On April 10, 2015, PwC released the latest in what is now a series of annual securities class action litigation reports. PwC’s report is generally consistent with the reports previously published by Cornerstone Research and NERA. What makes the PwC report noteworthy is its commentary on the trends the report’s authors believe could contribute to future securities litigation. The PwC report, which is entitled “Coming into Focus: 2014 Securities Litigation Study” can be found here. PwC’s April 10, 2015 press release about the report can be found here.
My prior posts about Cornerstone Research’s annual securities litigation reports can be found here and here, and about NERA’s report can be found here. My own analysis of the 2014 securities class action lawsuit filings can be found here.
Review of 2014 Securities Class Action Litigation
Number of Securities Suit Filings: According to the PwC report, securities suit filings during 2014 were below longer-term filing levels, although with 169 filings during the year, the 2014 filings were above both 2013 (160 filings) and 2012 (149 filings). The report speculates that perhaps because of the suspense involved in waiting for the U.S. Supreme Court’s ruling in the Halliburton case in early 2014, there were fewer securities suits filing in first half of 2014 (79) than in the year’s second half (90 cases).
Inverse Relation between Securities Suit Filings and Stock Market Performance: The PwC report’s authors note the “countercyclical nature of federal securities class action filings relative to stock market performance.” In years in which the stock market outperforms the preceding year, the number of securities suit filings declines. When the stock market underperforms the prior year, the number of filings increases. The authors note that this pattern held in 2014; even though the stock market’s performance during the year was positive, it was below that of 2013, and the number of securities suit filings in 2014 increased compared to the year before.
Accounting-Driven Securities Suit Filings Increase: As the financial crisis-related litigation has wound down, accounting-driven securities class action lawsuits have increased, largely as a result of regulators’ actions. Accounting-related securities suits increased during 2014 both in the total number of cases (53, up from 46) and as a percentage of all cases filed (31%, up from 29%).
Twenty of the 53 accounting-related cases filed during the year included allegations of improper revenue recognition. Another scheme that can be used to boost reported earnings is to understate expenses; of the 53 accounting cases filed in 2014, 16 cases alleged the understatement of liabilities or expenses (up from seven filings in 2013). Another common trend in accounting-related securities suit filings is an allegation of lack of adequate controls over financial reporting. 31 of the 53 accounting-related cases alleged inadequate control over financial reporting.
Health Industry Targeted: The health industry (including pharmaceuticals, medical devices and health services) again had the highest number of securities class action lawsuits. 44 of the 2014 securities suits involved companies in the health industry, representing 26% of all securities suit filings during the year, compared to 36 (23%) in 2013.
Smaller Companies Hit Hard: Two-thirds (66%) of all companies named as defendants in securities suits in 2014 were “small-cap” companies (market caps of $2 billion or less). About one quarter of all 2014 securities suit filings involved “micro-cap” companies (market caps under $300 million).
Filings Against Non-U.S. Companies Increased: 21% of the 2014 securities suit filings involved foreign domiciled companies, compared to 19% of cases in 2013. Companies headquartered or incorporated in China were the most frequent target, accounting for 11 of the 35 cases filed against foreign issuers.
Anti-Corruption Enforcement Driving Securities Suit Filings: In 2014, six federal securities class action lawsuit filing following the public disclosure of SEC or DoJ investigations related to potential FCPA violations. There were also at least three securities suits filed in the U.S. following the disclosure of a regulatory or anti-corruption investigation outside of the U.S.
IPO and M&A Activity and Securities Suit Filings: The number of IPOs during 2014 (288) was at its highest level since 2007. Securities suit filings related to IPOs also increased during 2014. According to the report, there were 19 non-accounting federal securities class action lawsuits related to IPOs in 2014, compared to 13 in 2013. The elevated levels of M&A activity during 2014, along with the increasing complexity of many of the deals, also contributed to the 2014 securities class action lawsuit filings. During 2014, there were 15 securities suits filed in response to deals, which was the same number as in 2013.
Average, Median, and Aggregate Total Settlements Declined: The 2014 average securities suit settlement (based on the date the settlement was announced) was $40 million, down from $50.8 million in 2013. The 2014 median settlement was $6.7 million, down from $9.1 million in 2013. The total value of settlements in 2014 decreased “fairly sharply” to about $2.9 billion, down from $3.3 billion in 2013 and (excluding outliers) the lowest total in 10 years. Only 35% of settlements were above $10 million, well below the average of 50% during the previous four years.
