Securities Class Action

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Earlier this month, I spent a week in the birthplace of D&O insurance, London.  In addition to moderating a panel at Advisen’s European Executive Risks Insights Conference, I met with many energetic and talented D&O insurance professionals, both veterans and rising stars, to discuss U.S. securities litigation and regulatory risks.  Themes emerged on some key issues.  What follows is a collection of my impressions and opinions about three of them—not quotes from any particular company or person.

1.  Greater frequency of securities class actions against smaller public companies gives D&O insurers an opportunity to innovate.

As I’ve observed over the past several years, a significant 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 in recent years, 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 shrunken in size to a level last seen in 1997.

Yet at the same time, the litigation costs of the typical defense firms (mainly firms with marquee names) have increased exponentially.  This two-decade mismatch—between 1997 securities-litigation economics and present-day 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, in my view, inadequate policy proceeds due to skyrocketing defense costs is the biggest risk directors and officers face from securities litigation—by far.

D&O insurers face a double-whammy: They are paying defense costs on smaller claims that are out of proportion to the actual risk because the lion’s share of cases against all companies, both large and small, are defended by the typical defense firms.  At the same time, insurers are unable to charge a sufficient premium for this risk, due to the softness of the market.

I strongly believe the solution lies in a more tailored D&O insurance option for smaller public companies.  Today, every public company buys some form of D&O indemnity insurance, which allows the company to choose their own lawyers and control their defense strategy.  Under this approach, securities litigation defense lawyers effectively control the D&O insurance claims process; even the most veteran in-house lawyers are almost always securities litigation rookies.  Is that in the insureds’ interest?  Is the one-size-fits-all D&O insurance model right for smaller public companies, whose insurance proceeds are being disproportionately being spent on defense costs?  Is there demand for an optional product that gives insurers greater control, up to and including an optional duty to defend D&O product for smaller companies?

London insurers and brokers are working through these issues. I’m extremely hopeful that there will be innovation for smaller public companies and their directors and officers—insureds who most need the guidance and protection of their insurance professionals.

2.  In the wake of Morrison, greater strategic control is needed to deal with the risk of separate actions around the world.

In Morrison v. National Australia Bank, 561 U.S. 247 (2010), the U.S. Supreme Court held that the U.S. securities laws only apply to “transactions in securities listed on domestic exchanges, and domestic transactions in other securities.”  In the aftermath of the decision, it was widely assumed that the frequency of U.S. securities class actions against foreign issuers would decline.  Yet it has not.  For more background, I refer you to Kevin LaCroix’s September 26, 2016 post in his blog, The D&O Diary.

Despite Morrison, foreign issuers whose securities are traded in the U.S. are still subject to a securities class action with respect to those securities.  To add insult to injury, plaintiffs’ lawyers are also bringing separate actions around the world to recover for losses suffered from securities purchased outside of the U.S.  The result is vastly more expensive claim resolution due to multiple actions around the world, with many lawyers madly working in each jurisdiction, and a greater practical settlement value due to the “let’s just get this over with” dynamic—but with uncertainty about the ability to obtain a worldwide release.  So insurers now face a world in which claims are more severe, and in which the anticipated decline in the number of claims has not materialized.

London insurers and brokers are grappling with how to bring some order to this chaos.  I don’t see an easy fix.  As long as U.S. courts can’t accommodate all claims, worldwide litigation can’t be “won”—it can only be managed and settled as efficiently as possible.  This requires strong strategic control of the overall litigation, both to orchestrate settlements in the most efficient fashion and to avoid lawyers in every jurisdiction doing duplicative and unproductive legal work.

Critically, strong strategic control must be imposed by an independent lawyer—someone who would obviously be paid for his or her time, but who otherwise has no financial interest in the worldwide work.  Independence would give the strategic lawyer freedom from law-firm economics when making decisions about which lawyers should be doing what—and which lawyers should be doing nothing—as well as about when to settle.  In other words, if Dewey Cheatham & Howe is worldwide defense counsel, with multiple offices and dozens of lawyers working on the case, the strategic leader should not be a Dewey Cheatham & Howe lawyer.

But who would play such a role?  Although many companies of course have excellent in-house lawyers, very few have in-house lawyers who formerly were prominent securities litigators.  So should the strategic quarterback be a securities litigator from a firm other than the worldwide defense firm?  Should it be the broker?  Should it be a lawyer for the primary or a low excess carrier?  These are all good possibilities.  And how can this arrangement be put in place before the litigation defense is already beyond control?  Having the discussion is an important first step, and London insurers and brokers are working hard to figure this out.

