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Tidal Wave of IPO “Laddering Litigation” Swamps D&O Market
The Plus Journal
September 2001 Volume XIIII Number 9
BY: Matthew Deneen and James J. Hooghuis
The primary purpose of this overview is to examine the exposure of Initial Public Offering (“IPO”) Issuers and their directors and officers (“D&O’s”) to shareholder class actions arising out of IPO’s that commenced trading between 1997 and the year 2000. The analysis is based on our due diligence on the subject of IPO laddering litigation. It is based in part on our own investigation and knowledge of securities laws, case law and daily discussions with various outside corporate defense counsel. For reference purposes, the average increase in IPO’s during the first day of trading during 1997, 1998, 1999 and 2000 were respectively- 13.74%, 20.14%, 69% and 55.5%(1).
Approximately 156 (as of 8/22/01) Issuers and their D&O’s have been named in hundreds of class actions filed since the first of the year. Although these suits name the Issuer companies and their senior management, all or nearly all of the intentional wrongdoing is alleged to have been perpetrated by the investment bankers (“Underwriter” or “Bankers”) that took them public. The Issuers appear to have been dragged into the controversy based on various theories including that of strict liability. These cases have been dubbed “laddering lawsuits” which alludes to the alleged artificial inflation of the Issuers stock price based on the Bankers misconduct. In addition to the laddering claims there are civil regulatory investigations and preliminary criminal proceedings pending against the investment bankers. The laddering litigation is but one part of a larger movement to increase the scrutiny of Wall Street’s practices during the most exuberant days of the “New Economy”.
The laddering lawsuits were triggered by a Wall Street Journal article published on December 6, 2000 entitled, “Seeking IPO Shares, Investors Make Offer to Buy More in the Aftermarket”(2). Although Credit Suisse First Boston (“CSFB”) is a central figure in the controversy, all of the leading investment bankers have been questioned, investigated or named in various litigation. The laddering claims target the investment bankers’ methods in allocating and distributing shares of hot IPO’s. Preferred hedge funds and institutions are alleged to have paid excessive commissions or “kickbacks” in order to receive an allotment of shares. In exchange for receiving shares at the IPO price, Underwriters allegedly demanded that their preferred customers commit to purchase a specified number of shares in the immediate aftermarket of an IPO, thereby creating artificial demand for the stock. This “tie-in agreement” would serve to drive the price of the stock upwards, “to the moon” in many cases. The practice would help ensure a successful IPO and generated more fees for the bankers. It is unclear whether the tie-in agreement committed the purchasers to buy more shares in just the first day of IPO trading or during some longer time period.
The Securities and Exchange Commission (“SEC”) expressed concern about “tie in agreements” as early as 1984. In a 1984 report on the “Hot Issue Market”, the SEC took the position that Tie-In Agreements are manipulative, stating, in pertinent part, as follows:
A few cases involve “tie-in” arrangements by which underwriters of hot issues require customers, as a condition of participation in a hot issue offering, either (1) to agree to purchase additional shares of the same issue at a later time and at an increased price, or (2) to participate in another hot issue offering. This practice stimulates demand for a hot issue in the aftermarket, thereby facilitating the process by which stock prices rise to a premium. Selling securities in this manner often violates the antifraud and anti-manipulative provisions of the federal securities laws.
Many years later, during the summer of 2000, the SEC again publicly addressed this issue. On August 25, 2000 the SEC issued Staff Legal Bulletin No. 10 in which they reiterated Regulation M (1997) that prohibits banks and investors from engaging in manipulation that “undermines the integrity of the market”. It specifically states that “Tie-ins” are illegal (there are references to tie-in arrangements as “Laddering”). The SEC was recently criticized during Congressional testimony for not moving much sooner. By August 2000 most, if not all, of the alleged damage was done.
News of the criminal investigations of the Underwriters by the Department of Justice and of an SEC investigation hit the street on December 7, 2000 in the WSJ article, “US Investigates Exchange of Commissions for IPO’s”(3). It stated that the U.S. Attorney in the Southern District of New York (S.D.N.Y.) was investigating CSFB with regard to several IPO’s. Forbes also published an article on December 7, 2000, “Disaster of Day; Investment Banks”(4) discussing the alleged market manipulation by the Underwriters. On December 13, the WSJ published an article entitled, “SEC Intensifies Inquiry into Commissions for Hot IPOs”(5) which disclosed that the SEC had issued subpoenas for the Underwriters’ files for all IPO’s completed between 1999 – 2000. The WSJ followed up with an article entitled, “SEC Probes IPO of VA Linux” on January 8, 2001(6) . The article discussed whether the excessive commissions paid to the Underwriters were illegal kickbacks. On January 11, 2001, VA Linux, two of its officers and CSFB were sued in federal court in New York. The suit alleged securities violations and fraud. Since that first suit hundreds of additional suits have been filed against an ever-growing list of companies that went public over the past few years.
