Board Oversight of Securities Class Action Defense: A Winning Path

Securities class action lawsuits are no fun for anyone involved. They name the company’s executives—and sometimes board members—as defendants and seek significant damages. But companies can achieve victory in one or both of two ways: 

(1) Most securities class actions can be dismissed early on with the right approach by skilled lawyers; and

(2) All companies and their boards can “win” a securities class action if they use it to give their disclosure and governance a checkup. 

Treating a securities class action as an opportunity for oversight improvement is especially important in light of the Delaware Supreme Court’s decision earlier this summer in Marchand v. Barnhill, which held that a shareholder derivative action could proceed based on sufficient allegations that the board failed “to put in place a reasonable system of monitoring and reporting about the corporation’s central compliance risks.” 

Directors can use a securities class action as an opportunity to learn more about the company’s disclosure system. By working with candid securities class action defense counsel to answer three key questions, boards can fulfill their duty of oversight, gain valuable information, and help prevent future disclosure problems that could result in shareholder suits and/or government investigations:

1. Are the company’s disclosure systems sound? Securities class actions follow stock-price drops that can reflect a disconnect in disclosure—the market didn’t understand something about the company. Even if the lawsuit lacks merit, there’s always a good lesson to be learned from simple misunderstandings. Is information for forecasting flowing smoothly? Does the management discussion and analysis (MD&A) need to be refreshed? Are the company’s risk factors tailored to its real risks? Do investor calls need more oversight? The board can use this as an opportunity to take a close second look at the quality of the company’s disclosures and disclosure systems. 
2. Are management’s disclosures fair and honest? Although the subset of securities class actions challenging a registered stock offering do not require plaintiffs to prove fraud, securities class actions challenging the vast array of other types of public statements—10-Ks and -Qs, press releases, statements in investor calls, among others—require plaintiffs to allege and prove that management committed fraud. To be sure, plaintiffs’ lawyers cast a wide net and unfairly ensnare a great many honest executives, but the allegations of fraud are an opportunity for directors to ensure that management’s disclosures are fair and honest. This can typically be accomplished by asking securities class action defense counsel to keep the board informed as counsel develops the facts relevant to its representation during litigation.     
3. Is the company’s disclosure counsel giving good guidance? A company’s outside corporate counsel plays a key role in good disclosure, giving guidance in connection with public statements and stock-trading decisions. In order to ensure the company has the right resources in place for making fair and honest public statements, directors should see that corporate counsel has a big enough budget to do good work. Too often, law firms do disclosure work on a small budget, as a client-relations service to the company that helps them get larger projects down the line, or under a procurement or bid process to keep legal costs down. This type of limited, loss-leader work can result in less informed and thoughtful disclosure work by law firms. It would behoove directors to examine the budget to ensure funds are sufficient to achieve the company’s disclosure goals. Directors also need to be sure that corporate counsel has an open, independent line of communication with the board. Doing so will avoid problematic coziness between corporate counsel and management.

To obtain oversight benefits from a securities class action, boards need to ensure the company selects securities class action defense counsel who will give candid and unconflicted answers to these three questions. The defense firm should not have previously advised on any issue relevant to the securities class action—the company’s class-period public statements (press releases, regulatory filings, investor calls, and the like), any stock offering that may become part of the litigation, and any stock sales or corporate transactions that may be evidence of a motive for fraud. Quite often, management’s answer to key questions such as “Why didn’t you disclose that?”, or “Why did you sell stock then?” is that outside corporate counsel said it was allowable or didn’t say it wasn’t okay. It is important for defense counsel to probe these issues free of a conflict between their duty to the clients and their desire to protect themselves, their law firm, or their corporate partners. 

To ensure that management avoids improperly engaging corporate counsel, directors must involve themselves in the defense counsel selection process. It is difficult for directors to displace defense counsel once engaged, so they must get involved at the first sign of a potential problem. Directors don’t need to micromanage defense counsel selection, but, at a minimum, they must insist that management interview several defense firms, analyze the potential conflict between outside corporate counsel in addition to each firm’s merits, and be certain that the board will receive candid answers to key oversight questions. 

Doug Greene leads BakerHostetler’s firm-wide Securities and Governance Litigation Team. He has defended securities litigation full time for more than 20 years, and is one of the country’s most experienced securities defense lawyers. He devotes a significant amount of time to thought leadership, and has authored three U.S. Supreme Court amicus briefs in recent years. 

Jessie M. Gabriel is a partner in BakerHostetler’s Securities and Governance Litigation Team and leads the firm’s Investment Funds Practice.​ She brings a unique perspective to securities class action defense, based on her deep familiarity with the financial services industry and economic consulting background.

Bruce Vanyo is the chair of Katten Muchin Rosenman’s Securities Litigation Group. He has defended securities class actions for 40 years and is widely regarded as the country’s most experienced securities defense lawyer. He led the Silicon Valley’s advocacy of securities class action reform that led to the Private Securities Litigation Reform Act of 1995.