• Make any untrue statement of a material fact; or
• Omit to state a material fact necessary to make a statement made, in light of the circumstances under which it was made, not misleading.

In practical terms, a company or a person violates Rule 10b-5 by making an intentional or reckless misrepresentation or omission of fact that influences the price of a public company’s stock. Rule 10b-5 applies to virtually any type of statement by a public company, officer or director, including statements in periodic reports, press releases and analyst calls. Purchasers or sellers of publicly traded stock can sue even if they did not see, hear or rely on the alleged misstatement in deciding to trade in a company’s stock. These purchasers and sellers rely on the fraud-on-the-market presumption, which allows them to allege that they relied on the integrity of the market price for the stock to reflect all publicly available material information. Rule 10b-5 imposes liability even when the defendant was not a party to a securities transaction, such as when an investor buys stock via a transaction on a stock exchange.

A company, its officers and directors, and any other person who makes a false or misleading statement may be directly liable for damages under Rule 10b-5. Any individual who disseminates material misstatements with the intent to defraud may also be held liable under Section 10(b) and Rule 10b-5. Those who control the company may be liable as well – even if they did not personally make any false or misleading statements.

Although liability under Rule 10b-5 is broad, there are some important limitations. A company or person is not liable for mere negligence. Instead, Rule 10b-5 imposes liability only on a defendant who acts with scienter, which means with knowledge of or reckless disregard for the falsity of a statement or the materiality of an omission. In addition, a defendant is liable only for economic losses actually caused by the alleged misrepresentation or omission. In light of these limitations, defendants often assert a multipronged defense to claims under Rule 10b-5, arguing the following:

• The statement was not false or misleading, or the omission was not material;
• The defendants did not know or recklessly disregard the fact that the statement was false or misleading; and
• The alleged misrepresentations or omissions did not cause the economic losses allegedly suffered by the plaintiffs.

Two sections of the 1933 Act, Sections 11 and 12(a)(2), impose liability for misstatements in registration statements and prospectuses. Those sections often overlap, but they are not identical. They have different elements and provide for recovery of different types of damages.

Section 11 – Liability for Misrepresentations in a Registration Statement

Section 11 of the 1933 Act permits shareholders to recover damages for misstatements or omissions of material fact in a registration statement – including the prospectus. With limited exceptions, Section 11 does not require a plaintiff to prove that he or she relied on the alleged misstatement, nor that the defendant acted with scienter (the requirement of knowledge or reckless disregard that a statement was false or misleading for claims under the 1934 Act). To state a claim under Section 11, a plaintiff generally must allege only the following:

• The registration statement or prospectus misrepresented or omitted a material fact at the time it became effective;
• The plaintiff bought securities traceable to that registration statement; and
• The plaintiff suffered damages (typically a loss due to a decline in the price of a security).

A shareholder may bring a Section 11 claim against, among others:

• The company issuing the securities;
• Any director of the company at the time of the offering; or
• Any person who signed the registration statement.

Other potential Section 11 targets include any person who controls these primary defendants, as well as underwriters and accountants.

Directors and officers of the company (but not the company itself) and some other defendants may assert an affirmative defense of reasonable care. In addition, all defendants may have available the following affirmative defenses:

• The plaintiff knew the truth when he or she purchased the securities; and
• The misstatement or omission, if it occurred, did not cause the plaintiff’s damages.

Section 12(a)(2) – Seller’s Liability

Section 12(a)(2) of the 1933 Act provides shareholders with a right to sue for a misstatement or omission of material fact in a prospectus or oral communication used to offer or sell securities to the public. Any investor who purchases a security in a public offering can assert a Section 12(a)(2) claim against any person who offers or sells the security. Section 12(a)(2) applies only to sales of securities in public offerings, not to trading in the secondary market or to private sales of securities. It also applies only against those considered to be offerors or sellers of the securities at issue. Within those parameters, Section 12(a)(2) imposes relatively few requirements on a plaintiff. A plaintiff need not prove reliance, scienter or that the misstatement or omission caused the purchase. To recover, a plaintiff must prove only that:

• The defendant offered or sold securities;
• By the use of any means of interstate commerce (e.g., an interstate mailing or electronic communication);
• Through a prospectus or oral communication;
• Which included a misstatement or omission of material fact; and
• The plaintiff was ignorant of the truth.

