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Volume 11, Number 6 ­ July/August 2002
Securities Class Actions
A company's bad news gets worse
By Lisa Klein Wager and Adrienne M. Ward
First, shareholders lose money. Second, shareholders gang up and sue the
company. Does it have to be that way?
In 1995, Congress enacted the Private Securities Litigation Reform Act of 1995
(PSLRA), intended to drastically reduce the routine filing of multiple securities class
actions on the heels of every negative announcement by a public company. It did –
for about three months. Since then, filings have climbed and actually exceeded pre­PSLRA rates. More than
200 new issuers have been sued in each of the last several years, with the number
of filings rising dramatically in 2001 to more than 300. With weakened markets and
such recent, record settlements as the unprecedented settlement of the securities
claims against Cendant Corp. for $3.25 billion, it is anticipated that the number of
companies sued will remain close to the peak reached in 2001. This article provides an overview for business lawyers and business people of what to
expect when a suit is filed, and offers suggestions to assist in controlling exposure
from such litigation.
For every public company, there will come a time when it has to announce news
that the market won't like. Some of those times are more likely than others to bring
on a class action. It is important to recognize the risk that a class action will be filed
and prepare for it. Early crisis management — including the retention of counsel
experienced in defending securities class actions — can appreciably increase the
company's chances of succeeding in a future motion to dismiss or for summary
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judgment. Implementation of an action plan should begin before a negative press release is
issued. Ideally, it will follow periodic reviews of the company's investor relations,
insider trading and disclosure practices. In addition to responsible revenue­
recognition practices, there are other best practices that companies can institute —
regarding investor relations, drafting of disclosures and trading by insiders — that
will reduce exposure to securities litigation. These include proper use of the safe
harbor for forward­looking statements, avoiding entanglement with analysts or
adoption of third party statements, and establishing 10b­5(1) trading programs. The most frequent cause of a new class action is the announcement of a financial
restatement or the discovery of accounting irregularities. While only 20 percent of
cases filed in the last five years followed actual restatements, more than half
contained allegations of accounting fraud. The announcement of a regulatory or criminal investigation also ignites class
actions. For example, the December 2000 announcement of inquiries by the SEC
and the U.S. attorney into IPO allocations and other underwriting practices has
spurred more than 1,000 lawsuits in New York against approximately 300 issuers
and their underwriters. Other common catalysts include missed expectations, the failure of a new or
anticipated new product, a change in business strategy, or the cancellation of a
significant contract, coupled with a drop in stock price.
During the days and weeks that follow a negative announcement, it is common for
multiple complaints to be filed. The typical defendants in a securities class action
include the issuer, the CEO, the CFO, any other officers and directors who sold stock
or made public statements, and sometimes the auditors and underwriters.
Most claims are made under Section 10(b) of the Exchange Act, which prohibits the
making of a material misstatement or omission in connection with a purchase or
sale of securities. If there has been a securities offering during the relevant period,
claims also may be filed according to Sections 11 and 12 of the Securities Act. While
there are a number of differences between the two, one of the most significant is
that Securities Act claims generally do not require proof of scienter (intent to
defraud).
Except for variations in class periods and constituents, the early flurry of complaints
often will be virtual duplicates of one another. They may say very little beyond
quoting public materials and concluding that any decline in the company's stock
price resulted from a fraudulent scheme to inflate it. Often these initial pleadings are
simply "placeholders," and are part of the process by which plaintiffs' firms vie for
control of potential class actions.
