It is time to re-think the one-size-fits-all model of securities litigation defense. Currently, securities cases against all companies – gigantic, tiny, and everything in between – are primarily defended by law firms with marquee names featuring sky-high billing rates and big budgets. That model is ill-fitting for many companies.

There are many reasons why companies hire firms with marquee names – some good, some bad. A bad reason is political cover – the board of directors won’t second-guess the legal department for choosing a well-known firm. A recent article titled, “Why Law Firm Pedigree May Be a Thing of the Past,” on the Harvard Business Review Blog Network (“HBR article”), discusses this phenomenon in colorful terms:

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

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

The article reports on two survey questions.

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

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

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

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

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

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

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

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

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

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

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

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

To be sure, there are excellent securities litigators at many such firms.  But the blanket notion that they are more capable than firms that emphasize value is false.  And it’s not even a probative question when the lawyers at value-based firms came from firms with marquee names. In the WSJ article, Blockbuster’s general counsel, in explaining why his company often seeks out attorneys from more economical areas of the country, pointed out that many of the attorneys in less expensive firms came from more expensive firms.

There obviously is a baseline amount of expertise and experience that is necessary to handle a case well, but law-firm name is a fleeting consideration. Much more important are the individual lawyer’s actual abilities, strategic vision for the litigation, personal attention, and attention to efficiency are key considerations.

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

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

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

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

In defending a securities class action, a motion to dismiss is almost automatic, and in virtually all cases, it makes good strategic sense.  In most cases, there are only four main arguments:

  • The complaint hasn’t pleaded a false or misleading statement
  • The challenged statements are protected by the Safe Harbor for forward-looking statements
  • The challenged statements weren’t made with scienter, even if the complaint has adequately pleaded their falsity
  • The complaint hasn’t adequately pleaded loss causation

For me, the core argument of virtually every brief is falsity – I think that standing up for a client’s statements provides the foundation for all of the other arguments.  For most clients, it is important to stand up and say “I didn’t lie.”   And an emphasis on challenging the falsity allegations encompasses clients’ most fundamental responses to the lawsuit:  they reported accurate facts; made forecasts that reflected their best judgment at the time; gave opinions about their business that they genuinely believed; issued financial statements that were the result of a robust financial-reporting process; etc.

The Reform Act, and the cases which have interpreted it, provide securities defense lawyers with broad latitude to attack falsity.  In my mind, 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.   Then, we can usually support the truth of what our clients said 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; showing 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 we ultimately make based on the complaint and judicially noticeable facts.

Yet many motions to dismiss do not make a forceful argument against falsity, 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, and do not engage in a detailed defense of the statements with the available facts.  Others simply attack the credibility of the “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,” which posits that even if false, the challenged statements were immaterial.*  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.

That’s risky.

It’s risky for several reasons.  First, detailed, substantive arguments against falsity are some of the strongest arguments that defendants can make.  Second, those arguments provide the foundation for the rest of the motion.  The exclusion of a strong falsity argument weakens the argument against scienter, and fails to paint the best possible no-fraud picture for the judge – which is ultimately what helps a judge to be comfortable in granting a motion to dismiss.

Failing to emphasize the falsity argument weakens the scienter argument.

The element of scienter requires a plaintiff to demonstrate that the defendant said something knowingly or recklessly false – in order to do this, plaintiffs must tie their scienter allegations to each particular challenged statement.  It is not enough to generally allege, as plaintiffs often do, that defendants had a general “motive to lie.”  When I analyze scienter allegations, I ask myself, “scienter as to what?”  Asking this question often unlocks strong arguments against scienter, because complaints often make scienter allegations that are largely detached from their allegations of falsity.  Often, this is the case because the falsity allegations are insufficient to begin with.  But many motions to dismiss are unable to point out this lack of connection, because they don’t focus on falsity in a rigorous and thorough way.

Focusing on falsity also is necessary because of how courts analyze falsity and scienter.  Although falsity and scienter are separate elements – and should be analyzed separately – courts often analyze them together.   See, e.g., Ronconi v. Larkin, 253 F.3d 423, 429 (9th Cir. 2001) (“Because falsity and scienter in private securities fraud cases are generally strongly inferred from the same set of facts, we have incorporated the dual pleading requirements of 15 U.S.C. §§ 78u-4(b)(1) and (b)(2) into a single inquiry.”).  Arguing a lack of falsity thus provides essential ingredients for this combined analysis.  Even when courts analyze falsity and scienter separately,  a proper scienter analysis requires a foundational falsity analysis, because as noted above, scienter analysis asks whether the defendant knew that a particular statement was false.  Without an understanding of exactly why that challenged statement was false, and what facts allegedly demonstrate that falsity, the scienter analysis meanders, devolving into an analysis of knowledge of facts that may or may not be probative of the speaker’s state of mind related to that statement.

The tendency to lump scienter and falsity together is exemplified by the scienter doctrines that I call “scienter short-cuts:” (1) the corporate scienter doctrine (see, e.g., Teamsters Local 445 Freight Division Pension Fund v. Dynex Capital, Inc., 531 F.3d 190, 195-96 (2d Cir. 2008) and Makor Issues & Rights, Ltd. v. Tellabs Inc., 513 F.3d 702 (7th Cir. 2008)), and (2) the core operations inference of scienter (see, e.g., Glazer Capital Management LP v. Magistri, 549 F.3d 736 (9th Cir. 2008)).  Under these doctrines, courts draw inferences about what the defendants knew based upon the prominence of the falsity allegations.  The more blatant the falsity, the more likely courts are to infer scienter.  A superficial falsity argument weakens defendants’ ability to attack these scienter short-cuts, which plaintiffs are asserting more and more routinely.

Failing to emphasize the falsity argument fails to paint the best possible no-fraud picture for the judge.

I contend that it is a good strategy for a defendant to thoroughly argue lack of falsity, even if there are better alternative grounds for dismissal, and even if the challenge to falsity is unlikely to be successful as an independent grounds for dismissal.  This is for the simple reason that judges are humans – they will feel better about dismissing a case based on other grounds if you can make them feel comfortable that there was not a false statement to begin with.  For example, courts are often reluctant to dismiss a complaint solely on Safe Harbor grounds because it is seen as a “license to lie,” so it is strategically wise also to argue that forward-looking statements were not false in the first place.  Similarly, even if lack of scienter is the best basis for dismissal, it is good strategy to defend on the basis that no one said anything wrong, rather than appearing to concede falsity and being left to contend, “but they didn’t mean to.”

