study set suggests the following:

  • Context and clarity are important. Omnicare will protect statements of opinion so long as they are genuinely held and not misleading in their full context.  If a company wants to express an opinion regarding its interactions with the FDA, it can protect itself by accurately and clearly disclosing the important underlying facts (positive and negative) regarding that interaction as well.  Moreover, if a company wants to make optimistic projections regarding the approval process more generally, it should keep in mind that any negative feedback from the FDA, whether disclosed or not, will be part of the overall context in which those statements of opinion are judged.
  • Companies need to be careful not to mislead. Selective disclosure of some facts but not others can create difficulties and must be done with care and transparency.  If a company chooses to disclose interim FDA feedback, it should do so fairly, reporting both positive and significant negative components of that feedback at the same time.  With expert guidance, it is possible to emphasize the positive while acknowledging the negative in a way that will not leave the company open to challenge at a later date.
  • Companies should be careful not to overstate or misconstrue FDA opinions. These can later be contradicted by the agency when an approval decision is made, opening the company up to allegations that it intentionally misrepresented the interim feedback it received.  A biotech company most often will be best served by couching any optimism it wants to express in terms of the company’s opinions and expectations—rather than positively characterizing the FDA’s feelings or intentions—and sticking to accurate, factual accounts of FDA feedback.

IV. Conclusion

Our study shows that, contrary to popular belief, development-stage biotech companies actually have less to fear from federal securities cases than do many other types of corporate defendants that have a far easier time securing insurance coverage.  Over the last decade, these cases have been dismissed at a high rate early in the litigation process, and even more so in recent years.  Biotech startups may well end up being sued if and when their flagship products are not approved by the FDA, but courts are sympathetic to the inherent risks of the industry and seem primed to dismiss these suits when defendants can present a credible narrative of good faith conduct.  By getting expert disclosure advice before making important announcements, and by hiring litigation counsel who will affirmatively tell the company’s story at the motion to dismiss stage, small biotech companies and their insurers can guard against litigation and give the company an excellent shot at early dismissal in any securities suits that are ultimately brought against them.


[i] Specifically, we applied the following, over-inclusive search terms to all federal district court decisions from March 6, 2005 through October 3, 2016 in the Westlaw database: (pslra “private securities litigation reform”) & (FDA “food and drug administration” f.d.a.) /p (clinical medical bio! biotech! genom! gene genetic phase trial drug study therapy treatment) & “motion to dismiss.”  This produced 298 results, only 61 of which met our study set criteria as described above (additional cases met the same criteria except that they were brought against companies that already had at least one drug or device on the market).

[ii] In each case, only the district court’s final decision on the defense’s motion(s) to dismiss was included in the study set.  Any earlier dismissals, where plaintiffs were allowed to amend the complaint and the court then ruled on a subsequent motion to dismiss, were excluded so that sequential opinions in the same action were not double-counted.  Likewise, cases that did not yet have a final decision on the motion to dismiss were excluded (e.g., if the court initially dismissed with leave to amend and a subsequent motion to dismiss was pending).

[iii] Decisions where the securities fraud claims concerned something other than the clinical trial and FDA approval process for their primary drug or device candidate (e.g., alleged financial improprieties, marketing, sales, post-approval manufacturing issues, etc.) were not included in the study set.

[iv] See Svetlana Starykh & Stefan Boettrich, NERA Economic Consulting, Recent Trends in Securities Class Action Litigation: 2015 Full-Year Review, at 19, available at (only 54% of the securities class action motions to dismiss that were resolved between January and December 2015 were granted, with or without prejudice).

[v] Omnicare, Inc. v. Laborers Dist. Council Const. Indus. Pension Fund, 135 S. Ct. 1318 (2015).

[vi] The Reform Act provides a safe harbor for forward-looking statements that are identified as such and accompanied by “meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement.” 15 U.S.C. § 78u–5(c)(1)(A)(i).

[vii] This district court dismissal was excluded from our primary study set because, although it otherwise met our study criteria, Sanofi is a well-established pharmaceutical company with numerous drugs already on the market.

[viii] As the court explained: “[A]n SPA can only be modified by written agreement between the FDA and the sponsor and then only if it is intended to improve the study. Failure to follow the agreed-upon protocol constitutes an understanding that the SPA is no longer binding.”  In re Cell Therapeutics, 2011 WL 444676, at *1.

Following is an article I wrote for Law360, which gave me permission to republish it here:

Among securities litigators, there is no consensus about the importance of developments in securities and corporate governance litigation.  For some, a Supreme Court decision is always supreme.  For others, a major change in a legal standard is the most critical.  For me, the key developments are those that have the greatest potential to significantly increase or decrease the frequency or severity of claims against public companies and their directors and officers.

Given my way of thinking, there are three developments in 2016 that stand out as noteworthy:

  • The persistence of securities class actions brought against smaller public companies primarily by smaller plaintiffs’ firms on behalf of retail investors—a trend that began five years ago and now appears to represent a fundamental shift in the securities class action landscape.
  • The 2nd Circuit’s robust application of the Supreme Court’s Omnicare decision in Sanofi, illustrating the significant benefits of Omnicare to defendants.
  • The demise of disclosure-only settlements under the Delaware Court of Chancery’s Trulia decision and the 7th Circuit’s subsequent scathing Walgreen opinion by Judge Posner.

I discuss each of these developments in detail, and then list other 2016 developments that I believe are important as well.

1. The Securities Class Action Landscape Has Fundamentally Changed

The Private Securities Litigation Reform Act’s lead plaintiff process incentivized plaintiffs’ firms to recruit institutional investors to serve as plaintiffs.  For the most part, institutional investors, whether smaller unions or large funds, have retained the more prominent plaintiffs’ firms, and smaller plaintiffs’ firms have been left with individual investor clients who usually can’t beat out institutions for the lead-plaintiff role.  At the same time, securities class action economics tightened in all but the largest cases.  Dismissal rates under the Reform Act are pretty high, and defeating a motion to dismiss often requires significant investigative costs and intensive legal work.  And the median settlement amount of cases that survive dismissal motions is fairly low.  These dynamics placed a premium on experience, efficiency, and scale.  Larger firms filed the lion’s share of the cases, and smaller plaintiffs’ firms were unable to compete effectively for the lead plaintiff role, or make much money on their litigation investments.