The first thing to do after learning that a class action complaint has been filed is to
take a deep breath — there will be plenty of time to respond to the complaint. The
PSLRA created certain procedural steps that must be completed before a class action
can move forward. First, the PSLRA's procedures provide for the consolidation of related cases and
appointment of lead plaintiff. Lead plaintiff motions must be filed within 90 days
after the initial announcement of the suits is published. Although courts have taken
different approaches in selecting the lead or "most adequate" plaintiff, there is
presumption in favor of the plaintiff or group of plaintiffs who suffered the greatest
dollar value loss. While defendants do not have standing to oppose these motions, it
is important that they monitor these proceedings. Defendants may and should file
amicus briefs if there are important issues to raise. The PSLRA also calls for the lead plaintiff to select counsel to represent the class,
subject to the approval of the court. Some courts take an assertive role in this
process. The court may reject proposals it concludes are cumbersome or likely to
increase fees; it may even institute a competitive bidding process. After lead counsel
is selected and a consolidated complaint filed, the baton will officially pass to the
defendants.
The consolidated complaint to which defendants will respond may well be expanded
and contain more substantive allegations than the earlier placeholder complaints.
During the time period between the complaint's filing and the filing of a consolidated
complaint, plaintiffs' counsel will have conducted an investigation, including seeking
out former and disgruntled employees and interviewing customers and vendors.
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Defendants need to anticipate such activity and engage in their own preparation.
Defense activities generally should include:
reviewing the company Web site,
consulting with the company's insurance carrier,
investigating scienter allegations,
gathering information about securities holdings and trading by insiders,
considering the retention of consultants, and
planning a motion to dismiss and a contingent defense plan.
In some cases investigation of the proposed lead plaintiffs also may be appropriate.
In most cases, discovery is not sought by plaintiffs until after the resolution of the
motion to dismiss. If discovery is sought, however, defendants should apply to have
it stayed.
In certain cases, especially those involving financial fraud, this early period will be
complicated by the need for an internal investigation or lead to parallel regulatory
inquiries. These situations raise a number of difficult issues and require prompt
attention by counsel to ensure coordination between their management and the
defense of the class action.
There are good reasons to file a motion to dismiss in almost every securities class
action and approximately 24 percent of such motions result in the outright dismissal
of the case. The most common grounds on which to base a motion to dismiss are:
failure to plead with particularity, failure to plead a material misstatement or
omission, and failure to plead strong inference of scienter. Adequate particularity is the "who, what, when, where and how" of the alleged
wrongdoing. Regardless of whether a claim charges fraud, the PSLRA requires any
securities complaint based on an alleged misrepresentation or omission specifically to
identify each misleading statement or omission and state the reason why the
statement or omission is misleading. Failure to satisfy this requirement is grounds
for dismissal. See In re Staffmark Inc. Securities Litig., 123 F. Supp. 2d 1160, 1166
(E.D. Ark. 2000). The motion to dismiss also may challenge the materiality of alleged misstatements
and omissions. In assessing materiality of an alleged omission or misrepresentation,
the court should consider all documents referenced in the complaint, as well as SEC
filings and other publicly available materials.
Some alleged misrepresentations are not actionable because they are opinion,
puffery or simply distort the record. Other times, the prospectus and registration
statement contain risk disclosures undercutting allegations that the documents
painted a misleading picture. See, for example,In re Ultrafem Securities Litig., 91 F.
Supp.2d 678 (S.D.N.Y. 2001) (dismissing with prejudice claims under the Securities
Act and Exchange Act). The market's failure to respond to a challenged disclosure
may also implicate against materiality.
Perhaps the most fruitful ground on which to move to dismiss is failure to plead
facts raising a strong inference of scienter, a statutory requirement of the PSLRA.
While the circuits have adopted varying interpretations of the requirements for
pleading scienter, a motion on this basis is most likely to be successful where certain
factors traditionally viewed as evidence of scienter are absent. A common focus of
such motions is whether individuals engaged in substantial and unusual insider
trading or whether there is other evidence that individuals engaged in or personally
benefited from an alleged fraud other than in the most generic way (such as would
apply to every director or officer). See In re Trex Co. Inc. Securities Litig. No. 7:01­
CV­00517, 2002 U.S. Dist. Lexis, at *30 (W.D.Va. May 29, 2002).
