MoFo Perspectives Podcast
In this episode of the Above Board podcast, Morrison & Foerster partner and host Dave Lynn speaks with Judson Lobdell, San Francisco-based partner and former Assistant U.S. Attorney, about securities class action litigation, which often arises following a significant decline in a company’s stock price. Judson provides an overview of the securities class action litigation environment, offers practical guidance on the risk factors that directors and management should consider, and provides tips on preparing for and responding to securities class action lawsuits.
Read more on this topic: A Summary Guide to Securities Class Action Litigation.
Speaker: Welcome to MoFo Perspectives, a podcast by Morrison & Foerster, where we share the perspectives of our clients, colleagues, subject matter experts, and lawyers.
Dave Lynn: Hello, welcome to the Above Board podcast. This is your host, David Lynn, and I’m co-chair of Morrison & Foerster’s Corporate Finance Capital Markets practice. I’m very pleased to be joined today by my colleague Judson Lobdell, who is a partner based in Morrison & Foerster’s San Francisco office. Judson has extensive experience in the fields of securities litigation and criminal law, including securities class actions, shareholder derivative suits, SEC enforcement actions, criminal jury trials, and DOJ and SEC investigations, as well as internal investigations, and Judson was a former assistant U.S attorney, and he’s tried many cases as well as argued cases in the U.S. Court of Appeals for the D.C. circuit and the D.C. Court of Appeals. Judson has lectured and written extensively in the area of securities litigation, and he recently published a summary guide to securities class action litigation, which is available in our Above Board Resource Center. Justin, thank you very much for joining me today.
Judson Lobdell: Oh yeah. My pleasure, Dave.
Dave Lynn: As you note in your summary guide to securities class action litigation, securities class actions are routinely filed against public companies when there’s a decline in their stock price. And despite the efforts over the years to reign in these kind of actions, they’re really more prevalent than ever. And they can prove to be very costly for companies who find themselves in the position of having to defend against these sort of lawsuits. What are the most common types of securities class action claims, and what do plaintiffs typically allege in these lawsuits?
Judson Lobdell: Well, there are many different varieties of securities class actions. I guess the key thing that they all have in common is a stock price decline resulting in a significant loss of market capitalization. So from the perspective of plaintiff lawyers—and these cases are driven by plaintiff lawyers, that’s the critical element because it’s likely to lead to large potential damages and by extension a large award of attorney’s fees. So that’s the starting point. And from there, you can kind of divide the cases into two basic types. First is, where are the plaintiff claims securities fraud? So fraud claims are brought under Section 10(b) of the Securities Exchange Act of 1934. They are hard cases to prove because there are a lot of elements where the plaintiff has the burden of proof. I guess the three most important of these are falsity, scienter, and causation. So I’ll break those down a little bit.
Judson Lobdell: Falsity means that the corporate representative made a statement that was misleading to investors. So there’s got to be a statement. An omission alone is not enough for a fraud case, a plaintiff can’t just say, “Gee, if I’d known everything that the insiders knew, I wouldn’t have bought where the price would’ve been lower.” There’s actually got to be a false or misleading statement, typically on an earnings call or in an SEC filing. So the next element is scienter, and that means an intent to defraud investors. So it’s not enough to show that there was a misunderstanding or that the sub‑certification process broke down or, there was an executive who was careless. There’s got to be an actual intent to defraud on the part of the person responsible for making this statement. And finally, causation means that the stock price was inflated because of the false statement and that the stock price dropped because the truth came out.
Judson Lobdell: So, we all know stock prices go up and down for many reasons. And it’s often very difficult to kind of disentangle all those reasons and prove why a stock went up or down on a particular day, but that’s an element the plaintiff must prove. So that’s the first type of securities litigation. Securities fraud. It’s very hard to prove. It’s easy to allege, but it’s very hard to prove. The second type of case, it comes up when there’s a securities offering, typically an IPO, could be a SPAC, and these are oftentimes called Section 11 cases based on Section 11 of the Securities Act of 1933. So these cases center around the contents of the registration statement or the prospectus, and the plaintiff has to show that there was a false or misleading statement in that offering document. Unlike with a securities fraud case though, an omission can be enough.
