One phenomenon I have noted on this blog is the rise of event-driven securities class action lawsuits. Rather than being based on alleged or financial misrepresentations, as has traditionally and historically been the case in securities suits, these suits follow in the wake of and are based on adverse events in the company’s operations. A recent high-profile example of an event-driven suit is the securities class action lawsuit that was filed against Arconic in the wake of the Grenfell Tower fire last year. In the following guest post, Richard H. Zelichov, a partner at Katten Muchin Rosenman LLP specializing in defending issuers and their directors and officers in securities class actions and stockholder derivative litigation, takes a look at the event-driven litigation phenomenon and the larger rise of securities suits based on mismanagement allegations. I would like to thank Richard for his willingness to allow me to publish his article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this site’s readers. Please contact me directly if you would like to submit a guest post. Here is Richard’s article.
The United States Supreme Court held in Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1977) that corporate mismanagement does not constitute securities fraud under Section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder. The securities laws were not intended to create a federal private right of action for corporate mismanagement. They have a limited purpose to prevent deception in connection with the purchase or sale of securities.
The holding of the Court in Santa Fe, however, seems somewhat quaint in light of the tremendous increase in what has been called “event-driven” securities litigation over the last few years. Event-driven securities litigation results when something negative happens in connection with a company’s operations, its stock price falls, and the company gets sued for securities fraud alleging that the company should have disclosed this negative operational event earlier. The negative event in most of these cases results, at worst, from some form of corporate mismanagement in connection with the company’s operations whether it be an issue related to obtaining FDA approval, a product-liability issue, cybersecurity breaches, or otherwise. Event-driven securities litigation contrasts with cases about financial misrepresentations or omissions.
The question that follows: How is the increase in event-driven securities litigation consistent with Santa Fe? On the one hand, there is nothing inconsistent between the express holding of Santa Fe and the increase in event-driven securities cases. Santa Fe did not hold that misleading statements about alleged corporate mismanagement were not actionable under Section 10(b). In addition, since Santa Fe was decided, there has been an increase in mandatory and other disclosures by issuers that might be viewed as misleading or incomplete for failure to disclose an adverse operational event. Regulation S-K did not even exist as a uniform repository for the non-financial disclosure requirements for public companies when the Supreme Court issued its Santa Fe decision in 1977.
On the other hand, however, these event-driven securities cases – to the extent that they are being filed and not dismissed — effectively reject the justification for Santa Fe that Section 10(b) does not create a federal private right of action for corporate mismanagement. In so doing, these cases are stretching the bounds of numerous long standing legal principles as company shareholders attempt to turn corporate mismanagement into securities fraud. At its most obvious, company shareholders are pushing the bounds of what constitutes a false, misleading, or misleadingly incomplete statement for purposes of Section 10(b). See, e.g., Brody v. Transitional Hospitals Corp., 280 F.3d 997, 1006 (9th Cir. 2002) (an omission “must affirmatively create an impression of a state of affairs that differs in a material way from the one that actually exists”); SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 862 (2d Cir. 1968). Complaints are filed claiming that statements that a company tries or aims to comply with the law are misleading if the company has violated any law in connection with its operations. Thus, basic accurate statements about a company’s code of ethics are attacked as fraudulent. Complaints are filed claiming that risk disclosures designed to warn shareholders of potential problems are misleading if the “risk” at issue has already come to pass and the disclosure is framed as conditional. Thus, statements that were intended to help insulate a company from liability under the safe-harbor for forward-looking statements under the Private Securities Litigation Reform Act of 1995 (the “Reform Act”) are becoming a basis for liability. Indeed, complaints are filed alleging that a company put at issue whatever alleged operational problem has occurred – the event — by claiming that any statement remotely related to the alleged operational problem was misleading for failing to disclose the event.
The event-driven securities cases are also stretching the bounds with respect to whose scienter can be imputed to the corporation. Shareholders are arguing for ever expanding theories of “collective scienter” to claim that knowledge of employees with no involvement in the development of a company’s public statements should be sufficient to establish knowledge/scienter on behalf of the corporation. See, e.g., Southland Sec. Corp. v. Inspire Ins. Solutions, 365 F.3d 353, 366 (5thCir. 2004); In re Omnicare, Inc. Sec. Litig., 769 F.3d 455, 476 (6th Cir. 2014). So if a lower level employee was knowingly engaged in wrongdoing about which senior management did not know. But senior management or the company puts the subject of the wrongdoing at issue by discussing it then plaintiffs are claiming that they have sufficiently alleged scienter. Relatedly, shareholders are pushing the bounds of theories of what company executives can be presumed to know as part of a company’s “core operations.” Thus, for example, complaints are filed suggesting that senior company executives must know about all issues related to a company’s core product or service even if those issues are not core to the core product’s performance.
Event-driven securities cases also often follow from disclosures from government regulators, other litigation such as product liability cases, or investigative reporting by the press. In these situations, the shareholders are “behind” and attempt to use information from these sources in order to satisfy the particularity requirements of the Reform Act. These efforts too are pushing through long standing principles of securities law about reliance on unproven allegations from complaints in other lawsuits. See, e.g., Lipsky v. Commonwealth United Corp., 551 F.2d 887, 893 (2d Cir. 1976).
Each of the topics discussed in the paragraphs above could be subject to further analysis, but that is beyond this particular article. Rather, this article simply highlights that event-driven securities cases are turning corporate mismanagement into private claims for violation of the federal securities laws. These cases are thereby violating core principles of what the federal securities laws were intended to encompass.