The history of securities litigation is marked by waves: from the IPO laddering cases, to the Sarbanes-Oxley era corporate scandal cases, to stock options backdating, to the credit crisis, to the Chinese reverse-merger cases, to event-driven/lawsuit blueprint cases, certain types of cases have predominated at different times.
Are we entering a wave of COVID-19 cases? My view is:
- We will not see a wave of cases challenging pre-COVID-19 disclosures and governance triggered by the fallout from COVID-19 in February, March, and April 2020.
- But companies and their directors and officers who are not hyper-vigilant about what they say and how they say it and/or whose boards are not highly attentive will face shareholder suits if and when they suffer problems in the next several years precipitated or exacerbated by COVID-19.
First, why don’t I think there will be a wave based on the economic downturn over the past two months? Everyone is in the same boat, so it’s difficult for plaintiffs to identify and prove that any particular company’s disclosures or governance problems caused economic harm. And plaintiffs need to choose extra-wisely, because many judges would be offended by accusations of fraud and poor oversight over problems caused by a pandemic – it would feel opportunistic.
But going forward, disclosure and governance will be judged far differently – almost in the polar-opposite way. Moving forward, judges will have no patience for companies whose disclosures are not careful or boards whose oversight fails to meet the moment. The legal standards governing disclosure and governance litigation are judged from inferences drawn in context by judges who are themselves living the context. They will be critical of disclosures that feel exaggerated and governance that feels lax. Company-specific stock drops and governance failures will be easy for the plaintiffs’ bar to spot in the coming months and years.
So, how does a company and its directors and officers stay out of category (2) – how do they avoid securities and governance suits in the next several years based on disclosures and governance in the next several quarters? The tools the law gives companies to win shareholder suits allow them to avoid them or prevail if they’re sued incorrectly. I break it down by type of shareholder suit.
Securities Class Actions
Under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 under it, a plaintiff must show (1) a false or misleading statement (2) made with intent to defraud (scienter), among other elements. The Private Securities Litigation Reform Act of 1995 (Reform Act) protects forward-looking statements if the statement is accompanied by meaningful cautionary language.
The U.S. Supreme Court’s Omnicare decision says that courts must examine the full factual context to determine whether a statement was false or misleading, and its Tellabs decision says that courts must weigh competing inferences, both fraudulent and non-fraudulent, from the full set of contextual facts to determine whether any false or misleading statement was made with scienter.
The full-context rule helps defendants win more cases, because it lessens litigation-by-soundbite – defendants almost always fare better if what they said is examined in a broader frame. And it allows defendants to avoid being sued in the first place through thoughtful disclosure that reduces investor surprise and deters plaintiffs’ lawyers from suing or, if one does, from piling on.
Here are practical tips to reduce the risk of making false or misleading statements, and failing to obtain safe-harbor protection:
- Speak factually. This seems obvious, but companies must be more factual than ever in their disclosures. Although statements of opinion receive heightened protection under Omnicare, in the current environment, companies should be careful with words like “significantly” or “improving” when they can use facts and figures, and when they use those sorts of terms, they need to give more context than usual.
- Show your work. Create the context under which your statements will be judged by explaining yourself. Investors are listening to every word and interpreting, extrapolating, and perceiving hopeful overtones. Investors will create the context if you don’t.
- Describe your real risks. The Reform Act’s safe harbor for forward-looking statements only applies if a company’s cautionary statements are “meaningful.” In ordinary times, judges hesitate to apply the safe harbor unless the company’s risk disclosures feel like the real and dynamic risks the company faces and are not boilerplate or static. In these times, companies need to lay out their risks extra-authentically to have a decent shot at safe harbor protection. Here too, investors will hear hope in risk disclosures that aren’t extremely candid.
Here are practical tips to reduce the risk of a plaintiff’s lawyer or judge feeling like any false statement was made with intent to defraud:
- Avoid unnecessary discretionary stock sales. A director or officer should not unnecessarily sell significant amounts of stock outside of 10b5-1 plans absent an understandable reason, which the company should disclose so their securities class action defense lawyer can use it to combat allegations of a motive for fraud. In these times, large, unexplained stock sales are more likely to be viewed as suspicious by judges.
- Avoid executive compensation increases. Executives should be careful about taking new, enhanced, or special compensation. While I believe judges decide motions to dismiss based on whether they think executives are honest, and not whether they are well compensated, increased compensation during this time is perilous. Executive compensation cuts are a personal and company-specific matter, and I don’t think judges should or will judge an executive negatively based on failure to take cuts.
- Let your candor shine. Candid, abundant, and generous disclosure will help executives avoid scienter allegations even if they said something that is technically inaccurate or misleading in context. Generous disclosure will help the judge see that executives were doing their best to be honest in challenging circumstances and find a way to dismiss the litigation. (For a discussion of the relationship between the falsity and scienter elements, please see my post “Falsity is Fundamental.”)
Shareholder Derivative Litigation
In general, directors will not be liable for harm to their corporations if they are engaged, informed, inquisitive, and avoid or appropriately address conflicts. As with corporate disclosures, governance will be judged by judges who understand that COVID-19 is a big deal for all people and companies, and directors who are engaged in genuine and documented ways will fare best.
Here are practical tips to avoiding governance problems and suits or, if one is filed, setting up a successful defense:
- Trust your intuition. Companies set up processes for board engagement and often appropriately filter things to directors. That is perfectly fine for normal times, but in this environment, directors need to trust their intuition about what their companies need from them, and then engage in ways that make sense in the circumstances. This should be an explicit discussion: boards and management should decide together what information board should receive during this unprecedented time. Many judges are going to take almost a strict liability approach for directors, and fine distinctions between director and management duties aren’t going to predictably carry the day.
- Don’t worry about liability. Just govern. Directors who are engaged and working hard have less to worry about than directors who worry that greater involvement will expose them to greater liability. I believe judges will apply the spirit of Good Samaritan laws – relieving good-faith helpers from liability – to director liability in this environment. Many directors and their advisors say, “nose in, fingers out.” In this crisis environment, I think directors need to have the courage to stick their fingers in – and toes too – if it’s helpful to management.
- Be a trusted advisor to management. Be there for your executives holistically. They need your kindness, courage, and creativity – and maybe basic friendship – now more than ever.