Historically, bubbles are followed by suits. After the Dot-Com Boom came the Dot-Com Bust, along with years of shareholder litigation. Ditto for the Credit Crunch. As we emerge from The Lockdown, SPACs are enjoying roaring popularity in the capital markets. Presumably, at some point the market will turn. Some SPACs no doubt will perform well and become models of business success. For those SPACs that do not thrive after going public, one can anticipate that the plaintiffs’ securities bar will be innovative in devising claims. This post is not about that.

Rather, this post ponders what a wave of SPAC shareholder suits may mean for the Directors and Officers Liability Insurance industry. My hypothesis is that, in the coming years, we may experience a volume of coverage disputes not seen in the shareholder litigation world since the individual/entity allocation battles of the 1990s. These disputes may be, not just between insured and insurer, but also between the different towers of insurance implicated by the lawsuits. Before the wave comes ashore, it may be useful for future participants to contemplate which conflicts will emerge and how they might play out.

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TL;DR: The battle over filing Section 11 lawsuits in state court may be approaching resolution. Multiple California courts have now upheld “Federal Forum Clauses,” which require shareholders to litigate Section 11 claims in Federal court. Judicial validation of such provisions has significant implications for companies going public and for the D&O insurance industry.

TROTS [The Rest of the Story]:

1. Over the last decade, one of the hot topics in securities litigation has been The Forum Wars: may shareholder claims under Section 11 of the Securities Act of 1933 be brought in state and Federal courts, or only in Federal court alone?
2. This post presumes familiarity with the basics of Section 11. For a reader innocent of such familiarity the two Supreme Court decisions cited below (one the United States Supreme Court, the other the Delaware Supreme Court) provide a useful statutory primer. The Section 11 for Dummies version is this: Section 11 gives shareholders a virtually no-fault claim against a public company for material misstatements or omissions in its IPO prospectus. The claims against the company’s directors, and against the underwriters of the offering, are nearly as potent. In the security-plaintiff bar’s armory, the Section 11 claim is a magic bullet.

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On October 8, 2020, a new Ninth Circuit ruling deepened a circuit split over whether allegations in another civil lawsuit could constitute a corrective disclosure in a securities fraud class action. See In re BofI Holding, Inc. Sec. Litig., 2020 U.S. App. LEXIS 31938 (9th Cir. Oct. 8, 2020) (the panel was comprised of Judges Paul J. Watford, Market J. Bennett, and Kenneth K. Lee, with Lee concurring in part and dissenting in part). The Ninth Circuit joins the Sixth Circuit in declining to adhere to a categorical rule that allegations in a civil suit can never constitute corrective disclosures. Id. at *20 (citing Norfolk Cty. Ret. Sys. v. Cmty. Health Sys., 877 F.3d 687, 696 (6th Cir. 2017)). The Eleventh Circuit remains at the other end of the spectrum, holding that, as a matter of law, allegations from civil suits cannot constitute corrective disclosures, even partial. See Sapssov v. Health Mgmt. Assocs., 608 F. App’x 855, 863 (11th Cir. 2015) (noting that “a civil suit is not proof of liability”). As a reminder, a corrective disclosure occurs when “information correcting the misstatement or omission that is the basis for the action is disseminated to the market.” 15 U.S.C. § 78u-4(e)(1).

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On September 1, 2020, the California Superior Court, San Mateo County, granted a motion to dismiss a putative securities class action brought under the federal Securities Act of 1933 because the company’s charter provided that such lawsuits may only be maintained in federal court. [1] The ruling was long awaited by companies, securities litigators, and observers of the decade-long saga of IPO litigation in state courts. It is the first ruling enforcing such a provision after the Delaware Supreme Court upheld their validity under Delaware law earlier this year in Sciabacucchi.

The ruling confirms that companies about to go public—whether through a public offering, direct listing, or SPAC transaction—should adopt a federal forum provision in their charter or bylaws to eliminate the risk of duplicative securities class actions being filed in state court to extract a quick settlement. The ruling also suggests that a federal forum provision adopted after the going public event may also be enforceable under certain circumstances. Finally, the language of the provision matters and should be carefully weighed with experienced counsel.

The decade-long battle over state IPO litigation

The federal Securities Act of 1933 allows shareholders to sue the company, the signatories of its registration statement, any company control persons, and any underwriters, in connection with a registration statement that allegedly suffers from material misrepresentations or omissions. The plaintiff is not required to plead fraud. Strict liability applies to the company (while the other defendants benefit from an affirmative due diligence defense that realistically can only be established after incurring significant costs of discovery). Most public companies that experience a stock drop after going public are targeted by such lawsuits, styled as class actions and seeking damages sometimes ranging in the billions. Most of these lawsuits are dismissed by federal courts. So plaintiffs began filing them in state courts.

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The Covid Crisis will affect every aspect of litigation. Growing familiarity with video-conferenced hearings likely will lead to the elimination of wasteful status-conference calendars, in which scores of lawyers sit around a courtroom for hours waiting for a 10-minute appearance to update the court on developments in a particular case. Courtroom automation, largely limited thus far to fancier projectors and displays, will adopt efficient technologies used in everyday business interactions.

