Tag Archives: 10b5-1

Tips for Avoiding Securities Litigation

Here are tips on how public companies can better protect themselves against securities claims — practical steps companies can take to help them avoid suits, mitigate the risk if they are sued and defend themselves more effectively and efficiently.

Avoiding suits

Companies can avoid many suits with what I’ll call “better-feeling” disclosures. Nearly all public companies devote significant resources to accounting that conforms with GAAP, and non-accounting disclosures that comply with the labyrinth of disclosure rules. Despite tremendous efforts in these areas, events sometimes surprise officers and directors — and the market — and make a company’s previous accounting or non-accounting disclosures appear to have been inaccurate. But plaintiffs’ lawyers decide to sue only a subset of such companies — a smaller percentage than most people would assume. What makes them sue Company A, but not Company B, when both have suffered a stock price drop because of a development that relates to their earlier disclosures?  There are a number of factors, but I believe the driver is whether a company’s disclosures “feel” fair and honest. Without the benefit of discovery, plaintiffs’ lawyers have to draw inferences about whether litigation will reveal fraud or a sufficient degree of recklessness — or show that the discrepancies between the earlier disclosures and later revelations was due to mistake or an unanticipated development.

What can companies do to make their disclosures “feel “more honest? An easy way is to improve the quality of their Safe Harbor warnings. Although the Reform Act’s Safe Harbor was designed to protect companies from lawsuits over forward-looking statements, there are still an awful lot of such actions filed. The best way to avoid them is by crafting risk warnings that are current and candid. A plaintiffs’ lawyer who reads two years’ worth of risk factors can tell whether the risk factors are boilerplate or an honest attempt to describe the company’s risks. The latter deters suits. The former invites them.Another way for companies to improve their disclosures is through more precision and a greater feel of candor in the comments they make during investor conference calls. Companies sweat over every detail in their written disclosures but then send their CEO and CFO out to field questions on the very same subjects and improvise their responses. What executives say, and how they say it, often determines whether plaintiffs’ lawyers sue — and, if they do, how difficult the case will be to defend. A majority of the most difficult statements to defend in a securities class action are from investor calls, and plaintiffs’ lawyers listen to these calls and form impressions about officers’ fairness and honesty.

Companies looking to minimize the risks of litigation should also take steps to prevent their officers and directors from making suspicious-looking stock sales — for obvious reasons, plaintiffs’ lawyers like to file suits that include stock sales. If a company’s officers and directors don’t have 10b5-1 plans, companies should establish and follow an insider trading policy and, when in doubt, seek guidance from outside counsel on issues such as trading windows and the propriety of individual stock sales, both as to the legal ability to sell, and how the sales will appear to plaintiffs’ lawyers. Even if officers and directors have 10b5-1 plans, companies aren’t immune to scrutiny of their stock sales — plaintiffs’ lawyers usually aren’t deterred by 10b5-1 plans, contrary to conventional wisdom. So companies should consult with their counsel about establishing and maintaining the plans, to avoid traps for the unwary.

Defending suits

Whether a securities class action is a difficult experience or a fairly routine corporate legal matter usually turns on the company’s decisions about directors’ and officers’ indemnification and insurance, choice of defense counsel and management of the defense of the litigation.

Deciding on the right director and officer protections and defense counsel require an understanding of the seriousness of securities class actions. Although they are a public company’s primary D&O litigation exposure, most companies don’t understand the degree of risk they pose. Some companies seem to take securities class actions too seriously, while others might not take them seriously enough.

The right level of concern is almost always in the middle. A securities class action is a significant lawsuit. It alleges large theoretical damages and wrongdoing by senior management and often the board. But the risk presented by a securities action is usually very manageable, if the company hires experienced, non-conflicted and efficient counsel and devotes sufficient time and energy to the litigation. Cases can be settled for a predictable amount, and it is exceedingly rare for directors and officers to write a personal check to defend or settle the case. On the other hand, it can be a costly mistake for a company to take a securities class action too lightly; even meritless cases can go wrong.

The right approach involves several practical steps that are within every company’s control.

Companies should hire the right D&O insurance broker and treat the broker as a trusted adviser.

There is a talented and highly specialized community of D&O insurance brokers. Companies should evaluate which is the right broker for them — they should conduct an interview process to decide on the right broker and seek guidance from knowledgeable sources, including securities litigation defense counsel. Companies should heavily utilize the broker in deciding on the right structure for their D&O insurance program and in selecting the right insurers. And, because D&O insurance is ultimately about protecting officers and directors, companies should have the broker speak directly to the board about the D&O insurance program.

Boards should learn more about their D&O insurers.

Boards should know their D&O insurers’ financial strength and other objective characteristics. But boards should also consider speaking with the primary insurer’s underwriting executives from time to time, especially if the relationship with the carrier is, or may be, long-term. The quality of any insurance turns on the insurer’s response to a claim. D&O insurance is a relationship business. Insurers want to cover D&O claims, and it is important to them to have a good reputation for doing so. The more the insurer knows the company, the more comfortable the insurer will be about covering even a difficult claim. And the more a board knows the insurer, the more comfortable the board will be that the insurer will cover even a difficult claim.

Boards should oversee the defense-counsel selection process, and make sure the company conducts an interview process and chooses counsel based on value.

The most important step for a company to take in defending a securities class action is to conduct an audition process through which the company selects conflict-free defense counsel who can provide a quality defense — at a cost that leaves the company enough room to defend and resolve the litigation within policy limits. Put differently, the biggest threats to an effective defense of a securities class action are the use of either a conflicted defense counsel, defense counsel who will charge an irrational fee for the litigation or counsel who will cut corners to make the economics appear reasonable.

Errors in counsel-selection most often occur when a company fails to conduct an interview process, or fails to consult with its D&O insurers and brokers, who are “repeat players” in D&O litigation and thus have good insights on the best counsel for a particular case. Although the Reform Act’s 90-day lead plaintiff selection process gives companies plenty of time to evaluate, interview, and select the right defense counsel for the case, many companies quickly hire their corporate counsel’s litigation colleagues, without consulting with brokers and insurers or interviewing other firms.

The right counsel may end up being the company’s normal corporate firm, but a quick hiring decision rarely makes sense under a cost-benefit analysis. The cost of hiring the wrong firm can substantial — the harm includes millions of dollars of unnecessary fees; hundreds of hours of wasted time by the board, officers and employees; an outcome that is unnecessarily uncertain; and an unnecessarily high settlement — and there’s very little or no upside to the company.

On the other hand, it costs very little to interview several firms for an hour or two each, and the benefit can be substantial – free and specialized strategic advice by several of the handful of lawyers who defend securities litigation full time, and potentially substantial price and other concessions from the firm that is ultimately chosen.  The auditioning lawyers can also provide guidance to the company on whether its corporate counsel faces conflicts and, if so, the potential harm to the company and the officers and directors from hiring corporate counsel anyway.

When Not to Use Regular Counsel

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.

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 (intent or knowledge of wrongdoing), 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 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, because 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.

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.