NEW YORK-A year after enactment of the Private Securities Litigation Reform Act of 1995-designed to prevent frivolous shareholder lawsuits-the caliber of the federal cases brought is improving, but the overall numbers of suits aren’t dropping because of a shift to state courts.
That was the consensus among panelists at a PR Newswire seminar Dec. 10 entitled, “What Your Company Can Do to Protect Itself from Shareholder Lawsuits.”
The increased burden of proof, which the new law requires in order for plaintiffs to sue in federal courts, has had several consequences to date. It has resulted in cases with more realistic grounds being brought to federal courts, thereby reducing the overall numbers headed to these tribunals.
Because the quality of these lawsuits has improved, they also are less likely to be settled out of court. That is so even though smaller companies now are more likely to be sued.
“Plaintiffs are staying away from larger companies because they are better financed to fight to the bitter end,” said Larry Fenster, an attorney with Brobeck, Phleger & Harrison L.L.P., New York, which defends companies against securities class-action lawsuits.
Prior to the enactment of the law, the average market capitalization of a defendant company in a securities class-action lawsuit was $2.08 billion, said Karen Donovan, a reporter for The National Law Journal. In 1996, the first full year after the law went into effect, that market capitalization average had dropped to $529.3 million.
At the same time, however, the federal law also has resulted in an increased number of shareholder lawsuits filed in state courts, a venue that rarely was used prior to 1996, Fenster said.
Conditions of the new federal act don’t apply at the state level. The Securities and Exchange Commission has thus far shown no inclination to have federal pre-emption inserted into the act, preferring instead to let case law decide the issue, said Lou Thompson, president of the National Investor Relations Institute, Vienna, Va.
State courts also have become a more popular forum for shareholder lawsuits because those adjudicating such cases tend to be less sophisticated about this complex area of the law, Donovan said.
State court filings also permit plaintiffs to avoid the “safe harbor” provision, a key element of the new federal law. Consequently, the safe harbor doesn’t seem quite so protected, and companies are therefore reluctant to take advantage of it, she said.
According to Thompson, “The central theme we took in drafting the law and its impact on corporate disclosure was to create a safe harbor that would allow companies to discuss forward looking information.”
He disagreed with Donovan’s view that companies are reluctant to use the safe harbor provision out of fear of legal action in state courts where it doesn’t apply. Citing a recent university study, Thompson said, “companies that were willing to discuss forward looking information before are more so now; companies that weren’t still aren’t.”
In providing forward looking statements, clarity in layman’s terms is essential since the courts will view safe harbor through the eyes of individual investors, Thompson said. Groups of individual investors are still most likely to file suit even though the new law allows the federal courts to designate pension funds and other large institutional investors, which have the most stock at stake, to be lead plaintiffs in these cases.
“A lot of big institutional investors don’t like shareholder suits because they see the costs as dragging down the companies’ stock and they see a lot of these suits as frivolous,” Thompson said.
Fenster noted the number of plaintiffs’ law firms specializing in class-action securities litigation has risen dramatically to more than 140, compared with a dozen in 1980.
To gain safe harbor in making forward looking statements, Thompson offered this advice: “You can say, `we expect’ or `we project’ or `we forecast’ that revenues will grow by 40 percent if orders continue at the same pace.
“Warn investors there is a risk, but you don’t have to mention all risk factors in order to be protected. If the risks are in your 10Q report or earnings releases, you can refer to these documents.”
“Puffing adjectives” in 10K and 10Q reports are, however, a red flag for prospective plaintiffs,” Fenster said. “The universe of people who care about your unique product or service is comprised of plaintiffs’ lawyers,” he said.
Despite companies’ fears about forward looking statements, failed forecasts comprise only about 6 percent of all class-action securities lawsuits, Thompson said. An additional 40 percent of the cases allege accounting fraud.
“Plaintiffs are looking for severe, one day, over the cliff (stock) price drops,” Fenster said.
Another common reason for shareholder lawsuits is the sale of stock by insiders either before the release of bad news or during an initial or secondary public stock offering, he said.
“The more stock as a percentage of your holdings you sell and the closer in time it’s sold before bad news, the more likely you are to get sued,” he said. “It’s best never to sell in an IPO or a secondary offering and, if you must, sell less than 10 percent of your holdings.”
The overwhelming majority of corporate executives provide projections with hard numbers to securities analysts even though that is another practice that gets companies get sued by shareholders, Fenster and Thompson said.
In stock price projections, “if the spread is narrow among analysts, that is evidence of you giving them hard numbers,” Fenster said.
“There is the puppet theory that analysts are mindless scriveners taking orders and the conspiracy theory that the brokerage firms they work for are market makers in your stock.”
Companies should focus on the macro and micro economic business dynamics and establish a dialogue with analysts “without getting to `therefore’,” he added.
“I know 78 percent of you review draft analysts reports, which gives Larry (Fenster) heartburn,” Thompson said. “Discuss only factual errors and then get rid of it. But don’t go to the shredder after a lawsuit is filed because that’s destruction of evidence.”