The laddering complaints basically allege the Underwriters, the Issuer and certain directors and officers violated Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated there under. In connection with the IPO, the Issuer filed a registration statement, which incorporated a prospectus (the "Prospectus"), with the SEC. The complaints allege that the Prospectus was materially false and misleading because it failed to disclose, among other things, that: (i) the Underwriters had solicited and received excessive and undisclosed commissions from certain investors in exchange for which the Underwriters allocated to those investors material portions of the restricted number of the Issuer’s shares issued in connection with the IPO; and (ii) the Underwriters had entered into agreements with customers whereby the Underwriters agreed to allocate the Issuer’s shares to those customers in the IPO in exchange for which the customers agreed to purchase additional Issuer’s shares in the aftermarket at pre-determined prices.
We reviewed most of the articles written to date and a good number of the laddering complaints. Although at first glance the suits appear to mirror one another, there are some differences worth noting. First, the plaintiff’s bar has taken two distinct paths in deciding the Class Period. Many firms, including Milberg, Weiss, Bershad, Hynes & Lerach, LLP (“Milberg, Weiss”) have chosen to end the class period on December 6, 2000, the date of the first WSJ article. Other plaintiffs firms end the class period on an arbitrary date that precedes the filing date of their lawsuit by several days or weeks. In all cases, the beginning date of the class period is the date of the IPO. The class period may make a material difference as it relates to determining the Statute of Limitations as a defense to these types of cases. Actions filed under Section 11 of the 1933 Act and Section 10 of the 1934 Act must be filed within one year of discovery of the alleged fraud. By focusing on the WSJ article, the plaintiffs have arguably set the bar for the Statute of Limitations to expire on December 6, 2001. Therefore, we believe the majority of the laddering claims will be filed on or before December 6, 2001.
Many of the earliest lawsuits did not bring fraud allegations under section 10(b) of Securities Exchange Act of 1934 (under Rule 10b-5) against the Issuers. However, all of them contain 10b-5 allegations against the Underwriters. Milberg, Weiss was recently chosen by the court as the lead plaintiff’s counsel in two cases (VA Linux and Merrill Lynch B2B Holders). Significantly, the VA Linux consolidated amended complaint does not include a Section 10 claim against the Issuers. This is very relevant as the damages available under Section 11 claims may be less than those potentially available under Section 10.
In general, the laddering complaints are more alike than not. Some attorneys speculate that all of the suits will eventually be consolidated. The question is, who will consolidate the claims, the court or someone else? The law firm of Wolf, Haldenstein, Adler, Freeman & Herz presented a solution to the court in a suit entitled, Shives v. Bank of Boston in order to position themselves as lead counsel in one or more Master Class Actions. The suit named 24 corporate Issuers and their D&O’s as well as 25 Underwriters under one umbrella action. The court has not issued any rulings regarding the consolidation of these cases.
The Basic Allegations in Laddering Suits
Kickbacks
The laddering suits allege violations of securities laws in connection
with the IPO of each respective Issuers’ common stock. They allege
that the Prospectus misrepresented the commission paid to the Underwriters.
It is further alleged that the Underwriters breached NASD and SEC rules
and regulations by soliciting, receiving and not disclosing the additional,
excessive commissions from certain investors in exchange for preferential
allocations of shares in hot IPO’s.
The practice of offering excessive commissions is outlined as follows:
In exchange for IPO shares customers agreed to pay the Underwriters excessive
commissions on transactions in other securities (commissions greater than
those contemplated under NASD and SEC regulations and which, when added
to the seven percent commission disclosed on the front page of the Prospectus
resulted in the Underwriters receiving greater underwriting commissions
and fees than were disclosed in the Prospectus). In some cases, the amount
of the commission was determined ex post facto by agreement including
specific formulas tied to investors profits made on the IPO. The plaintiffs
argue these payments were illegal kickbacks.
Tie-in Agreements
Most investors that purchased shares in the aftermarket were unaware of
any tie-in agreements. Underwriters allegedly forced institutions and
funds that wanted IPO shares at the IPO price to agree to buy additional
shares of the same stock in the immediate aftermarket, regardless of the
trading price. Tie-in agreements potentially artificially inflate demand
and thereby the price of a stock. The agreements benefited the Underwriters
because they could exercise their “green shoe” option to issue
more shares for themselves at the ground floor IPO price. They would also
receive additional commissions earned from handling open market trades
in the stock.