Judson Lobdell: So it’s sufficient in this context to show, well, there was material information that was required to be included in a registration statement that wasn’t there. As a practical matter, these cases are typically brought against companies in the first year or two after they’ve gone public, and there are key differences between Section 11 cases and fraud cases. I guess, first and most importantly, there’s no scienter requirement. So a misleading statement or in an omission is enough. There’s a due diligence defense, meaning that a defendant can prevail if it shows that it was unaware of the false statement and took reasonable measures to ensure that the material was in the registration statement, but the burden’s on the defendant here, not on the plaintiff, in contrast to a fraud case, and there’s no requirement of proving fraudulent intent. The second key difference is that these claims are not just brought against companies and their officers.
Judson Lobdell: They can also be brought against corporate directors, outside auditors, bankers, and others who sign the registration statement or participate in the selling process. And the third key difference that I’ll mention here relates to the causation and damages. So, there’s basically what amounts to a presumption that a decline in the price of the stock below the offering price is due to the misrepresentation. And defendant can rebut that presumption by showing the price decline was due to other things, but the burden here lies with the defendant, not the plaintiff. And I guess finally, Section 11 cases are a lot harder to get dismissed earlier in the stages of the litigation. So, in other words, before discovery, and that’s true for a lot of reasons, including the fact that they can be brought in state court not just federal court. So that’s a long answer to your question, Dave, there are two kind of varieties of securities class action. Section 11 cases, much easier for the plaintiffs to pursue, but they’re really limited for the most part to new companies.
Dave Lynn: Securities class action litigation often does not happen in a vacuum in the sense that the government may also take an interest in the circumstances that can give rise to the private claims. How do parallel government investigations and proceedings complicate the defense of a securities class action case?
Judson Lobdell: Well, these parallel proceedings can really complicate the defense a great deal, in some ways that are obvious and others that are less so. I’ve talked about a lot of them in the guide. I’ll just go over a few of them here. The first is that government investigation just makes the plaintiff’s job a lot easier. Plaintiff can piggyback on the work done by the government. So for example, the plaintiffs will generally demand in discovery copies of all the documents that were sent to the government and the investigation and transcripts of all the testimony taken by government investigators. The second complicating factor is that government investigations often target individual corporate officers, not just the company, and as a result of that, officers will typically get their own separate representation. And that means that you may have five different law firms rather than just one. And when there are five different law firms reviewing documents and interviewing witnesses and making strategic decisions in the best interests of their own individual clients, it’s a lot harder to pursue a unified defense, and it’s a lot more expensive.
Judson Lobdell: The third factor is related to the second, and that is that there’s the potential for conflicts to arise between and among the different individual defendants and the company. And that’s especially likely where one or more of the officers involved has left the company. So in defending one of these cases, say an SEC enforcement action or a DOJ criminal investigation, the company may wish to point the finger at a former employee. And that may be a winning strategy in reaching a favorable settlement with the government. But the problem is that pointing the finger like this plays into the hands of a plaintiff in a private action because companies are typically liable in civil cases for the actions of their officers while acting as agents of the company. And I guess the fourth complication is that parallel proceedings can have a significant impact on settlement. A pending securities class action may make it a lot harder to settle with the government because unless the government agrees to a settlement that doesn’t involve any admission of wrongdoing, the admission can be used against the company in the private action. So, as a result, the existence of the pending government investigation creates a strong incentive to settle the class action. And that’s just to give you a flavor of the complexities involved. There are many others, some of which are discussed in the guide.
Dave Lynn: What are the risk factors that directors and management should be looking for when they’re considering the potential for securities class action litigation?
Judson Lobdell: There are several, the most important by far is a stock drop following company-specific news. It’s actually a little more complicated than that as we explain in the guide, because if the stock price rebounds enough after the initial drop, it’s possible for potential damages to evaporate, but for the most part, a large stock drop that follows company-specific information and results in a significant decline in market capitalization is going to lead to securities litigation almost without regard to the other factors. The next factor that I’ll talk a little bit about here is—I guess follows from what I said before, and that is in the context of a new company. If the stock price falls below the offering price for that company, it’s a lot easier to prove a case because you get the benefits of Section 11, as I’ve discussed earlier. The next risk factor is insider stock sales.
Judson Lobdell: So large sales by insiders provide plaintiffs with a motive that they can use in their story of securities fraud and where sales are suspicious in terms of the timing or the amount, the plaintiffs have a much better chance to survive a motion to dismiss. Another risk factor would be a restatement, financial restatement, or an announcement that the financial statements can no longer be relied upon. Obviously, there are many restatements that turn on technical accounting issues or actions taken by lower-level employees, but, still, courts are very reluctant to dismiss cases based on restatements. And another is government investigations for the reasons that I’ve already discussed. I suppose the final one I’ll talk about is bad publicity. And it’s the case that if a company is portrayed publicly in a negative light, plaintiffs are more likely to believe that they would be able to convince a court and a jury that the company engaged in securities fraud.
