NC: Hello. Welcome to Securities Laws and Corporate Governance: The Advent
of a Meltdown? This event is the first in a series of Internet broadcasts presented to you by
Reliance National. My name is Nick Conca. I'm an attorney with Reliance National, and I'll be your
moderator for this broadcast. In sponsoring events of this type, it's our goal at Reliance National to
provide critical information to our policyholders and brokers on the issues that affect them the
Today, we focus on the legal liabilities of corporate directors and
officers under the federal securities laws. For the next 90 minutes, you'll be hearing from three of
the nation's leading experts on corporate governance and securities class action litigation. They'll be
addressing the critical issue of whether we are indeed approaching the advent of a meltdown. In other
words, did the Private Securities Litigation Reform Act of 1995 fulfill its intended purpose of reducing
the number of routinely filed class action suits, and if so, how come over 600 cases have been filed
since that legislation's enactment, with a record number being filed in 1998?
In that regard, is further legislative reform required? Conversely,
have we seen an alarming decline in the quality of financial reporting by corporations? These and other
issues will be addressed by our panel of experts.
Let me introduce them to you. To my far left, we have William Lerach,
who's a name partner and head of the San Diego office of Milberg Weiss Bershard Hynes & Lerach, the
nation's largest law firm specializing in representing plaintiffs in class action litigation. Next, to
my immediate left, we have Tower Snow who is chairman of Brobeck Phleger & Harrison, a law firm
based here in San Francisco with offices nationwide. Tower is a leading defense counsel, representing
corporations and their directors and officers in securities class action litigation.
And the man in the middle, Professor Joseph Grundfest, who directs the
Roberts Program for Law, Business, and Corporate Governance at the Stanford University School of Law.
Joe has also been a commissioner of the Securities and Exchange Commission.
All three of our panelists have testified before Congress on a wide
variety of securities law issues. Welcome gentlemen, to all of you, and I would also like to extend a
hearty welcome to our live audience here in San Francisco as well as those of you who are viewing this
broadcast over the Internet. A special hello also goes out to those viewers watching this broadcast at
town hall type meetings that we've set up in Denver, Chicago, Philadelphia, and at Ricker Auditorium in
New York City.
To make this program as educational as possible, we've provided for you
on your computer screens a number of links to various web sites which contain information on the issues
that we'll be discussing today, and you're certainly invited to visit those sites at your earliest
convenience. You'll also find a link to a survey that we've prepared to solicit your feedback on
A word about our format today. I'm going to pose a question or raise
an issue with a member of our panel, and once our panelist responds, the other gentlemen will have a
chance to comment. Additionally, you viewing this on the Internet will find a box immediately below
this video which will allow you to e-mail your questions to our panelists. Finally, towards the end of
this session, we're going to open the floor to questions from our live audience here in San
And with that, Professor Grundfest, I'm going to pose the first
question to you. You heard the first statistics that I mentioned. I recently also read a statistic
indicating that a corporation today has a 25% greater chance of being sued today under the Reform Act
than it did before the Reform Act was enacted. Can you explain that?
JG: No. (Laughs) Let's take a step back. There are numbers that we know and
translating those numbers into statistics can be an exercise fraught with danger if it's not done with
care. What we do know, pretty much for the first time in history - because of a provision of the Reform
Act which requires public notice when litigation is actually filed, not merely when it's settled - we do
know the number of companies that are being sued. And if we do a simple nose count, I think we can
safely say that the number of companies being sued is now running at a record pace. We had more
companies sued in 1998 than in any period prior to the passing of the '95 Reform Act. Now, that's a
number. There are different ways to express that number. You can take it as a percentage of total
publicly traded companies, you can express it in various forms of market capitalization, and any good
statistician can honestly make that number go up and down from a variety of different perspectives. But
I do think that it's fair to say that the one non-debatable point is that the total number of companies
being sued is up relative to where it was prior to reform.
WL: Of course, that comes at a time when we are probably in the 10th or 12th year
of a huge IPO boom which has created a large number of new public companies, and oftentimes public
companies that have the characteristics of rapid growth, dependence on one product, dependence upon
stock option compensation of executives - that perhaps makes them more prone to getting in trouble under
federal securities laws. I would like to see someone figure out as a percentage of existing public
companies what number of companies are being sued today as compared to some years ago. My suspicion is
it's probably flat or even somewhat less.
TS: Yeah, I think people though should be careful about reading too much into the
numbers. Joe is right, the number of filings is up, the number of companies sued is up. I actually
think, though, that doesn't necessarily mean that this is a more hostile environment for public
companies. If you really dig down deeper, one dynamic that's at work here is that more and more cases
are being dismissed. Indeed, over 50 percent of all motions to dismiss that have been filed have been
granted in whole or in part, and I would suggest that part of what is happening here is that the
plaintiffs' bar is hedging its bets. They believe that fewer cases will survive, and as a result, they
are filing more cases. And I think that's right. I think that as the cases go downstream, what we'll
see is more and more cases will be thrown out early and fewer will go the whole road.
JG: Well you know it's interesting. Bill and Tower's views are very interesting,
but relative to what we know, they're forward-looking statements, they're forecasts, you know, they're
NC: Do they get safe harbor proper protection?
JG: Well, I don't know, what are you guys trying to sell? There are some things
that we do know, all right, and that I think are non-debatable, and then Bill might be right and Tower
might be right, spinning off of what we do know. One of the other things that we do know, which I think
is an unassailable fact, the cases are taking much longer to resolve. There is an inventory that is
building up in the federal judiciary of remarkable proportions. So Tower may well be right that some of
these cases are getting dismissed out early on, but these cases may also be appealed up and they may be
sitting in that inventory. There's a pig in the python.
All right, we have more than 600 companies that have been sued, rough
calculation suggests that about 100 of those cases have been settled or dismissed with prejudice and are
out of the system. That leaves 500 cases still sitting somewhere in the federal judiciary waiting to be
resolved. Now we can do a simple accounting exercise, and we can do what most companies have to do, and
that is value the inventory. You've got an inventory of litigation sitting on the shelf in courts of
appeals and in district courts around the country. What is the value of the 500 cases that are still
TS: Well the numbers are actually even more traumatic that what you suggest because
the 600 cases are federal cases, and of course there are many state cases out there. There are actually
750 cases, federal and state, that have been filed in the post-reform era, and less than 50 have been
settled. So we actually have nearly 700 cases in the pipeline post-reform, and of course there are
still some pre-reform cases sitting out there.
NC: I want to ask Bill a question. I mean, a lot of those cases in the pipeline
are your cases. Why aren't they moving toward settlement? What is happening with these cases?
JG: Well because you aren't offering enough money, that's why. (Laughter)
NC: Aside from that fact?
WL: Well I think Joe is right in one way that he says. It's very early on in the
life of this new statute to really judge its ultimate impact. We were saying before the program began,
we'll continue to sit here and predict, but year after year our predictions have proven to be wrong, and
the situation will evolve as appellate decisions come down. But I do think it is true that currently,
the combination of the discovery stay with the heightened motion to dismiss standard for plaintiffs to
overcome has slowed the cases down dramatically. I don't know the number of cases, new PSLRA cases,
that have settled - probably only 40 or 50 cases have settled.
The slowdown is going to continue until the professionals on both sides
of the cases get the information they need, the appellate direction they need, to adequately price the
cases. If the plaintiffs win the first four or five appellate decisions, the price of the cases is
going to be higher than if the plaintiffs lose. And if there is no externality driving a given company
to settle a case now, why not just sit and wait and see what happens; I think that's part of what's
TS: Yeah, I think that the Reform Act really in many respects has been 'the law of
unintended consequences.' It's done a lot of things certainly none of us foresaw it doing. And one
thing is, it slowed how these cases move downstream because of the requirement for the court to consider
who appropriately should be the lead plaintiff, who should be lead counsel, the discovery stay. But
other things have changed too. The plaintiffs almost uniformly are asking for more money. The demand
has gone up. In many cases, the demand to settle a case has gone up dramatically. What's happening on
the defense side? On the defense side, the defendants are emboldened. Why are defendants emboldened?
Because the defendants believe the Reform Act, long-term, is going to be much more beneficial to them
than to the plaintiffs.
What else is happening? The insurance industry, I think, is tired of
paying out very, very significant claims, and the insurance industry is emboldened, and in fact, most
insurance carriers would like to see more cases go to trial. And lastly, last year, three cases went to
trial, for the first time in many, many years, three securities class actions went to trial in the
United States. What happened? The defendants won all three. And when the jurors were polled in those
cases, what did we learn? The jurors in fact get it. I think we're going to talk about this later, but
jurors get it. They can sort through the facts in these cases and make intelligent decisions, so the
plaintiffs are looking for more money, and the dynamic on the defense side is that people are digging
their heels in more and are more willing to fight.
JG: Tower, there was a decision yesterday in UDC, during a trial that was against
Arthur Anderson, and there again, it was a victory on the defense side. So to the extent that we want
to look at trends, the first thing you learn as a statistician, it's hard to extrapolate from four
observations. But it's been a while since plaintiffs have had a big win at trial in a class action
NC: I want to focus on trials later. I want to ask you another question, Bill.
