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 fifth of my “5 Wishes for Securities Litigation Defense” (April 30, 2016 post) is to move securities class action damages expert reports and discovery ahead of fact discovery.  This simple change would allow the defendants and their D&O insurers to understand the real economics of cases that survive a motion to dismiss, and allow the parties to make more informed litigation and settlement decisions.

Securities class actions are often labeled “bet the company” cases because they assert large theoretical damages and name the company’s senior management and sometimes the board as defendants.  In reality, however, very few securities class actions pose a real threat to the company or its directors and officers.  Most securities class actions follow a predictable course of litigation and resolution.  Nearly all cases settle before trial.  And, with the help of economists, experienced defense lawyers and D&O insurance professionals can predict with reasonable accuracy the settlement “value” of a case based on historical settlement information and their judgment.

Historically, settlement amounts were driven by an accurate understanding of the merits of the litigation and damages exposure.  Cases that weren’t dismissed on a motion to dismiss were often defended through at least the filing of a summary judgment motion and the completion of damages discovery.  This kind of vigorous defense is no longer economically rational in the lion’s share of cases, because of the high billing rates and profit-focused staffing of the typical defense firms—primarily firms with marquee names.  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 fact and expert discovery and summary judgment anymore.

The reality of these economics is increasingly leading to mediations and settlements very early in the litigation, if a case isn’t dismissed.  But, though rational, this comes at a high price.  Early settlements are, by definition, less informed than later settlements.  Plaintiffs’ lawyers must push for a higher settlement payment to compensate for the risk that they are settling a meritorious case for too little, and to increase the baseline for a smaller percentage fee due to a lower lodestar.  Defendants and their insurers tend to be willing to overpay because they are saving on defense costs by not litigating further, and because there may be some downward pressure on the settlement amount since the plaintiffs’ lawyers will be doing less work too.

Damages considerations also loom large.  At an early mediation, before damages expert discovery, the parties typically come to the mediation only with a preliminary damages estimate that neither side has thoroughly analyzed, much less tested through intensive work with the experts and expert discovery.  Rigorous expert work often significantly reduces realistic damages exposure.  For example, stock drops that lead to a securities class action are often the result of multiple negative news items.  A rigorous damages analysis parses each item from the total stock drop to isolate the portion caused by the revelation of the allegedly hidden truth that made the challenged statements false or misleading.  A defense firm that is motivated to settle the litigation sometimes does not want to do this work, so that it can use the large bet-the-company damages figure to pressure the insurer into settling for an amount that the plaintiffs will take.  A defense lawyer might say, “Our economist says that damages are $1 billion, so the $30 million the plaintiffs are demanding is a reasonable settlement.”  But expert analysis and discovery may well push the $1 billion number down to a much lower number, which in turn would dramatically reduce a reasonable settlement amount.  Worsening this problem is the increasing unwillingness of mediators and plaintiffs’ lawyers to base settlement amounts on historical data—which places the preliminary damages analysis at the center of the negotiations.

This problem leads to my fifth wish: expert damages analysis and discovery should be the first thing we do after a motion to dismiss is denied.  This will help us know if the case is really a big case, or is a small case that just seems big.  Everyone would benefit.  Plaintiffs and defendants would be able to reach a settlement more easily, based on true risk and reward.  Insurers would know that they are funding a settlement that reflects the real risk, in terms of damages exposure.  And courts would feel more comfortable that they are approving (or rejecting) settlements based on a litigated assessment of damages.  Indeed, placing damages expert work first would help serve the core policy of our system of litigation: “to secure the just, speedy, and inexpensive determination of every action and proceeding.”  Federal Rule of Civil Procedure 1.

Although the logic of my wish would lead to full fact discovery before mediation as well, so that settlements can be fully informed, I favor a continued stay of fact discovery during early expert discovery.  Early expert discovery can be accomplished relatively quickly and efficiently, whereas fact discovery can be immediately and wildly expensive—which is primarily what drives very early settlements.  And although plaintiffs and defendants often disagree about the relevance of fact discovery on damages, the absence of fact discovery for consideration in damages analysis is a factor the parties can weigh in evaluating the damages experts’ opinions.  Unless and until the cost of discovery becomes more manageable, continuing the fact-discovery stay while expert damages discovery proceeds would strike the right balance.

