Securities Litigation Law, Who is The Enemy Now?
By sunset on Election day last November , that sigh you heard wasn't the wind in bare autumn branches; it was a collective exhalation of relief from biotech CEO's across the nation - relief that California's much debated proposition 211 had finally bitten the dust. Prop 211, designed to circumvent stricter federal guidelines by making it easier to file shareholder class action suits in state courts, got only 26 percent of the vote, but not before it had succeeded I scaring the bejesus out of hightech and biotech industries.
Among other things, Prop 211 would have made fraud-on-the-market the state law, made executives and their advisors personally liable for fraud, and perhaps in its most controversial provision -brought within California jurisdiction companies with even one share holder in the state.
Although opponents of the measure that Prop211 would have resulted in mass relocation of company headquarters and the barring of Californians from buying shares, such drastic results have for the moment been rendered moot.
But now that the bogeyman is dead (or at least for the moment napping), what about the Private Litigation Securities Reform Act of 1995, the federal law that stirred the backlash in the first place.
A KNOCK ON THE DOOR
Securities class action lawsuits take a familiar form: something goes wrong - say, a projection you've made about earnings fails to materialise-and your company's stock takes a sudden dive. The next thing you know, your shareholder's lawyer is knocking on your door with a fat briefcase and a happy smile.
In the early 1990s such cases took a dramatic upward turn. Annual filings against all companies hovered against all companies hovered in the low-to mid-100s throughout the 1970s and 1980s, then suddenly shot to nearly 300 a year from 1990 onward, according to Washington D.C.-based Class Action Reports.
The effect on a company can be staggering: time and resources are tied up fighting the action, which (if it is not dismissed) is almost always followed by an out-of -court settlement simply for financial expediency, regardless of any wrongdoing. In biotech, shareholder suits have targeted Alza, Amgen, Cephalon Chiron, Molecular Biosystems,and Xoma, among others. The average cash settlement of such suits by biotech companies is about $7 million, but they can go much higher, according to the Law and Economics Consulting Group (LECG) in Emeryville, California. Genetech settled such a suit for $29 Million in 1998.
Not all defendants of securities class action suits are innocent victims of circumstance, of course. Many securities suits involve genuine fraud or deception and are well founded. Even defence attorneys support them-at least, when they are not directly involved in the case at hand-because the strength of financial markets depends on investor confidence in their honesty and fairness.
But by the early 1990s some people on the industry side thought things had spun out of control. Biotech lawyers and Lobbyists routinely started using words like "harassment" and "ransom". They referred to certain famous plaintiffs' as "scum". Those attorneys, in turn, accused biotech CEOs of being cheats and frauds, out to hide their own malfeasance and take their shareholders to the cleaners.
Whichever side you believe, the fact remains that the most notorious strike suits are filed primarily by a few law firms that specialise in them, and can , as mentioned, be based on as little as an unexpected stock drop or bad news from the FDA.
The upswing in such cases in the 1990s hit he high tech industry particularly hard because of its traditionally volatile stocks; indeed, about a third of settlements resulting from these suits were in high tech, according to National Economic Research Associates of White Plains, New York. This led to fierce lobbying by an alliance of such firms, which were gladly joined by their firms by their brethren in Biotech. This rough and somewhat unlikely confederation-rumpled scientists, sockless software engineers, pinstriped CEOs, and slick professional lobbyists-wanted so-called frivolous lawsuits out of their hair. They got so much more than that.
What they got passed dramatically, no less, over a presidential veto, the only such override in the history of the Clinton administration-was the Private Securities Litigation Reform Act of 1995. Many people in biotech broke out the champagne, under the impression that the act had saved their bacon.
CELEBRATING TOO SOON
They may not be prepared for the hangover, however. Although the immediate and obvious response-California's Proposition 211-predictably provoked dire predictions of collective corporate doom, the Reform Act itself may arise as many ugly questions as it purports to resolve. John Avery, an SEC attorney who has written comprehensively about the act and its implications, remarks dryly that "while the act does not clearly achieve its goals of bringing meaningful reform to the system, it will take years of litigation to resolve the many uncertainties it creates.
In other words, companies planning on making changes would do well to thoroughly acquaint themselves with the law before they do anything drastic. One bib reason is that regardless of any legal challenges it faces, the act applies only to federal courts, not state courts-to which plaintiff's attorneys can be expected to expeditiously transfer their lawsuits.
SAFE HARBOUR
The best known aspect of the act is its "safe harbour" provision, which protects companies from legal action for so-called forward looking statements. Company officers can, in other words, theoretically indulge in a little optimism as long as they provide some "meaningful" cautionary language that identifies reasons things might not turn out as they'd like(and like the financial markets to believe). Sounds swell doesn't it? Keep reading
"In biotech, the people starting these companies have to be optimists" Says Vincent O'Brien. a principal of LECG. "the shareholders want them to be optimists. If they are not the company is not going to make it. But a lot of times when I look at these lawsuits, I can see that the management doesn't see the trouble ahead, because they are so enamoured with their technology and it's so hard to make it work. "O'Brien thinks that 10 to 20 percent of the cases he sees have merit, a figure in line with that reported by attorneys on both sides.