JG: Real weird, I had Bill agreeing with me for a moment there. (Laughter)
TS: Well, don't change the topic.
NC: We can't have any agreement during this panel discussion. Let's assume
for purposes of argument that I'm an associate at Milberg Weiss. Very well paid,
obviously. (Laughter) I want to bring a case. I need your approval to bring this
case. When I conference the case with you, what do you want to hear from me?
In other words, what are the earmarks of a good case from your perspective?
WL: Well first of all, not that it's directively responsive, associates don't start
cases, certainly not in our firm, I don't know about other firms. The starting of a securities class
action case is a very important decision. It involves a major financial commitment on the part of the
firm, and in the new litigation environment, requires us to be very careful to make sure that the case,
at least in our judgment, meets the heightened pleading bar. So just as a starting point, the cases are
actually started by partners, often by myself, but by other experienced partners. We think that's
What do we look at? There's no mechanical formula, notwithstanding
some of the lore that surrounds the field. There's no magic button to be pushed, there is no magic
formula that we utilize. We gather a great deal of information.
We obviously look at the price action of the stock. If a stock has
gone down 25 points in one day, upon a revelation of unknown news, that's one situation. If a stock's
gone down 25 points over five weeks with a group of disclosures coming out, it's a different thing, so
you look at the stock price action. We also looked very closely at the motive or the reason behind it.
If you can't figure out a crisp, clear economic motive to deceive, the case is not going to have any
appeal. But the motives can be all over the place. A company can be on a growth by acquisition spree,
and therefore need a high common stock price. Insider trading is an obvious motive and something we
look at, but it can be more subtle than that.
A lot of companies pay their executives year-end or even quarterly
bonuses for meeting pre-existing earnings-per-share targets, internal targets. If we see that and we
see what looks to be an accounting fraud case, that can be a motive as well. We look at industry
publications, we look at analysts' reports. In many of the cases, we spend weeks or months trying to
analyze and synthesize that information. We have forensic accountants who review it, we have private
investigators who go out. So I have a complaint that ... I wish I could tell the company, it's in my
briefcase over there, they'll get it in a few days. (Laughter) They're going to get it about four days
before the statute of limitations runs out, and I'm sure that they've probably even forgotten what they
did at this point. But cases can take a long time to get ready.
JG: It's interesting. You know, Bill suggests that there is no formula, but we've
studied the patterns of allegations, we've done what we call textual analyses of complaints. And it
appears that you can explain a very large percentage of plaintiffs' behavior with a couple of critical
variables. Between 50 and 60 percent of the complaints being filed allege some form of trading by
insiders during the period when the fraud is alive, and if this isn't consistent with your experience, I
mean just ...
WL: No, that is consistent.
JG: And roughly 60 percent or so are also alleging some form of accounting problem,
sometimes articulated as a violation of GAAP or GAAS, other times it's articulated in another way. But
again, roughly 60 percent. Only about ten percent of the cases that we're seeing filed currently fail
to allege either an accounting issue or trading by the insiders. So it's a pretty simple equation that
if you've got a sufficient amount of market cap loss in a sufficiently short period of time, and if when
you click on Yahoo and call up the call symbol, all right, and look at the insider trading, you find
trading during the period that you think the fraud was alive, Bill probably says, "Let's get on
file." That's probably enough to go.
WL: But one could look at those facts and conclude that they are indicia of
misbehavior by the insiders.
JG: I'm not suggesting otherwise.
WL: You know we filed a case the other day with an extraordinary amount of ... $189
million of insider trading by executives in about a six- or seven-week period before the stock went from
high 40s to the low 20s, and it was a pretty spectacular reallocation of wealth between the public
investors and the insiders.
TS: Yeah, I think the plaintiffs really look at what I would call primary factors
and secondary factors. The primary factors would be, as you suggest, Joe, insider trading and
accounting restatement or something of that nature. Another thing could be the announcement of a SEC or
DOJ investigation of the company. But you don't just start with trading, you've got to dig down. If,
for example, the trading represents ten percent of an officer's or director's overall holdings, that's
probably not going to excite Bill too much. If it represents 75 percent of the individual's holdings
and the company's stock goes in the tank, 30 days later I'd say he's going to be real excited.
He's also, I think, going to look at what I would call the secondary
factors, and among them would be, does the company have good risk factor disclosure? He's going to look
at the Qs, the Ks, other public documents the company puts out and see if the company is warning about
the risks as well as talking about the upside. He's going to look at whether the company states the
facts or tries to spin them and engages in a lot of self-congratulatory hype. He's going to look at
whether the company is making projections.
We were talking earlier that you see these really wild projections out
there now where companies are predicting a 200- or 300-percent revenue increase for the next quarter or
year. If they don't make that or come close to it and they're selling, that's going to excite Bill.
And I think also he's going to look at what guidance the company is
giving to the Street. And it's clear that if there's very extensive guidance, hard number guidance by a
company, and other guidance by a company, particularly if it entangles the company with the analyst,
it's going to interest him more. So you know there are a lot of things he looks at, and I don't think
there's any formula as he's said, but what it does do actually for a company is, it gives you an idea of
how you can take steps to proactively lower your litigation exposure.
NC: Let me ask Bill a follow-up question. We've talked about accounting issues;
we've talked about insider trading. My question pertains to the safe harbor. Has the safe harbor sort
of taken out of the mix what I'll call the purely forward-looking statement cases?
WL: It has not. The safe harbor is a very complex topic. It's a very complex part
of the statute. I don't think it was really understood by those who wrote it, and I think people who
are dealing with it on a counseling basis and on our basis, coming at it, find it to be somewhat of a
Rube Goldberg device with the distinction between oral statements and written statements and I sort of
sympathize with the executives. I think they find it impossible to comply with it. And my experience
to date ... first of all, I thought it was going to be the worst thing in the world, and I think it may
well turn out from a public policy standpoint to really debase the quality of public disclosure in the
public company context. I mean, giving corporate officers a license to deliberately lie, if that's what
it means, we're all going to rue the day that we did that. However, to date, it hasn't really seemed to
have that impact, and plaintiffs have been able to plead their forecast cases.
JG: Exactly. And I do think, I do think that this concern about executives going
out and willfully lying, thinking that you can cover it by important cautionary language, I think that
was speculative to begin with, and I put the challenge to you Bill. Can you think of one situation
where you think that one executive has actually done that?
WL: Well I have seen situations, Joe, where the following has occurred. Conference
call, some poor stooge is put up at the beginning of the conference call to read a disclaimer that says,
"We're going to make forward-looking statements, they may or may not be accurate. Read our SEC
filings." We then see in the transcript corporate executives making rather bold and specific
forecasts followed as soon as the trading window opens a couple of days later by significant insider
trading, and those forecasts not being achieved in that quarter. Now, you tell me, did he lie or she
lie, or not? Were they emboldened to be more specific with their false forecasts because of the comfort
they got by the disclaimer that was read? I don't know the answer. I do see the conduct, and I don't
know the answer.
TS: Yeah, I actually can come to Bill's assistance. I do think there are cases,
and I have seen cases in the post-reform environment where the executives are making hard-number
projections and the evidence is pretty compelling that the executives knew there were very significant
GAAP issues on the revenue recognition, which goes straight to what's going to the public domain at the
same time. So I do think those cases are obviously out there. The SEC's, I mean, going downstream in a
number of them.
JG: But it's really very interesting. Again, you can devote an entire legal career
to the safe harbor, but a safe harbor does not apply to GAAP. All right, so what you've just done is
you've just described a situation that I would argue wouldn't be ...
TS: Right, but the projection ...
WL: It doesn't apply to GAAP, but see, in order for the projection to be credible,
it has to build on a base of existing earnings, which are often 15 to 20 percent overstated due to
preshipments or other ... So you can't ... I want to go back to what you said. You can't separate false
forecasts from false financial reporting, they go hand in hand and build on one another.
TS: Right, and the projections, Joe, are made independent of the financial
statements themselves, so they are actionable. The other thing which I would just note in terms of the
projections companies are using and the ways companies are trying to avail themselves of this safe
harbor is that even today, four years after the Reform Act, many companies are doing it wrong, that they
are making projections in writing and they are not including any risk factors in the writing which
contains the projections. That does not bring you within the safe harbor. Similarly, companies are
making oral projections and they're referring over to, you know, a document, a 10-Q or a 10-K. You go
to the document, there's nothing in it. There are no risk factors, there's no safe harbor language.
Or the other thing we see is companies who will issue a quarterly
report. They'll try to avail themselves of the safe harbor by incorporating by reference another
document which does contain risk disclosure. Again, that's invalid on its face. The document which
contains a forward-looking statement must itself contain risk factors. So I would urge companies that
want to avail themselves of this protective mechanism to understand it, because many companies do
WL: There's another problem then that comes up, and this is a real outbreak of
lawyer's disease when it comes to drafting the cautionary statements in the SEC filings. You know what?
They never get shorter, they never get simpler, all they do is get longer and longer. It's like the
growth of the indenture from one page in 1,500 to 1,700 pages 300 years later. And if you look at the
annual reports or SEC filings of a number of major and well-represented public companies, they will now
have three, four, five pages of, however well intentioned, nevertheless appearing to be boilerplate
disclosure of every possible conceivable factor that could adversely affect their results.