A defendant may assert an affirmative defense of reasonable care, i.e., the defendant did not know, and in the exercise of reasonable care could not have known, of the misstatement or omission.

A successful plaintiff who still holds the security is entitled to rescission and may recover the consideration paid for the security, minus any income. Where the plaintiff has sold the security, he or she may recover rescissory damages, generally the difference between the purchase price and the resale price, plus interest, and minus any income or return of capital on the security.

Forward-Looking Statements

Forward-looking statements, such as forecasts of earnings or revenues, have historically served as the basis for private claims under the 1933 and 1934 Acts. To encourage companies to make forward-looking statements, Congress created, in the Private Securities Litigation Reform Act of 1995, a safe harbor defense against federal securities law claims for forward-looking statements. Under this safe harbor, a forward-looking statement cannot be the basis for liability if the company:

• Properly identifies the statement as a forward-looking statement; and
• Accompanies the statement with meaningful cautionary statements that identify important factors which could cause actual results to differ materially from those forecast in the forward-looking statement.

A company does not need to identify all important factors, or even the factor that ultimately causes actual results to differ from those forecast in the forward-looking statement, as long as it issues the most complete cautionary statements possible in the circumstances. (We provide practical guidance on this safe harbor in Chapter 5.)

Liability for Endorsing Third-Party Statements

A company or person may be liable for false or misleading statements made by stock analysts or other third parties if that company or person:

• Gives false or misleading information to the analyst or third party;
• Expressly or implicitly adopts a third-party statement as its own; or
• Endorses or adopts a third-party statement after publication, such as by distributing the statement to the public.

Duty to Correct and Duty to Update

A company has a duty to correct a material statement of historical fact that the company discovers to have been untrue when made. The company must correct the prior statement within a reasonable time after learning that the original statement of historical fact was not true when a failure to correct would affect the total mix of information available for investors to use to make informed investment decisions. In contrast, there is no general duty to update statements that were true when made. The federal courts disagree on exactly when a historic statement requires updating. At the least, some courts have held that the duty to update applies to prior statements that are forward-looking in nature and still “alive” in the minds of investors at the time of some conflicting or contradictory development, or that relate to a fundamental transaction, such as a merger. In addition, one federal circuit has held that a company must update prior disclosures which, while still technically accurate, were diminished in importance and value due to new information.

Frequently, the passage of time causes a forward-looking statement, although reasonable when made, to become outdated or, if viewed as a current statement, to be materially misleading. Because it may be difficult to determine when an earlier statement has become materially misleading in light of developments, the best practice is to:

• Identify statements as accurate only on and as of the date they are made, and
• Explicitly disclaim any intention or obligation to update them.

If it is not clear whether updating a prior disclosure is necessary, it may be prudent to consult with internal or external counsel about the circumstances and current applicable law.

Shareholder Class Actions

Plaintiffs often bring claims under the 1933 and 1934 Acts as shareholder class actions. A shareholder class action is a lawsuit brought by a purchaser or seller, or a relatively small group of purchasers or sellers, on behalf of all investors who purchased or sold the securities during a specified time, known as the class period. Plaintiffs and their lawyers often file shareholder class actions when a company’s negative public announcement triggers a drop in the company’s stock price.

Defendants often move to dismiss a shareholder class action complaint on the ground that it fails to allege facts which satisfy the relevant legal standards. If the court grants that motion, the court dismisses the case either:

• With prejudice, meaning that plaintiffs are not entitled to amend and refile a complaint making the same legal claims based on the same alleged misconduct (such a decision may be subject to appeal); or
• Without prejudice, meaning that plaintiffs have an opportunity to correct any defects in the complaint and file an amended complaint making legal claims based on the same alleged misconduct.