This started to change with the wave of cases against Chinese companies in 2010.  Smaller plaintiffs’ firms initiated the lion’s share of these cases, as the larger firms were swamped with credit-crisis cases and likely were deterred by the relatively small damages, potentially high discovery costs, and uncertain insurance and company financial resources.  Moreover, these cases fit smaller firms’ capabilities well. Nearly all of the cases had “lawsuit blueprints” such as auditor resignations and/or short-seller reports, thereby reducing the smaller firms’ investigative costs and increasing their likelihood of surviving a motion to dismiss.  The dismissal rate was low, and limited insurance and company resources have prompted early settlements in amounts that, while on the low side, appear to have yielded good outcomes for the smaller plaintiffs’ firms.

The smaller plaintiffs’ firms thus built up momentum that has kept them going, even after the wave of China cases subsided.  For the last several years, following almost every “lawsuit blueprint” announcement, a smaller firm has launched an “investigation” of the company, and they have initiated an increasing number of cases.  Like the China cases, these cases tend to be against smaller companies.  Thus, smaller plaintiffs’ firms have discovered a class of cases—cases against smaller companies that have suffered well-publicized problems (reducing the plaintiffs’ firms’ investigative costs) for which they can win the lead plaintiff role and that they can prosecute at a sufficient profit margin.

As smaller firms have gained further momentum, they have expanded the cases they initiate beyond “lawsuit blueprint” cases—and they continue to initiate and win lead-plaintiff contests primarily in cases against smaller companies brought by retail investors.  To be sure, the larger firms still mostly can and will beat out the smaller firms for the cases they want.  But it increasingly seems clear that the larger firms don’t want to take the lead in initiating many of the cases against smaller companies, and are content to focus on larger cases on behalf of their institutional investor clients.

The securities litigation landscape now clearly consists of a combination of two different types of cases: smaller cases brought by a set of smaller plaintiffs’ firms on behalf of retail investors, and larger cases pursued by the larger plaintiffs’ firms on behalf of institutional investors.  This change—now more than five years old—appears to be here to stay.

In addition to this fundamental shift, two other trends are an indicator of further changes to the securities litigation landscape.

First, the smaller plaintiffs’ firms often file cases against U.S. companies in New York City or California—regardless where the company is headquartered—diverging from the larger plaintiffs’ firms’ practice of filing in the forum of the defendant company’s headquarters.  In addition to inconvenience, filing cases in New York City and California against non-resident companies results in sticker-shock, since defense firms based in those venues are much more expensive than their home town firms.  The solution to this problem will need to include greater defense of cases in New York City and California by a more economically diverse set of defense firms.

Second, plaintiffs’ firms, large and small, are increasingly rejecting the use of historical settlement values to shape the settlement amounts.  This practice is increasing settlement amounts in individual cases, and will ultimately raise settlement amounts overall.  And it will be increasingly difficult for defendants and their insurers to predict defense costs and settlement amounts, as more mediations fail and litigation proceeds past the point they otherwise would.

2. Sanofi Shows Omnicare’s Benefits

In Tongue v. Sanofi, 816 F.3d 199 (2nd Cir. 2016), the Second Circuit issued the first significant appellate decision interpreting the Supreme Court’s decision in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318 (2015).  Sanofi shows that Omnicare provides powerful tools for defendants to win more motions to dismiss.

As a reminder, the Supreme Court in Omnicare held that a statement of opinion is only false under the federal securities laws if the speaker does not genuinely believe it, and is only misleading if it omits information that, in context, would cause the statement to mislead a reasonable investor.  This ruling followed the path Lane Powell advocated in an amicus brief on behalf of Washington Legal Foundation.

The Court’s ruling in Omnicare was a significant victory for the defense bar for two primary reasons.

First, the Court made clear that an opinion is false only if it was not sincerely believed by the speaker at the time that it was expressed, a concept sometimes referred to as “subjective falsity.”  The Court thus explicitly rejected the possibility that a statement of opinion could be false because “external facts show the opinion to be incorrect,” because a company failed to “disclose[] some fact cutting the other way,” or because the company did not disclose that others disagreed with its opinion.  This ruling resolved two decades’ worth of confusing and conflicting case law regarding what makes a statement of opinion false, which had often permitted meritless securities cases to survive dismissal motions.  Omnicare governs the falsity analysis for all types of challenged statements. Although Omnicare arose from a claim under Section 11 of the Securities Act, all of its core concepts are equally applicable to Section 10(b) of the Securities Exchange Act and other securities laws with similar falsity elements.

Second, Omnicare declared that whether a statement of opinion (and by clear implication, a statement of fact) was misleading “always depends on context.”  The Court emphasized that showing a statement to be misleading is “no small task” for plaintiffs, and that the court must consider not only the full statement being challenged and the context in which it was made, but must also consider other statements made by the company, and other publicly available information, including the customs and practices of the relevant industry.

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

Due to the importance of its holdings and the detailed way in which it explains them, Omnicare is the most significant post-Reform Act Supreme Court case to analyze the falsity element of a securities class-action claim, laying out the core principles of falsity in the same way that the Court did for scienter in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007).  If used correctly, Omnicare thus has the potential to be the most helpful securities case for defendants since Tellabs, providing attorneys with a blueprint for how to structure their falsity arguments in order to defeat more complaints on motions to dismiss.

The early returns show that Omnicare is already helping defendants win more motions to dismiss.  The most significant such decision is Sanofi. In Sanofi, the Second Circuit became the first appeals court to discuss Omnicare in detail, and to examine the changes that it brought about in the previously governing law.  Sanofi was not, as some securities litigation defense lawyers have claimed, a “narrow” reading of the Court’s decision.  Rather, it was a straightforward interpretation of Omnicare that emphasized the Supreme Court’s ruling on falsity, and the intensive contextual analysis required to show that a statement is misleading.  It correctly took these concepts beyond the Section 11 setting and applied them to allegations brought under Section 10(b).

Statements about Lemtrada, a drug in development for treatment of multiple sclerosis, were at issue in the case.  Sanofi and its predecessor had conducted “single-blind” clinical trials for Lemtrada (studies in which either the researcher or the patient does not know which drug was administered), despite the fact that the U.S. Food and Drug Administration had repeatedly expressed concerns about these trials and recommended “double-blind” clinical studies (studies in which both the researcher and the patient do not know which drug was administered).

