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June 23, 2016 Articles

Securities Fraud Class Actions: A Practical Approach to Your Initial Case Assessment

Four issues that may be more important to your client than your knowledge of Basic v. Levinson and Halliburton I and II

By Jessie M. Gabriel and Sumon Mazumdar

Your first securities fraud class action can feel overwhelming. The substantive law is expansive, confusing, and constantly in flux. You are dealing with multiple acts of Congress and a variety of regulations, not to mention the unique challenges associated with class action litigation of any kind. But there are a number of practical considerations that should also factor into your initial case assessment. Below are four issues that may be more important to your client than your knowledge of Basic v. Levinson and Halliburton I and II.

Insurance: Is There Any and What Does It Cover?
One of the good things about securities litigation is that defense costs are often covered by insurance. If you are a defense attorney, this is one of the first conversations you need to have with your client. This is not only relevant to getting your bills paid, but it is one of most important considerations for clients who are trying to estimate their anticipated legal spend.

The first thing you need to ask is whether your client has coverage. Many companies carry director’s and officer’s liability insurance (often called “D&O”), which may cover not only these executives but the company as well. Next, ensure the company has provided notice of the claim to the carrier. Most insurance policies will only cover fees incurred after notice has been provided.

The second step is to confirm your representation with the carrier. Many insurance carriers have lists of preapproved law firms with whom they have negotiated reduced rates. If your firm is not on the approved list, all hope is not lost. Depending on the terms of the policy, your client may have the right to choose its own counsel. Even if the policy does not explicitly allow for that, your client may be able to argue that you are the best firm for the job if you have a preexisting relationship with the client and the client lobbies strongly for you.

Finally, you need to review the terms of the policy to determine the scope of the coverage. Most policies will cover attorney fees. Policies vary more significantly, however, regarding the extent to which the insurer will cover settlement payments or a judgment. You also need to understand the coverage cap. These terms directly affect the potential cost to the company of the litigation and may affect your litigation strategy depending on the allocation between insurer and insured.

This information is equally important to plaintiffs’ counsel as they assess the value of their case. While plaintiffs are entitled to this information as part of initial disclosures under Federal Rule of Civil Procedure 26(a)(1)(A)(ii), because discovery is automatically stayed in securities class actions until after the court rules on any motions to dismiss, plaintiffs’ counsel may only get their copy if they can withstand a challenge on the pleadings.

Document Preservation and Review: Is There a Litigation Hold in Place and How Are We Going to Efficiently Produce and Review This Information?
The single biggest cost in securities class actions that get past the motion to dismiss and class action phases is discovery. Plaintiffs often request massive quantities of data, justified by a long class period and the expansive notion of scienter. This leaves defendants with huge costs for preservation, collection, and pre-production review, and plaintiffs with the burden of reviewing all the materials they requested.

One of the first topics of discussion after your client is served with a lawsuit, or is considering filing a lawsuit, is how to preserve documents. All federal circuits recognize a duty to preserve that arises when litigation is reasonably anticipated. This can generally be accomplished by issuing a litigation hold to all potentially relevant parties, as well as by suspending any automatic deletion protocols for electronically stored information. The recent revisions to the Federal Rules of Civil Procedure address the consequences of neglecting your preservation obligations. Fed. R. Civ. P. 37(e).

The production and review of this information is delayed in securities fraud class actions by the Private Securities Litigation Reform Act. However, the stay provides a good time to get your discovery strategy in order, to find an effective and cost-conscious vendor, and to provide a reasonable cost estimate to your client. In addition, under the new rules, you need to be ready to discuss discovery and to start producing much earlier. See, e.g., Fed. R. Civ. P. 26(d), (f). Remember also that collecting data is not just about production; it’s also about learning about the strength of your own case. A basic understanding of the case and a good vendor can help you formulate an efficient plan for culling the most relevant documents well before you start producing.

Related Actions: Are There Any and Where Do They Stand?
Events that trigger securities fraud class actions often trigger other proceedings as well. Companies and executives will be best served if you provide a consistent strategy across all actions, even if this means coordinating with other firms. This approach is even more important to counsel for the plaintiff because he or she may lose the status of lead plaintiff to another plaintiff in a related action.

Many complaints under the Securities Exchange Act of 1934 are preceded or accompanied by investigations and claims by government agencies, such as the Securities and Exchange Commission, and nongovernmental organizations, such as the Financial Industry Regulatory Authority. These actions can directly affect a private party securities class action because plaintiffs may strengthen their claims if one of these entities has already obtained discovery and found fault with the company.

There may also be other private party actions filed against the company either before or after your particular lawsuit. Just because your case is a class action does not mean that all shareholders have to fall into line. Any shareholder can file his or her own, separate action on behalf of a class. Even though these suits are then consolidated and one plaintiff selected to lead the class, it is important to anticipate this process. The plaintiffs’ lawyers have a direct stake in their particular plaintiff being appointed lead plaintiff and, thus, their firm being appointed to lead the litigation.