If the court denies the motion to dismiss, the case proceeds to the discovery phase. Because most securities lawsuits allege misconduct implicating an extended time period and multiple aspects of a company’s operations and financial condition, discovery is often broad, costly and time-consuming. Once the plaintiffs obtain access to extensive internal records of the company, the plaintiffs’ allegations of misconduct, including what was not properly disclosed, often change and expand.

CEO/CFO Certifications

A public company’s CEO and CFO are required to certify their company’s periodic reports. The certification requirement itself does not appreciably increase the potential liability of a CEO or CFO in securities class actions. However, plaintiffs have used the certifications to allege that, based on the CEO’s and CFO’s required review of a periodic report, they knew, or were reckless in not knowing, that the periodic report contained material misrepresentations or omissions. The SEC uses certifications in enforcement proceedings and related litigation. (We discuss practical tips for compliance with the certification requirements in Chapter 4.)

Retention and Destruction of Documents

Accountants are required to retain a broad range of documents relating to audits or reviews of a company’s financial statements, including audit and review work papers, for seven years from the end of the fiscal period in which the audit or review was conducted. In addition, Sarbanes-Oxley imposed criminal liability on any person – not only an auditor – who “corruptly” alters, destroys, mutilates or conceals a document or other record with the intent to impair its integrity or availability for use in an official proceeding.

These statutory provisions, along with court decisions regarding spoliation of evidence, have elevated the importance of companies’ document management practices.

Whistleblower Incentives and Protection

The Dodd-Frank Act created an SEC whistleblower program to help the Division of Enforcement discover and prosecute securities law violations. The SEC whistleblower program’s three key elements are (1) providing financial awards to a successful whistleblower, (2) protecting the whistleblower against retaliation and (3) maintaining the anonymity of the whistleblower. The SEC makes financial awards to individuals who voluntarily provide original information that leads to successful SEC enforcement actions resulting in monetary sanctions exceeding $1 million. These awards range from 10% to 30% of the sanctions the SEC collects.

The Dodd-Frank Act shields from retaliation any employee who participates in proceedings alleging violations of selected federal securities laws, if he or she has a reasonable belief that a securities violation has occurred, is in progress or is about to occur.

Most ERISA litigation involving the company’s stock, whether or not specific to an alleged stock-drop, focuses on whether the defendants in fact breached fiduciary duties owed to the plan participants. A person or entity generally is considered a fiduciary for purposes of ERISA if:

• Exercising any discretionary authority or control with respect to management or disposition of assets of an ERISA plan;
• Providing investment advice for a fee; or
• Exercising any discretionary authority or responsibility in the administration of an ERISA plan.

A plan fiduciary who is found to have breached fiduciary duties owed to the ERISA plan may be held personally liable to plan participants for the plan’s losses resulting from the fiduciary’s breach. Other equitable remedies are also available under ERISA.

Change-of-Control Transactions

Change-of-control transactions are especially fraught with potential conflicts of interest for directors and are a common source of litigation, whether brought by frustrated potential acquirers or by shareholders dissatisfied with the terms or outcome of a transaction. For example, shareholder plaintiffs often allege that directors have approved a merger or other change-of-control transaction to entrench themselves or to obtain benefits for themselves or a favored shareholder. The duty of the Board in a change-of-control transaction is fairly clear, at least in theory:

• The Board must act in the best interests of the company and all of its shareholders; and
• If the Board decides to sell the company, it generally must take reasonable steps to obtain the best available price and cannot unduly favor a lower-valued transaction.

