On November 21, 2014, after a securities class action trial that lasted less than three days and after less than a day of deliberation, an eight-person jury entered a verdict holding former Longtop Financial Technologies CFO Derek Palaschuk liable for the company’s alleged misrepresentations about its financial condition. According to Nate Raymond’s November 21, 2014 Reuters article about the verdict (here), the jury will return on Monday, November 24, 2014 to determine the damages to be awarded to investors. Max Stendahl’s November 21, 2014 Law 360 article about the verdict can be found here (subscription required).
As detailed below, trials in securities class action lawsuits are extremely rare – there has not been a trial in a securities class action lawsuit to reach a verdict since 2011. As also discussed below, there were a number of other unusual features about this case, including both the brevity of the trial and the dearth of witness testimony and other evidence.
During the period 2010 to 2012, plaintiffs’ lawyers rushed to file a wave of securities suits against U.S.-listed Chinese companies, including against the Xiamen, China-based Longtop Financial (as detailed here). Unlike many of U.S.-listed Chinese companies caught up in the wave of securities litigation, Longtop Financial did not obtain its U.S. listing through a reverse merger, but instead it became a public company through a conventional IPO in 2007. Its shares traded on the NYSE. At one point, its market capitalization exceeded $1 billion.
Questions began to dog the company after Citron Research published an April 26, 2011 online report critical of the company. Among other things, the report questioned the company’s “unconventional staffing model,” alleged prior undisclosed “misdeeds” involving management, and referenced “non-transparent” stock transactions involving the company’s chairman, among other things. Other critical research coverage followed.
Longtop’s problems took another turn for the worse in May 2011 when, in advance of the high profile IPO of Chinese social networking company, Renren Network, Longtop’s CFO, who sat on Renren’s board as chair of the audit committee, resigned from the Renren Network board to prevent the questions at Longtop from affecting Renren’s IPO.
Then on May 23, 2011, in a filing with the SEC on Form 6-K, the company announced that both its CFO and its outside auditor, Deloitte Touche Tomatsu (DTT) had resigned. In its accompanying press release (here), the company said that DTT stated in its May 22, 2011 letter of resignation that it was resigning as a result of, among other things,
(1) the recently identified falsity of the Company’s financial records in relation to cash at bank and loan balances (and possibly in sales revenue); (2) the deliberate interference by certain members of Longtop management in DTT’s audit process; and (3) the unlawful detention of DTT’s audit files.
DTT further stated that it was “no longer able to rely on management’s representation’s in relation to prior period financial reports, and that continued reliance should no longer be place on DTT’s audit reports on the previous financial statements.”
A copy of Palaschuk’s terse May 19, 2011 resignation letter can be found here.
Securities class action lawsuits followed. The actions were consolidated before Judge Shira Scheindlin in the Southern District of New York. The defendants in the lawsuits included the company, certain of its directors and officers and Deloitte Touche Tohmatsu. The plaintiffs alleged that the company had falsified its financial results by exaggerating revenues, underreporting bank loan balances, and transferring employee expenses to an off-balance sheet entity.
In April 2013, Judge Scheindlin dismissed the claims against the audit firm. As discussed in detail here, on November 14, 2013, Judge Scheindlin entered a default judgment order including a damages award of $882.3 million against the company and its former CEO, Wai Chau Lin.
Following the dismissal of the auditor and the entry of default judgment against the company and the CEO, the sole remaining defendant left in the case was Palaschuk, the former CFO, whom the plaintiffs were able to serve in Canada in 2012 and who filed a motion to dismiss the plaintiffs’ claims against him. In a June 29, 2012 opinion (here), Judge Scheindlin, though acknowledging that the online research reports may well have been biased owing to the online analysts’ financial interests as short sellers of Longtop’s stock, denied Palaschuk’s motion. Among other things, she found that the plaintiffs had sufficiently alleged that in various company press release and financial filings, Palaschuk had made misleading statements about the company’s financial condition and the basis for its growth.
According to Nate Raymond’s Reuters article, in a July hearing, Palaschuk told the Court that he saw no reason “to have my insurance company pay for something where I wasn’t reckless.”
Trial in the plaintiffs’ case against Palaschuk commenced on Wednesday, November 19, 2014. The entire trial took less than three days, as investors were unable to call witnesses in China. Palaschuk himself was the only fact witness.
Palaschuk reportedly testified that in a May 2011 telephone conversation Lin, the company’s former CEO, had confessed to fraud, but that prior to that phone call, he (Palaschuk) didn’t know about the supposed false accounting. He claimed in his trial testimony that he acted in good faith and took steps to investigate the factual allegations as they arose.
According to the Law 360 article, the plaintiffs counsel argued in her closing argument that Palaschuk had repeatedly ignored warning signs of a “culture of fraud” at Longtop. The red flags included fake contracts and reports by outside analysts claiming the company’s revenues were too good to be true. The article quotes counsel as having argued that “when confronted with these warning signs – with these warning signs that begged for investigation – defendant Palaschuk failed to adequately respond. The lack of action the defendants took to find the truth is truly mind-boggling.”