Judges have enough latitude under the pleading standards to dismiss or not, in most cases.  The pivotal “fact” is, in my opinion, whether the judge feels the case is really a fraud case, or not.  A motion to dismiss that vigorously defends the truth of what the defendants said is more likely to make the judge feel that there really is no fraud there.  Conversely, if defendants make an argument that essentially concedes falsity and relies solely on the argument that the falsity was immaterial, wasn’t intentional, or is not subject to challenge under the Safe Harbor, a judge may stretch to find a way to allow the case to continue.  Put simply, a judge is more likely to dismiss a case in which a defendant says “I didn’t lie,” than when defendants argue that “I may have lied, but I didn’t mean to,” or “I may have lied, but it doesn’t matter,” or “I may have lied, but the law protects me anyway.”  Even when a complaint might ultimately be dismissed on other grounds, I think that a strong challenge to falsity is essential to help the judge feel that he or she has reached a just result.

*Many statements that defense counsel argue are “puffery” are really statements of opinion that could and should be analyzed under the standard that originated in the U.S. Supreme Court’s Virginia Bankshares decision:  in order to adequately allege that a statement of opinion is false or misleading, a plaintiff must plead with particularity not only that the opinion was “objectively” false or misleading, but also that it was “subjectively” false or misleading, meaning that the opinion was not sincerely held by the speaker.  My partner Claire Davis recently posted a discussion of statements of opinion.

Cyber security is top of mind for companies, and cyber-security oversight is top of mind for corporate directors.  I recently co-moderated a panel discussion for directors on board oversight of cyber security and cyber-security disclosures.  I thought I’d share my thoughts on some of the key issues.

What are the board’s fiduciary duties in the area of cyber-security oversight?  Board oversight of cyber security conceptually is no different than oversight of any other area of risk.  The board must take good-faith steps to ensure that the company has systems designed to address cyber-attack prevention and mitigation, and to follow up on red flags it sees.  The board’s decision-making is protected by the business judgment rule.

It is important for directors to understand that cyber-security oversight isn’t exotic.  Because cyber security is a highly technical area, some directors may feel out of their depth – which may help explain why Carnegie Mellon’s 2012 CyLab survey revealed that some boards are not sufficiently focused on cyber-security oversight.  But with the help of experts – on which directors are entitled to rely – boards can ask the same types of questions they’re used to asking about other types of risk, and gain a similar degree of comfort.

How do I pick the right experts?  Directors should be comfortable that they are receiving candid and independent advice, and need to be mindful that the company’s internal IT group may have trouble being self-critical.  So in addition to receiving appropriate reports from the IT group, directors should periodically consult outside advisors who are capable of giving independent advice.

Given the importance of cyber security, will courts impose a higher standard on directors?  Directors’ basic duties are not heightened by general political and economic concerns about cyber security, or even the magnitude of harm that the company itself could suffer from a cyber attack.  But the magnitude of potential harm does matter.  If a substantial portion of a company’s value depends on the security of its cyber assets, common sense dictates that directors will naturally spend relatively more time on cyber security.  In my experience, that’s the way directors think and work – they analyze and devote more time to their companies’ most important issues.  And from a practical perspective, directors’ actions, or inaction, will be judged against the backdrop of a really bad problem.  Judges are human beings, and often do make decisions that are influenced by the presence of particularly severe harm.

How does cyber insurance fit in to the board’s job?   Cyber insurance allows the company to shift a specific and potentially very large risk.  As such, it is important that boards consider cyber insurance among the types of expenditures appropriate to prevent and mitigate cyber attacks.  Shifting risk through cyber insurance also can help directors avoid a shareholder derivative action, by reducing the attractiveness of the suit to plaintiffs’ lawyers, or reduce the severity of an action that is filed, making it easier and less expensive to resolve.

Are there any court decisions on directors’ duties in the area of cyber security?  No.  Although a TJX Companies, Inc. shareholder brought a derivative suit following a significant data breach, Louisiana Municipal Police Employees Retirement Fund v. Alvarez, Civil Action No. 5620-VCN (Del. Ch. July 2, 2010), the case settled early in the litigation.  As a result, the court never had the opportunity to make any substantive rulings on the plaintiffs’ allegations that the board failed to adequately oversee the company’s cyber security.

What is the board’s role in overseeing the company’s disclosures concerning cyber security?  The board’s duty is the same as it is with any corporate disclosure.

Does the SEC’s October 13, 2011 guidance on cyber-security disclosures enhance the board’s oversight responsibilities?   No.  As the guidance itself notes, it does not change disclosure law, but rather interprets existing law.  The guidance does, however, put a sharper focus on cyber-security disclosures, and provides the SEC and plaintiffs’ counsel with a checklist of potential criticisms – though those criticisms would really just be based on existing law.

The sharper focus on cyber-security disclosure isn’t meaningless, however.  The SEC has issued cyber-security comments to approximately 50 public companies since issuing its guidance.  The guidance, moreover, provides another opportunity for the board to discuss cyber security with management, and the increased focus should result in incrementally better disclosure.  And the SEC may well speak again on the subject; last spring, Senator Rockefeller asked new SEC Chair Mary Jo White to further address cyber-security disclosures.  (For a good discussion of the SEC’s guidance, I recommend an article by Dan Bailey, which was reprinted in the D&O Diary, and a recent D&O Diary post discussing a Willis survey of cyber-security disclosures.)

Are there any disclosure securities class actions alleging a false or misleading statement based on failure to follow the guidance?  No.  There was a securities class action against Heartland Payment Systems for a stock price drop that plaintiffs attributed to Heartland’s alleged misstatements concerning its cyber-security protections.  In re Heartland Payment Sys., Inc. Sec. Litig., CIV. 09-1043, 2009 WL 4798148 (D.N.J. Dec. 7, 2009).  The litigation was dismissed because the plaintiffs had not sufficiently alleged that the company made a false or misleading statement or, if it had, did so with scienter.  However, that case was filed prior to the SEC’s cyber-security guidance.  At least one commentator has suggested the outcome might have been different if the SEC guidance had informed the analysis.

Is there a wave of cyber-security shareholder suits coming?  What type of suits will there be?  If there is a wave, it looks like the lawsuits primarily will be shareholder derivative actions, not securities class actions.

There has not been a wave of cyber-attack securities class actions because companies’ stock prices generally haven’t fallen significantly following disclosure of cyber attacks.  If that trend remains, shareholder litigation over cyber security primarily will take the form of shareholder derivative litigation, seeking to recover from directors and officers damages for the harm to the corporation caused by a cyber attack.

The vast majority of options backdating lawsuits were derivative actions due to the lack of significant stock drops, and many of them survived motions to dismiss and resulted in significant settlements.  However, unlike the options backdating cases, in which many motions to dismiss for failure to make a demand on the board were complicated by directors’ receipt of allegedly backdated options or service on compensation committees that allegedly approved backdated options, directors’ governance of cyber security should be judged by more favorable legal standards and with a more deferential judicial attitude.  For that reason, I anticipate that plaintiffs’ attorneys will file derivative cases mostly over larger cyber-security breaches, in which the litigation environment will help them overcome the legal obstacles, and will not routinely file over less significant breaches.