This is the right time for the legal profession—and the business community more broadly—to reinvent depositions. Like many of the discovery rules adopted in the 1930’s and ’40’s, depositions had a noble objective: to eliminate trial by surprise. The theory was: give both sides full information, and the case will either be settled earlier or be tried more efficiently.

Like so many well-intentioned reforms, this one failed miserably. Depositions are one of the few forms of punishment not regulated under the Eighth Amendment. The entire structure and incentives are Goldbergian (Rube, not Arthur): lawyers on both sides are paid by the minute; there is no neutral present to prevent abuse or waste of time; surprise and wearing-down are the names of the game. Review a random sampling of depo transcripts, and your reaction will not be pride in our profession.

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Since the Cyan decision in 2018, plaintiffs have gone hog-wild over state court Section 11 suits. The victory last week in the Delaware Supreme Court in the Sciabacucchi case (pronounced “Sha Ba Cookie”) provides a hopeful path forward for the issuer community. Here are some thoughts on how the decision may impact the D&O insurance world.

What is This All About?

Shareholder claims involving a public offering (of equity or debt) can be brought pursuant to Section 11 of the Securities Act of 1933. A U.S. Supreme Court decision in 2018 confirmed that Section 11 claims may be brought in Federal or state court. Cyan, Inc. v. Beaver County Employees Retirement Fund, 138 S. Ct. 1061 (2018). State court is generally a favorable forum for plaintiffs. Historically, state judges have been reluctant to toss out meritless Section 11 claims that would not have survived scrutiny in Federal court.

In response to Cyan, many companies began to include a Federal Forum Provision (“FFP”) in their Articles of Incorporation. The Provision specified that a shareholder could only bring a Section 11 claim in Federal court. (Professor Joseph Grundfest of Stanford Law School was the principal proponent of such provisions. If you are interested in more detail about them, look at his article.)

No such provision is required for after-market shareholder class actions, brought under Section 10(b) of the Securities Exchange Act of 1934. By statute, those claims can only be brought in Federal court.

Plaintiffs sued in the Delaware Court of Chancery to invalidate the Provisions. Plaintiffs prevailed in the trial court, but lost on appeal. The decision—in which my firm, Wilson Sonsini, represented the prevailing parties—is here.

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On May 31, 2019, Vice Chancellor Sam Glasscock of the Delaware Court of Chancery issued a decision refusing to dismiss a stockholder’s fiduciary duty claims challenging the compensation of Goldman Sachs’ board of directors. [1] The case highlights the type of claim potentially available to stockholders in challenging board (and sometimes executive) compensation, and it provides important guidance for boards when considering the possibility of such a challenge. The decision also reflects the relative uptick we have seen in demands and challenges from stockholders and plaintiffs’ attorneys relating to board compensation.

Background

The Goldman Sachs decision builds on the Delaware Supreme Court’s 2017 ruling in Investors Bancorp, which concluded that director compensation involves an inherently conflicted decision on the part of a board and that, as a result, in a stockholder challenge to board compensation, a court may apply the entire fairness standard of judicial review, rather than the more deferential business judgment rule, absent adequate stockholder approval of the compensation at issue. [2] Under the entire fairness standard of review, the court examines the fairness of the compensation itself as well as the company’s processes relating to setting the compensation. Because the standard is fact-intensive and searching, it can result in protracted litigation that survives the pleadings stage. Importantly, Investors Bancorp further held that a stockholder vote approving director compensation can effectively preclude an entire fairness claim, but that the stockholder vote must approve specific amounts of compensation or self-effectuating formulas to be effective. This aspect of the ruling appeared to reverse several decisions from the Delaware Court of Chancery concluding that stockholder approval of director compensation within “meaningful limits” could eliminate entire fairness claims. Finally, the Investors Bancorp decision also permitted the plaintiff to challenge executive compensation paid to management members of the board where the board’s deliberations and approvals relating to that compensation appeared sufficiently intertwined with its decisions about director compensation.

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The dominant features in the shareholder litigation environment in California today are fragmentation and uncertainty:

• Plaintiffs’ bar fragmentation means ‘too small to sue’ no longer applies
• Uncertainty as to whether IPO lawsuits can be brought in state court or only Federal
• Uncertainty in the evolution of merger and fiduciary duty suits
• Uncertainty as to the strength of the Safe Harbor for forward looking statements
• Uncertainty as to the evolving risk profile for private companies, which historically were less concerned about shareholder lawsuits

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On May 18, 2015, the U.S. Supreme Court unanimously held in Tibble v. Edison International that fiduciaries of 401(k) retirement plans have a continuing duty under the Employee Retirement Income Security Act of 1974 (ERISA) to monitor an investment alternative offered under a 401(k) plan after it is selected. In monitoring an investment alternative, the fiduciaries must engage in a prudent process. [1]

Although the principle described in Tibble was well understood by many 401(k) plan fiduciaries, the decision nonetheless serves as an important reminder that it is necessary for 401(k) plan fiduciaries to implement a due diligence process that will withstand scrutiny from the federal courts and the U.S. Department of Labor upon review.