Judson Lobdell: So that’s clearly true where there are statements by analysts following a conference call that results in a stock price drop that they have lost confidence in management or that they believe that the information recently disclosed should have been disclosed earlier, but it’s even true where the negative publicity relates to things unrelated to the stock price drop. So that’s another risk factor. I guess there’s one more that I ought to mention, which is simply the fact that the more careful a company is whether its external communications, the more tightly controlled those communications are, the less likely it is to be sued because the less likely it is that they’re going to be spontaneous off‑the‑cuff remarks on conference calls or at investor conferences that ultimately turn out not to be true.
Dave Lynn: What are the steps that boards and companies could take to reduce the risk of a securities class action litigation being filed against them and to strengthen their defense in the event that there is an action that gets filed?
Judson Lobdell: Well, there are a lot of things that can be done, and I put a checklist together in the guide. I won’t go over it all right now, just hit a few highlights. One of the easiest and most important steps is to take full advantage of the Safe Harbor provision in the securities laws that protects forward‑looking statements. So the Safe Harbor protects companies and executives who make forecasts or other forward-looking statements. The level of protection is much greater where the statements are accompanied by what the statute calls meaningful cautionary statements. So every statement directed at investors, including on every conference call that is forward looking should reference an updated Safe Harbor warning. And this can seem overly formal or legalistic to some business people, but it’s critical because without that explicit reference to a Safe Harbor warning, the protection provided by the law is greatly diminished.
Judson Lobdell: So that’s the first and I would say the most obvious thing that can be done. The second thing is for companies just to make sure that every statement made on conference calls is fully vetted. Those statements should get the same rigor that are applied to SEC filings. Statements on conference calls should be scripted and not just the initial statements, but also answers to questions. So if there’s a question that’s asked that maybe isn’t expected, the CEO shouldn’t just go ahead and answer it. It’s much better course to say, well, we don’t have anything more beyond what we’ve already discussed and what’s in our SEC filings on that topic. Another thing that can be done is that when opinions are offered, that is when a CEO or a CFO says something on a call that can’t be ticked and tied to a specific internal document with numbers attached to it...
Judson Lobdell: That statement should be clearly identified as an opinion. It’s as simple as saying “in my opinion,” and then providing that opinion. And again, that may seem overly formal and legalistic, but those little throat-clearing phrases can make a difference in terms of getting a securities case dismissed. It’s—I’ve talked a lot about conference calls, but it really is the case that conference calls are where companies get in trouble in this area. Typically, companies are pretty good vetting their SEC filings, but there’s a natural tendency when executives get on those conference calls, and it’s legitimate. They want to be responsive to investors. They want to provide information that can be material to investing decisions, but where they’re speaking in an extemporaneous way, that can lead to problems.
Dave Lynn: Great. That’s all great advice. And, despite their best efforts, companies often find themselves in a situation where there is a threat of securities class action litigation, and what should they do when they find themselves in that situation?
Judson Lobdell: There are really only two things to do in that situation. The first is that the in-house lawyers should advise anybody involved in the investor communications of the potential for litigation and that they should exercise care in their non-privileged communications on that topic. That is their communications with anybody other than lawyers. So that’s the first thing. And the second thing is to talk to a securities litigator. This is not an area where you should try to do it yourself. So there are other things that can be done, of course, but those are things that should be done in consultation with a securities litigator. I’ll just give you one example, which may illustrate this point. Often when bad news comes out, there was somebody inside the company who predicted it in advance. If that employee’s still with the company, they’re going to need to be interviewed.
Judson Lobdell: And that interview should be done by a lawyer, and it should be done by someone who has experience in that situation. If the employee has left the company, there’s a natural tendency to want to reach out. But before that happens, there are a lot of factors that need to be considered. You don’t want to be in a situation where you’re accused of trying to intimidate a witness or tampering with evidence. So those situations have to be handled with great care. And it’s important that an experienced securities litigator be involved in all those activities. So we address some of these issues in the guide, but it’s important that when they arise, someone who’s got experience in this area be involved.
Dave Lynn: Great. Well, thanks for all those insights. And thanks so much for putting together the guide, which I think is really a must read for management and directors at public companies.
Judson Lobdell: Well, Dave, thank you for giving me the chance to talk with you about these things.
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