More than 55 percent of new class action filings in 2001 contained allegations of
improper trading by insiders, and approximately 50 percent contained allegations of
accounting fraud. That is because such allegations often have been viewed as indicia
of scienter. Neither type of allegation is dispositive, however, and courts will look
below the surface of such allegations and dismiss cases where the alleged inference
is weak or rebutted. See, for example, Galileo Corp. Shareholders Litig., 127 F. Supp.
2d 251, 262 (D. Mass. 2001).
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As noted above, the key to disposing of insider trading allegations is to demonstrate
that they were not "substantial and unusual." Plaintiffs typically focus on profits
gained from such sales. Defendants should call the court's attention to the
percentage of shares sold compared to their total holdings (including options) and
compared to all insider holdings. Additionally, they may point to prior patterns of
similar sales, 10b­5­1 trading programs as well as external motivators for stock sales
(such as retirement, tuition or major purchases.) These factors will undercut the negative inference plaintiffs would draw from the
mere fact that sales occurred. Defendants also may point to purchases by other
insiders, especially those close to the allegedly concealed information (such as sales
and financial officers) to militate against a finding of scienter.
Although restatement and accounting irregularity cases are traditionally viewed as
difficult to get dismissed early, even they can be dismissed where the alleged indicia
of scienter are weak or rebutted. Scienter also has been found lacking in
restatement cases where the restatement did not result from an especially visible
customer relationship, was not especially large relative to the overall revenues for
the period at issue, or involved complex or novel accounting rules that were deemed
subject to legitimate debate. See In re E. Spire Comm. Inc. Securities Litig., 127 F.
Supp. 2d 734, 742­43 (D. Md. 2001).
After restatements, a common type of securities class action continues to be those
based on missed estimates. Many of these cases are based on analysts' estimates,
which the company is alleged to have "adopted" or become "entangled with" rather
than forecasts actually put out by the company. In such cases, plaintiffs' lawyers
often allege that defendants have been "stuffing the channels" and attribute any
insider sales to intentional efforts to profit in an inflated market. In reality, missed estimates are a fact of life. They may result from a variety of
innocent reasons, including the simple fact that estimates are, after all, only
estimates. A company with a popular product may come off allocation and discover
that distributors have been stockpiling inventory for competitive reasons. There may
be unexpected delays in regulatory approval of new products, sales slowdowns or
shipping delays due to weather or materials shortages, or other unforeseen
complications in filling or shipping orders. In addition to the grounds for dismissal discussed above, missed­estimate cases may
be dismissed under the PSLRA's safe harbor for forward­looking statements, or the
bespeaks caution doctrine. The PSLRA's safe harbor protects certain written and oral forward­looking
statements (FLS). A written FLS is protected if it is "accompanied by meaningful
cautionary statements identifying important factors that could cause actual results
to differ materially from those projected in the forward­ looking statement." An oral
FLS is protected if it cross­references a readily available written document containing
such risk disclosures. Even statements framed in the present tense can be forward
looking if their truth or falsity cannot be determined until some future date. Harris
v. IVAX Corp. , 182 F.3d 799, 806 (11th Cir. 1999), mot. for rehearing den. , 209
F.3d 1275 (11th Cir. 2000). Moreover, even if a forward­looking statement does not contain cautionary
statements, plaintiffs must plead a strong inference of actual knowledge by the
defendant to survive a motion to dismiss. 15 U.S.C. § 740­4(c)(1)(B). Under the
related "bespeaks caution" doctrine, a forward­looking statement accompanied by
clear language explaining the risks involved is not actionable. See Klein v. Maverick
Tube Corp., 790 F. Supp. 68, 69 (S.D.N.Y. 1991).
