First, the stock goes into a tailspin. Smelling blood, the lawyers quickly follow with shareholder lawsuits, and at best, an expensive hassle ensues. That's why executives across the land let out a cheer when one of the most notorious class-action securities firms, Milberg Weiss Bershad Hynes & Lerach, was slapped with a $45 million jury verdict. The jury ruled that Milberg Weiss unfairly targeted Lexecon Inc., a Chicago-based consulting firm, in one of its class actions and ruined its reputation. For once the shoe was on the other foot.
But the cheering has faded--and the lawsuits continue. Mark Nebergall, vice president counsel for finance and tax policy for the Software and Information Industry Association, doesn't expect the ruling against Milberg Weiss to have much effect on the number or quality of securities litigations. Very little has. "Companies are still afraid of the Bill Lerachs of the world," says Nebergall, of a Milberg Weiss senior partner who is known for his hardball tactics.
The Private Securities Litigation Reform Act of 1995, designed to shield companies from frivolous shareholder suits, ultimately has not slowed the stampede. The number of cases filed against companies dropped in 1996, the first year after the legislation went into effect, but grew to a record 235 in 1998. The act's safe-harbor provision delivers uncertain protection, since litigants remain free to claim that sinister motives lurk behind sharp stock declines. Even the most innocent companies are vulnerable if they aren't careful about what they say and how they manage insider trading.
Although a 1998 law forcing cases to federal courts may provide some relief, most companies remain unwilling to roll the dice with a jury. In weighing the costs of a defense and the risk of defeat, settlement generally carries the day.
In fact, the preponderance of settlements has created few tests for the Reform Act, says John Coffee, a law professor at Columbia University's School of Law. He says there have been only a few appellate decisions and that what district court decisions have been made have been split. Of course, the gray areas don't get cleared up if there are no decisions to set precedents. Moreover, the courts have been inconsistent, says Stuart Grant, an attorney with Grant & Eisenhofer, a Wilmington, Delaware-based law firm that represents large institutional investors in securities suits. Decisions vary not only from court to court, but from judge to judge, says Grant.
Despite the Reform Act's highly touted Safe Harbor for Forward-looking Statements, companies are still being accused of fraud when their expectations don't pan out. True, there are fewer cases based solely on forward-looking statements, but failed forecasts are still cited as evidence of wrongdoing in roughly half the lawsuits filed since the act was passed. "In general, companies are very wary of making forward-looking statements and of taking advantage of the safe harbor until there is evidence that these safeguards are real," says Robert Hinckley, vice president of strategic plans and programs at Xilinx Inc., a San Jose, California, maker of integrated circuits and software design tools.
Company executives who are not skilled at making projections in public, or of touting new technology, could find themselves in the same mess as Norcross, Georgia-based Theragenics Corp. The onetime Wall Street darling was slapped with a securities class-action lawsuit that alleged the company made false and misleading claims about the outlook of its TheraSeed product, a tiny, radioactive seed that is implanted in patients to fight prostate cancer. The first suit was filed January 22, soon after the stock price dropped almost 34 percent--on January 11--when the company missed Wall Street's consensus earnings estimates by two cents. In court documents, plaintiffs pointed to press releases and statements by CEO M. Christine Jacobs, which they claimed were false and misleading.
The 1995 act requires the plaintiffs to prove that not only were the statements "reckless," but that company officials knew they were false as well. In the Theragenics case, as in many others based on missed forecasts, the plaintiffs allege that insider selling is proof that company officials knew the statements were wrong and wanted to keep the stock price up until they could sell shares (see "Defensive Measures," below).
The company denies the allegations of impropriety. "We believe this is precisely the type of frivolous class-action lawsuit Congress considered abusive and sought to curb when it reformed the securities laws," Jacobs stated in a company release. Moreover, Theragenics said it intends to "vigorously defend the litigation."
Still, proponents contend that forward-looking data is much safer as a result of the Reform Act. "There have been [fewer] allegations of false statements," says Professor Coffee. Lou Thompson, president of the National Investor Relations Institute, in Vienna, Virginia, adds: "Invoking the safe harbor is the best protection. To not use it is almost insane."
Race to the Internet
The act has also failed to end the so-called race to the courthouse, though it has altered the venue. In the pre-act era, plaintiffs tried to be the first to file a complaint against a company whose stock had dropped, because courts usually named the first to file as lead plaintiff. The idea was to file first, find the dirt later. The Reform Act now requires parties filing a class action to publish a notice so that other members of the class can come forward. The court is then supposed to choose the applicant with the largest financial interest to serve as lead plaintiff.