Exposing the fraud
The basic laddering complaint states that the truth began to emerge on
December 6, 2000, when The Wall Street Journal began to publish articles
regarding a joint SEC and U.S. Attorneys' investigation into the payment
by certain investors of extra-large, undisclosed kickbacks for allocations
in initial hot IPOs. The articles singled out Credit Suisse as a prime
culprit and stated that Credit Suisse had received government requests
for information in connection with the probe. The December 6 article also
stated that the NASD was investigating IPO allocation practices at several
other securities firms.
Causes of Action: For the purposes of this article only Sections 10 and 11 claims will be discussed
For Violation of Section 11 of the Securities Act of 1933
Alleged Against all Defendants
The Securities Act of 1933 was enacted to regulate the issuance and sale
of corporate stocks, bonds and other securities. The ‘33 Act creates
both civil liability and potential criminal penalties. Failure to comply
with the ‘33 Act can result in liability for the corporation, directors
and officers and third parties such as lawyers, accountants and underwriters
that assisted with the sale of securities.
Section 11 of the ‘33 Act imposes civil liability for untrue statements of material fact or an omission of a material fact in a registration statement or prospectus. A “material fact” is defined by the SEC as a matter “as to which an average prudent investor ought reasonably to be informed before purchasing the security registered.” Plaintiffs do not need to show reliance upon the untrue statement or omission unless the securities were acquired after the Issuer has provided an earnings statement for a period of at least one year beginning after the effective date of the registration statement. Of particular importance, causation, scienter and privity need not be proven under Section 11.
Liability and Defenses under Section 11
In a lawsuit, the plaintiff-purchasers of securities must only show the
existence of a material misstatement or omission to establish a “prima
facie” case. In other words, there is absolute or strict liability
for those “persons” who violate Section 11. The plaintiff does
not need to prove intent to commit fraud. Once the investor demonstrates
that a registration statement was materially misleading then the burden
shifts to the defendants to assert one of several affirmative defenses
provided for in Section 11(e) applies.
Affirmative Defenses under Section 11
Due Diligence and Knowledge of Fraud
Under Section 11 the Issuer has basically two defenses available to them:
1) The purchaser knew of the untruth or omission at the time they acquired
the security and 2) the statute of limitations. In addition to the above,
non-Issuer defendants may assert a “due diligence” defense.
In order to establish a due diligence defense the defendant must establish
that: 1) they conducted a reasonable investigation and 2) that after the
investigation, they had reasonable grounds to believe in the accuracy
of the registration statement. There is case law that concludes the liability
of an insider director approaches the absolute liability of an Issuer.
Therefore, the due diligence defense may or may not be available to directors
or officers.
Statute of Limitations
Claims under Section 11 must be brought within one year after discovery
of the untrue statement or misstatement. We believe that the Dec 6, 2000
WSJ article is being used by “most” plaintiffs as the relevant
date for discovery of the fraud.
Damages and Mitigation of Damages
Once the investor demonstrates that a registration statement was materially
misleading (and they have proven reliance if need be) then the burden
shifts to the defendants to establish an affirmative defense.
Loss Causation Defense
This is essentially a showing that the decline in the value of the security
resulted from causes other than the untruth or omission in the registration
statement. Thus, a defendant, including an Issuer, may reduce or even
eliminate damages by proving that any or all of the decline in the value
of the security resulting in a loss to plaintiff was the result of factors
other than misstatements in the challenged portions of the registration
statement. In the cases at hand the slowdown in the economy may mitigate
damages.
Contribution from Co-Defendants under Section 11
Section 11(f), as amended by the 1995 Private Securities Litigation Reform
Act, provides that every person found liable for a Section 11 violation
may recover contribution from any person who would have been liable to
make the same payment. This includes culpable co-defendants and others
who are not named in the litigation. However, a person found guilty of
fraudulent misrepresentation may not recover contribution from one who
was not. Although a defendant may obtain contribution from a co-defendant(s),
case law generally does not permit contractual indemnification for violations
of Section 11.
Damages
Compensatory damages recoverable under Section 11 claims equal the amount
paid for the security (not exceeding the initial offering price of the
securities) less the value of the security at the date the suit was brought
or the price at which the security was sold before the suit was filed,
or the price at which the security was sold after suit was filed, if the
resulting damages are less than as calculated at the date of suit. The
maximum recovery is the price at which the securities were offered to
the public.
For Violations Of Section 10(b) Of The 1934 Act And Rule 10b-5 Promulgated
Thereunder.
