Minimizing-Post IPO Litigation

Joseph W. Bartlett, Founder of VC

Assuming the United States IPO market returns, an omnipresent issue that must be dealt with is how the directors of IPO candidates and their advisors can minimize the possibility of a class action suit, if the stock fails to perform up to expectations in the post-IPO period. An article by Williamson & Longo in the May 2001 issue of Start Up & Emerging Company Strategist, entitled "The Characteristics of the Class Actions Filed Against Emerging Companies in 2000," analyzes samplings from the 200 securities class actions brought against the IPO issuers over the last three years. The usefulness of this analysis is obvious: As Jack Auspitz, my partner at Morrison & Foerster frequently suggests, the best speakers at industry conferences on director, officer and issuer liability in the IPO process are the senior partners of firms that specialize in bringing plaintiffs' class actions. Plaintiffs' counsel know what they are looking for and it is up to issuers and their counsel, including counsel to the directors of IPO candidates, to understand how the other side thinks. If litigation is the moral equivalent of war, then it is up to the generals on one side (the issuer side) to understand how the generals on the other side are looking at the most appetizing strategies and tactics. Accordingly, in the absence of direct contact with the `general staff' of the plaintiffs' bar, it is useful, as the article indicates, to canvass what the plaintiffs have actually done, and what the complaints have focused on when an IPO security crashes. For emerging growth companies, a common count in the complaint has to do with the overall decline in the market for emerging growth company securities. The complainant alleges that the IPO purchasers should have been warned that the market was on the verge of a steep decline. However, this is typically an example of sloppy pleading. Judges these days are not allowing the introduction of evidence of the overall market decline as an offensive weapon; no single company is responsible for the dotcom meltdown and a lot of people were surprised by it, including a host of sophisticates. Therefore, it is unfair to fix responsibility on any one defendant. However, other allegations are more serious. Below is a partial list of the more serious allegations, with a suggestion that interested parties subscribe to the article itself:

  • That the issuer failed to disclose its dependence on a small number of customers, and those customers might have liquidity problems. The object of the plaintiff is to establish scienter: either knowledge or a reckless disregard of certain unhappy facts. The fact that the issuer had only one or a couple of customers is allegedly proof that the issuer's management must have known of the risk that revenues would fall off in the event of one customer failure. Obviously, if the Risk Factors section in the prospectus highlights that risk, it becomes hard for plaintiffs' counsel to survive a motion to dismiss.
  • Improper accounting is a big deal, primarily in today's regulatory climate. The principal count in a number of complaints has to do with revenue recognition. The most frequent abuse is `pipelining', which means shipping goods on consignment but booking the sales as completed sales. The `best practice' pointer on this issue? Make sure the financial statements comport with SEC staff Accounting Bulletin No. 101, Topic 13, "Revenue Recognition" and Topic 13-A "Views on Selected Revenue Recognition Issues." The Bulletin is in plain English and addresses many of the ambiguous situations frequently encountered, such as common revenue recognition when, the product is delivered but the sales agreement is awaiting sign off from the customer's legal department.
  • For the final two points, we quote from the Williamson & Longo article: "Allegations of insider stock sales or of internal reports inconsistent with public disclosures constitute the mainstay of plaintiff's scienter claims in nearly every action. In nine of the 20 emerging growth company actions sampled, insider sales or executive compensation is alleged to demonstrate scienter; similarly, for more established companies, sales or executive compensation is alleged in 10 of the actions. Likewise, 10 of the emerging growth company actions feature [inconsistent] internal reports, as do nine of the 20 actions against established issuers.

Note that the recent furor over underwriter behavior (conflicted analysts and IPO stock allocation based on soft dollar revenue) is another story that I will address when the dust settles. My guess is that most of the miscreants did what others in the industry have been doing for years, and are the fall guys because someone has to take the blame for all those losses. But, I will reserve judgment until all the facts are out and some cases adjudicated. The moral of the story is "Know Thine Enemy". Take a careful read of the preferences of experienced plaintiffs' counsel before initiating a securities placement. In particular, review the issuer's files for internal reports inconsistent with the disclosures to investors; if the issuer is public, be particularly careful of offerings contemporaneous with significant insider sales. Another tip in that regard has to do with a specific exclusion in a typical D&O policy: "The Company shall not be liable under Insuring Clauses 3 or 4 for Loss on account of any D&O Claim... (b) based upon, arising from, or in consequence of the actual or alleged violation of the securities Act of 1933, the Securities Exchange Act of 1934, rules or regulations of the Securities and Exchange Commission promulgated thereunder, any other federal, state, local or provincial statute relating to securities, or any rules or regulations promulgated thereunder, all as amended;" Obviously, this exclusion is bad news for defendant directors since the complainant will sound, in all likelihood, in breaches of `33 Act § 11 or, if a private placement, `34 Act Rule 10b-5. The good news is that the typical policy goes on to say: "However, if more than thirty days prior to the effective date of any Securities Offering: (i) an Insured Organization gives to the Company written notice of such offering; and (ii) the Insured Organization provides all information requested by the Company. "the Company agrees to provide to the Insured Organization a quotation for coverage for D&O Claims relating to the purchase, sale or offer to purchase or sell the securities subject to such Securities Offering. If the Insured Organization accepts the terms and conditions and pays the additional premium required by the Company, such coverage shall be afforded by endorsement to this policy and shall be subject to the terms and conditions set forth in this policy; including such endorsement. In this case, the lesson is that company management and its advisors had better send the required notice, if only to make sure the extra coverage is priced and the directors, as the real parties in interest, have an opportunity to know all the facts.