The plaintiffs alleged that Sanofi’s failure to disclose FDA’s repeated warnings that a single-blind study might not be adequate for approval caused various statements made by the company to be misleading, including its projection that FDA would approve the drug, its expressions of confidence about the anticipated launch date of the drug, and its view that the results of the clinical trials were “unprecedented” and “nothing short of stunning.”  Although FDA eventually approved Lemtrada without further clinical trials, the agency initially refused approval based in large part on the single-blind studies concern, causing a large drop in the price of Sanofi stock.

In an opinion issued before Omnicare, the district court dismissed the claims, in part because it found that plaintiffs had failed to plead that the challenged statements of opinion were subjectively false, under the standard employed by the Second Circuit in Fait v. Regions Financial Corp.  The Second Circuit stated that it saw “no reason to disturb the conclusions of the district court,” but wrote to clarify the impact of Omnicare on prior Second Circuit law.

The court acknowledged that Omnicare affirmed the previous standard that a statement of opinion may be false “if either ‘the speaker did not hold the belief she professed’ or ‘the supporting fact she supplied were untrue.’”  However, it noted that Omnicare went beyond the standard outlined by Fait in holding that “opinions, though sincerely held and otherwise true as a matter of fact, may nonetheless be actionable if the speaker omits information whose omission makes the statement misleading to a reasonable investor.”

In reality, Omnicare did not represent a change in Second Circuit law.  Although Fait only discussed falsity, without considering what it would take to make an opinion “misleading,” prior Second Circuit law had been clear that “[e]ven a statement which is literally true, if susceptible to quite another interpretation by the reasonable investor, may properly be considered a material misrepresentation.”  Kleinman v. Elan Corp., 706 F.3d 145 (2nd Cir. 2013) (citation and internal quotation marks omitted).  Omnicare simply brought together these two lines of authority, by correctly clarifying that, like any other statement, a statement of opinion can be literally true (i.e., actually believed by the speaker), but can nonetheless omit information that can cause it to be misleading to a reasonable investor.

The Second Circuit highlighted the Omnicare Court’s focus on context, taking note of its statement that “an omission that renders misleading a statement of opinion when viewed in a vacuum may not do so once that statement is considered, as is appropriate, in a broader frame.”  Since Sanofi’s offering materials “made numerous caveats to the reliability of the projections,” a reasonable investor would have considered the opinions in light of those qualifications.  Similarly, the Second Circuit recognized that reasonable investors would be aware that Sanofi would be engaging in continuous dialogue with FDA that was not being disclosed, that Sanofi had clearly disclosed that it was conducting single-blind trials for Lemtrada, and that FDA had generally made clear through public statements that it preferred double-blind trials. In this broader context, the court found that Sanofi’s optimistic statements about the future of Lemtrada were not misleading even in the context of Sanofi’s failure to disclose FDA’s specific warnings regarding single-blind trials.

Under the Omnicare standards, the Second Circuit thus found nothing false or misleading about the challenged statements, holding that Omnicare imposes no obligation to disclose facts merely because they tended to undermine the defendants’ optimistic projections.  In particular, the Second Circuit found that “Omnicare does not impose liability merely because an issuer failed to disclose information that ran counter to an opinion expressed in a registration statement.”  It also reasoned that “defendants’ statements about the effectiveness of [the drug] cannot be misleading merely because the FDA disagreed with the conclusion—so long as Defendants conducted a ‘meaningful’ inquiry and in fact held that view, the statements did not mislead in a manner that is actionable.”

3. Companies May Regret the Decline of Disclosure-Only Settlements

In combination with the Delaware Court of Chancery’s decision in In re Trulia, Inc. Stockholder Litigation, 129 A.3d 884 (Del. Ch. 2016), Judge Posner’s blistering opinion In re Walgreen Company Stockholder Litigation, 2016 WL 4207962 (7th Cir. Aug. 10, 2016), may well close the door on disclosure-only settlements in shareholder challenges to mergers.  That certainly feels just.  And it may well go a long way toward discouraging meritless merger litigation.  But I am concerned that we will regret it.  Lost in the cheering over Trulia and Walgreen is a simple and practical reality: the availability of disclosure-only settlements is in the interests of merging companies as much as it is in the interests of shareholder plaintiffs’ lawyers, because disclosure-only settlements are often the timeliest and most efficient way to resolve shareholder challenges to mergers, even legitimate ones.

I am offended by meritless merger litigation, and have long advocated reforms  to fix the system that not only allows it, but encourages and incentivizes it.  Certainly, strict scrutiny of disclosure-only settlements will reduce the number of merger claims—it already has.  Let’s say shareholder challenges to mergers are permanently reduced from 90% to 60% of transactions.  That would be great.  But how do we then resolve the cases that remain?  Unfortunately, there aren’t efficient and generally agreeable alternatives to disclosure-only settlements to dispose of a merger lawsuit before the closing of the challenged transaction.  Of course, the parties can increase the merger price, though that is a difficult proposition.  The parties can also adjust other deal terms, but few merger partners want to alter the deal unless and until the alteration doesn’t actually matter, and settlements based on meaningless deal-structure changes won’t fare better with courts than meaningless disclosure-only settlements.

If the disclosure-only door to resolving merger cases is shut, then more cases will need to be litigated post-close.  That will make settlement more expensive.  Plaintiffs lawyers are not going to start to settle for less money, especially when they are forced to litigate for longer and invest more in their cases.  And in contrast to adjustments to the merger transaction or disclosures, in which 100% of the cash goes to lawyers for the “benefit” they provided, settlements based on the payment of cash to the class of plaintiffs require a much larger sum to yield the same amount of money to the plaintiffs’ lawyers.  For example, a $500,000 fee payment to the plaintiffs under a disclosure-only settlement would require around $2 million in a settlement payment to the class to yield the same fee for the plaintiffs’ lawyers, assuming a 25% contingent-fee award.

The increase in the cash outlay required for companies and their insurers to deal with post-close merger litigation will actually be much higher than my example indicates.  Plaintiffs’ lawyers will spend more time on each case, and demand a higher settlement amount to yield a higher plaintiffs’ fee.  Defense costs will skyrocket.  And discovery in post-close cases will inevitably unearth problems that the disclosure-only settlement landscape camouflaged, significantly increasing the severity of many cases.  It is not hard to imagine that merger cases that could have settled for disclosures and a six-figure plaintiffs’ fee will often become an eight-figure mess.  And, beyond these unfortunate economic consequences, the inability to resolve merger litigation quickly and efficiently will increase the burden upon directors and officers by requiring continued service to companies they have sold, as they are forced to produce documents, sit for depositions, and consult with their defense lawyers, while the merger case careens toward trial.