Trends Likely to Drive Future Securities Suit Filings
Regulatory Activity Likely to Continue to Drive Securities Litigation Filings: Consistent with their observation that much of the 2014 securities litigation activity was “largely driven by the actions taken by regulators,” the PwC report’s authors suggest that the regulatory enforcement – and in particular, accounting enforcement — could continue to grow in the years ahead, leading to further securities class action litigation. In particular, the report suggests that the SEC’s increased focus on financial and reporting fraud is likely to lead to increased regulatory enforcement activity, with an attendant likelihood of increased follow on securities class action litigation activity.
Several current and likely future trends suggest the likelihood of increased regulatory enforcement. First, the SEC has deployed innovative analytic tools (such as the SEC’s Financial Reporting and Audit Task Force’s Accounting Quality Model) to detect anomalous patterns in financial reporting, supporting increased enforcement activity. Second, increased whistleblower activity encourage by the Dodd-Frank Act’s provision for whistleblower bounties is also likely to contribute to increased enforcement actions. Third, the increased attention to anti-corruption enforcement, both within the U.S. and abroad, is likely to continue.
The enforcement patterns suggest that, in addition to involvement in bribery or corruption schemes regulators will continue to be focused on targeting companies that lack comprehensive, accurate and reliable controls over financial reporting; have problematic accruals and reserves, valuation questions, revenue recognition issues, and frequently revised financial statements. When regulators target companies with these issues, “more often than not” the enforcement action is followed by securities class action litigation.
Cybercrime is a Growing Concern and Increasingly a Litigation Exposure: A company experiencing a data breach can attract regulatory scrutiny and even a regulatory enforcement action. In addition, “a successful cyber-attack also represents a potential liability exposure for corporate directors and officers via derivative lawsuits.” However, the report also notes that “it is not clear yet whether the continuing wave of data breaches will be a source of viable claims brought by the plaintiffs’ bar.” Nevertheless, “it is clear that company boards and senior management will continue to face scrutiny from a number of stakeholders for cybersecurity issues.”
IPO Activity and M&A Activity Will Continue to Drive Litigation: As long as the market for IPOs remains active, IPO-related litigation will continue to accrue. The PwC report notes that a factor contributing to the increased numbers of IPOs is the availability of the JOBS Act’s IPO on-ramp procedures, which, among other things, relieve “emerging growth companies” of certain disclosure and financial reporting requirements in connection with their offering. The PwC report states that this means “less transparency in the registration process,” which, taken together with the fact that the newer companies are “inherently higher-risk ventures” and “more susceptible to negative surprises” could mean “an increase in IPO-related federal securities class action litigation in the years ahead.
The increased size, complexity, and geographic scope of the merger and acquisition deals are also likely to contribute to increase levels of M&A-related litigation. The report’s authors also note that “with M&A volume predicted to be higher in 2015 than in recent years, it appears M&A-related securities litigation will remain robust and a significant business risk for yet another year.”
Although the various published securities litigation reports are directionally consistent, many of the specific numbers reported differ, in some cases substantially. Most of the differences can be explained by differences in the methodology used. For example, in counting the number of securities class action lawsuit filing, the PwC report counts multiple filings against the same defendant with similar allegations as one case, whereas other reports count multiple filings against the same defendant as separate claims where the filings occur in different judicial circuits, unless or until the separate cases are consolidated. Similarly, in calculating average, median and aggregate settlement amounts, PwC assigns settlements to a particular year based on the date the settlement was first announced; other reports assign the settlements according to the year the settlement was judicially approved.
As I noted in my own analysis of the 2014 securities lawsuit filings, it can be somewhat misleading to consider only the absolute numbers of securities suit filings in isolation from the number of companies listed on U.S. exchanges. The absolute number of filings, which in 2014 was below long-term average annual numbers of filings, might suggest that securities litigation activity is down. However, the number of companies listed on U.S. exchanges has declined substantially since the mid-1990s. Relative to the number of publicly traded companies, securities lawsuit filing activity is actually above long-term filing rates. Or, to put it another way, the likelihood that any given U.S.-listed company might experience a securities class action lawsuit is above long-term levels.
The PwC reports authors’ suggestion that there is likely to be increased levels of IPO-related litigation ahead corresponds to a prediction I made earlier this year. This projection is based on the assumption that increased IPO activity means increased IPO-related litigation. However, as I noted in a recent post, the number of IPOs completed in the first quarter of 2015 was well off from the levels of IPO activity seen in 2014, and the number of companies filing draft registration statements was also down during the first quarter as well. The significant numbers of IPOs completed during 2013 and 2014, as well as the usual lag between the IPO date and the date an IPO-related lawsuit complaint is filed, means that we will probably continue to see heightened levels of IPO-related litigation for some time yet. However, if the fall off in IPO activity that we saw in the first quarter of 2015 continues, the level of IPO-related litigation could start to fall off in time.