3.  The danger of a wave of D&O claims relating to cyber security remains real.

One of the foremost uncertainties in securities and corporate governance litigation is the extent to which cyber security will become a significant D&O liability issue.  Although many practitioners and D&O insurers and brokers have been bracing for a wave of cyber security D&O matters, to date there has been only a trickle.  Yet among D&O insurers and brokers in London and elsewhere, there remains a concern that a wave is coming.

I share that concern.  To date, plaintiffs generally haven’t filed cyber security securities class actions because stock prices have not significantly dropped when companies have disclosed breaches.  That is bound to change as the market begins to distinguish companies on the basis of cyber security.  There have been a number of shareholder derivative actions asserting that boards failed to properly oversee their companies’ cyber security.  Those actions will continue, and likely increase, whether or not plaintiffs file cyber security securities class actions, but they will increase exponentially if securities class action filings pick up.

I also worry about SEC enforcement actions concerning cyber security.  The SEC has been struggling to refine its guidance to companies on cyber security disclosure, trying to balance the concern of disclosing too much and thus providing hackers with a roadmap, with the need to disclose enough to allow investors to evaluate companies’ cyber security risk.  But directors and officers should not assume that the SEC will announce new guidance or issue new rules before it begins new enforcement activity in this area.  All it takes to trigger an investigation of a particular company is some information that the company’s disclosures were rendered false or misleading by inadequate cyber security.  And all it takes to trigger broader enforcement activity is a perception that companies are not taking cyber security disclosure seriously.  As in all areas of legal compliance, companies need to be concerned about whistleblowers, including overworked and underpaid IT personnel, lured by the SEC’s whistleblower bounty program, and about auditors, who will soon be asking more frequent and difficult questions about cyber security.

In addition to an increase in frequency, I worry about severity because of the notorious statistics concerning a lack of attention by companies and boards to cyber security oversight and disclosure.  Indeed, the shareholder litigation may well be ugly:  The more directors and officers are on notice about the severity of cyber security problems, and the less action they take while on notice, the easier it will be for plaintiffs to prove their claims.

Cyber security has improved, albeit not enough, in part because of the thought leadership and product development by insurers and brokers. So even if there is never a wave of D&O cyber security matters, the excellent work by insurers and brokers in London and around the world will have been worthwhile.

The Roots of D&O Insurance

London insurers and brokers are also focused on finding the right coverages for entities and individuals in the Yates-memo regulatory environment.  This of course can create tension between entities, who would like their investigations costs covered, and individuals, for whom D&O insurance was created.

I am a D&O insurance fundamentalist—director and officer protection should always be our North Star.  But a company can find the right path to protection of both individuals and the company with good communication between and among the company, its directors and officers, broker, and insurers—both at policy inception and when a claim arises.

It was a privilege to discuss this fundamental D&O insurance question, and many others, with thoughtful D&O insurance professionals who work just down the street from Edward Lloyd’s coffee house.

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.

Conclusion

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.

In this installment of the D&O Discourse series “5 Wishes for Securities Litigation Defense,” we discuss the third of five changes that would significantly improve securities litigation defense:  to make the Supreme Court’s Omnicare decision a primary tool in the defense of securities class actions.

As a reminder, in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318 (2015), the U.S. Supreme Court 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 we 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.

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 also other statements made by the company, and other publicly available information, including the customs and practices of the relevant industry.

Omnicare governs the falsity analysis for all types of challenged statements.  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.  Evaluating challenged statements in their broader context almost always benefits defendants, because it helps the court better understand the challenged statements and makes them seem fairer than they might in isolation. Omnicare now explicitly requires courts to evaluate challenged statements—both statements of fact and statements of opinion—within their broader contexts.

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.  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.

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.   

Yet Omnicare will fail to achieve its full potential unless defense lawyers understand and use the decision correctly.  Following the Omnicare decision, many defense lawyers commented publicly that Omnicare expanded the basis for defendants’ liability, and was otherwise plaintiff-friendly.  That is simply wrong.  We have published several articles that address these misunderstandings, explain how defense counsel should use the decision, and analyze how lower courts are applying it.  The early returns show that Omnicare is already helping defendants win more motions to dismiss.