Alleged against the Underwriters only in some cases and against the Underwriters
and Issuers in others.
Liability under Section 10(b) and Rule 10b-5 is based upon fraudulent
misrepresentations and/or omissions of material fact in connection with
the purchase or sale of a security. The Securities Exchange Act of 1934
and accompanying rules were enacted to protect investors in connection
with the trading of securities already issued and outstanding. However,
the Supreme Court has ruled that the availability of an express remedy
under Section 11 does not prevent an investor from also bringing suit
under Section 10(b) and Rule 10b-5 for an action involving a registration
statement. Section 10(b) of the ‘34 Act and SEC Rule 10b-5 are the
backbone of the anti-fraud provisions under the securities laws. It is
practically applicable to any transaction involving securities, regardless
of the nature of the transaction.
Investors must prove that the defendants made a material misstatement or omission, and that they were made intentionally or with reckless disregard for the truth. The federal courts are divided on the scienter standard, with some requiring a showing of intent while others allow or accept a recklessness standard in relation to the misrepresentation or omission. To prevail under Section 10(b), the investors must prove the following elements: a) a misstatement or omission; b) of a “material” fact; c) made with intent to deceive (scienter); d) on which the plaintiff reasonably relied; e) that proximately caused the resulting damage. In short, there is a higher burden of proof under Section 10 of the ‘34 Act, as compared with Section 11 of the ‘33 Act.
With respect to reliance, the courts have ruled that investors need not show that they actually relied upon the misleading statement. The investors need only show that they bought or sold at a price that had been affected by the statement. Under the “fraud on the market” theory, the mere issuance of a misleading statement establishes a rebuttable presumption of reliance.
Damages Under Section 10(b)
Violations of Section 10(b) and SEC Rule 10b-5 are actionable by both
the SEC and private plaintiffs. The SEC may seek monetary penalties or
a court order enjoining the violator from breaking the law again or even
disgorgement of the ill-gotten profits. In addition, private plaintiffs
can seek monetary damages measured as the difference between the purchase
and the sale price paid or which are received by the investor for the
security subject to some limitations. Rescission of the transaction has
also been a recognized remedy. Punitive damages are not recoverable.
Liability is joint and several for defendants found to have committed “knowing securities fraud.” “Reckless” conduct is not a “knowing securities fraud.” Non-“knowing” violators are responsible only for a proportionate share of damages. The trier of fact must determine the percentage of responsibility of each person alleged to have caused or contributed to violation, including defendants who have settled.
There is no Statute of Limitations stipulated under Section 10(b) actions but there is case law, which has dictated that the action must be commenced within 1 year after the discovery of facts constituting the violation and within 3 years of the violation.
In addition to the “loss causation” defense, Underwriters and Issuers will attempt to mitigate damages by the following:
Indemnity Under the Underwriting Agreement
In most of the Underwriting Agreements between the Issuers and the Underwriters, there is a two-way indemnification provision. However, in many agreements the scope of indemnity is broader flowing from the Issuers to the Underwriters than from the Underwriters to the Issuers. For instance, the indemnity is generally capped by the amount raised in the IPO. The timing of the indemnification is another issue. Should defense costs incurred by Issuers be immediately indemnified by the Underwriter? Some of the Underwriting Agreements include “indemnification as incurred” language, but it appears that most of them do not. Based on our conversations with defense counsel we know that most of the sued Issuers have already formally requested indemnification from the Underwriters. In two instances that we are aware of, the Underwriters have formally acknowledged the indemnity request. However, the Underwriters opine that it is too early in the litigation to determine if the indemnification provision is invoked. In addition, the Underwriters assert their own rights regarding indemnification from the Issuers. We believe that the Underwriters’ response was fairly predictable in that the Underwriters are still in the early stages of grappling with this litigation and they simply want to delay any type of indemnification until the facts and legal issues are fully developed.
Contribution Under Section 11 – May Be Available To Issuers/D&O’s
There is a contribution provision under Section 11(f) of the ’33 Act. The defendants may seek recovery from each other through contribution. The parties may argue over how the liability should be allocated. Recent case law interpreted Section 11(f)’s contribution provision to be based upon the concept of relative fault. Thus, if there is a verdict at trial, the percentage of liability of each defendant will be fixed and one defendant can recover from the others to the extent that the defendant has paid more than their fair portion of the judgment. However, a defendant found guilty of a fraudulent misrepresentation may not obtain contribution from a defendant found not guilty of such conduct. Unlike a contractual indemnity, contribution under Section 11(f) does not include reimbursement of legal fees or other expenses incurred with connection with the defense of the case. Each party usually bears its own fees and expenses.
