The corporation as a securities fraud plaintiff

Traditionally, most corporate counsel deal with securities litigation as defendants, frequently in class actions filed by a handful of plaintiffs’ firms alleging fraud concerning stocks, bonds
or other instruments traded on the public markets.

But in light of the financial crisis, corporations increasingly find themselves as potential plaintiffs in actions against investment advisers, bankers, brokers, hedge funds or others who persuaded corporate management to invest a substantial chunk of the corporate finances in supposedly “safe” fixed income or “cash equivalent” vehicles that turned out to be anything but.

In some cases, purchasers of asset-backed securities in the secondary market may have contractual rights, as opposed to rights under the securities laws, to force the sellers to repurchase the underlying mortgages in the securitization based on breaches of representations and warranties.

The issues confronting a corporate plaintiff are quite different than those raised by the sort of securities fraud class action suits that follow any large drop in stock price, or disclosure of misconduct, or government investigation.

Those cases follow a predictable pattern. They are filed in federal court. Federal law applies, including the heightened pleading requirements of the Private Securities Litigation Reform Act.

Between the PSLRA and the Securities Litigation Uniform Standards Act, the cases must be in federal court and decided under the well-developed body of federal securities laws.
A motion to dismiss will be filed. If successful, it might be appealed. If not, some discovery will begin.

While the expertise needed to successfully defend such a case is high, both the plaintiffs and the defendants have relatively few strategic decisions to make early in a case.
At some point, a judge will decide whether plaintiffs have met their pleading burden under the PSLRA and Rule 9(b) of the Federal Rules of Civil Procedure, perhaps with respect to more than one attempt at drafting a valid complaint. If the case makes it into discovery, a settlement likely will follow.

A corporation as a plaintiff, however, has a wider range of problems and potential hurdles that it must consider, as well as some distinct advantages.

Hurdles

The first decisions, and often the most important, are business ones. Whether the would-be-defendant is an investment bank or an investment adviser, if it is solvent and capable of paying a substantial judgment, it is likely still an important player in the business world.

Does the corporation want to sue a potential business partner? If the potential plaintiff is in the investment world itself, what is the business risk of taking on a major broker-dealer or bank, even if the claims have some merit?

A related consideration is whether the potential plaintiff is exposing itself to liability to its constituents, such as a corporation claiming to have been hoodwinked by a hedge fund or investment. Does that open it up to a claim by its shareholders that management should have been more diligent in researching potential investments?

On the other hand, if the corporation decides not to bring the claim, is there a risk of a derivative lawsuit seeking to take that decision away from the board and management?
Another key concern is how much time such an action could consume for senior management or the board of directors. Depending on who was involved in making the investment decision or hearing presentations from potential defendants, such an action could consume a lot of senior management and board time.

If substantial enough, the action could also attract some publicity, which is a concern for many companies that may prefer not to admit being deceived in a substantial investment for reasons beyond the potential liability concerns addressed above.

Strategic decisions

Once a corporation moves past those hurdles, a host of interesting strategic decisions arise.
Where there are other victims, should the case be filed as a potential class action? Or, as may well be the case, should the corporation look to join an existing class?

The advantage of a class action can be lower costs, particularly if the corporation retains a securities plaintiffs’ firm or joins a proposed class already represented by one. The contingency fee arrangements common in such cases provide for very little upfront investment.

But there are several downsides as well. First, the corporation largely loses control of the case. Counsel represent the whole class and will look for a settlement that will benefit the class and justify a fee. Any settlement must be approved by the court.

Second, such cases must be filed in federal court with a well-developed body of pleading hurdles to overcome.

Third, such claims are limited to facts and issues common to the class, typically based on written or public disclosures. A corporation that invested $200 million in a hedge fund likely received multiple presentations and other oral representations that may well be actionable in an individual suit but not in a class action.

Individual purchasers of securities generally have little incentive to fund litigation themselves given that the upside to each is relatively small. Though public and union pension funds are frequent plaintiffs in securities class actions, they are confronted with far different considerations than a corporation.

For a corporation, it may well be cost-effective to retain counsel on an hourly or non-contingent basis if the value of the potential claims is high enough, which is often the case.

If the corporation goes it alone, it still faces a number of strategic decisions. It must decide whether to file in federal court and allege federal securities law violations, or in state court under common law fraud and state blue sky laws, which sometimes have statutes of limitations that are longer than their federal counterparts.

Many of the federal law problems with such claims (which are benefits when the corporation is a defendant) remain as hurdles even in non-class claims. Parts of the PSLRA apply to any federal securities claim, not just a class action, including the stay of discovery and the heightened standard for pleading scienter, see 15 U.S.C. §78u-4.

On the other hand, state law on securities fraud is often undeveloped, and state courts may well apply the federal standards.

If the corporation decides to avoid federal court, then, in which state does it file?
It is possible that representations were made in multiple jurisdictions by numerous individuals. Each state will have its own statute of limitations on blue sky claims. State courts may apply different levels of rigor to evaluating complaints and be more or less likely to stay discovery.

State courts also tend to be more unpredictable that their federal cousins. Subscription agreements may also contain choice of law or venue provisions.

Ultimately, a court will decide which jurisdiction’s law will apply, but there is typically a preference for the forum’s law. All these considerations make the decision of where to file one of the most significant insofar as the texture and structure of the case are concerned.
Individual actions also face hurdles that are avoided in federal class actions. For example, for publicly traded securities, reliance is generally presumed under the fraud on the market doctrine. See Basic Inc. v. Levinson, 485 U.S. 224 (1988).

In individual cases, however, reliance may well be the most hotly contested issue, particularly when the purchaser is highly sophisticated and, at least in theory, capable of performing due diligence on its own.

Because reliance is a fact-intensive issue, it is often not capable of resolution at the pleading or even summary judgment stages. Much turns on the credibility of witnesses. That can be a double edged-sword for the plaintiff.

On the one hand, it helps the plaintiff overcome a motion to dismiss or for summary judgment; on the other hand, it takes away the opportunity for a clear-cut victory short of a trial verdict and the enormous expense that that entails.

Corporations considering a securities fraud action, or a related breach of contract claim, find themselves in what may be an unusual and uncomfortable position.

Despite the complexities and issues involved, counsel should not shrink from advising their corporate clients to consider asserting what may be valuable and viable claims.

Michael T. Marcucci is a shareholder and Roberto Tepichin an associate at Hanify & King in Boston. They concentrate their practices on complex business litigation, including securities litigation.