Here is a link to our most recent article, Omnicare, Inc. One Year Later: Its Salutary Impact on Securities-Fraud Class Actions in the Lower Federal Courts,  Critical Legal Issues Working Paper Series, Washington Legal Foundation (No. 195, June 2016).

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

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

The coming year promises to be a pivotal one in the world of securities and corporate governance litigation.  In particular, there are five developing issues we are watching that have the greatest potential to significantly increase or decrease the exposure of public companies and their directors, officers, and insurers.

1.  How Will Lower Courts Apply the Supreme Court’s Decision in Omnicare, Inc. v. Laborers Dist. Council Const. Industry Pension Fund?

If it is correctly understood and applied by defendants and the courts, we believe Omnicare will stand alongside Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), as one of the two most important securities litigation decisions since the Private Securities Litigation Reform Act of 1995.

In Omnicare, 135 S. Ct. 1318 (2015), the Supreme Court held that a statement of opinion is only false if the speaker does not genuinely believe it, and that it is only misleading if – as with any other statement – it omits facts that make it misleading when viewed in its full context.  The Court’s ruling on what is necessary for an opinion to be false establishes a uniform standard that resolves two decades of confusing and conflicting case law, which often resulted in meritless securities cases surviving dismissal motions.  And the Court’s ruling regarding how an opinion may be misleading emphasizes that courts must evaluate the fairness of challenged statements (both opinions and other statements) within a broad factual context, eliminating the short-shrift that many courts have given the misleading-statement analysis.

These are tremendous improvements in the law, and should help defendants win more cases involving statements of opinion, not only under Section 11, the statute at issue in Omnicare, but also under Section 10(b), since Omnicare’s holding applies to the “false or misleading statement” element common to both statutes.  The standards the Court set should also add to the Reform Act’s Safe Harbor, and expand the tools that defendants have to defend against challenges to earnings forecasts and other forward-looking statements, which are quintessential opinions.

Indeed, if used correctly, Omnicare should also help defendants gain dismissal of claims brought based on challenged statements of fact, because of its emphasis on the importance of considering the entire context of a statement when determining whether it was misleading.   For example, the Court emphasized that whether a statement is misleading “always depends on context,” so a statement must be understood in its “broader frame,” including “in light of all its surrounding text, including hedges, disclaimers, and apparently conflicting information,” and 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 was not misleading.  But many defense lawyers unfortunately choose to leave out this broader context, and as a result of this narrow record, courts sometimes take a narrower view.  With Omnicare, this superior method of analysis is now explicitly required.  This will be a powerful tool, especially when combined with Tellabs’s directive that courts must weigh 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.

Omnicare bolsters the array of weapons available to defendants to effectively defend allegations of falsity, and to set up and support the Safe Harbor defense and arguments against scienter.  Because of its importance, we plan to write a piece critiquing the cases applying Omnicare after its one-year anniversary in March.

2.  Will Courts Continue to Curtail the Use of 10b5-1 Plans as a Way to Undermine Scienter Allegations?

All successful securities fraud complaints must persuade the court that the difference between the challenged statements and the “corrective” disclosure was the result of fraud, and not due to a business reversal or some other non-fraudulent cause.  Because few securities class action complaints contain direct evidence of fraud, such as specific information that a speaker knew his statements were false, most successful complaints include allegations that the defendants somehow profited from the alleged fraud, such as through unusual and suspicious stock sales.

Thus, stock-sale allegations are a key battleground in most securities actions.  An important defensive tactic has been to point out that the challenged stock sales were made under stock-sale plans under SEC Rule 10b5-1, which provides an affirmative defense to insider-trading claims, if the plan was established in good faith at a time when they were unaware of material non-public information.  Although Rule 10b5-1 is designed to be an affirmative defense in insider-trading cases, securities class action defendants also use it to undermine stock-sale allegations, if the plan has been publicly disclosed and thus subject to judicial notice, since it shows that the defendant did not have control over the allegedly unusual and suspicious stock sales.

Plaintiffs’ argument in response to a 10b5-1 plan defense has always been that any plan adopted during the class period is just a large insider sale designed to take advantage of the artificial inflation in the stock price.  Plaintiffs claim that by definition, the class period is a time during which the defendants had material nonpublic information – although they often manipulate the class period in order to encompass stock sales and the establishment of 10b5-1 plans.