Accelerating the timing of damages expert discovery would align it with the work required by damages experts to analyze price-impact issues under the Supreme Court’s 2014 decision in Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014) (“Halliburton II“).  In Halliburton II, the Supreme Court held that defendants may seek to rebut the fraud-on-the-market presumption of reliance, and thus defeat class certification, through evidence that the alleged false and misleading statements did not impact the market price of the stock.   Unifying these two overlapping economic expert projects would create efficiencies for the lawyers and economists.  Completing both of them before fact discovery starts would avoid unnecessary discovery costs if the Halliburton II opposition defeated or limited class certification, or if the damages analysis facilitated early settlement.

I’m sure it is not lost on readers that I just argued for a fundamental reform in the procedure for securities class action litigation to fix a problem that is primarily caused by the inability of typical defense firms to efficiently and effectively defend a securities class action even through summary judgment.  To say the least, a system of litigation that can’t accommodate actual litigation is broken.  Significant change in securities litigation defense is inevitable.

I hope that this series has provoked thought and discussion about ways to re-focus our system of securities litigation defense on its mission: to help directors and officers through litigation safely and efficiently, without losing their serenity or dignity, and without facing any real risk of paying any personal funds.  Here, again, are my five wishes:

  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.  (5 Wishes for Securities Litigation Defense: A Defense-Counsel Interview Process in All Cases)
  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.  (5 Wishes for Securities Litigation Defense: Greater Insurer Involvement in Defense-Counsel Selection and Strategy)
  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.  (5 Wishes for Securities Litigation Defense: Effective Use of the Supreme Court’s Omnicare Decision)
  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 Wishes for Securities Litigation Defense: Greater Director Involvement in Securities Litigation Defense and D&O Insurance)
  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.

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 CourtsCritical Legal Issues Working Paper Series, Washington Legal Foundation (No. 195, June 2016).

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

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

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

Evolution of the Legal Issue

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

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

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

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

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

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

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

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

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

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

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

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

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

Item 303’s Lack of Practical Impact

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

There are several bits of D&O Discourse news to share:

1.  I hope that you can attend conferences at which I’m speaking this fall:

  • I am co-chairing ACI’s D&O Liability Forum in New York City on September 17-18, and moderating a panel discussing significant securities litigation developments.  Readers of D&O Discourse can receive a discount off the current price.  Please email me: greened@lanepowell.com.
  • I am co-chairing and speaking on a panel discussing board oversight of cybersecurity at a meeting of the National Association of Corporate Directors, Northwest Chapter, in Seattle on October 20, 2015.

2.  The ABA is accepting nominations for the list of the Top 100 Law Blogs.  If you are so inclined, I’d be grateful for your nomination of D&O Discourse. Nominations are due by the end of the day on August 16.  Here is the link to the nomination page.  Thank you.

3.  We continue to try to make D&O Discourse as useful as possible.  We now have three features:

  • The D&O Discourse blog itself:  In the blog, we provide opinion about key issues in the law and practice of securities and corporate governance litigation and SEC enforcement.  We write an opinion-based piece roughly monthly.
  • Twitter:  Because the D&O Discourse blog doesn’t attempt to chronicle current events, we started a Twitter feed to identify current developments that we think would be most important to our readers.  You can follow us by reading our Twitter feed on the left-hand side of the D&O Discourse blog, or on Twitter, @DandODiscourse.
  • LinkedIn:  We recently set up a special LinkedIn page, where we publish thoughts that are too long for Twitter but too short for a blog post.  Here is an example:

“In writing my 2014 year-in-review piece, it occurred to me that the judicial environment for securities and corporate governance litigation seems about as neutral as it has been in a long time. We’ve seen streaks of decisions that feel pro-plaintiff or pro-defendant, driven in part by judicial skepticism caused by the waves of corporate scandals since Enron and WorldCom. But over the past year or so, the decisions feel pretty even. The 2nd Circuit / 9th Circuit split over whether omission of matters covered by Item 303 of S-K can be actionable epitomizes the current judicial environment.”

Here is a link to our LinkedIn page.  Please click “Follow” to receive updates in your LinkedIn feed.

4.  In the upcoming issue of the PLUS Journal, my partner Claire Davis and I are publishing an article about the importance of the U.S. Supreme Court’s decision in Omnicare, based on one of our D&O Discourse blog posts.  As our readers know, Claire and I wrote an amicus brief that shaped the Supreme Court’s Omnicare opinion.

We hope you enjoy the rest of your summer.