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On March 24, 2015, the U.S. Supreme Court issued its decision in Omnicare, Inc., et al. v. Laborers District Council Construction Industry Pension Fund et al., addressing when an issuer may be held liable for material misstatements or omissions under Section 11 of the Securities Act of 1933 for statements of opinion in a registration statement.

Among other things, the Supreme Court held that an issuer may be held liable under Section 11 for a statement of opinion, even one that is sincerely held, if its registration statement omits facts about the issuer’s inquiry into, or knowledge concerning, a statement of opinion and if those facts conflict with what a reasonable investor, reading the statement fairly and in context, would take from the statement itself.

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With a minor change to the customary lock-up agreement, issuers and underwriters may be better able to fight frivolous IPO lawsuits. By allowing non-registration statement shares to enter the market, underwriters may prevent Section 11 strike-suiters from “tracing” their shares to the IPO. This could enable ’33 Act defendants to knock out the lawsuits against them.

Basics of Section 11 Standing and Tracing

Section 11 of the Securities Act of 1933, 15 U.S. Code § 77k, provides a private remedy for those who purchase shares issued pursuant to a registration statement that is materially false or misleading. The remedy applies to “any person acquiring such security.” Section 11(a). That is, a person may assert a claim with respect to shares issued pursuant to the particular registration statement.

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The blogosphere is abuzz over Halliburton. [1] Will the Supreme Court overturn Basic [2] and abolish the fraud-on-the-market presumption? Will the decision end shareholder class actions as we have known them? Presumably, by the Fourth of July, we will know.

The purpose of this post is not to predict the outcome of Halliburton. Rather, it is to begin thinking about ways in which the plaintiffs’ bar may respond if the Court does overturn Basic. Those who think that plaintiffs’ lawyers will go quiet into the night are, in my opinion, ignoring the lessons of history.

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The NASDAQ Stock Market LLC (Nasdaq) recently filed with the Securities and Exchange Commission (SEC) a proposed rule [1] requiring listed companies to establish and maintain an internal audit function. [2] The SEC is soliciting comments on the proposed rule through March 29, 2013. [3]

Under the proposed rule, the internal audit function would be required to provide management and the audit committee with ongoing assessments of the company’s risk management processes and system of internal control. In addition, new Rule 5645 would require the audit committee to:

• meet periodically with the company’s internal auditors (or other personnel responsible for this function); and
• discuss with the outside auditors the responsibilities, budget, and staffing of the company’s internal audit function.

Companies would be permitted to outsource their internal audit function to a third-party service provider other than their independent auditor. For companies that choose to outsource this function, Nasdaq has stated that the company’s audit committee maintains sole responsibility to oversee the internal audit function and may not allocate or delegate this responsibility to another board committee.

According to Nasdaq, the proposed rule is designed to:

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In the world of insider trading, Rule 10b5-1 plans are a blessing and a curse: a blessing, because they enable executives to diversify their company holdings in a stable, law-abiding manner; a curse, because they tempt cheaters into hiding their malfeasance in a cloak of invisibility.

For years, 10b5-1 plans received little scrutiny. In private shareholder lawsuits, plaintiffs’ lawyers generally scrunched their eyes shut and tried to ignore them. The SEC, having created the structure, lost interest postpartum. As a result, aggressive insiders sometimes were able to use the plans in ways the framers never intended.

Recently, journalists have started to focus on the specifics of 10b5-1 plans, along with perceived abuses of them. [1] Those articles appear to have roused the SEC. So this may be a good time for counsel, both inside and outside, to revisit their existing plans. In this post, I address what I consider to be best practices under 10b5-1. This does not mean that contrary practices are improper or unlawful. Think of it, rather, as 10b5-1 for the risk averse.

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Shareholder lawsuits over mergers are as ubiquitous as they are meritless. The incidence of suits over public-company acquisitions rounds to always. It doesn’t matter how high the premium or how clean the deal: someone (usually, one of the same someones) will sue.

The frequency of merger lawsuits has increased steadily over time. What has changed more abruptly is their life cycle. Until recent years, once a deal closed, the lawsuit usually went away. If the plaintiffs had been unable to wring out a “therapeutic” settlement pre-close (usually, “enhanced” disclosure + a fee) they ignored or dismissed the case after the acquisition was complete. The conventional wisdom was that plaintiffs’ leverage — threatening to interfere with the deal — was gone, and so there was no longer a path to payday.

In several recent cases, however, plaintiffs’ merger lawyers have refined their business model. They keep the litigation alive post-close. They take extensive discovery, especially against the executives of the acquirer, who now control the pursestrings. This phenomenon occurs even in situations where objective factors suggest a lack of merit to the claims: e.g., high premium; no contesting bidders; overwhelming shareholder approval; customary deal terms.

Why are the plaintiff lawyers pursuing these cases?

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