Now a couple of things come from this. They get themselves into the
boilerplate language of the legislative history of the Reform Act. Secondly, there's a whole line of
cases that say that cautionary language itself can be actionable because if you warn that a problem
might occur when it is already occurring, that is deception. And so this sort of mindless repetition of
"This may happen" or "That may happen" can all of a sudden turn into a
liability-creating fact. Also, I just think that when you point this out to a judge, and you point out
the fact that maybe the language of the risk factors hasn't changed at all in, like, six consecutive SEC
filings in a rapidly changing world, in a rapidly changing economy, it might suggest that it's nothing
but mindless boilerplate. It's a morass, the forward-looking statement situation.
TS: But the risk factors clearly have to be thoughtful, and they absolutely must be
updated quarter to quarter or more frequently if appropriate. But one thing I think we've learned from
the cases that have gone to trial, and also from the dismissals, is that triers of fact, and by that I
mean jurors or judges, are impressed with five or six or eight pages of risk disclosure. It's pretty
hard to say that the company's trying to hide the ball when you can turn to page after page after page
of disclosure which in effect says, "If this happens, we could be out of business, or we could be
very materially injured." So you know, is carefully tailored, always updated disclosure best?
Absolutely. But I'll tell you, boilerplate is a lot better than nothing at all, and that anything
JG: But as a practical matter, I think all this may be well and good with
respect to the safe harbor, but it's not the driving force in the litigation environment today. Safe
harbor debates, safe harbor arguments are of third- or fourth-order magnitude compared with other issues
that are driving this engine.
NC: All right, let's go to another issue, then. Oh, go ahead.
WL: The fact of the matter is, if you don't tell the truth, your stock collapses,
and the insiders have traded, investors are going to find a way to plead that case. I mean, the
ultimate refuge is in the truth, however difficult that may be for corporate executives to cope with.
NC: I want to switch gears. I want to talk about the pleading standard briefly,
under the Reform Act. We've seen one Circuit Court decision out there on the Second Circuit on the
pleading standard. Arguably that case was resolved in the plaintiff's favor, in that the case held that
the motive and opportunity standard prevailing for years in the Second Circuit still prevails under the
Reform Act. There are a number of Circuit Court decisions pending, oral arguments have been had.
Tower, do you have any predictions of what the guiding rule might be across the country?
TS: Well as you said, Nick, there has only been one decision so far under the
Reform Act on these issues, and it came down the plaintiff side of the fence, where a lower standard was
held sufficient. There are ways which a defense lawyer could argue that that case is distinguishable,
but clearly that's a win for the plaintiff's side. There are a number of other cases pending. One
always is wary of predicting what courts are going to do, but I think the reality is that if you look at
the panels that have been drawn to date in the cases that have been argued, there were better panels for
the plaintiffs than there were for the defendants. And if I'm a betting person, I would say that in the
first half dozen or so cases, I think the plaintiffs I think are probably likely to do better than the
Is that the end game? No, because the reality is that different panels
and different Circuits are going to come down different ways, and some of the cases are going to go for
the plaintiffs and some of the cases are going to be very pro-defense, and there will be others in the
middle. So I think that we have years of appellate decisions before we'll really know the lay of the
JG: And again, we're three and a half years from the adoption of the Act, we've
just had our very first decision. The decision they sent was quite a surprise to everybody. It wasn't
a case that people were really watching to be the trend-setter in this area, and the court comes out,
adopts the Second Circuit standard, and more.
There are ways to read the Second Circuit standard to make it stricter
and there are ways to read it looser. The body language in this decision really goes for a
pro-plaintiff, relatively low level of scrutiny in terms of the strong inference standard. There they
let a case go forward on what the court called the thinnest of reeds, in terms of motive and
opportunity. Weak motive, little ... weak motive and opportunities, and said, you know, enough to get
you past motion to dismiss.
TS: It's very important, I think, to remember though that these early appeals all
involve pleading standards. They have nothing to do with the merits of the cases. And that again, even
on this, I think, you know, it'll be at least two or three years before we have a better sense of where
the appellate courts are going. But none of this has to do with the merits of the cases. And as the
cases go downstream, I continue to believe we will see many, many cases thrown out as the cases
WL: I think that for those of us who practice in the field almost exclusively, even
before the new Act was passed, there had been a clear shift in the judicial attitude and in the judicial
landscape, in which there were an increasing number of dismissals of cases. And I think myself, and I
would expect Tower would agree with me, that this reflected a certain judicial evolution that there were
too many cases, it was too easy for the plaintiffs to get through the gate and get discovery and the
judiciary was doing a very good job of dealing with what we agree are two magnificent statutes, the '33
and the '34 Acts. Now it's interesting, and these are magnificent statutes that are very important to
our national economy and our national securities markets, and the courts know that. I wonder if the
Press decision, which was the case that was being talked about a minute ago from the Second Circuit, the
Stevelman case which came down from the second circuit a few days ago upholding another 10-b-5 case.
JG: But pre-'95 Act.
WL: Pre-'95, that, but applying theoretically the same standard. I wonder if we're
not seeing the same judicial bent to tilt a little against the contemporary wind. Perhaps a concern
that ... look, these Court of Appeal judges know what's happening in the district courts. Some of these
decisions that have been the most adverse to the plaintiffs have been written up in every national
periodical you could imagine. I wonder if there isn't just a little tilting back against ... to make
sure that the playing field gets evened out again, which after all is the judicial role.
NC: I've been asked to remind our viewing audience that you can still e-mail
questions into our viewing panel. They've agreed to answer any and all questions that are put to us. I
want to ask Bill about the lead plaintiff of selection process. It is no longer first filed, first
dominating. It is no longer a situation where plaintiffs' attorneys themselves can choose who leads the
plaintiff, the plaintiffs' class. There's a whole process you need to go through, there's a notice that
needs to be provided. You've got to go to the judge to figure out who is going to be selected as the
lead plaintiff and the lead counsel. Talk about how that's changed your practice over the last three
WL: Well it clearly has changed the practice of everybody in the field. Everyone
now has a shareholders relations department, a website and is very much attuned toward gathering shares
as it's called after these cases are filed. There is no question that for better or worse, the lead
plaintiff provision has a dramatic impact, because it impacts every single case at the very outset. It
is mandatory. You have gone from a world where plaintiffs' lawyers, no matter what others may have
thought, really were very careful about solicitation of clients and other overt activities for fear they
would be criticized, to now where they operate under a congressional mandate to advertise their services
and their cases. And it happened just like that, and the world changed.
What are some of the impacts that are happening? Well, if it was meant
to bring forth institutional investors to have them dominate the cases, it's had some impact, but not
near what people would have expected. I think its most dramatic impact, Tower always steals my line
about the 'law of unintended consequences'...
TS: No, no, it was my line.
WL: No, I thought of that line. (Laughter)
TS: Wait a minute ... (Laughter)
WL: But in any event, one really dramatically unintended consequence has been the
equalization of knowledge between the companies and the victims, or the shareholders. Remember, when
these kind of cases are normally started, the company has the benefit of knowing everything, the
shareholder is on the outside looking in. Now when a case is filed, it's publicized nationwide, the
technology exists for disgruntled present and former employees to anonymously provide the information
instantly over the Internet, for competitors to contact you. And I do think that's having a dramatic
impact, and don't think we don't go into those chat rooms, and we have a whole group of people who ...
because there can be thousands and thousands of messages that have to be read through and analyzed, and
there's a treasure trove of information. In fact, companies, I think, make a big mistake, sometimes get
involved in a dialogue in those chat rooms.
TS: It really is funny, you know, pre-reform, we would oftentimes see the same
plaintiffs, the same shareholders, time and time again. I mean, Mr. William Weinberger, the most
defrauded man on Earth; he'd been individually defrauded by 120 public companies. I mean, what an
unfortunate investor that guy was. (Laughter) You know, but now, I mean, that whole argument and mode
of attack has totally disappeared because they send out the press releases that go over the Dow Jones
news wire, and they get literally, I think, in some of these cases, thousands of calls. And then they
just simply go sort through the thousands, pick out the best people. Our line of attack is gone.
JG: But what's happening is even more interesting than that, because what the
statutes create is a presumption that the lead plaintiff shall be the plaintiff with the greatest
financial interest. What that leads to is a process where ... which is akin to what happened in the
Middle Ages. You know, in the Middle Ages, the aristocracy never actually fought, all right, you know,
during these jousts. They would have their champions, and my champion would fight against your
champion. So what's happening now is the law firms are all trying to get coalitions of investors so
that the law firms are able to say, "My coalition is bigger than your coalition, therefore I'm
going to ... you know, my guys are going to be lead plaintiff."
And why is lead plaintiff important now? Lead plaintiff is important
now because lead plaintiff then picks counsel, and you're going to get picked if your champion is the
one selected to be lead plaintiff. That has the statutory process reversed. The way it was supposed to
have worked was that the person with the greatest financial interest would have a presumption to be the
lead plaintiff... wouldn't be a conclusive presumption. The lead plaintiff would then try to select the
counsel most appropriate to represent the interests of the class in that environment. What's happened
is the process has been reversed. The plaintiffs' law firms are putting forward the coalitions in an
effort to take control of the case, and you get your coalition in, you get selected. I think that's
something that may change in the future.
