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January 01, 2012

Shareholders Class Action Claims

Lynda J. Grant

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To:        New York State Pension Fund General Counsel’s Office

From:    Lynda J. Grant

Re:        Shareholders Class Action Claims

We have been asked to review the potential class and derivative actions by GyneTech shareholders. There are three types of potential shareholder actions here: a class action, a derivative action, and an action under what is commonly known as a Unocal theory, concerning the scope of the defensive mechanisms that the GyneTech board institutes in response to the threat posed to the company by the two tender offers. (MedaStar and Kauffman launched competing proxy bids for control, but there is no indication that the company was in the middle of a proxy fight or that MedaStar and Kauffman had the votes to call a special shareholders meeting where they could call for a vote on the board. It seems more likely that they launched competing hostile tender offers to obtain sufficient shares so that they could remove management.)

The Class Action

The strongest claim, and the one most plaintiffs’ attorneys would like to bring in this instance, is the securities fraud class action. Assuming that Gray was correct regarding the results of the drug trial, the facts developed thus far indicate that upper-level executives at GyneTech, including Bass, may well have been aware of the drug’s deleterious effects; at the very least, plaintiffs can plead sufficient facts to satisfy the standards under Tellabs v. Makor for pleading scienter. That is, plaintiffs’ counsel will be able to make a cogent, compelling, and strong case of scienter by demonstrating that the defendant knew or was reckless in not knowing the falsity of the statements at issue.

The story in the Wall Street Journal caused the stock to drop to $78 per share from about $216 per share, an enormous drop. GyneTech is traded on the New York Stock Exchange, and thus must have at least 1.1 million shares publicly held. That would give shareholders damages of roughly $151 million if GyneTech held the minimum required by the NYSE, and in all likelihood it holds far more than that. Thus, most plaintiffs’ attorneys would want to file that case on behalf of a large institutional shareholder who was substantially damaged by the stock drop.

The class action also is attractive because the Wall Street Journal article strongly suggested that the problems with the drug were known to the company for a considerable period of time before the disclosure. Of course, if the stock price had started to recover, that would undercut damages under the Private Securities Litigation Reform Act. Under the PSLRA, damages are measured by the difference between the plaintiff’s sale or purchase price and the mean trading price of the stock during the 90-day period after the disclosure. In fact, however, the stock declined even more as time passed (albeit on different news).

So at this point there are sufficiently large damages and enough potential liability to make this a huge case—and likely to give rise to a big PSLRA fight for leadership by large institutional shareholders trying to control it. The PSLRA requires that the first to file disseminate a notice of that filing and of the class period, enabling other class members to move within 60 days to be lead plaintiff. Thereafter, the court determines the most adequate plaintiff—generally the plaintiff with the greatest damages—to act as lead. So that will be the first fight: the fight to control the litigation.

There are other issues that potential plaintiffs’ attorneys also will consider. It is unclear whether GyneTech is a start-up company with one product, but the fact that the stock dropped so precipitously would seem to indicate that the company lacks other marketable products. If that is the case, because the stock price has dropped to such a great extent, there could be some concern either that the stock might be delisted or that the company might file for bankruptcy. Given that it trades on the NYSE, and because it seems to have a fairly deep executive bench and extensive facilities, that seems unlikely.

Another issue that would concern plaintiffs’ counsel is the extent of the director and officer (D&O) liability coverage. Even if shareholders incurred over $150 million in damages, that will not do shareholders much good if there is nothing to recover against. Of course, the extent of D&O coverage will not be known until the parties make Rule 26 initial disclosures—well after the filing of the complaint and the lead counsel/lead plaintiff determination.

Assuming that we are satisfied with both potential liability and the availability of assets to satisfy a judgment on the securities claim related to the drug trial, our first issue will be how far back we can pull the class period on this claim. We understand that the market was completely unaware of the results of the drug trials; the form 10-Q failed to disclose the results. Therefore, we need to investigate two other facts: How long did executives at the company know that the drug trial demonstrated the negative effects of the drug, and what did the company say about the drug and its drug trials in its other public filings?

Given my experience with cases involving drug trials, the company probably has been making positive disclosures about the drug trial results for some time. I would obtain and analyze the disclosures about the drug trials, and, if supported by the Wall Street Journal article and potentially an investigation by a private investigator, I would recommend pleading a class case commensurate with the period of time during which the company was making these false affirmative disclosures. Because Bass made the initial announcement concerning the launch of the drug trial 18 months earlier, the class period will be something less than that; the company would not have known about the results for at least several months, if not more, after the launch.

