Two years ago, the repeat players in the world of shareholder class action litigation plaintiffs and defendants lawyers, D&O carriers and their coverage counsel -- consulted fortune tellers (or worse, each other) to foresee how the Private Securities Litigation Reform Act would change their professional lives. Would honest businesses be hit with fewer frivolous claims? Would companies purchase less D&O liability insurance? Would securities litigators have to retool and learn to read patents?
The revolutionary changes that some hoped, and others feared, would occur have not -- yet. With any major legal reform, it takes time for the new rules to become part of the legal system and begin altering behavior. The number of district court decisions construing the Reform Act is still small. The volume of appellate decisions is minuscule. But while its too early to draw longterm conclusions as to the efficacy of the Reform Act, various tactical battles during the past two years are worth noting.
A hallmark of securities litigation during the last two years has been the plaintiffs search for a hospitable home. The plaintiffs bars immediate reaction to the Reform Act was to shun federal court. Particularly in California -- which does not have the uniform blue-sky provisions of most states -- plaintiffs flooded the state courts with cases asserting novel, expansive theories under state law. Plaintiffs rationale was two-fold: to try to expand state laws substantively, thereby making recovery easier than under federal law; and to obtain quick discovery for use in drafting a federal complaint. Unlike the old days -- in which a plaintiff could sue first and find evidence later -- the Reform Act barred plaintiffs from obtaining discovery in federal court until their complaint survived a motion to dismiss. This discovery stay has been a major irritant to the plaintiffs bar.
In my opinion, plaintiffs state court gambit has been a failure and is over. Others may disagree. I base that conclusion on three factors. First, plaintiffs attempts to broaden dramatically state laws that have been on the books for years have not worked. Courts have consistently rejected plaintiffs attempts to apply to shareholder disputes statutes that impose lower burdens, or greater penalties, than do the securities laws.
Second, I believe that plaintiffs have come to realize that they will not be permitted to use courts in a particular state (i.e., California) to litigate the claims of shareholders around the country -- particularly when federal law provides ample remedies for nationwide classes. This issue is now before the California Supreme Court (in the Diamond Multimedia case). If the Court rules that the California securities laws only apply to investors who purchase their stock in California, then the potential damages in these cases will drop to a fraction of their current bloated size. If the Court holds that California rules the nation, then one can expect that pending legislation in Congress to preempt state securities laws for nationally traded companies will move to the fast track.
Finally, plaintiffs have not had much success milking the state cases for discovery that they can then use to file a federal complaint. In a number of recent state court decisions (starting with the Quantum case), courts have barred plaintiffs from sharing information between the different cases. Other courts have simply stayed discovery in the state case until the federal motions to dismiss were over.
As a result of these factors, the overwhelming percentage of shareholder class actions filed in recent months have been filed exclusively in federal court, without a tag-along state case.
In the old days, plaintiffs tried to be the first to file a complaint against a company whose stock had dropped, because courts often appointed the first-to-file as the lead plaintiff. Lead plaintiff = more work = higher fees. Congress was repulsed by this practice. The Reform Act therefore requires parties filing a class action to publish notice of it. Other class members can come forward to serve as named plaintiff. The court is required to choose the applicant with the largest financial interest to serve as lead plaintiff.
As with many other provisions of the Reform Act, this procedure has succumbed to the law of unintended consequences. Plaintiffs now compete to see who can issue the first press release. Their hope is that the release will attract additional class members, enabling the firm to win the contest by representing the largest financial interest. Thus, many plaintiffs firms continue to file quite rapidly after a stock drop, in order to fire the first release. One now sees dueling releases, sometimes issued by different law firms that have joined together in a single case, in hopes of snaring more victims.
The paradigmatic frivolous class action was one in which a company fell short a few orders at the end of the quarter, failed to achieve Wall Streets earnings target, and got sued after its stock dropped. One of the primary purposes of the Reform Act was to eradicate such missed forecast lawsuits. Congress created a Safe Harbor for forward-looking information, so that companies could provide guidance to investors about future results, without fear of liability if actual results did not meet their expectations. In addition, Congress imposed stringent pleading requirements, rejecting the boilerplate allegations in shareholder complaints that, whatever the company announced went wrong, management must have known about six months before.
In the immediate post-Reform Act period, plaintiffs tended to bifurcate their cases. Forecasting cases were filed in state court. Accounting fraud cases -- not protected by the safe harbor -- were filed in federal court. This bifurcation has disappeared. Company after company is being sued based on little more than having missed the Streets numbers for a quarter. Such claims are usually accompanied by conclusory allegations that the company also cooked its books.
It is, in my opinion, too early to draw conclusions about the efficacy of the Safe Harbor in stamping out forecasting claims based on 20/20 hindsight. The leading decision construing the Safe Harbor and the heightened pleading requirements (Silicon Graphics) is on appeal. If that decision is affirmed, routine missed forecast cases will diminish greatly. On the other hand, if the Court of Appeals adopts a pro-plaintiff interpretation of the Safe Harbor (a real possibility in the Ninth Circuit, where the case is pending), then the Reform Act could largely be gutted. Dont expect a decision before 1999.
This observation is anecdotal, not empirical. But it does seem as if far fewer shareholder class actions have settled in the two years since passage of the Reform Act than in the two years before. This may be because uncertainty in the legal landscape -- state court vs. federal, implementation of the pleading requirements -- has caused the respective parties valuation of particular cases to diverge. In addition, the Reform Act requires plaintiffs to disclose in the notice of settlement what their potential claims were. According to some plaintiffs lawyers, this has put them under pressure to obtain a larger percentage recovery than in the past.
One would have predicted that relations between insured companies and their D&O carriers would improve in recent years. The battles of days gone by over allocation are largely over: most companies today purchase either entity coverage or 100 percent allocations. Ironically, the availability of such coverage has in some cases had the effect of separating the companys interest from the carriers. A company that does not have to pay anything beyond the deductible -- win, lose, or draw -- may not care much about the cost of a settlement and may just want to get the unpleasantness over with. In some cases, plaintiffs have maneuvered defendants into ganging up on the carrier to fund settlements that would have been lower had the company had some skin in the game. If this becomes a trend, settlement amounts could rise materially. What to do about this, I leave to creative coverage counsel.
[In the interest of full disclosure, please note that Wilson Sonsini is counsel in the Diamond Multimedia, Quantum, and Silicon Graphics cases discussed in the article.]