In 1995, Congress passed the Private Securities Class Action Reform Act (PLSRA) over President Clinton’s veto in order to try to address perceived securities class action litigation abuses. According to a new report from the U.S. Chamber Institute for Legal Reform entitled “A Rising Threat: The New Class Actions Racket That Harms Investors and the Economy,” despite the PSLRA’s reforms, many of the same abuses that led to the PSLRA’s enactment have returned, and as a result the securities class action system is “spinning out of control.” According to the report, the time has come for Congress to intervene again to curb “abusive practices that enable the filing of unjustified actions.” The Institute’s October 23, 2018 report can be found here.
The “Skyrocketing” Number of Securities Lawsuit Filings
As evidence of the return of “abuses eerily similar to those of the 1990s,” the report cites a number of factors, including most notably the “skyrocketing” number of securities class action lawsuits. As I have noted on this blog, the number of securities class action lawsuit filings in 2017 was at historically high levels, and the torrid pace of filings continued in the first half of 2018. The number of filings this year are on pace to end the year close to last year’s record setting levels. The rate of litigation – that is, the number of lawsuits relative to the number of publicly traded companies – is even more alarming; with the litigation rate in recent months exceeding 8%, the likelihood of an individual publicly traded company getting hit with a securities suit is higher than it has ever been.
According to the report, not only is the number of lawsuit filings soaring, the lawsuits “are again filed without regard to their merit.” The report notes that whereas in the past, securities class action lawsuits were filed based upon allegations of financial misrepresentations, today “a huge proportion” of the class actions are being filed either based on (1) proposed M&A transactions, or (2) headline-grabbing events harming a company’s underlying business.
The Increase in the Number of Federal Court Merger Objection Lawsuits
With regard to the M&A litigation, the report document notes, as I have previously noted on this blog, that a huge percentage of M&A deals draw at least one lawsuit. The huge percentage of deals being targeted by itself “demonstrates that suits are filed with regard to the underlying merits,” as it is obvious that 80% of the deals do not involve fraud. The plaintiffs’ lawyers file these lawsuits because the short deal timelines provide incentives for defendants to quickly settle. Academic studies cited in the report have substantiated that the types of disclosure-only settlements by which most of these cases are settled provide little value to shareholders and the additional disclosures do not affect shareholder voting.
In recognition of these abuses, Delaware’s courts have evinced their hostility to merger objection lawsuits, as a result of which the cases increasingly are being filed in federal court. In order to avoid judicial scrutiny of disclosure-only settlements, the federal merger objection cases increasingly are being settled based on the defendants’ agreement to provide supplemental disclosures (making the case “moot”) and the defendants’ willingness to pay the plaintiffs’ lawyers a “mootness fee,” which typically are made without court approval.
The Rise in the Number of Event-Driven Securities Lawsuits
With regard to the second major securities litigation trend driving the increase in the number of securities class action lawsuit filings, the report notes that there has been “a dramatic growth in the new category of event-driven claims.” These kinds of claims allege that the defendant company misrepresented the risk that the adverse event would occur. The report cites as an example of these types of lawsuits the securities suit that was filed against Arconic following the Grenfell Tower fire. Other examples include the securities suits filed against companies following revelations of regulatory investigations; following disclosures of alleged sexual misconduct involving senior company management; or involving news of a cybersecurity incident at the company.
The plaintiffs’ lawyers are drawn to these kinds of event-driven suits because the event typically is accompanied by a sharp drop in the company’s share price. However, the “merits of these claims are highly suspect.” The report cites an article by Columbia Law School Professor John Coffee saying that these event-driven securities suits often are “fatally deficient” with respect to allegations of both scienter and loss causation. The report also cites the comments of observers that the scope of event-driven litigation could expand rapidly.
The Overall Decline in the Merits of Lawsuits Filed
The upshot in the proliferation of these new and expanding categories of securities class action lawsuit filings is that at the same time that the number of lawsuits has increased, the merits of the lawsuits filed has declined. The report cites an increasing rate at which the securities suits are dismissed – from about one-third to forty percent in the early years after the passage of the PSLRA to over 50% in the most recent years – as confirming that “plaintiffs’ lawyers are filing more legally-unjustified claims.” Moreover, the cases that survive or that otherwise settle increasingly are settled on a nuisance value basis, further underscoring the overall lack of merit of many of the cases that are being filed.
The Harm to Investors
This proliferation of “abusive securities class actions” is “hurting investors, not benefiting them.” In support of its assertion that the increasing number of lawsuits is hurting investors, the report cites a recent study by Chubb showing that between 2012 and 2016 the aggregate cost to companies of resolving M&A lawsuits – whether or not they settle or are dismissed – has increase by significant amounts. The report also cites academic studies concluding that even where securities litigation results in a cash settlement, the settlement itself represents little more than a shift of funds from one set of shareholders.
The Need for Additional Congressional Reform
The report contends that “the same sort of abusive practices” that led Congress to enact the PSLRA “are again in full flower and require Congressional attention.” In support of this assertion, the report details how the goals of the PSLRA’s lead plaintiff provisions have been undermined. In the lead plaintiff provision, Congress sought to encourage institutional investors to become involved in controlling securities lawsuits. However, increasingly the lead plaintiff in securities suits either is an individual or a public pension fund whose leaders have received political contributions from the plaintiffs’ law firms. As a result, there is a “missing monitor” in many shareholder lawsuits, which in turn may help to explain why plaintiffs’ lawyers are able to file so many lawsuits that are dismissed or settled for nuisance value. Either way, the lawsuits “are imposing a cost on the system and ultimately on shareholders, who are its intended beneficiaries.”
