Medical imaging firms get little relief from law designed to limit litigation

Lawsuits have increased in years since law’s passage

Publicly traded companies heaved a collective sigh of relief in 1995 when the Private Securities Litigation Reform Act was passed. The legislation was designed to reduce the number of frivolous shareholder lawsuits by limiting the liability of companies and their executives. It included safe harbor provisions covering the forward-looking statements or projections companies often make. The goal was to cut the cost of these legal actions for public companies and the judicial system. But it hasn’t worked out that way.

“The Reform Act in many respects has been ‘the law of unintended consequences,’” said Tower Snow, a leading defense counsel for corporations and their officers involved in securities class actions. “It has slowed how these cases move downstream. Plaintiffs are almost uniformly asking for more money; and defendants are emboldened because they believe the Reform Act is going to be much more beneficial to them than to the plaintiffs.”

Snow, who is chairman of the San Francisco law firm Brobeck Phleger & Harrison, was part of a panel discussion held May 13 in San Francisco and broadcast over the Internet. During the discussion, he and two other legal experts, Joseph Grundfest of Stanford University School of Law and William S. Lerach of Milberg Weiss Bershad Hynes & Lerach of San Diego, debated the effect of securities laws, particularly the Reform Act of 1995.

One of the biggest surprises following the passage of this law, according to the panelists, was that the number of class-action lawsuits brought against public companies increased rather than decreased. An all-time record for such litigation was set last year, with 235 companies named as defendants in federal class-action securities fraud lawsuits, breaking the previous record of 227 set in 1994, according to Stanford, which tracks these cases. In the medical imaging industry alone, seven companies have been sued since passage of the law:

• Digital x-ray developer Schick Technologies of Long Island City, NY;
• Bone densitometry vendor Norland Medical Systems of White Plains, NY;
• Former MRI vendor Caprius of Wilmington, MA;
• Nuclear medicine vendor ADAC Laboratories of Milpitas, CA;
• Independent service organization COHR of Chatsworth, CA;
• Imaging services firm U.S. Diagnostic of West Palm Beach, FL; and
• Imaging services firm Medical Resources of Hackensack, NJ.

From the time the law went into effect on Dec. 22, 1995, through June 14, 1999, 635 companies have been sued in federal court, according to Stanford. And there is no sign that the rush to court is subsiding; Stanford statistics indicate that this year could mark a new high. Why hasn’t the Reform Act of 1995 deterred such litigation?

“You get dramatically different answers to this question depending on whether you pose it to plaintiffs or defendants,” said Grundfest, a former commissioner of the Securities and Exchange Commission and now the director of the Roberts Program for Law, Business, and Corporate Governance at Stanford. “Plaintiffs claim that fraud is common in today’s stock market and point to many examples of accounting restatements and trading by corporate insiders while a fraud was allegedly alive in the market. Defendants claim that honest conduct in volatile markets is often mistaken for fraud, and that some courts have failed to implement the Reform Act properly because they don’t subject plaintiffs’ complaints to sufficiently searching scrutiny.”

In one case in medical imaging, Schick Technologies ran into trouble in November 1998, when company auditors disallowed $2.5 million of product sales processed on the last day of the third quarter. The company’s stock dived on the revelations, recovered, and then spiraled downwards, after the company later announced millions of dollars in charges due to accumulated bad debt in its accounts receivable. An onslaught of lawsuits led the company to issue a statement in January denying any wrongdoing and declaring its intent to vigorously defend against the impending litigation.

Financial shenanigans?Lerach of Milberg Weiss said that financial reports are far from the exact mathematics that many believe they are. Revenue may be booked long before it is received. There is no guarantee the company will ever see the money, particularly if agreements for return rights or restocking privileges are extended. These tactics have led some class action attorneys to joke that the generally accepted accounting principles (GAAP) so often cited by companies in their financial statements are really “cleverly rigged accounting ploys (CRAP).”