We are unaware of any case law governing the question of whether an Issuer can completely escape or reduce their liability under Section 11 by way of contribution. There is an issue as to whether the Issuer has a statutory right to contribution. Section 11(f) does not explicitly grant or deny this contribution to the Issuer itself. It does however, specifically list other parties such as D&O’s, Underwriters, accountants and lawyers as parties that may seek contribution from one another or from the Issuer. Corporate defense counsel have not fully evaluated this issue. However, there is some case law that suggests that the Issuer may also seek contribution from others under Section 11.
Contribution Provision within the Underwriting Agreement or under Common Law
Issuers may have alternatives to Section 11 contribution from Co-defendants. Many of the Underwriting Agreements reviewed by us contain a contribution provision drafted in the event the indemnity provisions are “unavailable.” The terms vary by agreement. In addition, co-defendants may also seek contribution from one another under Common Law.
To date, there have been no cross-claims or lawsuits filed by the Issuers against the Underwriters for contribution or indemnity. We have discussed this issue with outside defense counsel and monitoring counsel. They believe that an action by the Issuer at this juncture would only help the plaintiffs establish their case against the Underwriters.
Status of Pleadings
Recently, all of the laddering suits have been assigned to judge Shira Scheindlin. A global conference is scheduled for September 7, 2001. The court has also not ruled on the plaintiff’s request in the Shives v. Bank of America to create a “Master” class action of all the IPO Issuers and their Investment Bankers for all IPOs that went out from March 1997 to the filing of the case on June 6, 2001. Several defense counsel representing Issuers do not think it is likely the court will consolidate all the actions into one Master Class Action as the facts of each IPO are so different and unique. They may however, try and come up with a master discovery schedule and information exchange with respect to the Underwriters, who allegedly committed essentially the same wrongful acts in each case.
Several defense counsel have suggested that the court will most likely not rule on the Shives class certification until after the dispositive stage is completed in the first laddering case filed—VA Linux. The Motion for Lead plaintiff has been determined and the law firm of Milberg, Weiss has been appointed as lead plaintiffs’ attorney. They filed the first amended consolidated complaint on June 29, 2001. All of the status conferences that were scheduled in all of the other laddering cases were recently canceled and the S.D.N.Y. Assignment Committee is apparently examining their options on consolidation, case management and workflow issues.
The next step is for the defendants to file a Motion to Dismiss in the VA Linux case. All discovery is stayed pending the Motion to Dismiss, (in this case as well as all the other cases). However, it is important to note that an Anti-Trust case is pending against the Underwriters that may allow discovery to commence while there is a stay of discovery in the IPO laddering cases. The defendants in the laddering cases have asked the court to put a stay on discovery in the Anti-Trust case to comply with the Private Securities Litigation Reform Act’s stay of discovery provision. The court is considering this request. If granted, this could put a stay on discovery in the Anti-Trust case for several years while the motions to dismiss are completed in the 150+ cases. As can be imagined, the plaintiff’s bar is objecting to this request.
Recent New Allegations
Update on VA Linux
Milberg, Weiss recently filed a new amended and consolidated class action
complaint against VA Linux. The new suit incorporates several new factual
allegations and violations of securities laws. First, they state that
Frank Quattrone, the head of the CSFB San Francisco investment banking
arm, had set up three hedge funds in June of 1999. These hedge funds were
allocated shares of CSFB-led IPO’s and this was never disclosed as
a potential conflict of interest.
In addition, the suit alleges for the first time that the research analyst (employees of the Underwriters) authoring reports on the IPO were subject to material conflicts of interest as they had received, or were entitled to receive, compensation for investment banking services, including the offering, provided to VA Linux. The suit states there were conflicts of interests between the investment banking arm and the research side of CSFB (both arms reported to Frank Quattrone, who had up to 50 analysts and numerous investment bankers reporting to him). Conflicts of interests on Wall Street are the subject of ongoing Congressional hearings that began in June 2001.
Finally, the plaintiffs in VA Linux did not bring a Section 10 claim against the Issuers (only the Underwriters). Certain defense counsel have disclosed to us that in general, the Section 10 claims against the Issuers are very weak unless the plaintiffs can prove that the D&O’s had specific knowledge of the kickbacks and tie-in agreements but did not disclose them in the prospectus. Plaintiffs also added a new cause of action tied to Section 10 against the Underwriters, alleging violations of Rule 10b-5 and Regulation M, based upon CSFB’s deceptive and manipulative practices. Regulation M provides a definition of unlawful activities with relation to the distribution of securities via bidding. The regulation cites the SEC’s Staff Legal Bulletin No.10 which reiterates that tie-in arrangements are illegal.