 

 

Public companies around the country labor under a misunderstanding:  that the Private Securities Litigation Reform Act’s Safe Harbor protects them from liability for their guidance and projections if they simply follow the statute’s requirements.  But the Safe Harbor is not so safe – because they think it goes too far, many judges go to great lengths to avoid the statute’s plain language.  Companies and their securities litigation defense counsel can usually work around this judicial attitude and take advantage of the statute’s protections, however, with the right approach to preparing and defending the company’s disclosures.

The Safe Harbor was a key component of the 1995 reforms of securities class action litigation. Congress sought “to encourage issuers to disseminate relevant information to the market without fear of open-ended liability.”  H. R. Rep. No. 104-369, at 32 (1995), as reprinted in 1995 U.S.C.C.A.N. 730, 731.  The Safe Harbor, by its plain terms, is straightforward.  A material forward-looking statement is not actionable if it either (1) is “accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement,” or (2) is made without actual knowledge of its falsity.  15 U.S.C. § 77z-2(c)(1); 15 U.S.C. § 78u-5(c)(1).

Yet courts’ application of the Safe Harbor has been anything but straightforward.  Indeed, courts have committed some really basic legal errors in their attempts to nullify the Safe Harbor.  Foremost among them is the tendency to collapse the two prongs – thus essentially reading “or” to mean “and” – to hold that actual knowledge that the forward-looking statement is false means that the cautionary language can’t be meaningful.  See, e.g., In re SeeBeyond Techs. Corp. Sec. Litig., 266 F. Supp. 2d 1150, 1163-67 (C.D. Cal. 2003); In re Nash Finch Co. Sec. Litig., 502 F. Supp. 2d 861, 873 (D. Minn. 2007); Freeland v. Iridium World Commc’ns, Ltd., 545 F. Supp. 2d 59, 74 (D.D.C. 2008); Freudenberg v. E*Trade Fin. Corp., 712 F. Supp. 2d 171, 193-94 (S.D.N.Y. 2010).  Courts also engage in other types of legal gymnastics to take the statements out of the Safe Harbor, such as straining to convert forward-looking statements into present-tense declarations.  The court in City of Providence v. Aeropostale, Inc., No. 11 Civ. 7132, 2013 WL 1197755 (S.D.N.Y. Mar. 25, 2013), recently did so, characterizing a number of statements related to the company’s earnings guidance to be statements of present fact outside the Safe Harbor’s protection – and thereby essentially taking the guidance out of the Safe Harbor as well.  Even worse, the court articulated an incorrect rule of law: “the safe harbor does not apply to material omissions.”  Id. at *12.  But, of course, all forward-looking statements rely on, and necessarily omit, myriad facts – a prediction is, by definition, the bottom line of analysis.

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 statute only requires a company to identify “important factors,” not the important factors.  Judge Easterbrook’s mis-reading of the statute injected a subjective component into an objective inquiry; it purported to require courts to evaluate the company’s disclosure decisions – what the company thought were “the” important factors.  This error led the court to permit discovery on what the company thought was “important” – a procedure directly contrary to Congress’s clear intent that courts apply the Safe Harbor on a motion to dismiss and “not [] provide an opportunity for plaintiff counsel to conduct discovery on what factors were known to the issuer at the time the forward-looking statement was made.”  H.R. Rep. No. 104-369, at 44 (1995), as reprinted in 1995 U.S.C.C.A.N. 730, 743.

Frequently, courts simply avoid defendants’ Safe Harbor arguments, choosing either to treat the Safe Harbor as a secondary issue or to avoid dealing with it at all.  The Safe Harbor was meant to create a clear disclosure system: if companies have meaningful risk disclosures, they can make projections without fear of liability.  When judges avoid the Safe Harbor, companies’ projections are judged by legal rules and pleading requirements that result in less certain and less protective outcomes, even if judges get to the right result on other grounds.  And if they come to realize that they do not have the clear Safe Harbor protection Congress meant to provide, companies will make fewer and/or less meaningful forward-looking statements.

The root of these problems is that many judges don’t like the idea that the Safe Harbor allows companies to escape liability for knowingly false forward-looking statements.  Some courts have explicitly questioned the Safe Harbor’s effect.  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).  (Soon after the Second Circuit decided American Express, the Ninth Circuit also interpreted “or” to mean “or.”  In re Cutera, Inc. Sec. Litig., 610 F.3d 1103, 1112-13 (9th Cir. 2010).)

This judicial antipathy for the Safe Harbor won’t change.  So it is up to companies to draft cautionary statements that will be effective in the face of this skepticism, and for securities defense counsel to make Safe Harbor arguments that resonate with dubious judges.

I have had success in obtaining dismissal under the Safe Harbor when I am able to demonstrate that the company’s Safe Harbor cautionary statements show that it really did its best to warn of the risks it faced.  Judges can tell if a company’s risk factors aren’t thoughtful and customized.  Too often, the risk factors become part of the SEC-filing boilerplate, and don’t receive careful thought with each new disclosure.  But risk factors that don’t change period to period, especially when it’s apparent that the risks have changed, are less likely to be found meaningful.  And even though many risks don’t fundamentally change every quarter, facets of those risks often do, or there might be another, more specific risk that could be added.

Companies can help to inoculate themselves from lawsuits – or lay the groundwork for an effective defense – if they simply spend time thinking about their risk factors each quarter, and regularly supplement and adjust those factors.  There are situations in which competitive harm or other considerations will outweigh the benefit of making negative elective risk disclosures.  But companies should at least evaluate and balance the relevant considerations, so that they maximize their Safe Harbor protection without harming their business and shareholders.

I have also had success with Safe Harbor arguments that defend the honesty of the challenged forward-looking statements.  For example, the complaint, along with incorporated and judicially noticeable facts, often allow defense counsel to support the reasonableness of challenged earnings guidance.  Some defense lawyers avoid this approach because it is fact-intensive, which they worry may cause judges to believe that dismissal isn’t appropriate.  I have found, however, that judges who believe that the forward-looking statements have a reasonable basis (and are thus assured that they were not knowingly dishonest) are more comfortable applying the Safe Harbor, or granting the motion on another basis, such as lack of falsity.