Having, as those in the fields have already discovered, presumably with both joy and chagrin, the new law carries an unexpected twist.
"One of the most fascinating things abut the Reform Act is that it purports to protect statements that are lies-that are known to be false when they are made," according to Amy Fried, an attorney, with Hogan & Hartson in Baltimore. She adds that the court have yet to decide whether that aspect of the statute actually means what it appears to mean.
This part of the law apparently caused great consternation within the SEC when staffers realised its implications, Fried says. Another source familiar with SEC matters adds that many on the agency's staff "thought it went too far."
In an article in Business Lawyer, John Avery described the two "prongs" of the safe-harbour provision. In the first, the person making a statement is protected if the plaintiff fails to prove that the person who made it knew it was false or misleading. Such a statement requires no cautionary language.
Under the old prong, the person making the statement is protected if it is noted as being forward-looking and is accompanied by cautionary statements identifying factors that could cause results to differ materially from those in the forward looking statement. "Read literally" Avery writes, "this prong......would protect forward looking statements that were known to be false and misleading when made, provided they are accompanied by meaningful cautionary statements."
Indeed, the cautionary language itself could in some circumstances be taken as deceptive, according to James Finberg, an attorney with Lief Carbraser Heiman & Bernstein, a consumer law firm in San Francisco.
"Say a biotech company gives cautionary language that says their future income depends on FDA approval," he says," but they have a letter from the FDA that the product isn't effective and has serious side effects, that it is not likely to be approved-and they don't disclose that. Is the cautionary language itself misleading because it fails to say that approval is unlikely?"
Other questions yet to be resolved about the law's safe-harbour provisions include whether all such "important factors" must be identified or only some of them, and whether a company has to correct a statement it later discovers is false.
Thomas Seoh, general counsel of Guilford Pharmaceuticals in Baltimore, acknowledgements the conundrum. "The legislation allows the possibility that an officer may be speaking falsely and nonetheless be protected," he says. His advise to Guilford's management is straight from Mark Twain: "Tell the truth; there is less to remember."
In any case, companies should be aware that the act's safe-harbour provisions give no protection from SEC action and are not valid in some state courts-including California's-where plaintiffs may file lawsuits as an alternative to ( or along with) federal court. Companies may want to be careful about forward-looking statements, then, even though one of the key objectives of the act was to unencumbered them in this arena.
PLEADING REQUIREMENTS:
Another controversial aspect of the Reform Act has to do with heightened pleading requirements. Previously, shareholders could sue on the basis of company officer's' recklessness-for example making statements that were overly optimistic (and presumably inflated the value of the company's stock) but could not necessarily be shown to be intentionally fraudulent.
Under the Reform Act, however, plaintiffs must face a much more stringent test, successfully demonstrating at the outset of the case that the defendant acted with the "required state of mind"-intentional deceit. The act also requires plaintiffs to specify each allegedly misleading statement and make clear why it is misleading.
Much of this information normally comes out in the course of a trial; indeed, discovering it is partly what trials are all about . And although such provisions would seem a godsend to company executives, they go so far that they are likely to provoke legal challenges far into the future, according to experts such as John Avery. This is partly because of an additional provision mandating sanctions if the suits are judged frivolous. In fact, this provision, which some have likened ro a "loserpays" scenario, was one of the primary reasons President Clinton vetoed the bill.
Regardless of any future challenges, however the chilling effect of such constraints is already being felt. In the federal court for Northern California last Fall, Judge Fern Smith dismissed a shareholder suit against Silicon Graphics, stating in her opinion that "plaintiffs must allege specific facts that constitute circumstantial evidence of conscious behaviour by the defendants."
On September 25, a securities case against Scios, a biotechnology firm in Mountain View, California, was also dismissed. US district Judge Marilyn Hall Patel ruled that "plaintiffs have not pled facts sufficient to explain why defendants' summaries..... were false and misleading."
"There's certainly a suggestion that you need something close to a smoking gun in hand before you commence your case, and before you commence discovery -which would give you a better chance of appending such smoking guns," says Gene Goldman, a securities litigation partner at the Washington D>C> office of GMC Dermott Will & Emery. " Biotech companies will be a beneficiary of these decisions." He adds.
From the other side, plaintiff's attorney Paul Bennet, of the San Francisco firm of Gold Bennet & Cera, analysed what the changes will mean to a firm like his. "This law puts the substantive decision-making process at the beginning of the case, when the court is in a very position to make a substantive decision," he says. "The barriers to entry have been raised; you've got to know how to analyse what is going on to determine whether there is o is not a case.