The class period also will depend upon the price of the stock during the period in which false statements were made. Because we want to plead that the failure to disclose the truth about the drug trial inflated the stock price, we need to make sure that the stock price was, in fact, inflated. At a minimum, we can plead a six-day class period—from the day Gray sent her email (a Friday) to the day the Wall Street Journal article disclosed the truth (the following Wednesday). Given the enormous drop in the stock, this may be long enough, at least initially.

Moreover, given the board meeting on Monday and the subsequent authorization to file the form 10-Q that day, the entire board can be named for the misstatement or omissions in that document. In fact, the form 10-Q may contain the only actionable statement during that limited period. But because the stock rose from $167 to $216 and then dropped to $78 within that time period, those damages are still pretty substantial. Depending upon the size of our client’s damages, it is possible that under the PSLRA, we might not file an initial complaint but move to be appointed lead counsel or lead plaintiff within the appropriate notice period. The larger our client’s damages, and thus the greater chance of being appointed lead plaintiff/lead counsel, the less likely we are to file an initial complaint and the more likely we are to just file a motion to be appointed lead plaintiff.

If the defendants move to dismiss, then given the PSLRA stay of discovery pending a motion to dismiss, we are unlikely to obtain discovery; that is so even if documents already have been sent to regulators. Thus, assuming we are appointed lead plaintiff, our next step will be to investigate and then file a consolidated amended complaint with as much detail as possible so that we can overcome the fairly strenuous pleading requirements that apply to federal securities law claims. Our action would name at least the company as the issuer and Bass and the board as either primary violators or control persons: We need to name at least one director in order to invoke the D&O coverage. At this juncture, we also might want to name the entire board in light of the Monday board meeting and the deficient 10-Q disclosure, and we might try to pull the class period back to include earlier public filings that the entire board signed. For example, all board members should have executed the form 10-Q, so if false statements or omissions were made in that document and it was filed during the class period, we would have a basis for naming the entire board.

We have a fairly good basis at this stage to name and properly allege the scienter of Bass and perhaps other high-level executives as well. The board may have been generally unaware of the results of the drug trial, but given the importance that the market placed on this drug and the trials (as demonstrated by the stock price drop), and given the fact that Gray went “up the chain of command” and was possibly murdered over this issue, some of the board members also may have known. A good private investigator may help us uncover enough facts to plead the scienter of at least some board members.

We also will need to address the issue of causation. GyneTech trades on the NYSE, and its stock price clearly reacts to information that is made public. We do not know whether GyneTech is followed by analysts, but it seems that GyneTech trades on an efficient market, and any argument to the contrary would not be very strong. A better argument for defendants might be that the Wall Street Journal article was not a “clean” disclosure on just the drug trial issue but combined the disclosure of the drug trial results with suspicions about Gray’s death. If liability is strong on only one side of these two theories, it is possible that this argument on causation might give a court some pause.

This seems like a relatively strong case, likely to survive the inevitable motion to dismiss. Once that happens (that is, once the motion to dismiss is denied) the defendants’ next move will be to try to defeat class certification. Assuming that we have a strong plaintiff—generally the best way to thwart an attack on class certification—the court should certify the class of persons who purchased stock on the NYSE during the six-day period, if not longer. Of course, plaintiffs will try to get to merits discovery as soon as possible and fight any attempt by defendants to separate class and merits discovery and focus only on class certification first.

We also should consider a possible federal securities fraud claim relating to Bass’s “philandering.” This is certainly the weaker of the claims. But the disclosure of the affair did cause the price of the stock to decline from $78 to $24 per share, another steep drop. Most plaintiffs’ attorneys therefore would try to capture this drop as another element of damages.

There might be one more basis for a federal securities law claim—the company’s complicity in Gray’s murder—but this will have to be more thoroughly fleshed out and investigated. That may be a claim we plead down the road after criminal investigations are done.

Derivative Actions

For plaintiffs’ counsel who were not retained by large clients, the next logical case to file would be a derivative action against the entire current board of directors for mismanagement of the company. Generally, this would be filed in state court. Depending upon the jurisdiction (which should be the company’s place of incorporation or principal place of business), the derivative plaintiffs could attempt to commence discovery immediately after filing and surviving a motion to dismiss. But in most instances (although not always), state courts will deny this as an end run around the PSLRA stay of discovery pending a motion to dismiss the federal action.

The company also may receive some “demand” letters—that is, letters demanding some action by the board—as a precursor to the commencement of a derivative action. But that probably is not necessary. Given the red flags of the drug trial results, Gray’s attempts to go up the chain of command with her information, and the apparent importance of the drug to the company, a good argument can be made that a pre-suit demand upon this board would have been futile. And that is especially so because there already is a substantial basis for the liability of the current board members. But if derivative actions are filed without a pre-suit demand, we can expect the company to move to dismiss on the grounds that the plaintiffs failed to make a pre-suit demand and perhaps that the case is not yet ripe.