WL: I want to ask you, lawyers are the ones who have to go to court and argue, Joe,
I mean, you need a lawyer to approach the court and make any argument.
NC: Bill, are institutional investors figuring into this mix at all?
WL: A little bit, not much. I don't think it's been dramatic. I can think of only
one or two cases where they have literally seized the case. I think another factor that I wondered if
it was going to happen, I thought that institutional investors, whether they be labor union pension
funds or public employee pension funds, coming forward and being plaintiffs might impress the courts who
might realize that what they were dealing with were the lost life savings of workers who had been
cheated, their pension funds had been cheated. Frankly, I find judges just as hostile to the cases in
that environment as they were when the case was brought by William Weinberger or Rodney Shields or
whoever it was. So I don't think the courts are impressed, if you will, by the fact that institutional
investors are present at all, and in many instances, they haven't shown the institutional investors any
deference in the leadership fights.
TS: I think the institutions haven't really shown up in mass for a number of
reasons. One is an institution can lose $50 million, but it's not particularly meaningful in a $10
billion portfolio. They have limited resources. Most institutions would rather have their people
devoted to making investment decisions rather than running a lawsuit. If they show up as a class
representative, all of a sudden the institution has assumed a fiduciary responsibility to all the other
shareholders. Most institutions don't want that. And lastly, the reality, if an institution shows up
as the plaintiff, they subject themselves to discovery, and I think a lot of institutions don't want
companies probing into their proprietary trading strategies.
So there's no big incentive for institutions to show up, and when they
have, what is interesting is what Bill said. The courts haven't been particularly receptive to them.
The SEC recently has come in with a number of amicus briefs urging the courts to appoint the
institutions as the lead plaintiffs, and even with the SEC weighing in, and the courts haven't been
particularly receptive to them, which is exactly the opposite of what one would think if you look at the
manager's report for the Reform Act.
JG: There's something else that's going on as well, and that is when an institution
shows up and gives every indication that they don't intend to hire a particular law firm or what have
you, that law firm gins it up and attacks that institution, about how they're incapable, inappropriate,
they're not going to be adequate representatives of the class, their claims aren't characteristic. So
they wind up in effect trying to litigate the entire case just to be able to get in as to be lead
plaintiff. Now you take that same institution, you have them agree to pick that law firm, all of a
sudden, they're exactly the institution that Congress had in mind that would be the appropriate lead
plaintiff in the case. So let's keep our eye on the ball. What's going on here is not so much the lead
plaintiff selection, but it's the counsel selection that's driving the game.
WL: Well there is an issue that we're all concerned about with institutions. You
can belittle the individual investor, and I understand the arguments that were made. But you know, a
person who bought 1,000 shares of stock in a company and lost half his net worth or even ten percent of
his net worth is angry, focused, and wants a remedy. A big institution has a huge portfolio of
holdings, many of which conflict. What if that institution bought stock in XYZ Company, but XYZ
Company's underwriter is ... I'm going to use a name, Goldman Sachs or Merrill Lynch or whatever, and
they have a huge investment position in Merrill Lynch?
Now is that employee pension fund willing to destroy Merrill Lynch and
harm its huge investment in Merrill Lynch to get a $700 million recovery that it's got to share with a
whole group of investors over here? Now I think that's a legitimate question to ask. What if the
institution is audited by the same auditors that audited the company that committed the fraud? Are you
so myopic that you believe that that's not going to affect their judgment and how vigorously they will
prosecute the case? I guess it might be great that institutions are there, and they're wonderful in
many ways, but they are not conflict-free, nor are they really different than the old professional
What is the difference with Bill Weinberger bringing 100 cases ... the
man lived to be 100 years old, but we only sued once a year. (Laughter) He might have brought 100
cases, but the Louisiana Pension Funds have brought five or six cases in three or four years, the city
of Philadelphia has brought cases well in excess of five, the Florida State Pension Fund seems to bring
a case every couple of weeks. So, you know, are they any different than the old professional
JG: Bill, hold it there, this isn't on point, but if Weinberger filed 100 cases and
lived to be 100, how many have you filed Bill?
WL: I'm a lot younger than Weinberger is, I got a long way to go, too.
JG: Let me tell you something, Methuselah had better watch out, because the filing
is good for you that way.
NC: A question. Do institutional investors have an affirmative obligation on
behalf of their fundholders to file these suits?
WL: They've been told universally that they do not. I don't think there's anyone
who believes they do.
JG: A brief was filed two days ago, I believe, by the Department of Labor
suggesting that as part of fiduciary obligation of a ERISA fund, the fund should at least consider, all
right, take a fiduciary look at whether they should move forward. The brief, and I read it relatively
quickly, did not take a position that you are under any duty or obligation.
NC: Let's switch gears, here, I want to go to you, Professor Grundfest. The SEC
has been very vocal about accounting practices. Chairman Levitt, Lynn Turner, the Chief Accountant at
the SEC, have been very vocal with respect to certain accounting practices. Revenue recognition
practices, so-called big-bath reserving, accounting for in-process R&D. The SEC has also created
this Blue Ribbon Committee on Improving the Effectiveness of Audit Committees. As far as I know, no
real rule-making has come out of this. Could you give us a prediction in that regard?
JG: I could, I won't. I think it's much better to observe that for perfectly
understandable reasons, the SEC is worried about the quality of GAAP filed reports by United States
issuers today. They are concerned primarily by revenue recognition issues, they're concerned by some of
the practices described in Grace, some of these false reserves, some of these tin can accounts. And
they are trying to force the audit firms and publicly traded companies to get religion, in the sense
that just because GAAP may technically allow something to occur doesn't mean that it's good corporate
practice to push GAAP to the very edge. And let's face it, pressure has been put on many of the big
accounting firms, and they are backing away from prior positions. I'm hearing many companies in the
Valley and in elsewhere saying, "Our accountants are now telling us this year we can't do what we
were allowed to do last year." So the pressure is having an effect.
TS: I think you're unlikely to see a lot of rules coming out. The SEC has probably
doubled the number of on-staff accountants, but I think what we are likely to see is many more
enforcement actions directed at companies and also directed at accounting firms, and I think the other
dynamic you're going to see, and we're already seeing it, is the SEC going down the chain of command.
Not just going at the top people, but going all the way down to in fact very junior people, and seeking
to get a consent decree against them. And the signal they're trying to send is, you can't plead as a
defense that you're a good soldier. You can't, from a junior position, say, "I was only following
And what they're trying to do is really, as Joe said, is scare people
and put the fear of God in people from top to bottom so the people further down the chain of command
that might have to execute certain things aren't going to do it, they're going to blow the whistle.
JG: The SEC is and has to be a leveraged institution, and part of the dynamic of
figuring out when you're at the SEC is whom to sue, how to sue them, and how to settle the case, because
you can't afford to litigate most of your cases as well. So what you want to do is, you want to put the
fear of God into as many people as possible. That can lead to some very interesting litigation
patterns, but clearly that's the objective and it's not necessarily a dumb strategy, by a long shot, if
you look at the objective and the resources.
TS: The other thing is, also dealing with the SEC, what we're seeing pretty
regularly is the SEC is less willing to compromise. It is tougher to do deals. It's more or less take
it or leave it, and they're asking for more than they did in the past, and I think it's exactly because
of what Joe said is, they're really trying to send a signal to the markets that, "If you cross the
lines and we discover it, don't look for sympathy because there isn't going to be any."
WL: Well I'll moderately dissent from this fanny-patting of the SEC. The fact of
the matter is the SEC has been engaged in a lot more rhetoric than they have action. Now, part of that
is understandable due to the resource difficulties that they have. But the fact is, so far there's been
a lot more rhetoric and talk than there have been corporate executives or CFOs hauled to the dock for
the fraudulent accounting. It also suggests that, little bit here, the SEC is engaging in that
time-honored Washington custom of rushing to the aid of the victim. As Joe Grundfest's website pointed
out very early on after the passage of the new Act and long before the SEC said "boo" about
this, the private bar was beginning to allege in virtually all cases ... I don't know what your
statistic is, but 60 percent or something accounting fraud, and this was viewed and hailed as a very
major change in impact of the new Act.
And not to be too high-tech, but we've got an article on the Milberg
Weiss website if you want to look at it called "An Alarming Decline in the Quality of Financial
Reporting," which details a great deal about this upsurge in fraudulent financial reporting by
American companies and the reasons for it.
So the point I want to make is, it's not a coincidence that after the
private bar in '96 and '97 began to expose these accounting frauds through private litigations
investigated and filed by them, that the SEC suddenly started to jump on the bandwagon, as whether it
was the auditors or somebody was doing something inside these companies, because the number of
accounting restatements and admitted irregularities have literally soared to beyond-record proportions.
I mean, I've been in this field for 25 years, I can remember when if there were three accounting
restatements a year it was a big deal. There are many times today when there are two or three
accounting restatements a week and sometimes a day. There is something dramatically and horribly wrong
with the financial accounting of public companies in America.