If the complaint survives the motion to dismiss, the parties generally will stipulate to
a joint scheduling order that provides for periods of class and fact discovery. Unless
you are in the "Rocket Docket" (E.D. Va.), the completion of discovery and motions
for summary judgment generally takes upwards of six months and may take several
years. Using the information gained in class discovery, defendants may oppose the motion
for class certification. Such challenges are increasingly strategic, focusing on such
issues as conflicts among class segments and challenges to the efficiency of the
market and thus to the availability of a presumption of reliance by the purported
class. See, for example, Camden Asset Management, L.P, v. Sunbeam Corp. No. 99­
8275­Civ, 2001 U.S. Dis. Lexis at *34­36 (S.D. Fla. July 3, 2001) (denying motion
for class certification where class representatives, which were hedge funds and other
qualified investors, acknowledge that they purchased securities as part of a hedge
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strategy).
Although these challenges are historically difficult to win, defendants should not
blindly stipulate to a class without considering whether it is appropriate, particularly
in cases involving telecom and other technology companies. An economic consultant
can be of great assistance in identifying and developing arguments to defeat
certification of a class. If a class is certified, the parties will turn to substantive discovery, which includes
document production and depositions. This can be an extremely complex process,
particularly with increased reliance on e­mails as a method of day­to­day
communications. Fact discovery also may include discovery of third parties such as
former employees, vendors, customers, analysts, underwriters and auditors. Summary judgment motions, generally briefed after the close of discovery, offer an
opportunity to revisit the grounds for the motion to dismiss, particularly scienter and
materiality. For example, in shareholder litigation against Micrion Corp., the First
Circuit recently affirmed the grant of summary judgment dismissing the case on the
grounds that plaintiffs would not be able to prove scienter. Geffon v. Micrion Corp. ,
2001 U.S. App. LEXIS 8800 (1st Cir. May 10, 2001). Similarly, in Longman v. Food
Lion Inc. , 197 F.3d 675 (4th Cir. 1999), the Fourth Circuit affirmed the dismissal of
plaintiffs' charges on materiality grounds. Longman v. Food Lion, 197 F.3d 675 (4th
Cir. 1999). Arguments that may have been ill­suited for a motion to dismiss, including reliance,
loss causation and the one­year notice aspect of the statute of limitations, often are
more successful when raised in a motion for summary judgment.
Too often, settlement is only thought about in defining moments of a case after the
resolution of motions to dismiss or on class certification. Instead, settlement should
be thought about as the company and counsel investigate, brief their motions and
develop the evidence. After all, the arguments defense counsel makes on the
motion to dismiss or prepares for summary judgment are the same arguments
counsel will use to negotiate the terms of settlement with plaintiffs' counsel. Here again, an economic consultant can be of great assistance to defense counsel by
establishing negative causation factors, showing that the price effect on the market
of the alleged false information was minimal, and otherwise assisting counsel to
challenge plaintiffs' damage theories and estimates.
With settlement, as with all major strategy decisions, the company should inform
and consult with its insurance carrier. The more the insurance carrier understands
about the case, the more likely it is that the insurance carrier will agree with the
company's views on settlement.
It may be a matter of months or it could be years, but sooner or later, 99.5 percent
of securities class actions that are not dismissed are settled. It is the rare exception
when a case against an issuer or individual directors and officers reaches a jury.
Such outcomes often reflect nothing more than defense counsel's inability to
persuade the plaintiff or the insurance carrier of some critical piece of the
defendants' assessment of the potential liability. The rate of settlement should not be taken by companies as a sign that the PSLRA
has failed entirely. First, it is important to remember that more than a quarter of
cases are dismissed. In other words, plaintiffs get nothing. Second, the median
settlement is less than 6 percent of investors' alleged losses. Although the particular facts of a case and the company's financial health and
resources remain important factors in settlement negotiations, defense counsel's
strong arguments for dismissal and summary judgment can and do reduce the
amounts on the settlement table. Therefore, it should never be viewed as a defeat
when defense counsel can bring the case to a point where a settlement satisfactory
to all parties is achieved.
Wager is a partner and Ward an associate at Lewis & Bockius LLP, in New York City.
Their e­mails are [email protected] and [email protected],
respectively. David BenHaim, a summer associate at Morgan Lewis, assisted in the
preparation of this article.
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