Again, it’s hard to disagree with the logic and sentiment of these decisions, and the result may very well be more just.  But this justice will come with a high practical price tag.

Additional Significant Developments

There were a number of other 2016 developments that I believe may also significantly impact the frequency and severity of securities claims against public companies and their directors and officers.  These include:

  • The ongoing wave of Securities Act cases in state court, especially in California, and the Supreme Court cert petitions in Cyan, Inc. v. Beaver County Employees Retirement Fund, No. 15-1439, and FireEye, Inc., et al., v. Superior Court of California, Santa Clara County, No. 16-744.
  • The lack of a wave of cyber security shareholder litigation, and the conclusion in favor of the defendants in the Target and Home Depot shareholder derivative cases, which follows the dismissal of the Wyndham derivative case in 2014.
  • The challenge to the SEC’s use of administrative proceedings, including Lynn Tilton’s tilt at the process.
  • The Supreme Court’s decision on insider trading in Salman v. U.S. 137 S. Ct. 420 (2016), rejecting the 2nd Circuit’s heightened personal benefit requirement established in U.S. v. Newman, 773 F.3d 438 (2nd Cir. 2014).
  • The persistence and intractability of securities class actions against foreign issuers after Morrison v. National Australia Bank, 561 U.S. 247 (2010).
  • The 8th Circuit’s reversal of class certification under Halliburton II in IBEW Local 98 Pension Fund v. Best Buy Co., 818 F.3d 775, 777 (8th Cir. 2016).
  • The 9th Circuit becoming the first appellate court to hold that Section 304 of Sarbanes-Oxley allows the SEC to seek a clawback of compensation from CEOs and CFOs in the event of a restatement even if it did not result from their misconduct. U.S. Securities & Exchange Commission v. Jensen, 835 F.3d 1100 (2016).
  • The 2nd Circuit’s lengthy and wide-ranging decision in In re Vivendi, S.A. Securities Litigation, 838 F.3d 223 (2nd Cir. 2016), affirming the district court’s partial judgment against Vivendi following trial.

The history of securities litigation is marked by particular types of cases that come in waves:

  • the IPO laddering cases, which involved more than 300 issuers and their underwriters;
  • the Sarbanes-Oxley era “corporate scandal” cases, which involved massive litigation against Enron, WorldCom, Tyco, Adelphia, HealthSouth, and others;
  • the mutual fund market timing cases;
  • the stock options backdating cases, most of which were actually derivative cases, but many plaintiffs’ firms devoted class action resources to them;
  • the credit crisis cases; and
  • the Chinese reverse-merger cases.

In fact, the out-of-the-ordinary type of securities case has become ordinary; we have been in a series of waves for the past 20 years.

But we are not in one now, and I’m often asked, “What’s next?”

Although I don’t know if we’re about to enter a period of quirky cases, like stock options backdating, I’m confident that we’re going to experience a storm of non-M&A securities class actions caused by a convergence of factors: an increasing number of SEC whistleblower tips, a drumbeat for more aggressive securities regulation, a stock market poised for a drop, and an expanded group of plaintiffs’ firms that initiate securities class actions.

The SEC’s Whistleblower Program

The Dodd-Frank Wall Street Reform and Consumer Protection Act directed the SEC to give bounties to certain whistleblowers.  With awards in the range of 10 percent to 30 percent of monetary sanctions over $1 million, the bounties were designed to attract meaningful tips.

The program caused a stir.  Plaintiffs’ law firms established whistleblower practice groups and hired former SEC enforcement officials.  The SEC created the Office of the Whistleblower, increased staffing, set up a website and hotline system, etc.  Corporate firms published myriad client alerts and held hundreds of seminars—and braced for their own bounties, in the form of new work caused by more internal and SEC investigations, and resulting securities class actions.  I told my family that I’d see them when I retired.

Yet it took a while for the whistleblower program to get rolling.  The number and amount of the early awards were surprisingly low.  But, as featured on the SEC’s website, they have increased steadily, and are now at significant levels.  In total, the SEC has paid out more than $100 million in bounties.  The number of tips has increased from 3,000 in the program’s first fiscal year to 4,000 last year.  SEC Chair Mary Jo White calls the bounty program a “game changer” and Director of Enforcement Andrew Ceresney says it has had a “transformative impact on the agency.”  Indeed, last year, the SEC filed 868 enforcement actions, a single-year high.

Calls for Increased Government Enforcement

Just as the bounty program is hitting its stride, the political environment again seems to be turning against corporations due to the perceived failure of the government’s securities enforcement efforts in the aftermath of the credit crisis and the recent Wells Fargo scandal, among other factors.  And, of course, this election season has been marked by widespread anti-establishment sentiment.

During my nearly 25 years as a securities defense lawyer, I have seen the pendulum swing back and forth, from outrage against corporations, to outrage against the unfairness of SEC enforcement and the ethics of plaintiffs’ lawyers.  Although I don’t think anti-corporate sentiment significantly changes the rate of government enforcement—they do the most they can with their resources, and are constrained by burdens of proof—I do strongly believe that anti-corporate sentiment increases the number and severity of private securities class actions.

We evaluate the state of the securities class action litigation environment primarily by reference to the rate at which cases are dismissed.  Over the history of securities litigation, the biggest driver of the rate of dismissal is not any legal standard, but instead is the overall public attitude toward the value of private securities litigation.  Whether facts are “particularized,” or an inference of scienter is “strong,” are subjective judgments that give judges wide latitude to dismiss a complaint, or not.  Judges are people.  They read the news.  They talk to friends.  They have children who are Millennials.  They have seen people they thought were good do bad things.  When public sentiment is anti-corporation, the judicial environment is inevitably influenced.