In order for directors’ decisions in a change-of-control transaction to be protected under the deferential business judgment rule described in Chapter 2, directors must agree to the transaction offering the best value reasonably available for the company’s shareholders. Use the three methods that we describe in Chapter 2 for dealing with conflicts of interest in a change-of-control transaction to help protect the directors from liability. If the business judgment rule does not apply, courts will employ an enhanced level of scrutiny when reviewing directors’ behavior in the face of a takeover threat.

The sale of a company will generally trigger dissenters’ rights pursuant to provisions in the governing corporate statute that allow for judicial review of price. The company must carefully comply with the statute’s provisions. Doing so can protect against claims for money damages in favor of a litigated statutory appraisal process. (The statutory dissent process will not preempt claims for injunctive relief or claims for fraud, misrepresentation or other serious impropriety.)

Shareholder Derivative Lawsuits

Plaintiffs frequently pursue corporate governance claims through shareholder derivative lawsuits. In a derivative lawsuit, a shareholder sues on behalf of the company, seeking relief for alleged claims that belong to the company but that the company has not asserted for itself. A derivative plaintiff cannot recover damages personally; instead, any damages or injunctive relief are solely for the benefit of the company. A company’s officers and directors are the most common targets of derivative claims, although plaintiffs may also target major shareholders and third parties.

A derivative plaintiff must comply with strict procedural requirements, including:

• The plaintiff must be a shareholder at the time of the alleged wrong and must remain a shareholder throughout the litigation;
• The plaintiff must be an adequate representative of the company’s other shareholders;
• The company usually must be made a party to the litigation, generally as a nominal defendant; and
• Before bringing suit, the plaintiff must make a demand on the Board that the company take steps to assert the claim.

Some states (but not all) permit a plaintiff to proceed without first making a demand on the Board if the plaintiff can demonstrate that such a demand would be futile. Futility can be demonstrated by establishing a reasonable doubt that:

• The directors acted disinterestedly and independently; and
• The directors exercised valid business judgment in authorizing the challenged transaction.

A company may assume control of derivative litigation by appointing a Special Litigation Committee of the Board to investigate the claims asserted by a derivative plaintiff and to determine whether pursuing the claims is in the company’s best interests. A Special Litigation Committee will have the power to terminate, settle or pursue the litigation, and may decide to permit the existing plaintiff to continue the suit. The Board should appoint disinterested independent directors to the Special Litigation Committee and give the Special Litigation Committee full authority to accomplish its investigation and to implement its decisions. Courts will often grant motions to stay derivative suits, including burdensome discovery, pending the outcome of a Special Litigation Committee investigation. Any decision by a Special Litigation Committee to terminate the litigation will be subject to judicial review, and a party challenging the termination decision may pursue limited discovery into the independence and good faith of the Special Litigation Committee’s investigation.

Alternatively, the Board may ask an advisory committee of independent directors to conduct an investigation and report the results to the full Board. The full Board will then determine how best to respond to the derivative litigation based on the independent committee’s recommendations. The risk of this approach is that, to the extent a derivative plaintiff has alleged that the full Board has some interest or involvement in the alleged misconduct or lacks independence, courts are less likely to defer to the independent committee’s recommendations and the full Board’s review than to a Special Litigation Committee composed of independent directors authorized to act independently on the results of an investigation.

Once a plaintiff has initiated a derivative action, the parties will need court approval to settle or dismiss it. In most derivative cases, notice of a settlement must be provided to the shareholders, and the court will convene a hearing to determine whether the settlement is fair and adequate. Attorneys’ fees may be awarded to plaintiff’s counsel – either out of the proceeds of the settlement or from the company itself – if the court determines that counsel’s efforts conferred a substantial benefit upon the company.

Shareholder Access to Corporate Books and Records

Statutes in numerous states, including Delaware, permit shareholders of public corporations to inspect some of a company’s books and records upon request to the company with sufficient advance notice. The statutes of the state in which the company is incorporated govern these inspections. In most cases, a shareholder must express a proper purpose for a books and records inspection request. Courts have generally upheld as proper purposes a shareholder’s desire to:

• Investigate possible wrongdoing or mismanagement by the company’s executive officers;
• Appropriately value shares of the company’s stock; and
• Communicate with other shareholders regarding proposals for shareholders’ meetings.