There have been surprisingly few key court decisions on this pivotal issue, but on July 24, 2015, the Second Circuit held that “[w]hen executives enter into a trading plan during the Class Period and the Complaint sufficiently alleges that the purpose of the plan was to take advantage of an inflated stock price, the plan provides no defense to scienter allegations.” Employees’ Ret. Sys. of Gov’t of the Virgin Island v. Blanford, 794 F.3d 297, 309 (2d Cir. 2015).

Plaintiffs’ ability to plead scienter will take a huge step forward if Blanford, decided by an important appellate court, starts a wave of similar holdings in other circuits.

3.  Will Delaware’s Endorsement of Forum Selection Bylaws and Rejection of Disclosure-Only Settlements Reduce Shareholder Challenges to Mergers?

For the past several years, there has been great focus on amending corporate bylaws to try to corral and curtail shareholder corporate-governance claims, principally shareholder challenges to mergers.  Meritless merger litigation is indeed a big problem.  It is a slap in the face to careful directors who have worked hard to understand and approve a merger, and to CEOs who have worked long hours to find and negotiate a transaction that is in the shareholders’ best interests.  It is cold comfort to know that nearly all mergers draw shareholder litigation, and that nearly all of those cases will settle before the transaction closes without any payment by the directors or officers personally.  It is proof that the system is broken when it routinely allows meritless suits to result in significant recoveries for plaintiffs’ lawyers, with virtually nothing gained by companies or their shareholders.

In 2015, the Delaware legislature and courts took significant steps to curb meritless merger litigation.

First, the legislature added new Section 115 to the Delaware General Corporation Law (“DGCL”), which provides:

The certificate of incorporation or the bylaws may require, consistent with applicable jurisdictional requirements, that any or all internal corporate claims shall be brought solely and exclusively in any or all of the courts in this State.

This provision essentially codified the holding in Boilermakers Local 154 Ret. Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013), in which the Delaware Court of Chancery upheld the validity of bylaws requiring that corporate governance litigation be brought only in Delaware state and federal courts.  The Delaware legislature also amended the DGCL to ban bylaws that purport to shift fees.  In new subsection (f) to Section 102, the certificate of incorporation “may not contain any provision that would impose liability on a stockholder for the attorneys’ fees or expenses of the corporation or any other party in connection with an internal corporate claim.” See also DGCL Section 109(b) (similar).

Second, in a series of decisions in 2015, the Delaware Court of Chancery rejected or criticized so-called disclosure-only settlements, under which the target company supplements its proxy-statement disclosures in exchange for a payment to the plaintiffs’ lawyers.  See Acevedo v. Aeroflex Holding Corp., et al., C.A. No. 7930-VCL (Del. Ch. July 8, 2015) (TRANSCRIPT) (rejecting disclosure-only settlement); In re Aruba Networks S’holder Litig., C.A. No. 10765-VCL (Del. Ch. Oct. 9, 2015) (TRANSCRIPT) (same); In re Riverbed Tech., Inc., S’holder Litig., 2015 WL 5458041, C.A. No. 10484-VCG (Del. Ch. Sept. 17, 2015) (approving disclosure-only settlement with broad release, but suggesting that approval of such settlements “will be diminished or eliminated going forward”); In re Intermune, Inc., S’holder Litig., C.A. No. 10086–VCN (Del. Ch. July 8, 2015) (TRANSCRIPT) (noting concern regarding global release in disclosure-only settlement).

We will be closely watching the impact of these developments, with the hope that they will deter plaintiffs from reflexively filing meritless merger cases.  Delaware exclusive-forum bylaws will force plaintiffs to face the scrutiny of Delaware courts, and the Court of Chancery has indicated that it may no longer allow an easy exit from these cases through a disclosure-only settlement.  And with cases in a single forum, defendants will now be able to coordinate them for early motions to dismiss.  Thus, the number of mergers subject to a shareholder lawsuit should decline – and the early returns suggest that this may already be happening.

Yet defendants should brace for negative consequences.  Plaintiffs’ lawyers will doubtless bring more cases outside of Delaware against non-Delaware corporations, or against companies that haven’t adopted a Delaware exclusive-forum bylaw.  And within Delaware, plaintiffs’ lawyers will tend to bring more meritorious cases that present greater risk, exposure, and stigma – and while Delaware is a defendant-friendly forum for good transactions, it is a decidedly unfriendly one for bad ones.  If disclosure-only settlements are no longer allowed, defendants will no longer have the option of escaping these cases easily and cheaply.  This means that those cases that are filed will doubtless require more expensive litigation, and result in more significant settlements and judgments.  Thus, although the current system is undoubtedly badly flawed, many companies may well look back on the days of this broken system with nostalgia, and conclude that they were better off before it was “fixed.”