When the judicial environment changes, plaintiffs’ lawyers increase their investment in securities litigation—both in the number of cases they file, and how hard they litigate cases.  Two waves of cases provide examples:

  • In the Chinese reverse merger cases, plaintiffs’ firms filed securities class actions against virtually every Chinese company about which there was a report of a problem.  Plaintiffs defeated nearly every motion to dismiss, especially in the Central District of California.  Although the economic recoveries in those cases weren’t substantial due to a lack of company and insurance resources, several smaller plaintiffs’ firms went all in.
  • In the stock option backdating cases, plaintiffs’ firms filed against nearly every company that had a potential backdating problem.  Plaintiffs defeated motions to dismiss at a high rate, and settled cases for relatively large amounts.  The backdating cases greatly raised the level of derivative settlements, established several smaller plaintiffs’ derivative firms as players in shareholder litigation, and were incredibly lucrative for larger plaintiffs’ firms.

Expansion of Plaintiffs’ Securities Class Action Firms

The stock-options backdating cases and the Chinese reverse merger cases have another thing in common: they have fueled an expansion of the plaintiffs’ bar.

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 a handful of 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 for cases that survive dismissal motions is fairly low.

These dynamics placed a premium on experience, efficiency, and scale.  Larger firms thus 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 for amounts that, while on the low side, appear to have yielded good outcomes for the smaller plaintiffs’ firms.

These outcomes built on gains smaller plaintiffs’ firms made during the stock options backdating cases, in which several smaller plaintiffs’ firms did quite well picking up matters in which the larger plaintiffs’ firms didn’t win the lead role, or working with the larger firms as co-counsel. Fueled by their economic and lead-plaintiff successes, these smaller firms have built up a head of steam that has kept them going, even after the wave of China cases subsided.  For the last several years, following almost every “lawsuit blueprint” announcement, a smaller firm has launched an “investigation” of the company, and they have initiated an increasing number of cases.  Like the China cases, these cases tend to be against smaller companies.  Thus, smaller plaintiffs’ firms have discovered a class of cases—cases against smaller companies that have suffered well-publicized problems 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.

Although it isn’t possible for me to know for sure, I strongly believe that there is a very large amount of capacity among the larger and smaller plaintiffs’ firms to increase securities class action filings.  Larger plaintiffs’ firms have only recently finished working through the bulge of the credit crisis cases, and employ a large number of securities class action specialists who have time for more cases.  And the smaller firms are aggressively filing cases and pursuing lead-plaintiff roles.

One of my mentors used to say that “nature abhors a vacuum,” when predicting that there would always be a steady supply of securities litigation.  In a twist on this maxim, I like to say that plaintiffs’ securities class action specialists aren’t going to become doctors or dentists—or even derivative litigation lawyers.  Instead, this large group of lawyers will always file as many securities class actions as they can.  And now, with smaller plaintiffs’ firms hitting their stride, the supply of plaintiffs’ securities class action lawyers is very large, and is looking for more work.

Is There a Securities-Litigation Storm on the Horizon?

I believe that the convergence of these factors, as well as the predicted drop in the stock market, will significantly increase the number of securities class actions.  Indeed, the next big wave in securities litigation may well not be a type of case caused by a unique event, such as options backdating, but instead a perfect storm of cases caused by a competitive blitz by plaintiffs’ firms, as companies report bad earnings results as the economy and stock market decline, and as whistleblower bounties and other SEC enforcement tools unearth disclosure problems.  And throw in other lawsuit-drivers, such as short-seller hit-pieces, and we could see an unprecedented storm of securities class actions.

One of my “5 Wishes for Securities Litigation Defense” (April 30, 2016 post) is greater involvement by boards of directors in decisions concerning D&O insurance and the defense of securities litigation, including defense-counsel selection. Far too often, directors cede these critical strategic decisions to management.

For most directors, securities litigation is a mysterious world ruled by sinister plaintiffs’ lawyers, powerful judges, and a unique legal framework that must be navigated by fancy defense lawyers who charge exorbitant fees. Directors react to this litigation with everything from unnecessary panic to an unjustified feeling of invincibility. The right approach is somewhere in the middle: “attentive concern.” Securities litigation can pose personal risk to directors as well as to their companies, but if directors educate themselves and pay attention, this risk is almost always manageable.

Of course, part of what makes the risk manageable is D&O insurance. But in the event of a claim, independent directors share their D&O insurance with the company and its management. Despite this competition for policy proceeds, directors typically leave management to handle D&O insurance decisions. Directors need to protect their own interests by having a greater role in deciding the features of their D&O insurance program and how the company uses the policy proceeds in the event of a claim.

Greater Involvement by Directors in Securities Litigation Defense

Why Should Directors Care?

Although much of the recent discussion about securities litigation has revolved around meritless merger litigation, securities class actions and associated shareholder derivative actions have always posed greater risk than merger actions. A securities class action alleges that a company and its representatives made false or misleading statements that artificially inflated the stock price. Directors are virtually always included in Section 11 cases, which challenge statements in registered offerings, and increasingly are also named in Section 10(b) actions, which can challenge any public corporate statement. Directors are often named in “tag-along” shareholder derivative actions as well, which allege that the directors failed to properly oversee the company’s public disclosures.

Often, it is difficult to know from the initial complaint whether a securities case will pose a personal risk to directors because it is merely a placeholder. Only after the court selects the lead plaintiff and lead counsel will the plaintiffs’ attorneys draft more substantial allegations and add defendants through an amended complaint. But regardless of any personal risk, directors have a duty to oversee the significant potential liability the company faces. For these reasons, directors should treat each one of these cases as if they are personally named.

The Economics of Securities Litigation Matter

One emerging risk to companies is that ever-increasing securities defense fees no longer match the economics of most cases, and are quickly outpacing D&O policy limits. In the past, securities class actions were initiated by an oligopoly of larger plaintiffs’ firms with significant resources and mostly institutional clients that tended to bring larger cases against larger companies. But recently, smaller plaintiffs’ firms with retail-investor clients have been initiating more cases, primarily against smaller companies. Indeed, in recent years, approximately half of all securities class actions were filed against companies with $750 million or less in market capitalization. As a result, securities class actions have shrunk in size to a level last seen in 1997.

Yet at the same time, the litigation costs of most defense firms have increased exponentially. This two-decade mismatch—between 1997 securities-litigation economics and 2016 law-firm economics—creates the danger that a company’s D&O policy will be insufficient to cover the fees for a vigorous defense and the price to resolve the case. Indeed, inadequate policy proceeds due to skyrocketing defense costs is directors’ biggest risk from securities litigation—by far.