Read the article, and you'll see that it's driven by momentum investors
who punish companies for missing by a penny, putting excruciating pressure on the managers to meet the
numbers. It's driven by an evolution of stock option compensation of executives where they get their
options every quarter with an expectation to sell, which only feeds into the pressure to keep the stock
price up. One thing that made America's markets the envy of the world is, we have the world's most
honest markets. If we lose that worldwide reputation of honesty and financial accounting, which
efficiently allocates capital, we'll all pay a hell of a price for it in the long term.
JG: Bill, two observations apropos of that. You know, first accounting seems very
crisp and clear, but the reality is when you've got to put together the accounting statements, there are
a bunch of judgment calls that get made, and it is possible for companies to work within GAAP and at the
edges of GAAP. But within GAAP, and then to wind up in situations where there are restatements.
Apropos of that, we are in a different economic environment. GAAP was structured to deal with a
particular type of economy. It doesn't suit all companies as well today as it did in the past, and
there are situations where these types of restatements and other accounting problems arise without it
being fraud. Now that said, I have to agree with you entirely. The volume of restatements, the volume
of these issues certainly is up. I think it's legitimate cause for debate and also for concern. The
extent to which it's also a cause, should be a cause for litigation, is I think something that's open to
TS: Yeah, just a data point on the SEC. The SEC at any given time has between
1,500 and 1,800 ongoing active investigations, and again, if you work on the defense side, many of these
are non-public, so they don't show up anywhere in the public domain. But you know how active the SEC
is, because you're all handling them in a private context. Each year, the SEC brings about 500
enforcement actions. I actually think those are remarkable statistics, given the staff of the SEC and
given the domain that they have to police. I think that, you know, are they doing everything that maybe
you would like to see them do? No. But I actually think they do a remarkable job, and boy, we
certainly tell our clients, "You'd better expect they're going to show up at your doorstep if you
cross certain lines," because I think they are.
JG: I have to concur with that, and again, what you have to do is, you have to look
at the shadow that they cast, not merely at the number of cases that they file.
WL: It currently hasn't been a very threatening shadow recently, given the conduct
of the corporate community. So, you know, I appreciate that they're a well-intentioned organization
JG: They have to leave something for you to do. (Laughter)
WL: There's plenty for us to do. The SEC is guilty, I think too often, of
cherry-picking, easy cases, small companies, being driven by statistics, rather than challenging some of
the so-called respectable companies that we know recently have been exposed to ... have been engaged in
what I think even you would agree with were pretty dubious accounting practices.
NC: In talking to ... I want to switch gears and talk about the discovery stay. In
talking to some securities litigators about this, they have said to me that it is the provision of the
Reform Act that had the greatest single impact on the way these cases are litigated. Do you agree with
WL: Well sure, it keeps the evidence of the wrongdoing from the plaintiff. It has
a very dramatic impact on the litigation as long as the discovery stays in effect.
TS: Now what a company would say is that discovery is the lever which forces
companies into settlement, because discovery totally disrupts the operations of the business, distracts
management from being able to run the business, particularly for smaller companies, high-tech and
emerging growth companies. The companies do not have the time to spend on discovery. Pre-reform
management spent, on the average, 1,000 hours per securities class action. That's just an impossible
position for companies to be in, so I happen to agree that the discovery stay has had a dramatic impact,
and it's had a very good impact because what it does is, it takes away from the plaintiffs' bar the
lever that forced companies that had not engaged in any wrongdoing whatever to settle the case.
NC: Has the discovery stay, though, created this enormous inventory that we were
talking about earlier? Is that really the single cause for the inventory?
WL: It is a cause along with the fact that there's a lack of appellate guidance on
how to process the cases in the district courts. There's no question a lot of district courts are just
not deciding motions to dismiss, they're just sitting there waiting for appellate guidance, so it's a
combination of the both.
JG: And you know counsel, in many situations, I think that's perfectly reasonably
behavior for the court. I mean, you know, why reach a decision only to find out that the Court of
Appeals has some different view and you're going to have to deal with the case under a new standard?
NC: Now as a practical matter, Bill, what exactly is going on in your offices
during a discovery stay on a given case? Are you investigating the case, are you contacting employees
at the company, are you interviewing securities analysts? What exactly is going on there?
TS: They're filing new cases. (Laughter)
WL: That too. (Laughter) Well, that actually is a legitimate point, Tower. The
fact of the matter is, if you can't prosecute your existing cases, you might as well file new cases and,
you know, get ready for the day when it comes that we know what the appellate rules are. I mean,
there's nothing irrational or surprising about that. But we do continue to investigate and monitor the
cases. You know, I wonder, sometimes the delay works in the plaintiff's benefit. I've seen situations
where, while the case is held up, other information comes out that helps the plaintiff plead the case
later on with a revised or amended pleading. Sometimes the passage of time, even if there's little
overt action, can be beneficial to the plaintiff.
TS: It's interesting that the passage of time can also help the defense. It can
help it in a couple of respects. If the company rebounds, I think it dampens the plaintiff's appetite.
And I also say, to the credit of the plaintiffs' bar, there have been a number of cases where additional
information did come to light, and the plaintiffs' bar did the responsible thing, it walked away from
the case. It voluntarily dropped the case and I give you credit for doing that. And, you know, the
delays worked for the defense as well as for your side.
WL: You know there is one sort of pernicious factor at work, and I wonder if you've
seen it or you, Joe. The 90-day bounce-back provision, the provision that was meant to eliminate as
damages in a securities case some portion of a steep decline in the stock, if during the succeeding 90
days the stock came back up. And it's a complex formula, but the long and short of it is that it
eliminates some of the steep decline as damage. A) I don't think it's had too much impact on the cases,
because the damages are normally so darn big it doesn't matter anyway. Companies don't seem to be able
to get their stocks back up in 90 days very often.
But I do ... I've seen a couple of situations where I thought companies
sort of maybe got pretty aggressive during that 90 days on trying to talk the stock back up, and I
wonder if they're not exposing themselves to danger in doing that, and in fact, I even believe that
certain insurance companies may make money available to companies to crisis-manage those situations to
push the stock back up, and I wonder what that implies.
TS: Yeah, well I agree. I think that companies need to be very careful about what
they say after their stock takes a hit, and the companies that engage in spin do so at their own peril
and risk, and they could be making things worse, not better. I think you're right, Bill, that this
provision really hasn't had much of an effect, and I think one reason is the market has been so
punishing to companies that disappoint. It doesn't forgive in 90 days, the stock tends to stay
WL: Also the stocks ... this is a point ... I give credit to Mel Goldman, who
pointed this out to me recently. It's sort of obvious, but nevertheless a good point. Do you realize
that virtually every day, if you watch the markets, a stock goes down 15, 18 points, not three or four
points? I mean, there is a lot of air in this market, and if you stumble or miss or whatever term you
want to use, the drop is A) dramatic. So it attracts attention and other things. Number two, it
creates huge damages, and it makes it almost impossible to make it back in the 90 days. And that's a
price the corporations are paying for dealing with these very, very high-priced securities.
JG: And the bounce back role, just from an academic's perspective, never made much
sense to me at all. I never found very much good that I could say about it. How and why it wound up in
there, you know, it's one of the mysteries of legislation magic.
NC: Well let's talk about the companies we're talking about ... and ask what advice
you might have for ABC Corp. The headline reads "ABC Corp Agrees with Analysts' Views of 11 Cents
per Quarter and a Dollar and Change for the Year." ABC Corp's Chief Financial Officer is quoted as
saying that he is comfortable with the estimates because it reflects the guidance he has given to
analysts. Now what advice might you give ABC Corporation?
JG: Well, pay up your policy. (Laughs)
TS: Yeah, right. I'm a pro-disclosure defense lawyer, and I think most members of
the defense bar that are counsel companies are pro disclosure. The enemy of public companies is
surprise, so I want companies talking to the financial community all the time. We want them to be
releasing in a press release, over the wire, any material developments. But we also want them in a
constant dialogue with the Street on immaterial information and a frank discussion about information in
the public domain, competitive announcements and other things.
As we said earlier, however, there are lines. One of the lines is
that public companies and their CFOs shouldn't do the work of the analyst. Wall Street analysts get
paid a lot of money. These are all MBAs. A lot of them make over a million bucks a year. They are
totally capable of coming up with their own financial models. So the advice I would give to Company ABC
is talk to the Street about your business, disclose material developments, point out what the operating
dynamics are that can affect you. But don't be in the business of creating the analyst's financial
model. Don't embrace hard number estimates by analysts because you've just then adopted them as your
own, and you probably have a legal duty to update them if they change internally, and let the Street
make its own evaluation of how you are likely to fair. A good way to think about this is a jigsaw
puzzle. A company should provide the Street with all the pieces for the jigsaw puzzle, but let the
Street put the pieces together.
WL: Yeah but, Tower, now in all honesty, let's be fair to the CFO of the company,
okay? He's now had the conference call and let's say he has skillfully fended off all requests for
specific information in the public part of the conference call. Now you know the first thing when he
hangs up is the phone rings, and it's the Merrill Lynch semiconductor analyst who says, "Okay,
let's go. How are we doing on the quarter? Here, I'm going to say, $1.21 for the year. How do you
feel? Feeling good? Feeling comfortable?" Now that guy - and I'm sympathetic - he is in a tough
spot. If he says, "I'm not going to tell you," the analyst is going to say, "Uh,
something's wrong. They're clamming up. They're not giving us guidance." And the fact of the
matter is, this market is so driven by momentum investors and earnings expectations, how can these
companies not provide the information to the analysts?