Stanford statistics indicate that 59% of the 635 federal suits brought since the Reform Act took effect allege accounting fraud. In another medical imaging example, ADAC is being sued for allegedly manipulating its financial statements (SCAN 1/20/99). Pomerantz Haudek Block Grossman & Gross, one of the firms suing ADAC on behalf of shareholders, alleges that the company overstated its quarterly results, net worth, and gross profit for fiscal years 1996 through 1998. This caused the nuclear medicine vendor’s stock to rise above $30 at one point, according to the firm, only to plunge to under $6 six months after company announced it would restate its finances.

Publicly held companies are being pushed to report positive earnings or risk devastating consequences, according to Lerach. The market is increasingly populated by momentum traders, who pounce on bad news and quickly drive down stock prices, he said. The temptation to falsify results has grown stronger with the explosion of new, small public companies, the use of stock swaps to pay for acquisitions and mergers, and the compensation of executives with cash bonuses and stock options for meeting financial goals.

But companies and executives can benefit only if they sell stock before the crash.

The San Francisco law firm Schubert & Reed represents shareholders who allege that six officers of ADAC, including former chairman and CEO David Lowe, used insider information to trade 442,000 shares of ADAC stock, which netted them more than $9.1 million.

“Under California law, if it is shown that there was illegal insider trading, the company is entitled to treble damages of $27 million,” said Justice Reed of Schubert & Reed.

Public companies and their executives may draw the attention of legal watchdogs when stock prices fall suddenly after insiders have dumped shares at premium levels. Another red flag arises when the companies themselves announce they must restate earnings, usually after being prompted by auditors. That news is usually followed by a feeding frenzy of litigators. A dozen law firms have filed class action suits against ADAC or its officers; nine have lined up against Schick.

Piling on by law firms representing shareholders happens frequently, particularly in federal court, as firms battle to have a judge name their clients lead plaintiff. Press releases are issued for each class action, sometimes bringing in thousands of calls from prospective clients, according to Snow.

Additionally, these lawyers may go shopping for information. The Internet provides a conduit between litigators and disgruntled former employees, as well as competitors. Three days after ADAC announced it would restate earnings, Reed posted messages on a Yahoo chat board, soliciting information that would help his firm’s ADAC case. The stratagem worked.

“We sign up clients who contact us over the Internet, but the goal of the exercise is to solicit information from insiders,” Reed said. “In this case, we were contacted over the Internet by informants who have significant information.”

Milberg Weiss Bershad Hynes & Lerach employs a group of people to go through the thousands of messages on chat boards of companies being sued. Lerach describes the information stored in the chat rooms as a treasure trove.

“In fact, companies sometimes make a big mistake when they get involved in a dialogue in those chat rooms,” he said.

No safe harborIronically, one of the most useful sources of information for plaintiff firms may be the Reform Act’s safe harbor statements, which were designed to help companies. The safe harbor provisions have prompted many publicly held companies to include boilerplate language in press releases warning that some of the information being released to the public is “forward-looking” and therefore is protected by the Reform Act. But rather than protecting companies and executives, these statements may help skewer them.

“Cautionary language itself can be actionable, because if you warn that a problem might occur when it is already occurring, that is deception,” Lerach said. “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.”

While the Reform Act of 1995 seems to have fallen short of its intended purpose, its ultimate effect is not yet known, as few cases have been settled or dismissed. An estimated 500 of the more than 600 cases brought since enactment of the Reform Act are still pending.

“There is an inventory building up in the federal judiciary of remarkable proportions—there’s a pig in the python,” Grundfest said.

The Stanford law professor estimates the value of this “inventory” at around $4 billion in damages. This number is based on the assumption that 80% of the pending 500 cases will be settled at an average of $10 million each. Lawyers will get as much as 30%, or $1.2 billion.

“This is a big business,” he said.

But the true value of shareholder litigation, according to some legal experts, may be that it serves as a warning to companies tempted to commit fraud. When the cost of initiating and defending these actions is finally realized, the threat of such lawsuits may be sufficient to deter the unscrupulous.

In murky legal waters, the line between fraud and honest failure can blur to save the scammers and harm the innocent. Even the good news of positive earnings can lead to unmet expectations and legal action later on—when lawyers, not brokers, make the deals.