The recent massive wildfires in California have caused the loss of dozens of lives, and many more people are missing. Thousands have been displaced and many millions more have been affected. The property damage has been devastating. The Camp Fire in Northern California alone has destroyed tens of thousands of 10,000 homes and businesses. Even as the fires raged, questions surrounding the fires’ causes were raised. Media stories have circulated raising the possibility that the electric utilities may be to blame for starting the fires. There undoubtedly will be substantial inquiries and perhaps even liability proceedings. Now it appears that the accountability process may not only include efforts by property owners and survivor and loved ones to recoup their losses, but it may also include securities lawsuits by utility company investors who claim they were misled about the company’s fire safety readiness and potential liability exposure.
On November 8, 2018, two wildfires, known as the Woolsey and Hill fires, began to burn in Southern California, between Ventura and Los Angeles Counties. The fires have destroyed or damages thousands of structures and tens of thousands of acres. Shortly after the fires commenced, an electric utility operating in the areas where the Woolsey and Hill fires started, Southern California Edison Company (SCE), reported to the California Public Utilities Commission (CPUC) that it had experienced an incident at one of its electricity substation just before the fires began. The CPUC later announced it was investigating the causes of the fires. Among other things, the CPUC is investigating whether SCE’s electrical facilities were in compliance with applicable rules and regulations. No determination of the cause of the blazes has yet been made.
Edison International is the parent holding company of SCE. Both Edison and SCE are publicly traded companies.
The Securities Lawsuit
On November 16, 2018, an Edison shareholder filed a securities class action lawsuit in the Central District of California against both Edison and SCE, as well as certain officer and directors of both companies. A copy of the complaint can be found here. The complaint purports to be filed on behalf of a class of investors who purchased Edison securities between February 23, 2016 and November 12, 2018. The complaint asserts claims for damages under Section 10(b) and 20(a) of the Securities and Exchange Act of 1934 based on the defendants’ alleged misrepresentations to investors.
Specifically, the complaint alleges that the defendants made false and misleading statements or failed to disclose that: “(i) the Company failed to maintain electricity transmission and distribution networks in compliance with safety requirements and regulations promulgated under state law; (ii) consequently the Company was in violation of state law and regulations; (iii) the Company’s noncompliant electricity networks created a significant heightened risk of wildfires in California; and (iv) as a result, the Company’s public statements were materially false and misleading at all relevant times.”
The complaint alleges that on November 12 when the CPUC announced that it was investigating Edison’s subsidiary SCE, Edison’s share price fell more than 12%, and that as the fire continued to burn over the next few days, Edison’s share price fell further. The complaint alleges that Edison’s share price fell a total of 32% from its price prior to the CPUC’s announcement.
There was a time not all that long ago when securities class action lawsuits were mostly based on allegations of financial misstatements or accounting misrepresentations. However, there are fewer financial restatements than there used to be. In the absence of alleged financial frauds, the plaintiffs lawyers (or some of them, anyway) are trying a different approach. Under this new approach, the plaintiffs seek to rely on problems the defendant companies have experienced in their operations that caused their share price to drop. First comes the event, then comes the lawsuit.
I have called this approach “event-driven securities litigation,” a name that others have adopted the term to describe this phenomenon. Event-driven litigation has become increasingly important in recent years, and it is in fact one of the significant factors explaining why the number of securities lawsuits filings is so high above historical norms.
In the wake of the wildfires’ devastation, there seems little doubt that those who suffered property losses and loss of loved ones might try to hold those responsible liable. But this new lawsuit was not brought by the property owners or survivors; it was brought by an investor in one of the potentially liable companies. Just eight days after the fire started and while the embers were still smoldering, while many are missing or homeless, and before any determination has been made either of the fires’ cause or the extent of culpable responsibility, an investor has filed a lawsuit claiming the fire hurt the value of his securities investment.
OK, the investor his not claiming the fire caused the loss to his investments. Instead he is saying that after the fire started the value of his investment declined, so the company’s prior statements must have been misleading.
There are a number of interesting aspects to the plaintiff’s complaint. The first is that even though the plaintiff only owns shares in Edison and only alleges misrepresentations by Edison, he names as defendants in his complaint both Edison and SCE, as well as directors and officers of both companies. Of course, it was SCE’s substation that potentially started the fires and it is SCE that is under investigation by the CPUC– but the plaintiff isn’t suing over who started the fire, he is suing over being misled supposedly about the Edison’s fire safety readiness and its vulnerability if there were to be a fire. Among many other things, the plaintiff is going to have a hard time showing that SCE and its directors and offices “made” the alleged misrepresentations and that SCE mislead Edison investors.
There is an even more curious feature of the plaintiff’s complaint. The complaint quotes at length from Edison’s SEC filings, with a particular focus on the company’s statements about fire safety readiness and the consequences to the company if the company’s facilities were to be involved in starting a fire. The statements the complaint quotes particularly emphasize the inherent dangers involved in transmitting electricity and the risks those dangers present to property and people. The company’s reports also emphasized that in the past the company has been subject to liability from wildfires, as well as the fact that the company’s insurance may be inadequate to cover the liability costs associated with future wildfires. The company’s statements also report that as a result of past incidents, the company has taken steps to improve its safety.
The overall impression is that the company is involved in a dangerous business; one of the risks arising from the dangerous business is that its facilities could cause a wildfire; if its facilities were to cause a fire, it could have significant adverse financial consequences for the company; and that the company has had operational problems in the past. The plaintiff is claiming to have been misled about the company’s fire safety readiness and the problems the company would face if its facilities caused a wildfire, but I have to say that is not how I read the statements the plaintiff’s complaint quotes at all. It looks to me like the company was pretty expressly telling investors that one of the risks that the company faces is the possibility that its facilities might cause wildfires, and if its facilities did cause wildfires, that could be a problem for the company.
There are potentially other problems with the complaint, including for example, establishing that the defendants acted with scienter.
Whatever else might be said about the complaint, it is at a minimum the latest example of the phenomenon of event-driven securities litigation. It joins the ranks of the data breach- related securities litigation, privacy-related securities litigation, and sexual misconduct-related securities litigation, among the growing category of event-driven securities lawsuits. Other examples include securities suits filed in the wake of the announcement of a regulatory investigation. The onslaught of these kinds of lawsuits is a significant factor in the significantly increased numbers of securities lawsuits that were filed in 2017 and that have been filed so far this year.
Among other things, these kinds of cases represent a significant problem for public company D&O insurance underwriters. Historically, the D&O underwriters’ approach to analyzing an applicant company was focused the company’s financials and financial disclosure practices. These aspects of D&O underwriting of course remain important. But the possibility that the applicant company might experience an adverse event in its business operations that could draw a securities lawsuit is a much more difficult risk to analyze, assess, and weight.
To a certain extent, any organization or enterprise might experience a significant operational setback that could cause damage to the company, its results of operations, and its prospects. For the underwriter, it is a challenge to determine the possibility that this type of risk represents a risk of future securities litigation, and how to weight that risk for pricing, risk segmentation, and risk selection purposes.
The underwriting problem that event-driven litigation involves represents just one of the ways in which traditional public company D&O underwriting based on analysis of financial statements may no longer be sufficient. In the current environment, the underwriter must also consider and assess the possibility that the company could experience a management liability claim following allegations of sexual misconduct, following a data breach, following a privacy-related incident, or following a regulatory investigation. In each case, the underwriters’ role has moved beyond the traditional financial statement analysis. As a result, the underwriters’ task has become even more complicated and challenging than in the past.