When a privately held company goes public, its litigation risks change dramatically. U.S. publicly traded companies face scrutiny from a broad audience – including state and federal regulators, shareholder advocates, the media, whistleblowers and plaintiffs’ law firms – and with it, a risk of more frequent and potentially damaging litigation. And because the boards of public companies also face greater scrutiny and more substantial risk, they – and their audit committees in particular – are more likely to sponsor internal investigations or take other steps that, in turn, lead to even more regulatory scrutiny and/or litigation.
It’s no surprise that the single biggest change in litigation risk in the transition from private to public is the potential exposure that comes with the company’s new, and far more extensive, disclosure and compliance obligations. What may be less obvious is that the increased exposure can give rise to a broad range of additional types of litigation – not just disclosure-driven private securities fraud claims, but shareholder, derivative, employment, regulatory and even criminal claims, all based on essentially the same underlying facts, but posing different challenges for the company and its defense.
Litigation travels in packs, and a single securities class action suit may trigger not just a government inquiry, but a host of related suits, including claims naming senior executives and board members as defendants. In planning for the risks a company may face once public, its directors and management often find it useful to review a snapshot of the kinds of claims they could face, and anticipate how to respond if those claims arise.
Common Public Company Litigation Risks
In litigation arising from public company disclosures and decision-making, each set of plaintiffs has its own agenda, theories and constraints, but they almost always cluster around the same alleged misconduct and try to translate it into a viable theory of recovery within their particular context. Four kinds of actions are particularly likely to travel together: (1) private securities class actions; (2) government investigations or enforcement actions; (3) shareholder derivative actions; and (4) ERISA litigation. In all four, management’s judgment and fiduciary duties on a material issue for the company are likely to be central to the action.
Private Securities Class Actions. The increased likelihood of private securities class action litigation arising from statements in the company’s disclosures and SEC filings certainly remains the first source of additional risk, and a driver of much of the other litigation. The overwhelming majority of such actions allege fraud claims under Section 10(b) and Rule 10b-5 of the Securities Exchange Act, and virtually all of them include allegations of misrepresentations in financial documents. Complaints also frequently focus on forward-looking statements; accounting-related claims had for a period become less prevalent but have recently re-emerged and currently appear in about a fifth of the filed cases. Securities fraud claims arising under analogous state statutes – like New York’s Martin Act – are also common. Although the number of securities class actions dipped below the historical average for a five-year stretch between 2008 and 2013 – due to a host of factors, including changes in the law – in recent years, litigation rates have been creeping back up toward their historical averages. Recent data and personal experience suggests that trend is likely to continue.
Government Investigations and Enforcement Actions. Government investigations and enforcement actions also are more common among publicly-traded companies – although as a general matter, litigation by private plaintiffs historically has far exceeded enforcement activity in this area. Not every securities class action is accompanied by an SEC investigation, but many are, and a subset of those may become the subject of a separately-filed SEC complaint. SEC actions commonly target the company, but the SEC recently has demonstrated a greater willingness to bring actions against senior executives and directors as well. The SEC’s broad investigative and enforcement power, and its ability to coordinate with and call in other government agencies and enforcement officials (and, in particular, to coordinate with DOJ investigations), mean that every company must take an investigation seriously and respond with care. Enhanced judicial scrutiny of settlements with the SEC – both as to financial terms and as to admissions – has only served to raise the stakes. And, although the SEC may be the primary enforcer of the securities laws, the DOJ and other agencies may also initiate action, both civil and criminal.
Shareholder Derivative Litigation. Public companies frequently face shareholder derivative actions. Plaintiffs and their counsel often file multiple, competing derivative cases at or around the time of a securities class action filing – although they may not wait for a securities fraud claim to be filed, and may target business decisions that do not ultimately trigger fraud claims. Shareholder derivative claims focus on alleged breaches of common law duties and obligations by the company’s managers and directors and are unique in this group because they must be brought on behalf of the company and seek to recover for its benefit – not on behalf or for the direct benefit of the individual shareholders. Derivative actions frequently trigger the creation of a committee of independent board members to oversee an internal investigation of the allegations.
Companies may incorrectly assume that any derivative action will be brought in the state of incorporation, whose law governs and whose courts are most familiar with those laws. That was once the case, but the trend has shifted notably in the direction of “out-of-state” suits. A company may be sued in any one of a number of forums, including the jurisdiction in which its headquarters is located and the jurisdiction where it principally does business, as well as the state where it is incorporated. Now, even Delaware corporations are frequently sued in other states, often in multiple states at once. As a result of this trend, companies have increasingly been forced to defend themselves in parallel actions in state courts that are less familiar with the law governing the claims and defenses.
ERISA Class Actions. ERISA class actions are quite common when a company’s stock drops – there, the plaintiffs purport to act on behalf of company employees and focus on the impact of the stock drop, and the conduct alleged to have caused it, for employees and their retirement plans, rather than for public stockholders. ERISA plaintiffs may rely on many of the same facts as the securities plaintiffs, but their allegations are for breach of the duties that are imposed on fiduciaries of an employee retirement plan under the ERISA statute, rather than violations of the securities laws. Because the defendants in an ERISA action should be the alleged fiduciaries of the plan, they may include individuals or entities who are not named in the securities actions (and may exclude some who are); in addition, the allegations may focus on disclosures and communications to plan participants in addition to those made to the market more generally.
What to Do?
In the face of these risks, what’s a company to do?
First, as noted, because so many of the litigation risks particular to public companies arise from and relate to SEC obligations, the steps that a company may take to ensure proper, fully compliant, carefully vetted filings and disclosures are the same steps that will help protect it against litigation down the road. Strong in-house securities and compliance teams can be among the first, and best, defense lawyers in these cases. Even so, plaintiffs – especially with the benefit of hindsight – may find fault and attempt to bring a claim.
If a company does face litigation or investigation arising from its disclosures, one of the best things it can do is view the actions holistically, and respond with a tightly coordinated global defense. While each line of attack – class action, derivative, ERISA and government – will involve its own set of issues and area of expertise, having a clear view of the entire chess board and understanding how the pieces move together, and in competition, can be invaluable.
A coordinated approach recognizes that although the substantive law and procedural posture of each action is different, they arise from the same core facts and have cross-cutting issues and implications. An effective defense holds in focus both the differences and the intersections, and approaches the actions in a coordinated way to minimize exposure across the entire portfolio of litigation. It also takes into account and balances the potentially different perspectives and interests of shareholders, management, and the board in dealing with the issues giving rise to the litigation or investigation. That isn’t easy. It requires attention to detail and breadth of knowledge across all of the implicated subspecialties, a coherent end-game and the ability to implement it. But, when it’s effective, a global approach can drastically reduce the burden on the company – both in terms of defense costs and inconvenience, and ultimate liability and exposure.