With respect to the Section 10(b) and Rule 10b-5 claims against the Issuers there does not appear to be any evidence (at least in the public domain) that would establish scienter which is required under this fraud statute and related case law. Interestingly, the plaintiffs allege in the new VA Linux case that at a meeting (called the “pricing meeting”) the day before the Issuer’s IPO, the Underwriters discussed the allocation of IPO shares and that a representative of the company was present. They do not allege that the company representative was involved in deciding the allocation of shares or participating in the tie-in scheme, but the plaintiffs want it to be known that VA Linux’s D&O’s were present at the final allocation meeting. This may be an effort to imply there was “scienter” on the part of the Issuer. Certain defense counsel have indicated that a company representative usually attends the “pricing call” but the Issuers are not involved with the allocation of shares. Defense counsel believes that the main focus of this meeting is to discuss and agree upon the pricing of the IPO. The Issuer may also discuss the quality of investors lining up to purchase shares in the offering (i.e. known funds with a long term commitment versus “flippers”).
Recent Trend
Some plaintiffs have filed suits solely against the Underwriters without naming the Issuers. Of the 150+ laddering cases brought to date, the plaintiffs do not name the Issuer in 29 of them. We are encouraged by this development but we are not sure what motivated the plaintiffs to drop the Issuers and D&Os in these cases. We believe that it may be a tactic being used by the plaintiff’s bar to compete for lead plaintiff. If so, the door is open for the Issuer and D&O’s to be named later.
Conclusion
Although there is nothing new about tie-in agreements, excessive commissions or preferential allocations of IPO shares, the scale of the alleged fraud in the recent wave of laddering litigation is historic. Hundreds of billions of dollars are at stake. To date, approximately 150 Issuers have been sued with possibly hundreds more to follow. The fraud, if true, implicates all of the top Wall Street bankers and 3-4 years of IPO activity. Therefore, the outcome is difficult to predict. No one has ever seen anything like it. From a D&O insurance standpoint, insurers no doubt appreciate the fact that the Underwriters and not the Issuers/D&Os are the focal point of the media, litigation and investigations. The media has focused exclusively on the Underwriters’ alleged misconduct. All of the regulatory and criminal investigations are directed at the Underwriters. Obviously, the Issuers are hopeful that the Underwriters are able to successfully defend these cases.
In a May 24, 2001 Economist article, the author states that “seasoned regulators admit that it will be hard to prove that Wall Street firms were systematically up to no good. It will take, at the least, a lot of incriminating tapes and emails to prove that brokers overstepped the line between vague requests (“take care of me”) and the demanding of binding promises”(7).
Underwriters will also no doubt invoke a defense based on a lack of causation for plaintiffs damages. Widener University Law School Professor Larry Hamermesh predicts the Underwriters will point to the broad based collapse of technology stocks as the cause for plaintiffs suffering and not their IPO practices. Professor Hamermesh was quoted in a May 4 C/Net article, “if the whole market tanks, it’s sort of hard to blame the issuer or underwriter.” This defense, known as a “loss causation defense”, may be a key to limiting the damages even if the plaintiffs show there were some abuses(8).
University of Florida finance Professor Jay Ritter agrees that plaintiffs will be fighting an uphill battle, “without strong evidence that the underwriters actually demanded purchases in the higher-priced aftermarket, the plaintiffs will have a tough time making their case stick”. Ritter also questioned whether investors can show they were harmed even if CSFB or other underwriters received higher commissions on other transactions in exchange for giving clients shares in hot offerings(9).
Although Underwriters are the clear focus of this controversy, the fact remains that the Issuers and certain of their directors and officers are parties to the 150+ lawsuits. It is widely believed that unless the plaintiffs can provide strong evidence that the D&Os were convinced by the Underwriters that they would personally benefit from the tie-in agreements and kickbacks, the Section 10(b) cases will not survive against the Issuers or the D&Os (Milberg Weiss has apparently come to the same conclusion as they are not bringing the Section 10 claim against the Issuers or D&Os in the VA Linux consolidated amended complaint). However, the Issuers may still be strictly liable for misrepresentations or omissions in the Prospectus under Section 11. Even so, there are many mitigating factors that may reduce or eliminate the liability of the Issuers.