TS: Oh see, because I think the scenario you described is totally accurate. It
happens to every public company in America and every CFO in America. But the name of the game is
discipline. And the answer I think to that analyst that calls, and probably every other analyst that
calls, is to say, "Look, I'll be happy to talk to you as long as you want about our company, but
we're not in the business of making projections or doing your financial model." And you say it
with a smile. Now what's interesting ...
WL: Okay, I'll say, "Okay ...
TS: Now let me finish.
WL: ... but you know what I'm going to do? Then I'm going to recommend my clients
buy DEF Company, because I've got a higher degree of confidence and visibility in their earnings than
TS: It doesn't happen, Bill, because, in fact, the analysts are smart and they can
come up with their own models. And the way to test that is... My firm, for example, represents
literally every investment bank in the country, and if you go and talk to the analyst individually or
collectively, what they'll tell you is, "Look, I am always going to ask that question. I'm going
to take any information I can get from the company. I'm going to love it if I get a hard endorsement or
I'm told they're comfortable with my numbers. But am I going to get angry at the company if the company
doesn't do that? No."
As long as the company is giving me a lot of information, as long as
the company has a frank dialogue - I'm a smart person, I can come up with my own projections. And that
is what happens. So is a company going to be tested? Of course. Is an analyst going to probe? Of
course. Does an analyst want that comfort? Of course. But does it mean a company has to give it? No.
And many, many public companies say no with a smile.
NC: The line we're talking about here, Tower, is the difference between guidance
and entanglement. I was wondering, Joe, could you kind of flush that out for us and see if we can draw
some kind of a line here for our audience?
JG: Well, what I always tell my students is, you can't take a clear picture of a
fuzzy object. And where you cross that line, it's not really a line. There's this gray zone and, you
know, different judges will call the shots differently. You know, for example, Tower said that when you
comment on the forecast, if you're internal forecast has changed, you could have a duty to update.
Well, that would depend upon how you commented on the forecasts. Which magic words did you use? The
way one court puts it is, if your words have a forward-looking connotation.
So, you know, I can comment on a forecast with or without a
forward-looking connotation. If we said, "Look, as of today, we're comfortable with those numbers,
but this is a rapidly changing business, everything could be different tomorrow.
TS: Yeah, I agree totally. That's why I used the word "may." As opposed
to would have a duty to update, because it does vary. I agree.
JG: Right. Exactly.
TS: And nobody is suggesting this is easy. This is, and many people have said
this, just like walking a tightrope. It is. But if CFOs really will take the time to understand the
lines of selective disclosure and what gets companies in trouble and what does not, I would suggest to
the audience that a company can just dramatically - and I mean dramatically - by 90 percent or more,
reduce their litigation exposure by good disclosure approaches. But you have to take the time to really
understand the environment and where the lines are.
JG: To reduce the litigation by 90 percent or more, you have to do what Tower says,
plus you've got to be really good about controlling insider selling. You've got to control the patterns
of the sales. You know, the rule, no sudden moves. And you've got to be really crisp on your
TS: And have good risk factors.
NC: Let's talk for a bit about the convergence of this issue and the Internet.
Several companies have ... most companies now have web sites where ... in which the companies will
actually link the viewer to SEC documents, and analyst reports. Sometimes just links to favorable
analyst reports. Is that a problem?
TS: I think that's a huge problem. The risk is that if a company puts analyst
reports on its web site, that a court is going to deem it to have incorporated their reports. The risk
is, of course, even greater if they put on the good reports, but don't put on the bad reports. Because,
obviously, they're only putting on what they like and what they want the market to believe. So there is
a huge risk there.
WL: How do you feel, though, if they include a disclaimer that we don't endorse, or
blah, blah, blah?
TS: A disclaimer, is better than no disclaimer. (Laughter) But the best policy is
don't put other people's reports on your company on your web site. It's that your ... somebody that
wants to learn about your company can go to the other sites and...
WL: Yeah. What about just listing ... I'm sorry Joe. But what about just listing
the firms that cover you and the analysts then giving the phone number, then giving the e-mail? Where
do you step over the line?
TS: Well, I think that's fine. I don't think there's risk in that. I think that a
number of companies do that, and it just says, "If you want to learn more about us, here are people
that follow us."
WL: And, but again ...
TS: Without comment.
WL: And they list the five guys that are fed bulls and they don't list the three
people who are...
JG: Then they're in trouble. See, I mean, you can rank order these procedures in
terms of, you know, safe to dangerous, safest to do nothing. All right? Next step, every analyst that
you're aware of, all right, that covers, here's their name, address, e-mail, alphabetical order, you
know, no selection in terms of who's favorable, who's positive. Plus cautionary language. These guys
follow the companies. They've got their views. These aren't our views. You want to find out what they
think? Call them.
WL: I just want to prove that participating in panels is educational to the
participants. We haven't done that check. (Laughter) We will. (Laughter)
JG: That's a very interesting point.
WL: That's very good.
NC: Well, I have a question.
JG: Bill, I'll send you a bill. Okay? (Laughter)
WL: As he writes with his red pen. (Laughter)
NC: I have a question here from the Internet. It comes from Phil Drake, an
accounting professor at, it looks like, Thunderbird Graduate School. Predictably, it's for you Bill.
If financial statement disclosure is poor, reads the question, why are accountants, i.e., independent
auditors, not typically attached as defendants? Research shows that accountants are sued in less than
10 percent of lawsuits while financial statement fraud is asserted in over 50 percent of the cases.
WL: Most of the financial statement fraud is in interim reports, and it's much more
difficult to name the accountants as liable for the interim reports, because they don't express an
independent opinion. With the curtailment of aiding and abetting, liability under ...
TS: Central Bank.
WL: ... Central Bank, it's tougher to get them in that situation. Number two, this
concept of proportionate liability that's worked its way into the federal securities laws has made the
accountants less attractive defendants. Number three, the accountants are very difficult customers to
deal with in a litigation context. And I think those factors together lead to people naming
accountants, probably only in the most egregious accounting fraud situations, where there is an opinion
of the accountants that you can point to.
TS: I would add one other thing as well. The percentage in the question is right,
10 percent or less. But in many cases, when the plaintiffs get discovery from the accounting firms, I
think it is likely that in some of those cases they are going to name the accountants at a later date.
What they're waiting to get are the accounting documents to see what they have.
WL: And unfortunately, a one-year statute of limitations.
TS: Statute of limitations.
WL: And a discovery stay materially disadvantages the plaintiffs in that
JG: Well, you get into the one and three game. You know, when does the one start?
How will the courts, you know, do this? So again, it's good business for people who litigate for a
WL: And also there's a new Ninth Circuit opinion...I don't want to be too lawyerly,
that might even suggest that actual knowledge is the test for the statute of limitations, which would
help with that problem pretty significantly.
JG: Right. More chapters to come.
NC: Tower, I want to ask you a question about taking these cases to trial. Your
firm is one of the few law firms to actually try a 10b-5 action recently. What lessons can you share
with us that you took away from the trial?
TS: Well, I think we've learned a lot of lessons. I didn't actually try the case.
My partner Bob Varian, who in fact is here, tried it. And we learned an immense amount. We learned a
lot in terms of tactics, of how to present a case successfully. But in terms of broad lessons that are
beneficial, I think there were a number of them. The first was that jurors do understand that the
federal securities laws are not investor insurance. That they're there to insure fair disclosure, and
full and accurate disclosure, but they are not an insurance policy for investment losses. That's very
important because the plaintiffs, of course, want to package these losses as investment insurance.
Either you win with the market going up, or if the market goes down, hey, you just call on the federal
securities laws and you get made whole anyway.
Second, we learned clearly that jurors understand risk, that they
understand that investing is very much a type of gambling. And that you roll the dice, and you're
trying to make money. They also understand there are different types of risks. It was very clear that
people understood that investing in IBM or General Electric is different from investing in an Internet
company. Or that investing in a mutual fund is different from investing in some small high-flyer with
"dot com" after their name. So they understand risk, that's also encouraging.
Third, American jurors understand that our markets are competitive,
that every business every day is an intensely competitive environment and there are going to be winners
and there are going to losers. And by definition, if there are going to be losers, investors and
shareholders are going to lose money. Not through any fraud, not through any wrongdoing, because that's
the nature of competition.
And then lastly, I think, in terms of general themes, one great
advantage defendants have in going to trial is that the defense witnesses tend to be real live people
who are there at the time. Officers, directors and employees, who oftentimes spent years building the
company. Whereas the plaintiffs case tends to be based around experts who are brought in after the
fact. And that for jurors to find a company liable, they oftentimes have to find a large number of
people, not just people within the company, but accountants, underwriters and others, a large number of
people that were there that lived it, that they lied. And most people actually have a hard time doing
that. Most people are not so cynical. And they are going to be reluctant to hold that a large number
of credible people are all in some conspiracy and all lied.