On the other hand, I believe the least effective arguments are those that rest on the literal terms on the Safe Harbor, which create the impression that defendants are trying to skate on a technicality.  It is these types of arguments – lacking in a sophisticated supporting analysis of the context of the challenged forward-looking statements and of the thoughtfulness of the cautionary language – that cause the courts to try to evade what they see as the unjust application of the Safe Harbor.  Defense counsel need to appreciate that Safe Harbor “law” includes not just the statute and decisions interpreting it, but also the skepticism with which Safe Harbor arguments are evaluated by many judges.

As I have previously written, the Sixth Circuit’s erroneous interpretation of the scienter component of the Supreme Court’s decision in Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011), is one of the biggest threats to the protections of the Private Securities Litigation Reform Act. 

The resulting flawed analysis – which I call “summary scienter analysis” – appears to be a battleground issue for plaintiffs’ securities litigation attorneys.  Their advocacy of summary scienter analysis in In re VeriFone Holdings, Inc. Sec. Litig., 704 F.3d 694 (9th Cir. 2012), while technically unsuccessful, resulted in an opinion that could cause collateral harm to scienter analysis in the Ninth Circuit. 

Unsatisfied with the court’s conclusions in  VeriFone, attorneys from Cohen Milstein Sellers & Toll recently attacked the decision in a May 2013 article titled, The Dangers of Missing the Forest: The Harm Caused by VeriFone Holdings in a Tellabs World,  44 Loyola U. Chi. L. J. 1457 (2013).  The article posits that the Supreme Court has delivered “repeated and clear instructions” that courts are to only analyze scienter allegations holistically and collectively.  It then relies on behavioral economic studies that purportedly show that judges are more likely to dismiss cases when undertaking a segmented analysis as opposed to a holistic one.

Although the article demonstrates why plaintiffs may be anxious to disregard an individual analysis of scienter allegations (because it results in more dismissals), the article is wrong as a matter of law.  The Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 324 (2007), expressly endorsed the sort of individualized scienter analysis the authors attack.  And Matrixx did not – and could not have, under Section 10(b) and the Reform Act – reverse course.   

The main threat is not a scienter analysis that carefully analyzes each individual scienter allegation within, and as an essential part of, a collective scienter analysis under Tellabs.  Such a methodology explicitly requires courts to go through an allegation-by-allegation analysis before they perform a collective analysis, imposing greater discipline and protecting against analytic sloppiness and error.  Rather, the main threat is the position that careful analysis of each individual scienter allegation is not required at all – or, in the view of the Sixth Circuit, is not even allowed. 

Origin of Summary Scienter Analysis

This advocacy of solely “collective “ scienter analysis traces back to the Supreme Court’s 2011 decision in Matrixx.  The issue in Matrixx was whether adverse health events from the company’s cold remedy Zicam were material – and thus were required to be disclosed to make what Matrixx said not misleading – if the number of events was not statistically significant.  Matrixx argued for a bright-line rule that disclosure is only required if the number of events is statistically significant.  The district court dismissed the complaint.  The Ninth Circuit reversed. 

In an opinion by Justice Sotomayor, the Supreme Court unanimously affirmed the Ninth Circuit, with most of the opinion devoted to the holding on the primary issue on appeal: statistical significance is not required to trigger a duty to disclose adverse events if what the company said is rendered misleading by the omission, or disclosure is otherwise required by law.  That ruling meant that Matrixx made material misrepresentations by virtue of omitting the adverse events from its public statements.

Following the materiality analysis, the Supreme Court’s affirmance of the Ninth Circuit’s scienter ruling was straightforward.  The Supreme Court articulated Tellabs’ scienter standard, without altering it in any way.  Then, applying Tellabs, the Court considered defendants’ non-culpable explanation: consistent with the lack of statistical significance, the adverse events were not a problem, and thus any misleading statements were not made with intent to defraud.  The Court found the culpable explanation of the allegations more compelling.  The allegations detailed instances of Matrixx’s concern about the events, such as hiring a consultant and convening a panel of physicians and scientists on the matter.  And, “[m]ost significantly, Matrixx issued a press release that suggested that studies had confirmed that Zicam does not cause anosmia [loss of smell] when, in fact, it had not conducted any studies relating to anosmia and the scientific evidence at that time, according to the panel of scientists, was insufficient to determine whether Zicam did or did not cause anosmia. “  131 S. Ct. at 1324.  In other words, the complaint alleged a misrepresentation that was either intentional or highly reckless.   

The vast majority of the commentary about the Matrixx decision concerned the materiality ruling.  The scienter holding did not appear to break any new ground – at least until the Sixth Circuit held that it did.  In Frank v. Dana Corp., 646 F.3d 954, 961 (6th Cir. 2011), the Sixth Circuit reversed the district court’s dismissal of the plaintiffs’ complaint.  In analyzing the complaint’s scienter allegations, the court noted that its Reform Act decisions had analyzed complaints “by sorting through each allegation individually before concluding with a collective approach” under Tellabs.  But the court decided to “decline to follow that approach in light of the Supreme Court’s recent decision in Matrixx …,” which the Sixth Circuit said “provided for us a post-Tellabs example of how to consider scienter pleadings ‘holistically’ ….  Writing for the Court, Justice Sotomayor expertly addressed the allegations collectively, did so quickly, and, importantly, did not parse out the allegations for individual analysis.”  646 F.3d at 961.

But Matrixx was not concerned with the proper methodology of scienter analysis under Tellabs.   Indeed, its comments on scienter were almost an afterthought.  The Court did not hold – or even suggest – that the “quick[]” way it addressed the scienter allegations was the required method of analysis.  Its analysis presumably was “quick[]” because it didn’t need to be lengthy, given the nature of the allegations, the secondary nature of the scienter issue in relationship to the disclosure issue,  and the procedural setting, i.e., a review of a scienter finding by the Ninth Circuit.  Thus, the Sixth Circuit read into Matrixx a holding that the Court didn’t reach.  To date, only the Tenth Circuit has endorsed the Sixth Circuit’s mis-reading of Matrixx – with a holding that seems to include a dangerous endorsement of “conclusory” scienter analysis.  See In re Level 3 Communications, Inc. Securities Litig., 667 F.3d 1331 (10th Cir. 2012) (“While its analysis was conclusory, the district court was under no duty to catalog and individually discuss the reports and witnesses plaintiff described.”) (citing Dana).   

But the plaintiffs certainly caught the Ninth Circuit’s attention with their  summary-scienter-analysis argument in In re VeriFone Holdings, Inc. Sec. Litig., 704 F.3d 694, 703 (9th Cir. 2012).  Following the Supreme Court 2007 decision Tellabs, the Ninth Circuit had evaluated its prior cases and decided on a two-step approach to scienter analysis:  courts must first analyze scienter allegations individually, and then analyze them collectively.   Zucco Partners, LLC v. Digimarc Corp., 552 F.3d 981, 991-92 (2009).  In VeriFone, the Ninth Circuit rejected the argument that Matrixx prohibits its two-step analysis:  “Matrixx on its face does not preclude this approach and we have consistently characterized this two-step or dual inquiry as following from the Court’s directive in Tellabs.”  704 F.3d at 703.  The court then reviewed other appellate decisions, and held that “[b]ecause the Court in Matrixx did not mandate a particular approach, a dual analysis remains permissible so long as it does not unduly focus on the weakness of individual allegations to the exclusion of the whole picture.”  Id.  