Historically, most securities defense firms have marquee names with high billing rates. Especially in cases against small-cap companies—now the lion’s share—it is more difficult for these firms to vigorously defend an action without risking that there will be too little D&O insurance left for settlement. To avoid this result, firms either cut corners or settle early for bloated amounts that make the defendants look like they did something wrong.

Quite obviously, directors should not be subjected to these hazards—which are created not by the securities class action itself, but by law-firm economics. The vast majority of securities class actions—if handled in the right way by the right defense counsel—can be defended and either won or settled, within D&O insurance policy limits, leaving no residual liability for either the company or its directors. With just a little time and effort at the beginning of the litigation, directors can put these cases on the right track.

The Importance of Directors’ Involvement in Defense-Counsel Selection

First and foremost, directors must ensure their company selects the right counsel. Securities litigation is a specialty field, and it can be nearly impossible to differentiate between the claims of expertise and experience made by the herd of lawyers that descends upon a company after a suit is filed. And it is a serious error—especially for mid-size and smaller companies—to use a law firm brand name as a proxy for quality and fit. Fortunately, many pitfalls of counsel selection can be avoided if directors keep in mind a few key principles:

  • Select a securities litigation specialist, and not a multi-discipline commercial litigator, even one who is highly regarded and/or from a marquee firm.
  • Educate yourself about the strategic differences between firms.
  • Avoid defaulting to your regular corporate firm.
  • Conduct an interview process.

An interview process is essential, in all cases. Directors should use the interview process to insist on a better alternative than the rote decision by most companies to simply retain their regular outside counsel, or a firm with a marquee name. To state the obvious, the most effective securities defense lawyers do not all work at marquee firms. Directors should insist that management interview a range of firms, including those that emphasize a combination of superior quality and reasonable cost—in other words, firms that offer good value. And directors should insist that management push for price concessions from all defense firms that management interviews.

The key is for directors to pay attention and to use the leverage of a competitive hiring process to find counsel to help them through the litigation safely, strategically, and economically.

Directors’ Oversight of D&O Insurance

As a refresher, a D&O insurance policy has three categories of coverage.

  • Side A coverage reimburses directors and officers for losses not indemnified by the company.
  • Side B coverage reimburses the company for indemnification of its directors and officers.
  • Side C coverage insures the company for its own liability.

Directors’ exposure to securities litigation has changed. Due in part to the changes in the plaintiffs’ bar noted above, directors are now much more frequent targets in securities class actions and related shareholder derivative claims—and the trend is very likely to continue. Even as directors’ involvement in securities and derivative suits is increasing, their share of the D&O insurance is effectively decreasing, due to more competition for policy proceeds.

For example, companies frequently seek D&O insurance coverage for various types of investigations, which may help the company, but can significantly erode the policy limits. Companies also deplete limits by, among other things, requesting coverage for employees beyond directors and officers, and seeking ways to avoid triggering the fraud exclusion, which can result in large defense-costs payments to rogue officers. These types of decisions might make sense in certain circumstances, but they should be subject to director oversight.

Perhaps the biggest threat to the sufficiency of directors’ D&O insurance policy is from their own lawyers, due to skyrocketing defense costs. Some insurers have a pre-set list of lawyers from which defendants are encouraged or required to choose. This means that some of the counsel-selection process is done before a claim is filed—which is another reason directors should be involved in the D&O insurance purchasing decision.

Some companies try to eliminate the competition between the company and individuals for policy proceeds by purchasing separate Side A policies that cover only individuals, but these policies do not address erosion from other individuals or by attorneys’ fees, and they only apply if the company cannot indemnify the directors. There are Side A products available specifically for outside directors, but those are infrequently purchased, probably because directors are usually not involved in D&O insurance purchasing decisions.

Independent directors don’t need to take over the process of handling the company’s D&O insurance, or spend an inordinate amount of time on these issues, in order to adequately protect themselves. Rather, they need to become more involved and understand their D&O insurance options and the realities of the claim process. They can do this simply by asking for direct access to the D&O broker and insurer, and by spending some time on D&O insurance decisions at board meetings.


At the same time directors’ securities litigation risk is increasing, they share an increasing percentage of their D&O insurance with the company, officers, and even their own lawyers. Directors can mitigate the risks of these trends by simply becoming more involved in purchasing their D&O insurance and overseeing the defense of securities litigation, including defense-counsel selection. In doing so, they will not only protect their own interests, but will also better oversee and manage the company’s risks as well.

One of my “5 Wishes for Securities Litigation Defense” (April 30, 2016 post) is greater D&O insurer involvement in securities class action defense.

This simple step would have extensive benefits for public companies and their directors and officers. D&O insurers are repeat players in securities litigation, and they have the greatest economic interest in the outcome – both in particular cases, and overall.  They want the defendants – their insureds – to win.  They employ highly experienced claims professionals, many of whom have been involved in exponentially more securities class actions than even the most experienced defense lawyers.

Given insurers’ stake and expertise, defendants should involve them in key strategic decisions – working with them to help find the right defense counsel for the particular case, to help shape the overall defense strategy at the inception of the case, and to help make good decisions about the use of policy proceeds.  With such an approach, I have no doubt that directors and officers would make it through securities cases more successfully, efficiently, and comfortably.

Yet in most cases, insurers are shut out of meaningful involvement in the defense, with many defense lawyers treating them almost like adverse parties, and other defense lawyers merely humoring them as they would a rich relative.  Although this dysfunction is rooted in a complex set of factors, it could easily be fixed.

Why Are D&O Insurers Alienated?

When the general public thinks about insurance, they usually think of auto insurance or other duty-to-defend insurance, under which the insurer assumes the defense of the claim for the insureds.  In contrast to duty-to-defend insurance, public company D&O insurance is indemnity insurance, under which the insurer is obligated to reimburse the company and its directors and officers for reasonable and necessary defense costs and settlement payments, up to the policy’s limit of liability.

Indemnity insurance gives the defendants control over the litigation, including counsel selection and strategic approach, with the insurer retaining limited rights to participate in key decisions.  Although those rights give insurers a foot in the door, competitive pressures among primary D&O insurers work to minimize insurers’ involvement.  For example, an insurer faced with unreasonably high defense costs must decide whether to pay them in full to avoid conflict, or to pay only the “reasonable and necessary” amounts, as the policy specifies – an approach that  maximizes the policy proceeds for the insureds by not squandering policy limits on excessive legal fees.  But if the insurer pays only reasonable and necessary amounts, it may be criticized in the marketplace by the broker or other insurers as being stingy with claims handling – and the insureds may be left holding the bill for the unreasonable excess fees.