But the provision has had unintended consequences. Plaintiffs' attorneys now rush to issue a press release, often widely circulated on the Internet, to attract class members. The hope is to accumulate the largest financial interest and lead-plaintiff status. The practice also promotes multiple filings, which are harder for companies to defend.
Consider World Access Inc. The Atlanta-based telecommunications company announced on January 5 that its fourth-quarter earnings would fall well short of analysts' expectations of 31 cents a share, and would be closer to 15 cents per share. The price of World Access common stock plummeted 42 percent, or 87/8, to close at 123/8. Just two days later, a complaint was filed on behalf of Carol Milite, who owned only 100 shares of the stock. Over the next few months, 22 suits were brought against World Access.
The suits allege that the company touted the positive effects of pending acquisitions while it knew that pricing pressures in the industry would have a negative impact. The company insists there is no evidence of wrongdoing, yet it won't have a clear opponent for a while, as various law firms compile alleged victims.
Not all the news is bad. There is some evidence that a higher percentage of complaints are being dismissed. A study by David Levine, a senior Securities and Exchange Commission enforcement adviser, and Adam Pritchard, a University of Michigan law professor, found that U.S. courts dismissed 60 percent of shareholder fraud suits filed against companies in 1996 to 1997, compared with 38 percent in 1990 to 1991.
For a time after the passing of the 1995 Reform Act, many cases that were dismissed were subsequently filed in state courts. For example, a case brought against Quantum Corp., a Milpitas, California, disk-drive maker, was dismissed in 1997 by a federal judge who wrote: "The court finds the plaintiff's allegations preposterous," only to be refiled in a state court. In 1998, Congress passed the Securities Litigation Uniform Standards Act, which has substantially returned securities litigation to federal courts. "The Uniform Act has largely reduced, but not eliminated, the risk of dual-tract litigation," says Steven Schatz, a senior securities litigation partner with the Palo Alto, California-based law firm Wilson Sonsini Goodrich & Rosati.
Some interpretational case law that could give the legislation more bite is also starting to filter through the courts. A case against Silicon Graphics that was dismissed in 1996 could set an important precedent on the higher pleading standards, though there is an appeal pending. One key aspect of the 1995 act is that it requires plaintiffs' lawyers to describe the alleged fraud in greater detail in their complaint, or the case can be dismissed even before discovery. The district court dismissed the Silicon Graphics case based on the new pleading standards--namely, that the complaint did not contain a "strong inference of fraud."
Either way, many contend that real securities litigation reform will not come until the exorbitant damages that plaintiffs are able to seek are reined in. "Until Congress or the courts do something about the measure of damages, you won't see frivolous cases go away to the full extent Congress would like," says Schatz.
The heyday for securities plaintiffs is far from over. And some companies have themselves to blame, as earnings management techniques become more prevalent. "Look at all the companies that are restating their earnings," says James Newman, publisher of the Securities Class Action Alert. "The use of stock as currency to pay employees puts more pressure on companies to have higher earnings and higher revenues," and more companies are willing to commit fraud to do it, he says.
Current events, too, may help line more lawyers' pockets. The Y2K Bug is certain to snag companies that mistakenly thought they were compliant. And the music is sure to stop at some point for the lofty Internet companies. "A liability for being sued right now is the high valuations of Internet companies with little profits," says Michael Morris, general counsel of Sun Microsystems, a maker of enterprise network computing products based in Palo Alto, California. "Some of them have disclosures that would curl your hair."
- Make sure everyone in the company adheres to revenue-recognition policies. "I see cases all the time where the CFO is unaware of the potential deviation from the policy," says Steven Schatz, an attorney with the law firm Wilson Sonsini Goodrich & Rosati.
- Use the safe-harbor language even during live correspondence, such as conference calls. "The safe harbor is the best protection," says Lou Thompson, president of the National Investor Relations Institute, in Vienna, Virginia. "But don't use the safe harbor when there are no forward-looking statements. Boilerplate is not going to work," he warns.
- To the extent that you give guidance to analysts, be conservative. And be careful not to disclose material information in casual conversation.
- Institute blackout periods for insider trading by senior officials and directors. Experts recommend blackout periods lasting from the last month of each quarter to two days after results are announced.
- Be careful with pre-announcements. They could make the company responsible for updating the information every time conditions change.
- Avoid hyping products and services. Speculating about the prospects for products, especially in trade journals and at trade shows, where safe-harbor language is rarely used, can be construed as false and misleading if they don't bear out.