The mismanagement claim would include counts on behalf of the company for costs and damages the company will incur as a result of the federal securities law case, the FDA investigation, and other regulatory and internal investigations; costs and damages the company will incur as a result of the drug participants’ suit; costs and damages the company will incur as a result of the Pringle settlement; and costs and damages the company will incur as a result of the Vitello suit, if there is any evidence that the company was involved in Gray’s death. The latter two claims are weaker than the former two.

The derivative action would be brought under the Caremark theory, with plaintiffs alleging that a majority of the board failed to properly supervise the drug trials and recklessly ignored red flags that showed the deleterious effects of the drug. Our limited knowledge at this point makes it difficult to assess the strength of this claim. Clearly, there was some mismanagement and some sort of cover up. In many drug trial cases, the board claims that it did not have direct responsibility for the particular trial and thus cannot be held liable under a Caremark failure-to-supervise theory. Here, the strength of this claim really will depend on how far up the chain of command Gray went in disclosing the drug trial results and how important the drug was to the company’s revenues. It also might depend on the duties and responsibilities of some of the subcommittees of the board and the access members of those subcommittees had to the management employees responsible for the drug trials. Many subcommittee members, for instance, are given unlimited access to management. The company’s internal reporting procedures may play a part in this analysis.

GyneTech has said that it will create a special committee of the  board to deal with these issues. If it takes that route, the derivative case will become more difficult, and it may be necessary to attack the establishment of the special committee. For instance, we might question whether a special committee of this board could really be independent given the substantial basis for liability against all of the members of the board. And we also might look to see whether there is a controlling shareholder who really controls the board, undermining any claim that the special committee is independent.

If a special committee is appointed, it undoubtedly will be unresponsive to the pre-suit demand letters. It will respond that the board is looking at the matter; it will say that it will respond more fully when it has concluded its investigation. For that reason, any plaintiffs’ counsel making a pre-suit demand should ask to make a presentation to the board to ensure that they are heard.

Alternatively, to avoid dismissal but have their cases pending and therefore part of any global settlement, the derivative plaintiffs might file suit but then agree to stay their actions pending the regulatory investigations and the completion of the federal securities action. In fact, if a special committee is appointed as we expect, that might be the best alternative for the derivative plaintiffs at this point. If the special committee decides not to take any action, plaintiffs then could file a derivative action attacking that decision.

The Unocal Case

Yet a third option arising from the board’s response to the tender offers, and potentially an add-on to the derivative action, is a Unocal-type case. Under Unocal, 493 A.2d 946 (Del. Ch. 1985), a decision by the Delaware Chancery Court that is followed in many jurisdictions, a board of directors essentially cannot take defensive measures that are unreasonable in relation to the threat posed. So if MedaStar and Kauffman are launching bona fide hostile tender offers, the company and board can institute reasonable measures to protect the company and ensure that its shareholders do not tender into inadequate offers. We do not yet know what measures might be taken in response to the hostile tender offers. But we should carefully watch what measures the board takes to make sure that the measures are meant to protect the shareholders, not to entrench this board.

It appears that Kauffman and MedaStar are launching competing tender offers (which is kind of silly; they probably should work together). If that is so, the company will have to respond under Rule 13e, which could give rise to yet another federal securities law claim—for false and misleading statements and omissions of material fact under federal law, or a breach of the duty of candor in the state court action.

Assuming that the company has taken defensive actions by the time we are ready to file our derivative action, we can combine that action with the Unocal claims and file a single suit in state court—our most likely course of action. Our theory will be that the mismanagement of the company resulted in the depression of the stock price, and now having mismanaged the company, the defendant board members are trying to entrench themselves by taking excessive and unreasonable actions in response to the tender offers.

Once that action is commenced, we will move for expedited discovery and a preliminary injunction to stop the defensive maneuvers. If the board’s maneuvers really are excessive, the court might grant that motion, and we will get immediate discovery, including at least brief examinations of some of the defendants before they are deposed in any other case. We certainly will ask for Bass’s deposition, the depositions of some of the outside directors, and maybe the depositions of one or two executives or employees in the Gray chain of command. This expedited discovery could demonstrate the viability of all potential claims, including the federal securities law claims. It also might create enough pressure on the defendants that they will want to work something out with the regulators and settle all the claims—always the endgame.

As you can see, we have several options to consider and a host of issues to analyze. I look forward to discussing all that with you at our meeting next Tuesday.


Lynda J. Grant

The author is with the Grant Law Firm PLLC, New York City.