In general, insurers take a relatively hands-off approach to D&O claims because they assume that their customers want them to stay out of the defense of the claim.  But in my experience, this is a misconception.  The priority for most companies and their directors and officers is simply the greatest protection possible, including assurances that they will not be left to pay any uncovered legal fees or settlement payments.  In fact, not only do most insureds not want to be stuck paying their lawyers for short-pays, they don’t even want to write any checks at all after satisfying the deductible – instead preferring the insurer to take charge of the bills and pay the lawyers and vendors directly.

In other words, most public companies actually want their D&O insurance to respond more like duty-to-defend insurance.  And if given a choice between having the freedom to choose any defense counsel and having total control over the defense, and saving on their premium and giving the insurers greater rights to be involved, I’m confident most public companies would choose to save on the premium, as long as they are confident that they will still be well-defended.  This is especially so for smaller public companies, for whom the cost of D&O insurance can be a hardship, and against whom the plaintiffs’ bar is bringing more and more securities class actions.  And few companies, large or small, would knowingly spend more on their premiums just to subsidize skyrocketing biglaw partner compensation – the D&O insurance elephant in the corner of the room.

Why do insurers have this misconception?  To be sure, after a claim is filed, the insurer often gets an earful from the insureds’ lawyers and broker about the insureds’ indemnity-insurance freedoms.  But these aggressive positions are typically not the positions of the insureds themselves.  Instead, these positions are driven by defense counsel, usually for self-interested reasons: to get hired, to justify excessive billing, or to settle a case for a bloated amount because the defense is compromised by mounting defense costs or the defense lawyer’s inability to take the case to trial.

Frequently, defense lawyers will set the stage for their clients to have a strained relationship with their insurers by feeding them a number of stock lines:

  • This is a bet-the-company case that requires all-out effort by us to defend you, so we have to pull out all the stops and do whatever is necessary, no matter what the insurer has to say.
  • The insurer may ask you to interview several defense firms before choosing your lawyers. Don’t do that. They’ll just want to get some inferior, cut-rate firm that will save them money.  But you’ll get what you pay for – we’re expensive for a reason! (And don’t forget that we have stood by you, through thick and thin, since before your IPO, back when you were a partner here.  Plus, we gave you advice on your disclosures and stock sales, so we’re in this together.)
  • The business of any insurance company is to try to avoid paying on claims, so the insurer may try to curtail our level of effort, and may even refuse to pay for some of our work.  But trust us to do what we need to do for you.  You might need to make up the difference between our bills and what the insurer pays, but we can go after the insurer later to try to get them to pay you back for those amounts.
  • The insurer will ask us for information about the case.  They’ll say they want to help us, but they’re really just trying to find a way to deny coverage.
  • We’ll tell you when we think the time is right to settle the case, and for how much.  The insurer will try to avoid paying very much for settlement.  But if we say the settlement is reasonable, they won’t have a leg to stand on.
  • We’ll need you to support us in these insurance disputes.  You don’t need to get involved directly – we can work with the insurer and broker directly if you agree.  Agree?  Good.

In this way, defense lawyers set the insurer up as an adversary.  But these self-serving talking points get myriad things wrong.

First, and most importantly, D&O insurers are not the insured’s adversaries in the defense of a securities class action.  To the contrary, insurers’ economic interests are aligned with those of the insureds.  Insurers want to help minimize the risk of liability, through good strategic decisions.  Although keeping defense costs to a reasonable level certainly benefits the insurer, it also benefits the insureds by preserving policy proceeds for related or additional claims on the policy, so that the insureds will not need to pay any defense or settlement costs out-of-pocket, and will avoid a significant premium increase upon renewal.  And insurers want their insureds to have superior lawyers – inferior lawyers would increase their exposure.  Their interest in counsel selection is to help their insureds choose the defense counsel that is right for the particular case.  The key to defense-counsel selection in securities class actions, for insureds and insurers alike, is to find the right combination of expertise and economics for the particular case – in other words, to find good value.

A D&O insurer’s business is not to avoid paying claims.  D&O insurance is decidedly insured-friendly – which isn’t surprising given its importance to a company’s directors and officers.  D&O insurers pay billions of dollars in claims each year, and there is very little D&O insurance coverage litigation.  Although D&O insurance excludes coverage for fraud, the fraud exclusion requires a final adjudication – it does not even come into play when the claim is settled, and even if the case went to trial and there was a verdict for the plaintiffs, it would only be triggered under limited circumstances.  Indeed, if they are utilized correctly, D&O insurers can be highly valuable colleagues in securities class action defense.  Because they are repeat players in securities class actions, they are able to offer valuable insights in defense-counsel selection, motion-to-dismiss strategy, and overall defense strategy.  They have the most experience with securities class action mediators and plaintiffs’ counsel, and often have key strategic thoughts about how to approach settlement.  The top outside lawyers and senior claims professionals for the major insurers have collectively handled many thousands of securities class actions.  Although their role is different than that of defense counsel, these professionals are more sophisticated about securities litigation practice than the vast majority of defense lawyers.

I have achieved superior results for many clients by working collegially with insurers – from helping shape motion-to-dismiss arguments, to learning insights about particular plaintiffs’ lawyers and their latest tricks, to selecting the right mediator for a particular case, to achieving favorable settlements that don’t leave the impression of guilt.  Treating insurers as adversaries robs defendants of this type of valuable guidance.

How Can We Achieve Greater Insurer Involvement?

D&O insurers should set aside their preconceived notions about what the insureds really care about and want.  Insurers need to appreciate that their insureds often welcome their expertise and experience – especially at smaller public companies that have less familiarity with securities class actions, and a more pressing need to control their costs.  Not only is there an opportunity for greater involvement within the current D&O insurance product, but there is a market for new terms and products that allow greater insurer involvement, with corresponding premium or coverage advantages to the insureds.