One area where I definitely agree with the PwC report’s authors is their suggestion of the likelihood that increased regulatory activity will continue to drive securities class action litigation. The SEC’s heightened monitoring for accounting fraud, the increased numbers of whistleblower reports, and the increased levels of anti-corruption enforcement are likely to continue to lead to follow-on civil litigation. One point the PwC report makes that is particularly important to note is the fact that regulatory outside of the U.S. has increased as well and this increased activity by regulators abroad has led to securities litigation in the U.S. (For example, consider the recent cases that have been filed against Petrobras, and Chemical & Mining Company of Chile, Inc.)
I also agree with the PwC authors’ inclusion of cyber security as an area of possible future litigation activity, but I agree also with their suggestion that it remains to be seen whether or not the plaintiffs’ lawyers will figure out a way to make money filing D&O lawsuits against the boards of companies that experience a data breach. There were two high profile derivative lawsuits filed in 2014 against companies that had been hacked (Target and Wyndham Worldwide), but there haven’t been any subsequent D&O lawsuits filed despite a number of very high profile hacks in the interim (e.g., Home Depot, Anthem, Sony Pictures). In addition, the Wyndham case was dismissed (as discussed here). The plaintiffs’ lawyers haven’t yet figured out how they are going to make money from the cyber breaches. That doesn’t mean that there won’t be viable data breach-related D&O lawsuits in the future, but for now, at least, the scourge of data breaches and hack attacks is not contributing significantly to the numbers of corporate and securities lawsuits.
The Problem with Plaintiffs’ Attorneys’ Fee Awards in Securities Class Action Litigation: The amount of the fees to be awarded to the plaintiffs’ attorneys’ in connection with securities class action lawsuit settlements is one of those recurring and troubling issues that never seems to be resolved. One of the goals of Congress in enacting the Private Securities Litigation Reform Act was to encourage class representatives to take a more active role in negotiating and monitoring plaintiffs’ attorneys’ fees. But that hasn’t really happened, according to a recent academic study.
In their February 11, 2015 paper entitled “Is the Price Right: An Empirical Study of Fee-Setting in Securities Class Actions” (here) Lynn Baker and Charles Silver of the University of Texas and Michael Perino of St. John’s University examined 434 securities class action settlements that were announced between 2007 and 2012. Their overall conclusion is the current system for setting plaintiffs’ attorneys’ fees is “deeply flawed.” The authors found that in the vast majority of cases, fees are determined after the fact, based only on the size of the settlement and the biases of the court. Congress’s goal in the PSLRA of encouraging lead plaintiffs to take a more active role in negotiating and monitoring plaintiffs’ fees has not been met.
Among other things, the authors found that in 85 percent of the cases, the plaintiffs’ lawyers were simply awarded the fees they asked for. With respect to the remaining 15 percent of cases in which the fees were cut, the authors could not find a meaningful way to predict why judges cut fees. The absence of readily identifiable factors for fee cuts suggests that the fee reductions are “for all intents and purposes random events.” The authors suggest that the cuts arguably reflect little other than the judges’ biases. The authors suggest that in order to avoid the problems with plaintiffs’ attorneys’ fee awards, the lead plaintiffs should be more active in negotiating the attorneys’ fees at the outset of the case.
Alison Frankel has a very good summary and discussion of the authors’ academic article in an April 10, 2015 post on her On the Case blog (here).
An Interesting Article about Cyber Insurance: There is no shortage of articles and other information about the cyber security threat, or even about cyber insurance. At this point, many of the articles on these topics have a certain repetitiveness about them. Just the same, I found an April 9, 2015 article published on the Cybersecurity Docket to be interesting. The article, entitled “Cyber Insurance: A Pragmatic Approach to a Growing Necessity” (here) and written by John Reed Stark and David R. Fontaine, suggests that rather than the standard approach to the process of acquiring cyber insurance, companies should “begin with a review of actual cyber-attacks experienced by others.”
The authors suggest that by analyzing and understanding the “workstreams” those companies have had to implement to respond to data breaches, companies can then “collaborate with its insurance brokers and originators to allocate risk responsibly and determine, before any cyber-attack occurs, which workstream costs will be subject to coverage; which workstream costs will fall outside of the coverage; and which workstream costs might be uninsurable.” I found the article interesting and worth reading.