"Ultimately, this will mean complaints are better, but at the end of the process, whether a complaint alleges, a lot of stuff at the beginning doesn't make that much difference if the facts are there," Bennet says. "The key to get ridding of cases on both sides is the prompt disclosure of core documents, because if the case is strong, it is in both sides' interest to try and resolve it. If it is weak it is going dismissed by a responsible attorney, because he is not going to want to invest his time and money."
Perhaps surprisingly, Bennet notes that the Reform Act may improve his firm's competitiveness. "In the eighties, people who historically had not been in securities litigation wandered in because saw money in it ," he says. "Those people are likely to wander out now, which is fine."
Bennet, who says he has rejected more than 90 percent of the securities cases brought to him (including several biotech cases), notes that "the most important day in any case is the day you decide to take it on. When we pass on a case, its because of a lack of information that there is a strong enough claim to warrant going forward."
PROPORTIONATE LIABILITY:
The Reform Act also changes how liability is assessed I many cases. Previously, "joint and several" liability meant that each of the defendants in a case-which would include for example, the company's accounting firm-could be held liable for the whole amount of the settlement.
The new law changes this to "proportionate liability" for defendants found not to have deliberately violated securities laws. (Joint and several liability still applies to defendants who knowingly break the law.)
In cases where one defendant settles a case but the others do not those who choose to fight on or to go to court , can do so without worrying that this will increase their exposure; regardless of how cheaply their erstwhile compatriots may settle, they will still be responsible only for their share, as determined by the court.
Attorney Bennett notes that the chief beneficiaries of this aspect of the law are likely to be accountants. "They were single-minded and up front about what they wanted: the abolition of joint and several liability unless it was knowing conduct," he says.
For biotech companies, one important aspect of the changes is a limitation on the damages plaintiffs can seek under the fraud-on-the-market theory of liability.
This refers to the information on which shareholders rely when they decide to buy a certain security. Federal courts have held that individuals are presumed to rely on astock's price as an accurate gauge of its value. Whether someone has bought the security had a chance to read a company's purportedly misleading statements is considered immaterial, because brokers, analysts, and others will have read them, and their judgement will be reflected in the stock's price. If they are deceived, that fraud is then reflected on the market.
Under the Reform Act, damages in such cases are limited to the difference between the price the plaintiff paid ( or received) for the security and its actual value, as measured by its mean trading price during the 90 day period following the issuing company's correction of its misstatement or omission.
Biotech companies should note, however, that many state courts-including those in California-do not recognise fraud-on-the-market as valid. As a result, lawsuits filed may leave companies just as exposed as they were before. (This is discussed further in the section on state court filings, below.)
LEAD PLAINTIFF:
The fourth aspect or the Reform Act is the requirement that the court appoint a "lead plaintiff" to represent the class, with the presumption that this should be the person or group with the largest financial stake in the case. The lead plaintiff must choose legal counsel for the class.
This last provision is critical; many experts expect it to have a huge impact on the functioning of the system. For one thing, plaintiffs' firms that make a business of bringing such lawsuits can find themselves stripped of a case they've worked to file, and indeed this has already happened in a Wisconsin suit. The economic incentive for monitoring and pursuing such cases, then, could have its legs cut out from under it.
Moreover, in such suits shareholders may find themselves on both sides of the fence if they lead a class action suit against a company whose shares they still own, because a settlement that damages the company also hurts them.
"Congress's intent was to get large institutional investors involved in deciding which suits had merit and were truly in the interest of investors involved in deciding which suits had merit and were truly in the interest of investors," says a source close to the SEC. "If a lawsuit comes, lawyers are going to siphon off a lot of money. Investors might decide they're better off not to purchase sue it. Instead, a large institutional investor might simply prefer to go to the board and tell them to fire the person at fault.
BIOTECH V THE SEC'S V THE FDA.
Biotech companies face a few unique dilemmas in navigating the minefield of information, misinformation and non information that can lead to securities litigation. Part of this has to do with negotiating the conflicting demands of federal regulatory agencies, particularly the SEC and the FDA.
"Its not as if this were an unsophisticated industry; the most detailed risk disclosures are for biotech companies, bar non," says Boris Feldman, one of the nation's foremost defendants' attorneys, with Wilson Sonsini Goodrich & Rosati in Palo Alto, California. "They were already telling you they had no revenue, no manufacturing, and no approved product. They did not know if the drug worked, and so far they'd killed a couple of rats. It is hard to make that uglier, other than saying, "we killed the rats."
Tension arises because the SEC wants companies to disclose everything material known about their products and prospect, whereas the FDA wants companies to keep quiet until it has had a chance to scrutinise their claims.