Yet the Verifone court then decided to skip the first step (a review of each individual allegation to determine if any of them itself is sufficient to plead scienter) and, instead, to “approach this case through a holistic review of the allegations,” though it emphasized that “we do not simply ignore the individual allegations and the inferences drawn from them.”  Id.   It found that the allegations – which included allegations of multiple significant accounting manipulations directed by the individual defendants – holistically sufficed to plead scienter.

Although the Ninth Circuit correctly understood that Matrixx did not alter the Tellabs scienter standard, its willingness to abandon an explicit two-step scienter analysis is an unfortunate consequence of the incorrect interpretation of Matrixx advanced by the plaintiffs.   The result is the implicit endorsement of an approach that could yield a more cursory analysis of individual scienter allegations by district courts.  This is troubling, because scrutiny of each scienter allegation, to understand and weigh it in relationship to each challenged statement, allows a court to properly weigh the allegations collectively.  Without such scrutiny, there is a risk that courts will under- or over-value one or more of the individual allegations and thus spoil the collective analysis. 

To the extent that they allow (or require) district courts to stray from this particularized analysis, both Dana and Verifone are incorrect, because individual  scrutiny of scienter allegations is required by the controlling law:   Tellabs and the two statutes at issue, Section 10(b) and the Reform Act.

Scienter Analysis under Tellabs

The Tellabs Court began its analysis by announcing several “prescriptions” about scienter analysis under the Reform Act.  The second prescription is that “courts must consider the complaint in its entirety, as well as other sources courts ordinarily examine when ruling on Rule 12(b)(6) motions to dismiss, in particular, documents incorporated in the complaint by reference, and matters of which a court may take judicial notice.”  551 U.S. at 322.  The Court’s third prescription is that “courts must take into account plausible opposing inferences.”  The Court noted that “[t]he strength of an inference cannot be decided in a vacuum.  The inquiry is inherently comparative.  How likely is it that one conclusion, as compared to others, follows from the underlying facts?”  Id. at 323.

In order to conduct this analysis, the Court expressly contemplated analyzing individual scienter allegations, and indeed itself analyzed two types of individual allegations:  financial motive, and knowledge of falsity.

  • Tellabs contended that the lack of a financial motive for fraud was dispositive.  The Court held that financial motive is a factor to be considered among other considerations.  Consideration of financial motive, in turn, requires an examination of stock sales and their context to determine whether they add up to a sufficient motive.   This, of course, amounts to scrutiny of individual allegations. 
  • Tellabs also contended that the complaint’s allegations were too vague and ambiguous to plead knowledge of falsity.  The Court agreed that “omissions and ambiguities count against inferring scienter,” though reiterated that courts must consider such shortcomings in light of the complaint’s other allegations.   Analyzing “omissions and ambiguities,” as the Court directed, is the core variety of individualized scienter analysis.  It involves looking at the complaint’s allegations of falsity, statement by statement, and analyzing the complaint’s allegations of knowledge of falsity, statement by statement. s. 

Thus, the Supreme Court in Tellabs expressly contemplated, and performed, the type of individualized scienter analysis that plaintiffs wrongly contend that Matrixx rejected.

Scienter Analysis under the 1934 Act and Reform Act

Matrixx, moreover, could not have departed from analysis of individual scienter allegations, because individualized scienter analysis is statutorily required by the 1934 Act and the Reform Act.  Section 10(b) and Rule 10b-5 prohibit the making of a false statement with intent to defraud.  If a complaint challenges two statements, it isn’t permissible under Section 10(b) – for example – to find scienter for Statement 2 and apply that finding to Statement 1.  If there is no scienter for Statement 1, it isn’t actionable.  And the Reform Act requires plaintiffs to plead scienter for each statement:

(b) Requirements for securities fraud actions … (2) Required state of mind

In any private action arising under this chapter in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.

15 U.S. C. § 78u-4(b)(2) (emphasis added).

So, under the relevant statutes, courts must engage in a scienter analysis for each and every statement the complaint challenges.  To do so requires examination of, in Tellabs’ words, “omissions and ambiguities” in the factual allegations about each statement, as well as pecuniary motivation and other factors present at the time the defendant made the challenged statement.  Such an analysis is exactly the type of scrutiny that plaintiffs’ attorneys are attacking through their incorrect interpretation of Matrixx. 

This issue will remain a key Reform Act issue to monitor.  I will blog about further significant developments.

 

When is an opinion a false or misleading statement?  If a company official says “I think the deal is fair,” is it a false statement just because the deal is objectively unfair?  Or only if the official also did not subjectively believe the deal was fair when he voiced that opinion?

With the Sixth Circuit’s opinion in Indiana State District Council of Laborers v. Omnicare, 719 F.3d 498 (6th Cir. 2013), a circuit split has developed around the question of what is required to demonstrate that a statement of opinion is false or misleading.  This issue is key to many securities class actions, which often hinge upon the truth or falsity of opinions, not facts.

People routinely express opinions that may be incorrect, or about which they may later change their minds.  But those opinions are not lies if they accurately reflect what the speaker thinks.  Thus, even if a deal is not fair by objective standards, the statement “I think the deal is fair,” is not false unless the speaker did not actually think that the deal was fair.  An opinion is thus “true” if it reflects what the speaker actually thought at the time that he spoke – regardless of whether it is objectively mistaken, differs from the opinions of others, appears to be unreasonable, or is later changed.  So, the truth or falsity of any statement of opinion necessarily turns on the speaker’s actual belief.

This analysis of what makes an opinion a false or misleading statement seems self-evident.  Thus, when the Supreme Court considered the issue of whether and when a fairness opinion can be an actionable false statement, it assumed that an opinion was not false unless it the speaker did not hold the belief stated.  Va. Bankshares, Inc. v. Sandberg, 501 U.S. 1083, 1095-96 (1991) (“Because such a statement by definition purports to express what is consciously on the speaker’s mind, we interpret the jury verdict as finding that the directors’ statements of belief and opinion were made with knowledge that the directors did not hold the beliefs or opinions expressed”).  The threshold question faced by the Virginia Bankshares Court was whether or not a statement of belief or opinion could ever be actionable under the federal securities laws, or was instead per se immaterial.  The Court found that “knowingly false” statements of opinion could be challenged because they can be material and factual “as statements that the [speakers] do act for the reasons given or hold the belief stated and as statements about the subject matter of the reason or belief expressed.”  Id. at 1092.  Making an assumption that the jury had found that the statement was subjectively false, the Court concluded that objective falsity was also necessary for the plaintiff to prove a false or misleading statement under Section 14(a).  Id.