Currently, the claims that concern the Issuers most are the Section 11 claims, which have a lower burden of proof than Section 10. Nonetheless, it will be difficult for plaintiffs to establish liability against the Issuer under Section 11. First, the plaintiffs have to prove that there was a misrepresentation in the Prospectus. The Underwriters provided the content at issue concerning their commission to the Issuer. The Underwriters will argue that the prospectus was not misleading. The plaintiffs will further need to prove that the commission issue is “material”. Plaintiffs must prove that the excessive commission paid to Underwriters by their clients on non-IPO transactions (in order to get hot IPOs) rendered the commission disclosed in the Prospectus a misrepresentation. This may be difficult if not impossible to show since Discovery is stayed pending the motion to dismiss the lawsuit. However, there is commentary in several publications that several hedge fund managers are providing information on kickbacks and tie-ins to the U.S. Attorney. On the other hand, many observers familiar with the Underwriters have commented in articles that it is not likely that there is much written evidence of the tie-in arrangements. Barry Barbash, former director of the SEC’s division of investment management, was quoted in a law.com posted article of June 29th stating, “proving this kind of conspiracy as a practical matter is very difficult, I can tell you that from my experience at the SEC.”(10) However, the Underwriters have to be concerned with the potential for disgruntled employees (or former employees) providing detailed information regarding their respective firm’s IPO allocation practices.
Underwriters and Issuers may also argue that the plaintiffs knew of the untruth or omission at the time they acquired the security. Most of the investors in on the ground floor of an IPO are sophisticated and knowledgeable regarding Wall Street practices. However, we anticipate the plaintiffs will counter by stating that the shares bought in the aftermarket were bought by many more individual investors than those initially allocated the IPO shares and were not aware of the Underwriters’ schemes.
Underwriters will ultimately come under pressure to settle these cases. Defense counsel commented to us that they see this largely being the Underwriter’s problem and that the Issuers are along for the ride. Unless there is specific evidence that certain D&O’s participated in the alleged tie-in scheme then the pressure to settle will be on the Underwriters. Frankly, many observers do not see these cases going to trial. Thus, we feel that the greatest potential for the Issuers to make payment will come from two scenarios. First, the Issuers are ultimately dismissed but are on the hook for the payment of defense costs. Second, if there is a global settlement all defendants may be pushed to contribute.
Final Thoughts On How The Laddering Lawsuits Will Be Resolved
To date, there is no consensus on the likely outcome of the litigation. Opinions vary from those that believe the Issuers and D&Os will get out of the lawsuits on an early motion to those that fear that they will be forced to contribute along with the Underwriters, toward a global settlement. We believe that a compelling argument can be made for a very favorable outcome for most of the Issuers and their D&Os.
In order for the Issuers/D&Os to be liable, the plaintiffs will need to establish that the Underwriters misconduct led to the misleading statement or omission in the prospectus. According to plaintiffs, the entire “New Economy” was built on a foundation of fraud perpetrated by Wall Street’s investment bankers and market research firms. In spite of the negative media spotlighting some rather obvious flaws in the way bankers conduct their business, plaintiffs will nonetheless have a tough time proving their cases. It may be difficult to prove the existence of a tie-in agreement absent a written agreement or incriminating emails, etc. It may also be hard to establish that there was an “agreement” in a legal sense. Showing that there was a purchase in the aftermarket will probably not by itself be enough to establish the existence of an illegal tie-in agreement. The commission disclosure in the Issuer’s prospectus must be shown to be a “material’ representation. Is the commission earned by the Underwriters material to an investor’s decision to purchase a security?
The SEC is under intense pressure from the public and Congress to do a better job regulating Wall Street. Their investigations will no doubt produce some fines, penalties, new regulations and possibly some enforcement action or prosecution in a few cases. We believe that the plaintiff’s idea of a tobacco-sized settlement is not likely. In order for that to happen, the courts would have to find that there was complete systemic corruption throughout one of the most prosperous periods in American history. It would be a colossal slippery slope. Our courts would have to in effect undo hundreds if not thousands of corporate securities transactions. Many of the affected companies would be substantially financially impaired and potentially be forced out of business. The integrity of Wall Street could be permanently impaired.
Public policy and sentiment may wind up supporting the Issuers. In addition to public policy supporting the value and integrity of our institutions, it would be arguably unjust to punish those that are fellow victims of Wall Street’s unsavory practices. Whatever pushed IPO stock prices to the moon, one thing is for certain, investment bankers left a ton of money on the table to the detriment of corporate Issuers. If an IPO shoots to the moon, arguably the price should have been higher (thereby putting more money in the hands of the Issuer) or maybe more shares should have been issued. There might have been fewer dot com casualties if the bankers hadn’t rigged the game to favor their institutional clients and hedge funds while pushing more fees into their own pockets.