4.  Will Item 303 Claims Make a Difference in Securities Class Actions?

The key liability provisions of the federal securities laws, Section 10(b) of the Securities Exchange Act of 1934 and Section 11 of the Securities Act of 1933, both require that plaintiffs establish a false statement, or a statement that is rendered misleading by the omission of facts.  Over the last several years, plaintiffs’ lawyers have increasingly tried to bypass this element by asserting claims for pure omissions, detached from any challenged statement.

Plaintiffs base these claims on Item 303 of SEC Regulation S-K, which requires companies to provide a “management’s discussion and analysis” (MD&A) of the company’s “financial condition, changes in financial condition and results of operations.”  Item 303(a)(3)(ii) indicates that the MD&A must include a description of “any known trends or uncertainties that have had or that the [company] reasonably expects will have a material … unfavorable impact on net sales or revenues or income from continuing operations.”

Both Section 10(b) and Section 11 prohibit a false statement or omission of a fact that causes a statement to be misleading, while Section 11 also allows a claim based on an issuer’s failure to disclose “a material fact required to be stated” in a registration statement. 15 U.S.C. § 77k(a) (emphasis added).  Item 303 is one regulation that lists such “material fact(s) required to be stated.”  Panther Partners Inc. v. Ikanos Communications, Inc., 681 F.3d 114, 120 (2d Cir. 2012).  Based on this unique statutory language, Section 11 claims thus appropriately can include claims based on Item 303.

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

Claims based on Item 303 seem innocuous enough, and even against plaintiffs’ interest. Plaintiffs face a high hurdle in showing that information was wrongfully excluded under Item 303, since they must show that a company actually knew:  (1) the facts underlying the trend or uncertainty, (2) those known facts yield a trend or uncertainty, and (3) the trend or uncertainty will have a negative and material impact.  In virtually all cases, these sorts of omitted facts would also render one or more of defendants’ affirmative statements misleading, and thus be subject to challenge regardless.  Moreover, in Section 11 cases, Item 303 injects knowledge and causation requirements in a statute that normally doesn’t require scienter and only includes causation as an affirmative defense.

Why, then, have plaintiffs’ counsel pushed Item 303 claims so hard?  We believe they’ve done so to combat the cardinal rule that silence, absent a duty to disclose, is not misleading.  Companies omit thousands of facts every time they speak, and it is relatively easy for a plaintiff to identify omitted facts – but much more difficult to explain how those omissions rendered an affirmative statement misleading.  Plaintiffs likely initially saw these claims as a way to maintain class actions in the event the Supreme Court overruled Basic v. Levinson as a result of attacks in the Amgen and Halliburton cases.  And even though the Supreme Court declined to overrule Basic in Halliburton II, the Court’s price-impact rule presents problems for plaintiffs in some cases.  As a result, plaintiffs may believe it is in their strategic interests to assert Item 303 claims, which plaintiffs have contended fall under the Affiliated Ute presumption of reliance, rather than under Basic.

But whatever plaintiffs’ rationale, Item 303 is largely a red herring.  Although it shouldn’t matter to securities litigation, it will matter, as long as plaintiffs continue to bring such claims.  And they probably will continue to bring them, given the current strategic considerations, and the legal footing they have been given by key appellate rulings in Panther Partners and Stratte-McClure.  Defense attorneys will have to pay close attention to these trends and mount sophisticated defenses to these claims, to ensure that Item 303 claims do not take on a life of their own.

5.  Cyber Security Securities and Derivative Litigation: Will There Be a Wave or Trickle?

One of the foremost uncertainties in securities and corporate governance litigation is the extent to which cyber security will become a significant D&O liability issue.  Although many practitioners have been bracing for a wave of cyber security D&O matters, to date there has been only a trickle.