So I think the overall moral is that companies will do much better than
many have thought in the past, going downstream when they believe that they're in the right. And as you
said, Nick, there are two other cases that went to trial, the results were the same, the defense won.
And Joe said yet another one. So there's four, four for the defendants, zero for the plaintiffs.
WL: I agree with much of what Tower says and I think that lawyers who try cases for
plaintiffs have to be very attuned to the risk issue. I think it's a very important issue. I think if
you handle it properly you can win for the plaintiffs. I think there is a certain statistical skewing
here that ... Tower, I think, will agree with me. It's the weak cases for the plaintiffs that get
tried. The defendants, on the bad cases, pay. They can't take the risk. If there is a liability risk,
a real liability risk, the cases are settled in most instances.
Most of the cases that are tried ... you know, the case that you're
mentioning, Arthur Andersen was the defendant, they're an institutional defendant, that's the way they
are, they take cases to trial. Everex was not the strongest case in the world. So there's a
statistical skewing. And plaintiffs have won cases too. I mean, it's not a one-way street.
TS: Yeah, I very much agree with what Bill said and see, actually, the very
important point is that it's critical if a company is sued, for the company and its lawyers and for its
(insurance) carriers to accurately and honestly evaluate the case at the beginning. Because if it's a
problematic case, the name of the game is dispose of it as quickly as you can, as cheaply as you can,
and everybody does a lot better.
If it's a strong case, and the company may well and probably should
decide to take it downstream, and let's try to get it thrown out. The plaintiffs really have to do the
same thing. And the danger to the defendants is where they misevaluate the case, and you go downstream
with a weak case. Then you're put in an increasingly untenable position where you either have to try it
or you have to pay an absolutely exorbitant amount of money. And that's a situation nobody wants to be
WL: And I recall an instance where a company got extraordinarily cross-wise with
its carrier, rather late in the game in a case. And it's just sort of a life
experience story. There was a very, very, very bad document from the defendants, which the plaintiffs
had, and as the case progressed, not only went a long way, big investment in the case, the plaintiffs
began to bang on the table with this pretty incriminatory document. Well, it turned out that either
through oversight or for some other reason, company counsel had not shared that document with the
carrier. And I think the carrier was extraordinarily unhappy late in the game being told, you know, pay
up $25 or $35 million, because of this document, when they felt the case could have been resolved
NC: Let's talk about settlement dynamics. We talked about the fact that there are
a great many cases in the pipeline waiting for something, either dismissal, trial, settlement, whatever.
I'd like to ask you, Joe, of the cases that we've seen that have settled, the Reform Act cases that have
settled, the 40 or 50 of them, do the settlement amounts appear to be rising, remaining static,
JG: Well again, you've got to be very careful about how you do the statistics. The
median and the mean can be very different over here. The mean, for those of you who don't remember
stats 101, the mean, the average, all right, is the average number weighted over all the cases. The
median is the middle number. So if you have 99 cases settled for $1 million, and one case settled for
$1 billion, all right, the average is going to be closer to a billion, the median is going to be closer
We have a skewed distribution, always have had a skewed distribution in
the settlements of these cases. We had a larger number of cases settling for small amounts. And you
get a small number of cases, you know, being the big homeruns. So in that kind of a distribution, what
you see is the median number is going to be lower than the mean. All right? The mean, the average, is
the number that's interesting to the insurer because that really describes the total amount you've got
to pay out. And the average is also interesting to you because that's how you get paid.
So if we look at the average, the average is currently running in
excess of $10 million. All right? I've seen ... it depends upon which sample you look at, time
periods. But generally the view is, the average is up over the pre-95 period. And again, you can find
different averages depending on which time periods you look at. What we can do is value the inventory
that we know is in the federal system. If we just take the federal cases, we know there are more than
600 of them, we would estimate roughly that 100 or fewer have been disposed of by settlement or
otherwise. That leaves 500 cases, all right? And that number is growing on a daily basis.
If you assume that the average settlement value is $10 million -- which
is actually lower than ... which is roughly what we saw in '95 and lower than what we're seeing now --
and if you assume that 80 percent of the cases in the pipeline today will be settled -- and that's the
percentage we saw pre-95 Act, all right -- you have a fascinating number. Eighty percent of 500 cases
in inventory gives you 400 expected settlements. An average settlement of $10 million gives you a value
on that inventory of $4 billion. All right?
Plaintiffs' lawyers typically look to get on average about 30 percent.
That's what you hope. There are larger cases where the numbers come in lower; when there is competition
for the right to represent the class number, it comes in closer to 20 percent. But if we take that 30
percent number, subject to all the caveats I just described, cashflow to plaintiffs' counsel for
inventory already in place is roughly $1.2 billion. This is a big business.
I can tell you stories that would make those numbers higher. I can
tell you stories that would make those numbers lower. But if you want a focal point, a place to start
the discussion, it's not a bad number.
TS: There's clearly a false sense of security, I think, out there with respect to
the settlement of cases, because there haven't been that many settlements, less than 50 in the last four
years. And that is not representative of what's going to happen. I don't think any of us know exactly
when, but there are going to be some huge numbers coming down the pike in ugly cases.
JG: The big bulk of it is still out there to settle.
TS: Yeah, and you know you can pick up the (Wall Street) Journal any day and
identify any number of companies who are ... there's absolutely, positively going to be a big ticket
settlement. The FCC is going to bring an enforcement action. The DOJ is looking at some of these.
There are going to be some big, big settlements. The ranges so far run from about $500,000 to $72.5
million. That just gives you a sense of the range of these 45 to 50 cases that have settled.
One other thing we've seen is that there are fewer cases at the very
bottom. That on pre-reform you would see cases going even below $2 million. You don't see very many of
NC: As our time is growing short, I'm going to invite our live audience to step up
to the microphone, those of you who dare, to ask a question. If nobody steps up, I will certainly
continue. Okay. Yes?
KK: I'm Karsten Klehs with Woodruff-Sawyer and Company. The settlement statistics
are very interesting. I have a further question. If the average settlement is 10 percent of damages,
is it that defense is doing a great job? Or that the plaintiffs' bar is doing a bad job? Or is the
investor who, Bill, you said is angry, are you doing a weak job for him?
WL: The damages in these cases are very difficult to calculate. And to ascertain
whether or not you're recovering 10 percent of the recoverable damages, or 50 percent, is a hard thing
to do. The defense takes the position in the cases that the damages are very small, that factors other
than the alleged misrepresentation led to the inflation of the stock or the decline of the stock. And I
think it's really something that's proven to be very difficult to deal with on a statistical basis.
There is a provision in the new Act that was meant to ... I don't know
what it was meant to do. Maybe provide more information. I think it's been a complete nothing. It's
just made class notices even more complicated and longer than they were before. I think the defense
lawyers do a very good job for their clients in these cases. I think they have a very strong arsenal of
weapons to use. And I think the plaintiffs do a pretty good job for their clients across the board in
these cases as well. These are hard fought out cases.
TS: I obviously am going to say the defendants are doing a great job. What Bill
said, I agree with. You have to keep in mind that when the case is brought, the plaintiffs are going to
come up with the biggest possible number they credibly can, it's in their interest to do that. And that
what they're trying to do, of course, is to put leverage on everybody to come to the table and do a
deal. So I've seen any number of reports that say, "Gee, the plaintiffs are only recovering 10
cents on the dollar, or five cents on the dollar." But nobody believes the initial number. It's
not a real-world number. So in fact the recoveries of cases that are perceived by both sides to have
merit are very significantly higher.
JG: I'll give you another perspective. That is, if defendants can't get the case
dismissed, either motion to dismiss or summary judgment, then given the way damages are calculated in
after-market cases, it is an impossible financial risk for the company to take. All right? Because in
many of these cases, you know, even if you give the defense all the arguments, the number that you come
up with would bankrupt the company and everybody that's within a thousand miles of it. All right? The
damage rules are nuts.
TS: Right. And that's why early ...
JG: You can't afford to litigate it. All right? So what you get is a very
different bargaining dynamic. You look at how much is the insurance coverage, how strong is the case,
how many other resources can we bring to the table, and that's the number that actually drives the
ultimate size of the recovery. So calculating the numbers as a percentage of the final amount, it's a
curious exercise, because the company can't afford to take that risk of taking it to trial, because the
damage rules are so insane.
WL: Plaintiffs can't really take the risk either, because the judge won't permit
them to bankrupt a company. I mean, we all know that. The judges are going to protect the company at
the end of the day.
JG: So you're saying the damage rules are insane because you're not going to let
them bankrupt the company. You're saying the damage rules are insane because the bank or the company
could be bankrupted. I think we're all agreeing that the damage rules are insane.
WL: Yeah, what Joe ... The damage rules are a function of the price of the stock,
the volume of the stock. The insiders are the ones who benefit most from that, whether they're using
the stock for acquisitions or for insider trading purposes. And I think for the ...
JG: But here's the paradox, Bill.
WL: ... company to then turn around and say, "Well, we're really sorry we
drove the stock to 75. We're sorry it fell to 20. We're sorry that we have $189 of insider trading
proceeds. But in order to provoke sanity in the process, we're going to cap the plaintiff's
JG: Bill ...
WL: And that's not right.