Summarizing the Virginia Bankshares holding in a concurring opinion, Justice Scalia emphasized that both subjective and objective falsity were required for liability:  “[T]he statement ‘In the opinion of the Directors, this is a high value for the shares’ would produce liability if in fact it was not a high value and the directors knew that.  It would not produce liability if in fact it was not a high value but the directors honestly believed otherwise.”  Id. at 1108-09 (Scalia, concurring).

Yet Virginia Bankshares is anything but a paragon of clarity.  It focused on the question of whether or not an opinion can ever be an actionable statement, and then backed into the question of subjective falsity by assuming that it existed in that case.  As a result, the circuit courts were slow to apply its holding.  Although the decision was rendered more than 20 years ago, its analysis of the standard for evaluating statements of opinion was not widely used until the last decade.

After Virginia Bankshares had been discussed and digested, however, most circuit courts began to cite to it for the rule that a statement of opinion is only actionable if it is both subjectively and objectively false or misleading.  See, e.g., In re Credit Suisse First Boston Corp., 431 F.3d 36, 47 (1st Cir. 2005) (citing Virginia Bankshares and holding that in order to challenge a statement of opinion plaintiffs must plead “facts sufficient to indicate that the speaker did not actually hold the opinion expressed,” or in other words, “subjective falsity”); Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1131 (2d Cir. 1994) (citing Virginia Bankshares to hold that “a statement of reasons, opinion or belief by such a person when recommending a course of action to stockholders can be actionable under the securities laws if the speaker knows the statement to be false.”); Nolte v. Capital One Fin. Corp., 390 F.3d 311, 315 (4th Cir. 2004) (“In order to plead that an opinion is a false factual statement under Virginia Bankshares, the complaint must allege that the opinion expressed was different from the opinion actually held by the speaker.”); Greenburg v. Crossroads Sys., Inc., 364 F.3d 657, 670 (5th Cir. 2004) (citing Virginia Bankshares for the proposition that a “statement of belief is only open to objection where the evidence shows that the speaker did not in fact hold that belief and the statement made asserted something false or misleading about the subject matter”); Helwig v. Vencor, Inc., 251 F.3d 540, 562 (6th Cir. 2001) (“‘Material statements which contain the speaker’s opinion are actionable under Section 10(b) of the Securities Exchange Act if the speaker does not believe the opinion and the opinion is not factually well-grounded.’”); Rubke v. Capitol Bancorp Ltd., 551 F.3d 1156, 1162 (9th Cir.2009) (fairness opinions “can give rise to a claim under Section 11 only if the complaint alleges with particularity that the statements were both objectively and subjectively false or misleading”).

But in Omnicare the Sixth Circuit reversed course, departing not only from numerous decision by other circuits, but also from its own precedent, ­­in holding that plaintiffs did not need to prove that defendants knew their opinion was false in an action brought under Section 11.  719 F.3d at 505-07.  The Omnicare court recognized its departure from holdings by the Second Circuit and the Ninth Circuit, which had specifically found that proof of subjective falsity was necessary in cases brought under Section 11.  See Fait v. Regions Financial Corp., 655 F.3d 105 (2011); Rubke, 551 F.3d at 1162.  But the court distinguished all the cases that required proof of the subjective falsity of opinions in a Section 10(b) context, including its own holding in Helwig v. Vencor – arguing that those decisions were only applicable in the context of a Section 10(b) action, in which proof of scienter was required.

In regard to Virginia Bankshares, the Omnicare court reasoned that the Supreme Court had not been squarely faced with whether a plaintiff must plead the subjective falsity of an opinion, contending that the Court’s comments regarding subjective falsity were both dicta and tied to the question of scienter.  “The Virginia Bankshares discussion, therefore, has very limited application to § 11; a provision which the Court has already held to create strict liability.”   Id. at 507.  Extending the “dicta” of Virginia Bankshares to a Section 11 case would be “most dangerous,” the Court ruled: “it would be most unwise for this Court to add an element to § 11 claims based on little more than a tea-leaf reading in a § 14(a) case.”  Id.

The Omnicare court was not the first court to observe that subjective falsity feels like a scienter requirement.  Other courts have noted that the question of subjective falsity in a Section 10(b) case may “essentially merge” with the scienter requirement, such that if a complaint demonstrates subjective falsity, it will also have adequately shown scienter.  See, e.g., Credit Suisse, 431 F.3d at 47.  But the Omnicare court missed the point when it held that proof of subjective falsity is only necessary in a case where there is a requirement that scienter be shown.  Like Section 11, Section 14(a) does not require proof that a speaker knew the statement was false.  In Virginia Bankshares, the court explicitly declined to address the question of scienter – so its discussion was necessarily centered around the element of falsity.  And the subsequent cases that have examined subjective falsity in the context of Section 10(b) have discussed it in terms of falsity, not scienter.  Simply put, an opinion is not false if it is genuinely believed by the speaker.  This question is separate from the inquiry as to the speakers’ intent in making the statement.  To conflate the two elements is an analytic mistake and legal error.

This distinction is most vital in cases such as Omnicare, brought under statutes for which proof of scienter is not required.  But it is also important in Section 10(b) cases, where scienter can be established by showing either actual knowledge or some form of recklessness, while subjective falsity requires plaintiffs to show a speaker knew his opinion was false. Preserving this focused inquiry is especially important when plaintiffs seek to prove scienter “holistically” or through doctrines such the core operations inference or corporate scienter, which cause the scienter analysis to be more and more removed from a showing that a speaker had actual knowledge of fraud as to a particular statement.

Analysis of the hypothetical statement “I think the deal is fair” illustrates these points.  Assume the deal was not objectively fair, but the speaker genuinely believed it was.  In that case, the statement was true and is not actionable – a scienter analysis is not even required.  If the falsity analysis got it wrong, however, we would then delve into a scienter analysis with a looser recklessness test, which would look at a variety of factors other than the speaker’s actual belief in his statement.  The error is worsened when the recklessness analysis is performed with analytic tools like the core operations inference and corporate scienter theory, which have the capacity to devolve into assumptions about the speaker’s intent based on company-wide factors, and under a holistic analysis that tends to look at scienter generally, rather than focusing on the speaker’s state of mind as to a particular challenged statement.  As a result, a speaker could be held liable for saying that he thought the deal was fair, even though that is what he actually thought, because of a judgment that the general factors present at the company suggest overall recklessness. The result is not just analytic impurity, but injustice – such that some cases that should be dismissed would not be.