We remain convinced that a wave is coming, perhaps a tidal wave, and that it will include not just derivative litigation, but securities class actions and SEC enforcement matters as well.  To date, plaintiffs generally haven’t filed cyber security securities class actions because stock prices have not significantly dropped when companies have disclosed breaches.  That is bound to change as the market begins to distinguish companies on the basis of cyber security.  There have been a number of shareholder derivative actions asserting that boards failed to properly oversee their companies’ cyber security.  Those actions will continue, and likely increase, whether or not plaintiffs file cyber security securities class actions, but they will increase exponentially if securities class action filings pick up.

While the frequency of cyber security shareholder litigation will inevitably increase, we are more worried about its severity, because of the notorious statistics concerning a lack of attention by companies and boards to cyber security oversight and disclosure.  Indeed, the shareholder litigation may well be ugly:  The more directors and officers are on notice about the severity of cyber security problems, and the less action they take while on notice, the easier it will be for plaintiffs to prove their claims.

We also worry about SEC enforcement actions concerning cyber security.  The SEC has been struggling to refine its guidance to companies on cyber security disclosure, trying to balance the concern of disclosing too much and thus providing hackers with a roadmap, with the need to disclose enough to allow investors to evaluate companies’ cyber security risk.  But directors and officers should not assume that the SEC will announce new guidance or issue new rules before it begins new enforcement activity in this area.  All it takes to trigger an investigation of a particular company is some information that the company’s disclosures were rendered false or misleading by inadequate cyber security.  And all it takes to trigger broader enforcement activity is a perception that companies are not taking cyber security disclosure seriously.  As in all areas of legal compliance, companies need to be concerned about whistleblowers, including overworked and underpaid IT personnel, lured by the SEC’s whistleblower bounty program, and about auditors, who will soon be asking more frequent and difficult questions about cyber security.

Conclusion

Of course, there are a number of other important issues that deserve to be on watch lists.  But given the line we’ve drawn – issues that will cause the most volatility in securities litigation liability exposure – we regard the issues we’ve discussed as the top five.

And the top one – whether lower courts will properly apply Omnicare – is a rare game-changer.  If defense counsel understands and uses Omnicare correctly, and if lower courts apply it as the Supreme Court intended, securities litigation decisions will be based on reality, and therefore far fairer and more just.  But if either defense counsel or lower courts get it wrong, companies and their directors and officers will suffer outcomes that are less predictable, more arbitrary, and often wrong.

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

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

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

Grading the Reform Act’s Key Provisions

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

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

Following are my grades for each of these provisions:

Falsity Pleading Standard – Grade: D

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

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

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

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

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

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

Scienter Pleading Standard – Grade: C

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

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

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

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

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

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

Safe Harbor – Grade: D

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

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

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

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

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

So, I give the Safe Harbor a D.

Lead Plaintiff Procedures – Grade C

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

The lead plaintiff procedures were also designed to prevent lawyer-driven litigation, by providing that the lead plaintiff is presumptively the plaintiff with the largest financial loss – i.e., a plaintiff with “skin in the game.”  While that goal is salutary, it has spawned complex and mixed results.  The Reform Act’s lead plaintiff process incentivized plaintiffs’ firms to recruit institutional investors to serve as plaintiffs.  For the most part, institutional investors, whether smaller unions or large funds, retained the more prominent plaintiffs’ firms, and smaller plaintiffs’ firms were left with individual investor clients who usually can’t beat out institutions for the lead plaintiff role.  At the same time, securities class action economics tightened in all but the largest cases.  Dismissal rates under the Reform Act are pretty high, and defeating a motion to dismiss often requires significant investigative costs and intensive legal work.  And the median settlement amount of cases that survive dismissal motions is fairly low.  These dynamics placed a premium on experience, efficiency, and scale.  Larger firms filed the lion’s share of the cases, and smaller plaintiffs’ firms were unable to compete effectively for the lead plaintiff role, or make much money on their litigation investments.

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

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

To be sure, the larger firms still mostly can and will beat out the smaller firms for the cases they want.  But it increasingly seems clear that the larger firms don’t want to take the lead in initiating many of the cases against smaller companies, and are content to focus on larger cases on behalf of their institutional investor clients.  The result is now two classes of plaintiffs and plaintiffs’ firms:  larger firms with institutional investor clients, as Congress intended, and smaller plaintiffs’ firms with smaller individual clients, which Congress sought to displace.   In a sense, we’re back to where we started, but now with more aggressive institutional investors to boot.

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

Discovery Stay – Grade: A

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

Conclusion:  The Reform Act’s Overall Grade

Grade: C+

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

 

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

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.