JG: I'm not going to disagree with you about any of those facts, because the
insanity lies elsewhere. But let's take a simple situation and, you know, it's a pure after-market
fraud. All right? The stock is driven up by $5 a share for a month. Let's assume that there is no
trading by the insiders, no sales by the corporation. Which right away makes it unrealistic from your
perspective. And then we'll roll it back. You know, who are the plaintiffs in that case? It's anybody
who bought during that month. All right? What damages they are going to claim? Five dollars a share,
as long as they held through the period when there was a corrective disclosure. But where do these
plaintiffs get the stock from?
WL: They buy it from other investors.
JG: The shareholders. And what was the effect of the fraud on those other
WL: Yes, but the other shareholders didn't perpetrate the fraud.
JG: I agree.
WL: If they benefited, it was ...
JG: I agree.
WL: ... innocent.
JG: I agree. But what happened ... what we have here is, to my knowledge, a unique
situation in the law. Where a dollar amount that economists would call a transfer payment, which does
not wind up in the pocket of the perpetrator, winds up being called by the law damages.
WL: That's because the law values honesty in the marketplace.
JG: I agree, it does. I agree that the law should value honesty. I question
whether this measure of damages is the appropriate measure in these cases. Because if there is no
rational relationship, either to the harm that's done, or to the benefit, that those who perpetrated the
TS: I want to go back to something Joe said, because it's really important. That
is the perspective of the board and what options a board has if the cases go downstream. Because this
is just really critical. Companies must honestly evaluate their case early, because if they fail to do
that, and if a company allows a weak case to go downstream because they're going to kill the plaintiffs,
or because, you know, there is no way we're going to give up, and they get downstream and don't win on
summary judgment, I would submit to you that there is no rational board in the country that is going to
permit the case to go to trial where there are hundreds of millions, or now frequently billions, of
dollars of potential damages.
Particularly if there is insurance and if the company can get out for,
you know, what might be an immaterial amount of cash, or a contribution of stock. And what early,
accurate evaluation does is, it allows the company to avoid ever being put in a box from which there is
no attractive exit and you can resolve the case early, go on with your business, and who cares. But
boy, where companies get in trouble is they misevaluate the case or they let their egos get in the way
of what should be a totally dispassionate business decision.
WL: It seem to me that there is a disconnect here. If defendants with their
D&O insurers are engaging in early case evaluation and then there's a stay of discovery, we wouldn't
have a backlog because there would be more settlements, because defendants would know what their cases
are worth, they'd be talking to the plaintiffs and we wouldn't have this backlog. I'm wondering what
the disconnect is. Are defendants not evaluating these cases early on?
TS: Well, there's a spectrum. I think some defense lawyers do and some don't. And
some companies want to and some companies say let's not spend any money until we see how the motion
does. I think the other really important dynamic is the plaintiffs oftentimes don't know how to value
with their case shut. Because they don't know how the appellate courts are going to come down. And I
don't blame them. They don't want to give away a good case for less than it's worth. I think that
maybe they have more visibility now, but in the last couple of years, they were unsure how to price
their cases ...
WL: More importantly ...
TS: ... so nobody was talking.
WL: More importantly if the defendants won't turn over at least core evidentiary
materials, the plaintiffs aren't in a position to evaluate the case. And defendants sort of find
themselves betwixt and between. They might want to settle, but they don't want to let the plaintiffs
look at the evidence. They're afraid if we get the evidence and they don't settle, they'll be
disadvantaged. So that's been a negative dynamic for settlement, I believe.
TS: But one dynamic that has worked in this environment is that in cases where the
defendant may feel there is exposure, we've been able to negotiate settlements and then voluntarily
produce what we both call confirmatory discovery. Where we do it on the side.
WL: Well, that ... yeah, I respectfully disagree with that. I have not done that,
and I do not believe in that practice.
TS: Well your colleagues in the plaintiffs bar are doing it.
WL: I can only speak for myself, and it is a practice that I do not favor, and I
don't think is correct. I think if plaintiffs are going to settle ... if plaintiffs are being asked, as
fiduciary litigants to settle a claim, they should insist at a minimum on disclosure of court
evidentiary materials so they can evaluate the worth of the case before they settle it.
NC: By court evidentiary material, are you referring to a complete document
disclosure and the opportunity to interview witnesses? What kind of volume are you talking about?
WL: No, I'm ... look, plaintiffs have to be realistic in this situation. It's not
going to be appealing to the defendant to go through a complete litigate-driven document production. On
the other hand, if plaintiffs believe themselves and believe what they say, we can give somebody a list
of eight or 10 categories of key documents that are very easy to gather -- monthly financial packages,
board minutes, forecasting annual plans, and the like -- and evaluate the case at that point.
NC: Okay. We have a question from the audience here.
MK: Mike Klaschka from Marsh. This is I guess, directed, two questions, towards the panel
and to Bill. What effect will the Year 2000 have across the board in the industry? And then, Bill,
what has your company been doing to kind of gear up for that?
TS: Well, on the Year 2000, there are Year 2000 cases, but frankly, the ones that
have been filed so far are much ado about nothing. They really aren't going anywhere. And the ones
that are going anywhere tend to be product cases, as opposed to securities cases. I mean, they're
called securities cases, but they're really product cases. I think there will be real, Year 2000 cases.
But I think we're likely to see them next year. And the reason why we're likely to see them next year
is that there is a spectrum of disclosure with regard to year 2000.
We're not going to know until next year who really was completely
forthright and who wasn't, who had a problem and didn't disclose it and who had a problem and did. And
I think that, you know, after the Year 2000, we're going to know who was compliant and who wasn't, who
checked with their vendors and suppliers and who didn't, and who said what they should have said, and
who didn't. So next year we'll see some real cases, and there will be some real cases because I think
some companies are doing a lot and some companies aren't.
To me the danger area is not whether American companies themselves are
Year 2000 compliant. Because I think most American companies will be. The danger is they haven't
checked other companies with whom they do business, particularly in Asia and in Latin America. They are
way ... and in Eastern Europe, they are way, way behind the curve. And to the extent American companies
are looking at companies in those areas as principal sources of supply, I think they have the
WL: Huge disasters are very seldom widely and accurately predicted in advance or
anticipated. In fact, by definition, disasters catch people by surprise and in an unprepared state. So
if we do have a huge Year 2000 disaster, it will be the first time in history that such a disaster was
so widely predicted and anticipated. (Laughter) I think there will be impact at the edges. And Tower
is right, I think the problem is in Asia, with the subcontractors, the contract manufacturers. I think
there will be some companies who suffer disappointments because something happens over in Asia. I just
don't think it's going to be as big as people think.
NC: Okay, and in our final moments, I'd like to ask our three panelists for some
predictions as to where this type of litigation is going. Tower?
TS: I actually believe we've already hit the high water mark on securities class
actions, notwithstanding the increased number of filings. I believe that in the early '90s, the courts
started to turn, that judges who had seen filing after filing after filing that looked pretty much the
same became increasingly cynical. And that everybody is taking a closer look. And I believe that over
time the filings will go down and will move more to a model which I think is the appropriate model.
Cases that involve real wrongdoing will go for significant amounts of money, as they should. That the
plain-vanilla cases, the cases built more on cosmetics than actual wrongdoing, either will not be filed
or will be thrown out on the way. And I think this will take a number of years to play out. But my own
belief is, we've passed the high water mark and that the environment steadily, not without, you know,
bumps on the way, but steadily will improve for public companies and their (insurance) carriers.
JG: I think it's a jump ball, still too soon to tell. But if you held a gun to my
head and forced me to predict, I think at the end of the day the courts and the plaintiffs and the
defendants will adjust and adapt in such a way that the '95 Reform Act will have only marginal impact on
the net cashflows that run through the business. I could imagine, you know, weaker cases perhaps not
being filed as often, being settled for less. But the bigger cases holding up for more. Bottom line,
this is a business. If you analyze it like a business and understand the profit and loss, the risk, the
cashflow effects, there's an equilibrium in the business. And I think people are going to adjust back
to that equilibrium.
WL: I think the securities laws, as I said before, two of the most important
national laws that we have, had a tremendously beneficial impact on capital formation in the country.
Private litigation is an indispensable part of that. Indeed, the preamble to the '95 Act, reemphasizes
the importance that private litigation is expected to play in keeping our markets as honest as we can
keep them. I think there's been a massive upsurge in public company creation in recent years. We've
discussed the increase in fraudulent financial accounting. I think the courts will act to protect
investors and privately enforce the '33 and '34 Acts. I think we will see more cases going forward,
better cases, more thoroughly researched, more thoroughly investigated, larger recoveries for investors.
Because, frankly, I think there's going to be more fraud in the marketplace going forward.
TS: It sounds like my firm's going to have a lot of business. (Laughter)
WL: I suspect it will. (Laughter)
NC: Well thank you gentlemen very much. In closing, let me just say that Reliance
National believes in the Internet, not only in terms of conducting e-commerce, but we believe it's a
fabulous medium for bringing people together, exchanging ideas, as we've done today. It is indeed a
great facilitator of communication. As I said before, we believe that this is going to be the first in
a series of Internet broadcasts that we intend to put on. I'd like to thank our panel for being here,
our live audience here in San Francisco, and those of you who have tuned in. Thank you.