It took the better part of two decades for the crucial holding of Virginia Bankshares to be well understood and widely applied by the circuit courts.  The Omnicare case represents a step backward in this analysis.  Hopefully, other circuit courts will decline to follow the Sixth Circuit in its abrupt wrong turn, and the Supreme Court will eventually clarify its Virginia Bankshares decision.

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

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

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

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

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

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

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

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

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

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

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

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

When selecting counsel to defend them against a securities class action, companies usually face the question of whether they want to hire attorneys from their regular outside corporate firm. Sometimes, companies will retain their regular outside firm as a matter of course, without even going through an audition process to interview other potential defense firms.

But while such an arrangement is frequent, it can be inappropriate.  Ethical and practical conflicts lurk beneath the surface that can make it unwise for a company to hire its regular outside firm for securities class action defense – and these conflicts need to be examined more closely by companies, their insurance carriers, and the counsel seeking to represent them.

It is a dilemma that all securities counsel faces at one time or another – when should they turn down representation of a firm client in a securities lawsuit?  Over the years, I have struggled with that question, and my analysis has evolved and grown sharper.  The north star of the analysis is a basic principle: attorneys should not represent a client when they have a conflict that could compromise the client’s defense.  In the context of securities litigation defense, a conflict can arise when it is in the client’s interest to rely on the defense firm’s corporate work as a defense against allegations of falsity or scienter, or to establish a due-diligence defense.  For the client, it is a question that boils down to whether the same firm that provided disclosure or stock-trading advice can make an objective decision about whether to disclose that advice in order to assert these defenses.

The company, not its lawyers, makes disclosures.  But lawyers play a prominent role in many disclosures, by drafting or editing them, by giving advice to the company about their adequacy, and by weighing in on decisions not to disclose certain information.  This is more true of some disclosures than others – public offering materials, for example, are likely to be largely drafted by the attorneys, who will weigh in on every important disclosure decision.   Lawyers also advise on matters that bear on scienter – primarily the presence or absence of material nonpublic information in connection with establishment of 10b5-1 plans and periodic stock sales, and on stock offerings.  Even if lawyers have not technically provided legal advice or representation on these matters, directors and officers often rely on their regular counsel to object to potential misrepresentations or ill-advised stock sales about which they had notice.

I am not suggesting that it is never appropriate for a company to hire its regular outside firm to defend a securities class action – in some cases, the firm may not have had any involvement in the disclosures or decisions that are being challenged, or that are likely to be challenged as the case proceeds.  For example, if the stock price drop that triggered the litigation was caused by a restatement, the litigation likely will not implicate the lawyers’ disclosure advice, since the case will be about the company’s financial statements, on which the lawyers didn’t work.

The above considerations yield two guiding principles:

  • If the securities class action challenges a disclosure on which a firm has provided disclosure advice, as to what was disclosed or what was not disclosed, the firm generally should not defend the litigation.
  • If the securities class action relies on stock sales as evidence of scienter, a firm that advised on the stock sales – or 10b5-1 plans under which the stock sales were made – generally should not defend the litigation.

In addressing this issue, some law firms tend to emphasize only the lawyer-as-witness problem, which in many states can be avoided by having another firm examine the defense firm’s lawyers.  But the problem can be more significant than this.

Let’s analyze the situation with a simple hypothetical.  A securities class action against Acme Corporation challenges a statement in Acme’s 10-K.  Acme’s regular outside corporate counsel provided advice to the company about the challenged disclosure, including advice that certain omitted information that allegedly made it misleading did not need to be disclosed.  As evidence of scienter, the lawsuit cites Acme’s officers’ sales of company stock pursuant to 10b5-1 plans established during the alleged class period. Corporate counsel advised that the officers had no material nonpublic information when they established the plans.

Acme and the individual defendants will have an interest in defending themselves by asserting that they relied on the law firm’s advice, both as to the disclosure decision and the stock sales.  At first blush, it may seem that the positions of Acme and its law firm are the same – both want to defend the correctness of the disclosures and stock-sale decisions.  But their interests are not the same.  Even if their lawyers’ advice was wrong, the defendants may be able to avoid liability, as long as their reliance upon it was reasonable and genuine.

On the other hand, Acme’s lawyers have an interest in preventing the disclosure of incorrect legal advice, which could not only prove embarrassing, but also expose them to liability.  And even if their advice was defensible, lawyers do not like to have their legal work, including their internal law firm communications, produced in discovery – and potentially dissected by competing firms.  And, like everyone, lawyers have a natural aversion to testifying, or to making themselves the focus of litigation.

This all means that defense firms that also serve as corporate counsel have enormous incentives to avoid having their clients introduce evidence about their legal work, even if that evidence is plainly in the clients’ interest.  These defense firms are motivated, consciously or not, to steer the clients away from a defense based on reliance on legal advice – something that may be easy to do without many questions being asked, because of the general bias against revealing privileged information.  This may not result in substantial prejudice if there are good defenses otherwise, but no doubt there is prejudice in many cases, which is largely (if not entirely)  invisible to the client – through, for example, higher settlement amounts than would otherwise be necessary, or pressure to settle a case that might otherwise be a good trial candidate.

So why do companies hire their corporate counsel so often?  I’d say there are three reasons.

First, it’s fair to say that outside counsel law firms don’t routinely go through this kind of analysis with their clients, before asking that they be hired to defend a securities class action. Few companies have been through securities class actions, so they need to be guided through this analysis in a candid fashion.  At most, regular outside counsel discusses the lawyer-as-witness problem, and correctly notes that it’s common for regular outside counsel to defend securities claims.  Second, companies often regard securities class actions as frivolous, and don’t take the counsel-selection process as seriously as they should.  Most companies think their case will be dismissed, so there won’t ever be any conflict issues, and it is safe to just hand the lawsuit off to their regular firm.  Third, firms tell companies that if a case does not get dismissed, it will settle – so, again, conflict issues will never arise.

Because the conflicts that arise from these situations are largely invisible to the clients and the carriers, and any visible effects – such as potentially higher settlements – cannot be measured, there is no outcry against the practice.  But the fact that the harm is difficult to detect or measure doesn’t mean it doesn’t exist, or that it is not potentially significant in some cases.

All of the above problems are exacerbated when a company hires its regular outside firm without even interviewing other firms.  In failing to interview other firms, companies fail to get an outside reality check regarding conflict issues, miss out on the free legal advice they will receive from the firms they interview, and give up the leverage they have during the selection process to get economic concessions from the firm that they ultimately hire.  In addition, without an audition process, companies have no way to compare the securities litigators from its regular outside firm with other securities litigators, and sometimes unknowingly engage less effective and efficient lawyers than they would if they simply took a half a day to interview a handful of firms.