Derivative actions are often coupled with securities fraud class actions. These claims are not brought on behalf of a class; rather, theoretically, they are brought on behalf of the company itself. Derivative plaintiffs typically allege breach of fiduciary duty by officers and directors who were involved in the company activity that prompted the class action. These actions are sometimes consolidated with the class actions.

Damages: What Is the Estimated Value of This Lawsuit?
Finally, your client will want to know the value of the claims alleged in the complaint and the likely settlement amount. This will obviously affect the client’s assessment of the total cost to defend the litigation and the case strategy. If your client is a public company, the valuation may also affect the extent to which your client must disclose details about the lawsuit to its shareholders.

In a typical Rule 10b-5 securities class action, plaintiffs allege that defendants’ misrepresentations or omissions artificially “inflated” the company’s stock price above its true value until one or more “corrective disclosures” revealed the truth about the alleged fraud and the stock price dropped as inflation dissipated. If the stock traded in an efficient market in which its price quickly impounded new information, then investors claim that they were harmed because they bought the stock during the class period when the price was inflated, relying on the integrity of its market price.

To understand some of the nuances of a damage analysis, let us consider a hypothetical example in which the alleged class period starts January 1 and ends on February 1. Plaintiffs allege that a single corrective disclosure on February 1 removed all prior inflation in the stock price. Suppose the stock traded at $12 per share on January 1 and fell to $9 after the disclosure on February 1. To obtain a very rough estimate of damages, one could start by multiplying the stock price drop over the class period ($3 per share in this example) by shares outstanding. But such an estimate ignores several issues that must be considered to determine the harm attributable to the alleged fraud, e.g., investors’ trading pattern during the class period and the level of alleged inflation at different points in time.

A better approach is to base the calculation on the change of inflation per share rather than on changes in the stock price per se. Suppose, in this example, the February 1 corrective disclosure is estimated to have removed 60 cents per share of artificial inflation and such inflation is reasonably estimated to have been constant at 60 cents per share over the entire class period. (Later we discuss how inflation may be estimated.) The damage per share for each individual investor is then typically calculated by comparing the change in the artificial inflation per share over the period the investor held the stock. Thus, damages for shares bought and resold during the class period equal inflation at the purchase date less inflation at the sale date. In this example, inflation on any date during the class period was estimated to be 60 cents. So damages on resold shares would be zero. Damages for shares bought and held till the end of the class period are simply the inflation at the purchase date (or 60 cents in this example) because, by then, all inflation has been removed from the stock price. In contrast, an investor’s actual gain or loss on his or her stock investment would depend on the change in the stock price over the holding period, which will likely be very different from estimated damages.

As the above example suggests, the class’s aggregate damages depend on each individual plaintiff’s trading records and the daily artificial inflation per share over the class period. Because these records are generally unavailable, simulation models (“trading” models) are often used to estimate the class’s trading behavior. However, such models are frequently subjected to Daubert challenges as they rely on restrictive assumptions, e.g., the propensity of shares bought during the class period being resold.

Estimating daily artificial inflation also involves statistical analysis and rests on various assumptions. First, every event related to the alleged fraud that introduced or removed artificial inflation must be identified. Second, the impact of each event on the stock price must be estimated, typically using a statistical procedure known as an “event study,” which calculates the price impact adjusted for market and industry factors. This “residual” price impact may be attributed to the identified event provided it is “statistically significant” (i.e., the residual return is sufficiently large compared with its normal variability so that the likelihood it was due to chance alone is reasonably low) and cannot be attributed to any confounding news unrelated to the alleged fraud.

In general, material misrepresentations are expected to introduce inflation (or have a positive price impact). The price impacts of alleged corrective disclosures are then used to estimate the inflation previously present in the stock price. For instance, returning to our hypothetical example, suppose the stock price fell by 10 percent from $10 to $9 on February 1, the final corrective disclosure date, and the expected return that day based on an event study was −4 percent, i.e., the stock’s residual return that day was −6 percent or −60 cents, which could arguably be considered a measure of all the artificial inflation previously present that the single corrective disclosure on February 1 removed, as we discussed previously. (Note there are others ways of calculating the daily artificial inflation during the class period. Alternative artificial inflation estimates would result in different damage conclusions.)

Finally, it may be helpful to gauge the likely settlement. To do so one could preliminarily consider publicly available studies that report settlements as a ratio of estimated damages in particular samples of cases. But estimates may vary depending on the manner in which these studies calculate damages and the facts and circumstances of each case. So, to obtain a more precise estimate of the likely settlement range, various other qualitative issues may have to be considered.

In short, any damage conclusion rests on several critical assumptions. Therefore, rather than relying on a single number to gauge the value of the claims alleged in the complaint, it may be useful to consider a range of outcomes by varying particular assumptions. Considering alternative damage scenarios may also help identify the strengths and weaknesses of your own case and assist you in devising your case strategy.

Considering each of these topics at the outset of a securities fraud class action will provide real value to your client, who will have to make decisions about the case based on more than just its legal merit. Once you have these issues resolved, you can turn your attention to the substance of the case knowing that you have already addressed the questions most important to your client.

Keywords: litigation, securities, securities fraud class action, insurance, litigation hold, related action, damages