Danger zone - dealing with securities lawsuits

Entrepreneur, April, 1996 by David R. Evanson

Your IPO hits the streets-and you're hit with a lawsuit. What gives?

Last year, 39,700 students graduated from law school. This is bad news since, to make a living, they have to start filing lawsuits. No opportunity, regardless of how inane it might be, is left untouched. And areas with real potential--like securities lawsuits--virtually bubble like the water above a piranha feeding.

For public companies, class action lawsuits by so-called "aggrieved shareholders" are a constant threat. For companies considering an initial public offering (IPO), class action suits are a major consideration.

Here's the most basic version of how the game is played. A publicly held company announces a dip in sales and earnings, and the price of its common stock drops--perhaps precipitously. An attorney files a lawsuit on behalf of shareholders claiming mismanagement of the company by its officers and directors and/or failure to disclose material deterioration in the company's principal lines of business. The company either a) dukes it out in court or b) settles out of court to make the suit go away for less time and expense than fighting it. In short, the company is blackmailed, but it's done by attorneys in a court of law.

For newly public companies, a lawsuit brought by shareholders can be particularly damaging and demoralizing, according to Joel Marks, director of corporate finance for J.W. Charles Financial Services Inc. in Atlanta, an investment banking and brokerage firm concentrating on emerging growth companies. Smaller companies, says Marks, have a shallower management pool, and the distraction of a lawsuit creates a disproportionately large disruption of the business--a malaise compounded by the fact that many of these entrepreneurs and chief executives already spent the better part of the previous year putting their deal together.

"But perhaps more painful," says Marks, "is the demoralizing effect on management. They're pumped up and ready to put their business plan into action--and then the summons arrives. They start wondering what they got themselves into."

Cross This Line

For IPOs, says Marks, there are two prominent danger zones. The first, he says, is a sudden and large drop in the price of the company's stock. "The larger and faster the drop," says Marks, "the louder the siren." Unfortunately, for new issues, volatility in the price of the stock can be a way of life, so this risk is endemic to the process. Happily, says Marks, reforms passed by Congress in December 1995 that took the benefits out of being the first attorney to file suit have dampened the courtroom rush that occurred on the heels of a price decline.

The second danger can occur when offerings are timed so they become effective within 30 days of a required earnings announcement. "If there's a negative surprise that was not foreshadowed in the prospectus," says Marks, "it looks like the company was selling stock ahead of bad news, and that can attract plaintiff lawyers."

The only good news in all this for IPO candidates, says Marks, is that the likelihood of smaller IPOs provoking a lawsuit is dramatically less than the odds faced by larger companies. "Still," he says, "if you're the one that gets nailed, knowing the odds doesn't make you feel any better." As a result, he offers these strategies to keep the lawyers and their nettling lawsuits at bay.

1. Assess your capabilities. "Everybody looks at what it will cost them to get their offering done," says Marks, "when they should really be concerned about the time [commitment required]." Problems develop when a company goes public on a Friday and management, drained by the effort required to do the deal, comes in flatfooted on Monday with no momentum. "That's when a company gets into a situation where its first earnings release as a public company shows a marked deterioration from previous comparable periods."

Marks says many companies will even put language in the earnings releases to the effect that the poor performance was due to management time spent on the public offering. "But that may not be a valid contention," he adds, "since there are ways to prevent [poor performance]."

For instance, he counsels client companies to evaluate whether or not some critical function upon which the deal is being sold, such as sales, engineering, or research and development, will suffer while senior management is sitting in drafting sessions or on road shows or in any one of the endless and mind-numbing meetings the process requires. If so, says Marks, the company has to make sure the underwriter can provide bridge financing (an advance on the proceeds from the offering) to hire personnel while the deal is underway.

"These are generally the kind of senior people you would hire anyway after an offering," says Marks. "Putting them in place before the deal helps ensure the company hits the street running and decreases the chance of a lawsuit due to a poor quarter."

2. Associate with the right professionals. One of the surest paths to legal trouble from an IPO, says Marks, is to use incompetent or inexperienced attorneys or accountants. That means if your attorney is your attorney because he's your brother-in-law, he's got to go.