There is a simple, common-sense remedy: the company should conduct an interview process during which it can ask other firms about the regular outside firm’s conflict (taking into account those firms’ interest in being hired) – a process that, as noted above, has advantages for the company anyway.  Alternatively, the company can engage securities litigation defense counsel who isn’t under consideration for the defense role to advise on the issue.  Under either procedure, the company should also seek advice from its insurers and broker, who have a unique and helpful perspective as “repeat players” in securities litigation, having typically been involved in a very large number of securities litigation matters.

Whoever does this analysis needs to think past the initial complaint to the claims that are likely to be asserted by the lead plaintiff in a consolidated complaint.  For example, if a class-period 10-K contains disclosures that are causally related to the reason the stock dropped, the analysis should consider the 10-K even if it isn’t mentioned in the initial complaint, because the lead plaintiff is likely to challenge it.  Or if there are class-period stock sales, the analysis should take them into account, even if the initial complaint doesn’t mention them.

If regular outside counsel were to advise their corporate clients to obtain counsel-selection advice through an audition process or an independent firm, as well as from their insurers and broker, they would do great service to their clients, in ensuring that the clients received the maximum amount of protection possible from their appropriate reliance on the advice of counsel to navigate the difficult waters of disclosures and stock sales.  Significant potential harm, albeit largely invisible and unmeasurable, can be avoided by simply insisting upon an impartial counsel-selection process that allows the client to evaluate the full spectrum of potential conflicts.  And even if the company and its directors and officers end up selecting the company’s regular outside counsel, the benefits of the selection process will most certainly serve the company well throughout the litigation.

I recently had occasion to review a number of motion-to-dismiss rulings, including some in which denial of the motion seemed to be an easy call.  I’ve since been mulling over whether there are circumstances in which it would be strategically advantageous not to make a motion to dismiss in a Reform Act case, or a motion to dismiss for failure to make a demand on the board in a derivative case.  I have never foregone such a motion, even when it was relatively weak.  But is that the right strategic and economic approach?*

Routine motions to dismiss are certainly part of the predominant, formulaic approach to securities litigation defense.  As I noted in my recent Law360 Q&A, a formulaic approach can yield inefficiency and insufficient strategic thought.  Two obvious examples are class certification and document discovery:

  • Courts rarely deny class certification motions based on shortcomings in the proposed class representative – and often, even if they did, it would not be to the advantage of the defense.  Yet in virtually every case, defense attorneys travel around the country to take depositions of class representatives to support futile class certification oppositions.
  • The universe of important documents in a securities case usually distills to a relatively small number.  Yet in virtually every case, defense attorneys review every page of a vast number of documents collected as potentially responsive to overreaching document requests – ignoring the efficiency and other advantages of a more strategic approach.

I’ve vowed to take a more strategic and efficient approach in these and other areas.  A superior defense doesn’t require that we do everything, including tasks with little or no strategic value.  It means that we position the case for the best possible resolution.  That goal involves strategic and economic considerations.

So, then, what about motions to dismiss:  are there circumstances in which it would make sense to forego one?  It’s hard to imagine all conceivable circumstances under which this question may be posed, but I think the answer is probably “no.”  But in all cases, including those in which the motion to dismiss is weak, we need to think about how we use the motion to the defendants’ strategic advantage.

In my experience, there is a small group of cases – maybe 10% of those filed – that are bound to get past a motion to dismiss.  In those cases, neither the quality of the lawyers, on either side, nor the temperament or ability of the judge even matters.  Among these cases, some are meritorious and some aren’t.  Sometimes the initial allegations appear strong, although the plaintiffs’ ultimate case is not, and sometimes they involve high-profile situations or defendants, in which a judge is almost certain to allow the plaintiffs a chance to develop their case.  Regardless, these are all hard cases that are not going to be dismissed on a motion.

I can make a strong prima facie strategic case for not moving to dismiss this class of case, especially cases that are ultimately defensible.  The motion to dismiss is the judge’s first look at the case.  Judges are people, and they form first impressions.  The emphasis that a motion to dismiss can bring to the one-sided presentation of the “evidence” in the complaint can do harm to later rulings.  So, I could argue that a better strategy is to answer the complaint and wait for a chance to make a good first impression with the judge, at a time when the defendants can introduce favorable evidence.  This strategy also has the benefit of saving the client and/or carriers a substantial amount of money.

On balance, however, I think that other strategic considerations outweigh the advantages of foregoing motions to dismiss.  The vast majority of securities and derivative complaints are potentially dismiss-able.  Plaintiffs assume that a motion to dismiss will be made and – because of the high pleading standards required for complaints in Reform Act cases, and to excuse demand in derivative cases – they fear dismissal even in the strongest cases.  Thus, to not make a motion to dismiss would be significant, and would suggest to plaintiffs (and to the judge, too, if she or he is experienced in securities cases) that the plaintiffs’ case is extraordinarily strong.  It might even seem to be a concession of some kind.  Just as importantly, a motion to dismiss is the defendants’ only real leverage before summary judgment, and because of the discovery stay, the defendants have an informational advantage during the motion-to-dismiss process (setting aside the availability of a books and records inspection in the context of derivative litigation).

The combination of these factors strongly suggests that defendants make a motion to dismiss, even if they know it is very unlikely to succeed – but that they do so within a larger strategic framework geared toward the best ultimate resolution of the case.  In a great many cases, mediating while the motion to dismiss is still pending will be the right strategy, to take advantage of the leverage and the informational advantage that defendants have during this time.  This strategy requires the utmost strategic thought and risk analysis at the outset of the case, and then impeccable communication among the defendants, defense counsel, and the insurers and broker.  Even if this process leads these parties to the conclusion that it is better to continue to litigate the case, rather than attempt an early settlement, it will lend strategic shape and direction to the litigation process.

The worst strategy – although it unfortunately seems to be a prevalent one – is to simply litigate the case full tilt, without serious evaluation of whether an early settlement is strategically or economically wise, and without adequate communication with the client or the carriers about the risks of the case.

 

* I don’t include merger cases in this analysis, because they present special considerations – principally quick settlements and multi-jurisdictional issues – that often make a motion to dismiss impractical.

 

On April 16, 2013, Law360 featured me in its Q&A series.

In the article, I address two critical economic issues in securities litigation defense: containing escalating defense costs, and managing electronic document review.  I also discuss the Supreme Court’s Amgen decision, a securities litigation defense lawyer who impressed me, a case that helped launch my career as a securities litigator, and a mistake that I made.

I hope you will take a moment to read the article.