It is highly unlikely the Issuers/D&Os were privy to the method used by top investment bankers to distribute or allocate their shares. The Issuer receives a “firm commitment” to a fully subscribed IPO in an underwriting agreement executed weeks or months prior to their IPO. At that point, the Issuer is guaranteed their money. So how does leaving all that money on the table benefit the Issuer or their D&O’s? Commentators have suggested that Issuers were told that their payoff would come in a secondary or follow-on offering. Only a handful of Issuers ever successfully completed such an offering. Therefore, it can be argued that the Issuers themselves are victims. There would no doubt be some discussion between Issuers and Underwriters regarding the quality and reputation of the institutions interested in the IPO. It is highly unlikely that the bulk of Issuers were aware of any side deal between the Underwriter and their institutional clients. No complaints reviewed allege a single act of intentional wrongdoing by a Director, Officer or Issuer. If the complaint is 40 pages long, 38 are devoted to the Underwriters liability. The Issuers, for the most part, are being dragged in on a theory of strict liability that does not require a showing of intent, just that the information in the prospectus is misleading.
Most Issuers have an indemnification agreement with the Underwriter. All of the laddering complaints focus on the commission box located in the first few pages of a Registration Statement/Prospectus wherein the Underwriters’ commission is disclosed. That information is supplied by the Underwriters to the Issuer. Therefore, the Underwriters should be held accountable for their own content. If the Issuer is held to be liable in this circumstance (under a theory of strict or joint and several liability) then it should be able to turn to the Underwriter for indemnification. However, it is possible that the indemnification could be held to be against public policy. If so, the Issuer may seek contribution within the underwriting agreement, under the Common Law or possibly under Section 11.
If there is an allocation of fault under Section 11, the D&Os and possibly the Issuers should benefit. The exact allocation could potentially be different in each case depending on the level of knowledge or participation in any scheme by directors and officers. The Issuers can file a cross claim against the Underwriters for a contribution of up to 100% of the liability.
The potential for any real severity against the Issuers or D&O’s will largely be determined by how well the plaintiffs prove their case against the Underwriters. Absent a very large or Tobacco-sized settlement against the Underwriters or a global settlement against all parties, the potential liability of the Issuer and D&O’s would likely be manageable. The impact on most insurers (other than primary carriers) and the D&O industry as a whole would be nominal. A large settlement does not necessarily translate into a severity situation for Issuers or their D&O’s but it does increase their risk.
Depending on how facts develop within the various regulatory investigations and lawsuits, it is possible that primary insurers fraud exclusions could be triggered. In the majority of cases, the Issuers were first time buyers of D&O at the time of the IPO. Therefore, it is possible that insurers may raise rescission issues at a later date (pre-IPO private companies run a heightened risk of coverage denials if they wait until the month before an IPO to purchase D&O insurance for the first time). In addition, how will the Issuers right to indemnification impact how a “Loss” is defined under a D&O policy? Will insurers successfully exercise their right to subrogation? In many situations, the primary carrier waived their right to a securities claim retention in the event the lawsuit is dismissed. Individually, the expense is nominal but in the aggregate that coverage alone could cost primary Insurers millions. It will be interesting to see how market leaders grapple with these issues.
ENDNOTES
1 Ritter, Jay R. , Some Factoids About the 2000 IPO Market (A brief history of the internet bubble). Posted on Jay R. Ritter’s website (http://bear.cba.ufl.edu/ritter/). April 4, 2001.
2 Pulliam, Susan, Seeking IPO Shares, Investors Make Offer to Buy More in After-Market. Wall Street Journal. December 6, 2000.
3 Pulliam, Susan & Smith, Randall, U.S. Investigates Exchange of Commissions for IPOs. Wall Street Journal. December 7, 2000.
4 Ackman, Dan, Disaster of Day: Investment Banks. Forbes. December 7, 2000.
5 Pulliam, Susan; Smith, Randall; Gasparino, Charles, Firms Receive Data Requests As SEC Steps Up IPO Probe. Wall Street Journal. December 13, 2000.
6 Pulliam, Susan & Smith, Randall, SEC Probes IPO of VA Linux. Wall Street Journal. January 8, 2001.
7 Mopping Up the Mess. Economist.com, May 17, 2001. From The Economist print edition: Vol. 359 Issue 8222, p64, 2/3p, 1c.
8 IPO Suits: Lawyers Predict Billions; Experts Say Not So Fast. Posted on C/Net News.com. Source: Bloomberg News. May 4, 2001.
9 Id.
10 Loomis, Tamara, High Tech-Fallout: Small Investors Find Conspiracy Behind IPO Plunge. New York Law Journal. Posted on Law.com website on June 29, 2001.
last updated: November 15, 2001
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