States vary in the type of corporate books and records that they permit shareholders to access, but they usually include at least the company’s certificate or articles of incorporation, bylaws and minutes of shareholders’ meetings. Shareholder inspection demands are often simply the prologue to a later event, such as shareholder derivative litigation, a request for a meeting with directors for the purpose of discussing proposed reform, preparation of shareholder resolutions or a proxy fight.

SEC

Each year the SEC brings hundreds of civil enforcement actions against companies and individuals that are alleged to have violated the federal securities laws. The SEC seeks sanctions, including prohibiting directors and officers from serving for public companies, fines and disgorgement, for these types of misconduct:

• Insider trading;
• Accounting fraud;
• Disclosure violations; and
• Aiding and abetting violations.

The SEC will often first seek an immediate injunction against defendants to prohibit unlawful acts and practices. It may then seek disgorgement, monetary penalties and other sanctions against the alleged wrongdoers. While the SEC does not have the authority to pursue criminal actions, it may refer criminal matters to the Department of Justice.

Typically, the SEC pursues initial investigations through an informal inquiry, interviewing potential witnesses and examining brokerage records, trading data or company documents to determine whether further investigation is warranted. Following the preliminary investigation, if the SEC issues a formal order of investigation, the SEC staff may issue subpoenas compelling witnesses to testify and produce books, records and other relevant documents to assist the SEC in its investigation. The SEC can authorize its staff to file a case in federal court or to bring an administrative action against individuals and companies.

Market Regulations

In addition to the SEC’s civil enforcement authority, securities markets have established self-regulatory organizations to govern the conduct of their members. The Financial Industry Regulatory Authority (FINRA) is involved in virtually all aspects of the securities business, including registering and educating industry participants, examining securities firms, rulemaking, enforcing its own rules as well as the federal securities laws, and administering a dispute resolution forum for investors and registered firms. The NYSE and Nasdaq also have their own regulatory, investigation and enforcement divisions.

FINRA investigates potential securities violations and, when appropriate, brings formal disciplinary actions against firms and their associated persons. If it appears that rules have been violated, FINRA Enforcement will determine whether the conduct merits formal disciplinary action, via either a negotiated settlement or a litigated proceeding. FINRA Enforcement also brings disciplinary cases on behalf of the securities exchanges with which it has entered into Regulatory Services Agreements. FINRA and exchange investigations are serious and may merit the assistance of qualified counsel.

Department of Justice and State Securities Regulators

The Department of Justice is also active, bringing criminal cases for alleged corporate fraud.

State securities regulators regularly conduct securities- related investigations and initiate enforcement actions in an effort to enforce state securities laws and return money to harmed investors.

• Side A coverage typically covers claims against officers and directors that are not indemnified by the company. Directors and officers can think of this as “worst case” coverage, which will be available to protect them if the company is unwilling or unable to make good on its indemnification obligations.
• Side B coverage typically reimburses the company for indemnified costs incurred in connection with claims against directors and officers. Because most solvent companies indemnify their directors and officers from such claims, policy payouts often involve this type of coverage.
• Side C coverage typically applies to claims against the company itself and is limited to securities claims.

D&O insurance policies routinely cover defense costs. These D&O insurance policies are wasting policies in which the amounts paid for ongoing defense costs in litigation or investigations reduce the total insurance proceeds remaining for settlement or for payment of a judgment or related expenses. D&O insurance policies are almost always claims-made policies, meaning that coverage is provided for claims made during the policy period, rather than for conduct occurring during that period. As a result, it is essential that the company and the insured directors and officers provide their D&O insurance carriers with prompt notice of any claims that might be covered. Any delay in providing notice could result in a loss of coverage.