"I would advise people in the biotech industry to be very cautious about that," says LECG's O'Brien. "Put out what the FDA allows you to, but don't try to put a positive spin on it. I know that it is hard to do because you need capital to keep your product going, but you can get in real trouble."
Feldman agrees that the best companies can do is balance. "They try to do enough that the securities lawyer asks you if you have discharged your obligation, but not so much that they get a call from somebody at FDA saying, " "What the hell are you guys doing? What are you hyping this for?"
STATE COURT:
As mentioned previously, many attorneys on both sides expect plaintiffs' attorneys to simply circumvent the federal statute by filing suits in state court.
"State court lawsuits are a big problem," admits Feldman, who says he has seen a rise in the proportion of such suits since passage of the act. "Companies may think they have a lot of protection now because of the Reform Act, but it is only protection against federal suits."
Over time," Feldman adds "federal judges have had enough experience with strike suits that they realised that many of them were garbage and threw them out. It's going to be a long education process for the state court."
Although state courts have obvious advantages for plaintiffs' lawyers-again , California state courts do not recognise the new federal provisions for pleading, or for safe-harbour language-they pose unique challenges, as well.
For one it may be harder to file a class action law suit in some states, including California, because they do not recognise the fraud- on the - market basis for a case. Plaintiffs' attorneys would have to prove that every single shareholder in the suit had read and understood the company's allegedly misleading statements had influenced their decision to buy stock - clearly an impossible task.
This may not be as much of a roadblock as it appears, however. In New York, which like California does not recognise fraud-on-the-market as a basis for class action, securities litigation attorney Goldman says that "courts are certifying the class even though the reliance requirement [i.e., what shareholders relied on to make their decision to purchase stock] will still come into play in trial. They're just saying, "We'll worry about that later.'"
However this will eventually play out - in New York, California, or elsewhere - is anybody's guess, but it seems clear that plaintiffs' attorneys and their clients will find ways around the federal law if it is in their interest to do so One way around it, of course, is to make it easier to file in state court - precisely the goal of California's Proposition 211.
SURVIVING:
Biotech companies reeling at threats from several directions at once (and not insignificantly, from inside) should pay attention to a few basic rule, according to O'Brien.
"Just having your stock drop doesn't get you sued," he says. "It also needs to be a surprise. You need to have been outperforming the market and your industry group, your stock needs to have stayed up while others have collapsed in a downturn-then all of a sudden there is bad news and your stock falls out of bed.
"It also greatly increases your chances if there is insider trading during the damages period," he says. "Those things together give you a very high probability of getting sued." Indeed if a company is big enough, with more than a couple of hundred million dollars in market capitalisation, O'Brien says it has about a 90 percent chance of facing a securities suit.
Moreover, less than 10 percent of such cases get dismissed, compared with roughly 30 percent of other kinds of cases. That 10 percent, however , is up from just 1 to 2 percent only 5 years ago, O'Brien says, and the trend may be accelerating largely due to the Reform Act.
Nevertheless, says a source close to the SEC, " in many cases, the facts are that the companies are not as spotless as they'd like you to believe. Often they are anxious to settle because they have actually had some exposure, such as evidence of insider trading."
Even O'Brien, who admits he is not noted for sympathy with the plaintiffs in such cases, describes in sobering detail how even well meaning companies can start down a slippery slope to fraud.
"People have gone to hell one step at a time," he says. "Sales go soft, so they start pumping things out the door at the end of the quarter. The next quarter they're waiting a day or two to close their books. Pretty soon they're doing some pretty things. They keep thinking, "Next quarter things will be better, we'll bail ourselves out." You see people shipping products that haven't been sold and then taking them back the next quarter. Some of its people who don't start out that way, but you also see people who decided they were going to cash in any way they could."
The biggest problem with strike suits, O'Brien says, is that "there is not an attorney in the country that will advise the company what to do. They will all say, "I don't know. If you say something, you can get sued. If you don't say something, it is equally likely that you will get sued. Companies are screaming about these things because they don't know what to do."
Baffled officers of biotech companies would do well to avoid even the impression impropriety, of course. They should also be prepared to continue to fight plaintiffs' attorneys who will in turn continue their struggle to make securities class actions easier to file.
SON OF PROPOSITION 211:
But 211 may be more dormant than dead, because one of its primary sponsors was the indefatigable strike-suit king, Bill Lerach, who raised more than $305 million for the cause. Lerach, a partner in the San Diego offices of Milberg Weisss Bershad Hynes & Lerach, oversees a team of roughly 50 lawyers who devote themselves exclusively to lucrative strike suits; in fact they are responsible for about a quarter of all of those filed. Whether an organisation that owes its financial existence to such suits will knuckle under to the new status quo is very much open to question, but it seems unlikely. (Letrach did not return calls to his office). Stay tuned.
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