The case went to the jury on Friday, November 21, 2014, and later that same day the jury entered a liability verdict in favor the plaintiffs and against Palaschuk. Damages in the case will be determined in separate proceedings that will begin on Monday, November 24, 2014.
As I noted at the outset, trial in securities class action lawsuits are extremely rare. According to information compiled by Adam Savett, Director, Class Action Services, Kurtzman Carson Consultants (KCC), LLC, including the trial against Palaschuk, there have been only 24 securities class action lawsuits that have gone to verdict since Congress enacted the Private Securities Litigation Reform Act (PSLRA) in December 2005. There have only been 13 trials during that period involving post-PSLRA conduct.
To put this into perspective, according to NERA (here), between January 1, 1996 and December 31, 2013, a total of 4,226 securities class action lawsuits were filed, meaning that only about one half of one percent of all cases filed during that period went to trial.
Taking post-trial proceedings into account (including post-verdict appeals), 12 of the 24 cases that have resulted in a verdict have gone for the plaintiffs and 12 have gone in the defendants’ favor.
Those familiar with securities class action litigation know that the cases that are not dismissed or otherwise resolved on procedural grounds almost always settle. It appears that this case did not settle because Palaschuk believed he did nothing wrong. You can certainly see that Palaschuk’s might conclude that he was being targeted on a sort of last-man-standing basis. It is hard to tell how much the difficulty of accessing witness testimony and other evidence hamstrung his efforts to defend himself. But his strategy to fight rather than settle seems to have backfired.
Of course, the trial verdict is only one procedural phase; Palaschuk can still attempt in post-trial motions and on appeal to have the verdict overturned. For now at least his decision to fight clearly didn’t play out as he had hoped. Depending on what happens in the damages phase, his decision to fight could wind up looking even worse.
Among the many reasons that these kinds of cases almost always settle is that the defendants recognize that they can’t run this risk of a jury verdict that might trigger the fraud exclusion typically found in D&O insurance policies (and that are usually only triggered “after adjudication” of fraud –meaning that a jury verdict is the potential trigger). Ironically, Palaschuk’s reason for refusing to settle (at least according to the July statement cited above) is that he didn’t think his insurer should have to pay anything even though he hadn’t acted recklessly. Depending on exactly what the jury actually decided here, Palaschuk’s decision to push this case to trial could wind up depriving him of any insurance, if the jury ruled that he had acted fraudulently (rather than merely recklessly). The jury verdict form has not yet been posted to the Court’s electronic docket so there is no way to determine exactly what was decided.
The insurance question is not only important to Palaschuk, it is important to the plaintiffs. It is extremely unlikely that the plaintiffs will collect a single penny of the cartoonishly inflated default judgment. If the jury verdict precludes coverage for Palaschuk under Longtop’s D&O policy, the plaintiffs will be left trying to enforce collect in Canada on his personal assets on the judgment entered against him. A judgment collection effort against a foreign domiciled individual seems likely to be an unpromising and possibly unrewarding project.
Just the same, it will be interesting to see what happens in the damages phase of this case. Post-trial proceedings seem likely. In any event, there is little about this case or about the mixed record of class action securities lawsuit trial verdicts that would encourage other defendants to try to push the cases against them to trial.
UPDATE: Dan Berger of the Grant & Eisenhoffer law firm and one of the trial counsel for the plaintiff at this trial communicated the following information to me: “the default judgment was not ‘cartoonishly inflated’ but rather computed by an expert using a typical event study; and we only tried a recklessness case against Palaschuk, so the judgment we have is not for intentional fraud and in theory should not be excluded by his D&O policy.”
What’s Next? Crowdsourced Litigation Financing, Apparently: In prior posts on this site (most recently here), I have noted the rise of litigation financing. Given this trend, and in the age of the Internet, it was perhaps inevitable that a litigation funding website facilitating crowdsourced litigation funding would arise. In any event, whether inevitable or not, a site for crowdsourced financing is now here.
According to its November 19, 2014 press release (here), a new venture called LexShares has launched “an online marketplace for investing in litigation.” The company’s website can be found here. According to the press release, the company’s online platform “connects accredited investors with plaintiffs in commercial lawsuits in order to make an equity investment in a specific case.” If the plaintiff wins, the investor will received a portion of the proceeds commensurate with the investor’s investment. If the plaintiff loses, the investors lose their investment.
According the press release, all legal claims investment opportunities to be posted on the LexShares website are “reviewed by its legal and securities professionals” and are to be offered to investors through a registered broker-dealer. Plaintiffs seeking to have their cases funded through the website must apply to have their cases posted on the site. Once the cases are posted, investors (who must have established their credentials as accredited investors) can review the case and decide if they want to invest. Investors who choose to invest can track the case on the site. The press release states that LexShares has already funded a case with a claim value of more than $40 million and currently has multiple other legal claim investment opportunities available for investment.
The press release quotes University of Minnesota Richard Painter as saying that “Litigation funding is maturing. The next logical step is using a technology platform like LexShares to broaden access to this asset class and equalize access to the legal system.”