If correctly understood and applied, the Supreme Court’s decision in Omnicare, Inc. v. Laborers Dist. Council Const. Industry Pension Fund, 135 S. Ct. 1318 (2015), will allow corporate officers to speak more freely, without fear of unfair liability.  And defendants will win more cases.

Yet I keep seeing commentary from defense lawyers saying that Omnicare expanded the basis for defendants’ liability.  That sort of statement is simply wrong, and fails to appreciate the muddled state of the pre-Omnicare standards for judging statements of opinion and the Omnicare standard itself.  Indeed, Omnicare – which applies to the “false or misleading statement” element of both Section 11 and Section 10(b) – will be the most helpful Supreme Court decision for defendants since Tellabs, if we in the defense bar use it right.

Pre-Omnicare Law Governing Statements of Opinion Was Muddled

To correctly understand Omnicare, it is critical to appreciate that the law on statements of opinion before Omnicare was a mess.  For a full discussion, I invite you to review pages 13-19 of our Omnicare amicus brief on behalf of Washington Legal Foundation.  Here, I’ll share what  I believe was going on in the cases, starting with the base case, the Supreme Court’s decision in Virginia Bankshares v. Sandberg, 501 U.S. 1083 (1991).

Virginia Bankshares held that an opinion may be actionable as a false statement of “fact,” to the extent to which it is a “misstatement of the psychological fact of the speaker’s belief in what he says.”  501 U.S. at 1095.  This makes sense.  If it’s raining and I say to someone from another city that the weather where I am is “nice,” my statement of opinion is true if I genuinely believe it.  It doesn’t matter if most other people wouldn’t think so.  But it also makes sense that my true opinion could be misleading to a reasonable person, since most people wouldn’t regard rainy weather as “nice.”  Virginia Bankshares only concerned the “falsity” of an opinion, and not the broader question of whether a “true” statement of opinion can omit facts that make the opinion misleading – just like any other type of true statement can be misleading.

Virginia Bankshares didn’t catch on.  I think there are two main reasons.  First, the decision is difficult to read and decipher.  Many doubted that the Supreme Court actually meant to create a subjective falsity standard, and many defendants and courts didn’t even cite the case when analyzing statements of opinion.  Second, the subjective falsity standard only covers the “false” half of the “false or misleading statement” element – the fact of the speaker’s state of mind.  Courts thus struggled to figure out how to harmonize Virginia Bankshares with the “misleading” half of the element, especially as defendants argued that a lack of subjective falsity alone defeated the entire claim.  I believe that these difficulties led courts to ignore or distinguish Virginia Bankshares, or to apply an alternative standard.

The most influential alternative standard was the disjunctive three-part test the Ninth Circuit established in In re Apple Computer Sec. Litig., 886 F.2d 1109 (9th Cir. 1989).  In Apple, the Ninth Circuit held that opinions are actionable if they (1) are not genuinely believed, (2) there is no reasonable basis for the belief, or (3) the speaker knows undisclosed facts that tend to seriously undermine the opinion.  Courts around the country followed the broad and plaintiff-friendly Apple standard to such an extent that it is fair to say it was the prevailing test for deciding whether an opinion was actionable.  Virginia Bankshares, if cited at all, was typically an afterthought.  Even after the Ninth Circuit first applied Virginia Bankshares in 2009, in Rubke v. Capitol Bancorp Ltd., 551 F.3d 1156 (9th Cir. 2009), it didn’t expressly overrule the incompatible Apple standard, and some courts, both inside and outside the Ninth Circuit, continued to refer to Apple.

Virginia Bankshares Recently Had Started to Catch On

Recently, in Fait v. Regions Fin. Corp., 655 F.3d 105 (2d Cir. 2011), the Second Circuit joined the Ninth Circuit in applying Virginia Bankshares.  Based on Fait and Rubke, and a few other circuit court decisions, defendants began to argue that an opinion can only be false or misleading if it was not actually believed by the speaker.  This, I think, is the source of the defense bar’s disappointment with Omnicare: they feel it is a step backward from the standard of law they hoped was developing – namely, one that makes a statement of opinion not actionable as long as the speaker genuinely believes it (i.e. is subjectively true), without considering whether it may nevertheless be misleading.