The report concludes that “the securities class action litigation racket is plainly inflicting serious harm on investors, companies, capital markets, and our entire economy.” The report argues that Congress should enact reform legislation that would deter the filing of “meritless cases”’; ensure that cases are brought because investors injured by fraud seek redress, not because “plaintiffs’ lawyers need additional ‘inventory’; and “prohibit abusive practices that undermine the ability of parties and the courts to address the merits of securities class action claims.”
The report cites a number of litigation trends and developments that have been highlighted on this blog. (Indeed, in many cases, this blog is the source on which the report is relying for some of its analysis. And, yes, I am very appreciative of the report’s very kind props, thank you very much. ) Like the report’s authors, I too have been alarmed by the dramatic rise in the number of securities class actions. For that reason, I agree that it could be time for Congress to consider whether additional securities class action reforms may be warranted.
It is probably worth noting that there is a sort of pendulum swing that seems to govern the periodic pushes for securities litigation reform. The pendulum swung in favor of reform in 1995 with the PSLRA. After the rash of corporate scandals at the beginning of the last decade, the pendulum swing resulted, in 2002, in the Sarbanes Oxley Act. After the global financial crisis, the pendulum swing resulted, in 2010, in the Dodd-Frank Act. In between the pendulum swings in favor of reform, the pendulum swung in the opposite direction, in favor of trying to encourage investment and capital raising. Thus, just two years after the D0dd-Frank Act, the pendulum swing resulted in the JOBS Act (which Congress has since amended several times).
It could be that with the accumulating evidence that is faithfully compiled in this report, the pendulum may have swung back again, in favor of reform. If you look at the pattern from the PSLRA to Sarbanes Oxley to Dodd Frank, the pendulum swing intervals are about seven or eight years. So the Institute’s call for reform appears to be right on schedule.
While I agree in many respects with the report’s analysis, I do have some points of disagreement. One concern relates to the conclusions the report draws about the increasing numbers of dismissals. It could be, as the report argues, that the increasing dismissal rate could be due to a declining overall quality of securities suit filings. However, it is possible that there are other factors that might explain the increased dismissal rate, at least in part. The increased dismissal rate could also be due to changes in U.S. Supreme Court case law interpreting the PSLRA’s reforms.
To cite just one example, in 2007, the Supreme Court held in the Tellabs case that under the PSLRA’s heightened pleading standard that a securities fraud complaint “will survive only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any plausible opposing inference one could draw from the facts alleged.” This articulation of the heightened requirements for pleading scienter undoubtedly led to an increased number of dismissals.
The Tellabs decision is only one of a series of rulings that increased the plaintiffs’ pleading burdens in securities suits. Arguably this changing legal landscape could explain, at least in part, the increase in the dismissal rate in more recent years as compared to the dismissal rate in the early years after the PSLRA’s enactment.
The report does not go into detail on the question of what specific reforms might be best calculated to eliminate the perceived abuses. The report is obviously leaving for another day the question of what reforms are indicated. Just the same, I do think it is worth noting here that there may be different answers for different aspects of the supposed evils identified in the report. For example, I believe the obvious abuses of merger objection litigation could be dealt with separately, and arguably more easily, than some of the other problems identified.
For example, Congress could easily pass legislation specifying that there is no private right of action under Section 14 of the Securities and Exchange Act of 1934; that simple move would eliminate federal court merger objection litigation and force claimants back into state court and the growing state court hostility to merger objection lawsuits.
Although I generally agree with many of the observations in the report, I do feel that there are some countervailing considerations.
For example, while there are many lawsuits that arguably could be characterized as abusive, not all securities lawsuit filings are abusive. Not all securities lawsuits lack merit. I make this point to emphasize that whatever reforms are considered or enacted, the revisions should not sweep too broadly and risk discouraging the meritorious lawsuits that are filed. To be sure, the report acknowledges this concern at various points, commenting, for example, that among the goals of any Congressional reform would be the objective to “encourage the cases involving real fraud.”
This latter point of not discouraging meritorious lawsuits fits within a larger consideration relating to our U.S. securities marketplace. One of the reasons why the U.S. securities marketplace is as respected as it is, and one of the reasons why a listing on a U.S. exchange is perceived as a mark of status and reliability, is that our marketplace is viewed as transparent and having integrity. One of the reasons our marketplace is viewed this way is that scrutiny is a very significant part of having a U.S. listing. This level of purifying scrutiny comes not only from the official government regulator, but also from the additional protections afforded through private securities litigation.
The U.S. Supreme Court has frequently noted that our system of private securities litigation is an important accessory part of the system for policing the integrity of our securities marketplace. (Indeed, the Court stressed that very point in the Tellabs decision — private rights of action under the securities laws, the Court said, are a “necessary supplement to Commission action.”) I stress that point here to emphasize that any reforms should take into account the important role that private securities litigation provides in policing our securities marketplace.
All of that said, I think the Institute’s report is interesting, includes a number of important observations, and is worth reading at length and in full. The report’s authors have pulled together a number of important trends and the overall impression is concerning. Clearly, and at a minimum, these are issues that should be discussed, and arguably even addressed.