Many insurers correctly address their claim-handling capabilities as part of the underwriting process.  As part of this discussion, insurers should set the expectation that the insureds will consult with the insurer about the defense-counsel selection process before the defendants select counsel.  Insurers have a unique perspective on the pros and cons of particular defense counsel, since they know the capabilities and economics of the relatively small bar of securities class action defense counsel very well.  They can help the insureds identify several defense firms that would be a good match for the substantive characteristics of the case.  For example, they might know that a particular firm has helpful experience in cases involving a particular industry or type of allegation, or has a good or bad track record with the assigned judge.  Insurers can also help match the economics of the litigation with particular firms.  They would know whether or not a particular firm is able to effectively defend a case within the limits of the D&O insurance, and conversely, they would know whether a firm has enough resources to effectively handle a large claim.

Although I am not an insurance lawyer, I believe this type of discussion is perfectly appropriate within the terms of existing insurance contracts.  But if there is any doubt, existing policy forms could be tweaked to explicitly include greater insurer involvement.  For example, the insurance contract could require the insureds to consult with the insurer about the defense-counsel process before engaging defense counsel, such as with a provision similar to the explicit requirement in D&O policies that insureds speak with the insurer before engaging in any settlement discussions.

Last, but certainly not least, I strongly believe that a public company duty-to-defend product for a “Securities Claim” would be highly attractive to many public companies, especially smaller companies.  Many companies would gladly pay somewhat less for their D&O insurance in exchange for giving insurers somewhat greater control, as long as they know that they will be defended well.  Such a policy would eliminate the risk that clients will have to make up for insurance short-pays, as they are often asked to do under indemnity insurance, while allowing the insurers to manage defense costs to help ensure that the policy proceeds will adequately cover the cost of defending and settling the litigation, and will not be needlessly expended.  As the cost of securities class action defense continues to skyrocket, even as the size of the typical securities case continues to decline, it is time for the D&O insurance industry to consider introducing a product that will provide excellent coverage at a fair price that is affordable to smaller companies.

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.

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

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

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

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

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

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

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

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

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

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

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

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

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.


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.

For most readers of this blog, it is now old news that securities class action filings were down in 2012, especially in the second half of the year – this was extensively discussed and examined over the last several weeks by Kevin LaCroix in his blog, The D&O Diary, by Cornerstone Research, and by Law360 and newspapers across the country.  These reports followed NERA’s December publication of data that showed a smaller decrease in filings.

I’ve received many questions about what it means. I don’t pretend to have all the answers.

But there is one thing I am certain of:  it does not mean that plaintiffs’ lawyers plan to stop focusing on securities class action litigation. I say that for one main reason:  there is a group of national, highly specialized plaintiffs’ lawyers whose practices are devoted to securities class actions.  Since the passage of the Private Securities Litigation Reform Act of 1995, these lawyers and their firms have devoted enormous resources to courting institutional investors to serve as lead plaintiffs and developing systems for evaluating cases and deciding which companies to sue.

These lawyers aren’t suddenly going to become intellectual property attorneys, or go into privacy law – and they are going to continue to put the resources they have invested in to good use. So, as long as these attorneys still practice law and Congress does not abolish this type of litigation, securities class actions will continue.  Companies will continue to have stock drops, and plaintiffs’ attorneys will continue to find ways to profit from them.

Plaintiffs’ lawyers would put it in less crass terms, of course. For example, Gerald Silk of Bernstein Litowitz, in a Law360 article by Max Stendahl, put it this way:

“It’s important to read this report for what it is: a snapshot in time of class litigation,” Silk said. “Our firm focuses on recommending to institutional clients highly meritorious securities litigation. As far as we’re concerned, we haven’t seen a trend one way or the other in that regard.”

Though securities class actions will continue, the type of actions filed will undoubtedly vary – just as they have for well over a decade – as plaintiffs’ attorneys encounter new obstacles, and find new opportunities.  In other words, plaintiffs’ attorneys adapt to survive. The best example of this evolution is their response to the Reform Act, which put in place many provisions to protect companies from securities class actions.  Many said that the securities class action was dead.

But the plaintiffs’ bar adjusted and found a way to work within the new system.  For example, they started to file securities class actions in state court, until Congress largely put an end to that through the Securities Litigation Uniform Standards Act.  They also began to use the ubiquitous “confidential witness,” obtaining internal company information from former employees, as a way to meet the Reform Act’s heightened pleading standards despite the mandatory stay of discovery during the motion-to-dismiss process.  And they developed new techniques to land the biggest fish as their clients, to meet the Reform Act’s standard to serve as the lead plaintiffs’ counsel.

In addition to adjusting to changes in the standards governing these actions, plaintiffs’ attorneys have also shown agility in responding to economic developments and public disclosure of potentially fraudulent practices.  As a result, a number of litigation trends have come and gone:

  • the IPO laddering cases, which involved more than 300 issuers and their underwriters;
  • the Sarbanes-Oxley era “corporate scandal” cases, which involved massive litigation against Enron, WorldCom, Tyco, Adelphia, HealthSouth, and others;
  • the mutual fund market timing cases;
  • the options backdating cases, most of which were actually derivative cases, but many plaintiffs’ firms devoted class action resources to them; and
  • the credit crisis cases, on which many plaintiffs’ firms are still spending much of their time.

In fact, you could say that the out-of-the-ordinary type of securities case has become ordinary:  we have been in the midst of one wave or another of them for the past 15 years.

Yet even as they ride out these litigation waves, plaintiffs’ firms have also continued to file plenty of plain vanilla stock drop cases – and they still dependably file them when there are very large declines and/or particularly bad facts.  Some years they file more, some years they file less – and much of this difference seems to be due only to the amount of resources the plaintiffs’ bar is expending on whatever securities litigation wave they are riding at the time.  But at the same time, there is no sign that their more standard fare is on its way out.  Indeed, excluding credit crisis and merger cases, both NERA and Cornerstone’s research shows that securities class action filings actually were down only slightly in 2012, and were up in both 2011 and 2012 compared to 2008-2010.

A final thought.  The prevailing wisdom is that the increase in reflexive shareholder suits following mergers has diverted plaintiffs’ resources from securities class action filings.  I believe there is little or no relationship between the two metrics.  The reason, again, concerns in part the identity of the plaintiffs’ lawyers: the plaintiffs’ lawyers who have driven the high volume of merger and acquisition cases are largely distinct from the specialized lawyers who drive the filing of securities class actions.

I have heard various other theories about why the number of filings was down last year, and some of them are persuasive.  But what I am sure of is that this is not the beginning of the end.