But whatever the merits of recent decisions, Virginia Bankshares concerns only “subjective falsity,” the first half of the “false or misleading statement” element.  In Omnicare, the Supreme Court prescribed the standards for analysis for both halves of the “false or misleading statement” element, which, of course, is legally required, because under Section 11 and Section 10(b), a true statement can be actionable if it is misleading.

Omnicare’s Second Prong is Simply the Misleading Half of “False or Misleading Statement” Element

Indeed, the “misleading” half of the “false or misleading statement” element was the real showdown in Omnicare.  At oral argument, it seemed inevitable that the Supreme Court would reject the plaintiffs’ argument that a genuinely believed opinion may nonetheless be considered “false” if it is later determined that the opinion was incorrect. But the Court also expressed discomfort with the potential loopholes that could be created by Omnicare’s position at the other extreme – that if a statement is phrased as an opinion, it cannot be found to be either false or misleading under the securities laws, as long as the opinion was honestly held by the speaker.

There were many wrong turns that the Court could have taken in rejecting these two extremes, running the risk of further confusing the law not only regarding the truth or falsity of opinions, but also muddling the law of scienter and materiality.  But the Court successfully navigated these potential pitfalls – including refusing to adopt the “reasonable basis” standard advocated by the Solicitor General – and instead adopted an analytically sound approach that is consistent with its previous securities rulings, holding that:

(1) a statement of opinion is only “false” under the securities laws if it is not genuinely believed by the speaker; and

(2) like any other kind of statement, a statement of opinion may be “misleading” if, when considered in context, it creates a false impression in the mind of a reasonable investor.

Omnicare thus simply stitches together (1) Virginia Bankshares’s subjective falsity standard and (2) the standard for “misleading” in the “false or misleading statement” element that has always applied to each and every type of challenged statement in each and every securities class action.  See, e.g., Brody v. Transitional Hosps. Corp., 280 F.3d 997, 1006 (9th Cir. 2002) (a statement is misleading due to omissions if it “affirmatively create[s] an impression of a state of affairs that differs in a material way from the one that actually exists”).

Although recent cases seemed to focus on subjective falsity, a rule of subjective falsity alone never could or would have been the law, because the misleading-statement half of the “false or misleading statement” is an integral part of the law of Section 10(b) and Section 11. Thus, the law on what can make a statement of opinion misleading inevitably would have developed in the courts, with or without Omnicare. For this simple reason, the view that Omnicare’s second prong is something new and plaintiff-friendly is wrong; it is simply the pre-existing “misleading” half of the “false or misleading statement” element.

The legal standard Omnicare established to evaluate misleading-statement allegations will greatly help defendants argue for dismissal of claims based on statements of both fact and opinion.  In evaluating what investors understood, the Court directed courts to consider the entire factual context in which defendants made the challenged statement.  In particular, the Court’s analysis emphasizes that whether a statement is misleading “always depends on context” and 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.”  135 S. Ct. at 1330.

A good motion to dismiss has always analyzed a challenged statement (fact or opinion) in its broader factual context to explain why it’s not misleading.  But many defense lawyers unfortunately leave out the broader context, and courts sometimes take a narrower view.  Now, this type of superior, full-context analysis is required by Omnicare.  And combined with Tellabs’s directive that courts consider scienter inferences based on 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, was made with scienter.  Plaintiffs can’t cherry-pick what the court considers anymore.

In the full context of the facts, Omnicare prescribes strict scrutiny of misleading-statement allegations, emphasizing the narrowness of its standard:  an opinion is not misleading just because “external facts show the opinion to be incorrect,” 135 S. Ct. at 1328, or if a company fails to disclose “some fact cutting the other way,” or if the company does not disclose that some disagree with its opinion.  Id. at 1329-30.  Rather, the Court seized upon the misleading-statement analysis that our amicus brief (alone among the parties and amici) had urged, finding that an opinion is misleading if it omits information that is necessary to avoid creating a false impression of the “real facts” in a reasonable investor, when the statement is taken as a whole and considered in its full context.  Unlike the “reasonable basis test” urged by the Solicitor General, the Court emphasized that this inquiry “is objective.”  Id. at 1327.  And the Court stressed that pleading a misleading opinion will be “no small task for an investor.”  Id. at 1332.

Thus, far from being plaintiff-friendly, Omnicare has expressly given the defense bar tools with which to make better arguments.  If the defense bar uses Omnicare correctly, the decision will have a profound impact on securities litigation defense and, most importantly, on the ability of directors and officers to speak their minds without fear of liability for doing so honestly.