As I have noted on this site (most recently here), many of the SPAC-related securities class action lawsuits filed in 2021 arose after the target company’s share price declined following a short-seller report. In the following guest post, Nessim Mezrahi, Stephen Sigrist, and Carolina Doherty review the extent to which plaintiffs’ lawyers generally are relying on short-seller research to try to substantiate fraud-on-the-market claims. Mezrahi is cofounder and CEO, Sigrist is VP of data science, and Doherty is VP of business development at SAR. A version of this article previously was published on Law360. I would like to thank the authors for allowing me to publish their article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is the authors’ article.
Our data and analyses indicate that global litigation exposure to securities class actions that allege violations of the federal securities laws under Section 10(b) and 20(a) of the Securities Exchange Act and SEC Rule 10b 5 promulgated thereunder, amounts to $100.1 billion in the fourth quarter of 2021.
This is a notable increase of $57.4 billion, or 135%, relative to the third quarter of 2021.
In 2021, litigation exposure of U.S. issuers amounts to $199.1 billion with a notable decrease of about 35% in alleged market capitalization losses relative to 2020. Litigation frequency also declined by approximately 22%.
Litigation exposure of non-U.S. issuers, public corporations that trade via american depositary receipts amounts to $19.2 billion, a material decrease of about 85% relative to 2020. Litigation frequency also declined by approximately 52%.
Our analysis of 131 Rule 10b-5 securities class actions indicates that plaintiffs continue to rely on short-seller research to substantiate fraud-on-the-market claims.
Around 21%, or 27 of 131, of fraud-on-the-market securities class actions rely on short- seller research that affected the price of common stock of the defendant company when the negative information was disseminated to investors.
About 19% of securities class actions, or 22 of 118, against U.S. issuers rely on short-seller research to support alleged violations of the Exchange Act and Rule 10b-5. The litigation exposure, or market capitalization losses, amounts to $12.35 billion, or about 6% of total U.S. securities class actions Rule 10b-5 exposure.
About 38% of securities class actions, or 5 of 13, against non-U.S. issuers also rely on short-seller research. The litigation exposure amounts to $5.1 billion, or about 27% of total non-U.S. issuer securities class actions Rule 10b-5 exposure.
In 2021, directors and officers were exposed to potential liability on about 21% of private securities fraud suits that allege fraud on the market based on research funded by activist short-sellers and their backers who aim to drive down the stock price of the target companies.
According to reporting by Reuters, on Dec. 10, 2021, the U.S. Department of Justice launched an effort to “prob[e] the relationships among the hedge funds and firms that publish negative reports on certain companies, often with the aim of sending the stock lower.”
We estimate that in 2021, about 14% of plaintiffs’ alleged corrective disclosures rely on stock price declines linked to short-seller reports. Interestingly, about 62% of these alleged truth-revealing disclosures exhibited a single-day residual stock price decline that was statistically significant at the 95% confidence standard. This means that about 38% of stock drops driven by short-sellers do not exhibit back-end price impact and the presumption of reliance in the corresponding securities claim may not apply.
Plaintiffs may likely also fall short of successfully alleging loss causation in this sample of deficient securities class actions driven by short-sellers. Recently, in In re: Facebook Inc. Securities Litigation, the U.S. District Court for the Northern District of California dismissed the plaintiffs’ third amended complaint against Facebook without leave to amend, because investors failed to successfully plead loss causation.
According to Kevin LaCroix of The D&O Diary,
[I]n the surge of SPAC-related litigation that has been filed this year, one of the distinctive features of the filings has been that many of the lawsuits have followed shortly after a short seller published a report critical of the defendant company.
Securities class actions driven by short-sellers fit nicely into plaintiffs’ economic incentives because (1) the defendants’ market capitalization losses are certain, (2) investors incurred trading losses, (3) public opinion may galvanize in favor of investors, and (4) there is an approximately 50% probability of surviving the motion to dismiss for them to attain a third of the potential settlement.
For example, in In re: Tal Education Group Securities Litigation, the U.S. District Court for the Southern District of New York approved a $7.5 million settlement and attorney fees of up to 33.33% of the settlement fund, including interest, which it said was “reasonable in light of the work performed and the results obtained.”
This securities claim relies on a single alleged corrective disclosure from a third-party disseminator — Muddy Waters Research LLC — a well established short seller.
According to a panel discussion hosted by Yeshiva University’s Benjamin N. Cardozo School of Law in 2007, two leading litigators acknowledged that litigation strategy centers on the economics and potential aggregate damages. According to Sam Rudman of Robbins Geller Rudman & Dowd LLP, it’s not necessarily about “more or less fraud in the market.” According to Rudman,
As someone who’s done a lot of settlements, I can tell you that the biggest difference for me lately is the volatility. Cases where companies happen to be trading at $20 get bad news, it goes from $20 to $18 is one case that might have happened six months ago. $20 to $18 — that case isn’t big enough for Max or me to do it, even if we think it’s a great case. Then that stock goes from $20 to $10 today, and now a case gets filed. I think a big challenge that dramatically changes these cases is the volatility and what’s at stake. If it’s a big damages case, Max or I will put resources into it. Our clients are going to want to do the case. If not, we’ll work on the cases that we can. It’s not about more or less fraud in the market. These cases are approached by the plaintiffs, a lot of the time by the clients using a cost basis analysis. … One of the first questions a client asks is how much did I lose, what are the market losses, is it something worth pursuing. If they haven’t lost a lot of money, people might say it’s rather inefficient.
Market volatility is likely certain coming into 2022 after a record-breaking year for U.S. equities; according to Barron’s, “[t]he S&P 500 hit its 70th record close of 2021 on Wednesday. That’s the benchmark’s most record closes in a year since 1995, according to Dow Jones Market Data. For the year, the S&P 500 rose 27%.”
Expectations of interest rate increases may spur trading volatility; according to The Wall Street Journal, “the central bank’s interest-rate-setting committee are likely to strongly support raising borrowing costs to try to combat high inflation.”
Short-sellers will continue to expand the sample of securities claims that contingency litigators pursue against directors and officers of U.S.-listed corporations by claiming fraud on the market.
According to the 2019 dissertation study of current assistant professor of accounting, Antonis Kartapanis of the Texas A&M University Mays School of Business, “activists, although quite accurate in their allegations, also make a lot of ‘inaccurate’ allegations which impose some costs on targeted firms and those firms’ shareholders. The findings validate executives’ concerns that many of the allegations are inaccurate.”
The profit-maximizing relationship between short-sellers and shareholders’ counsel also presents issues of investor typicality in class certification proceedings.
According to professors Christine Hurt and Paul Stancil of the Brigham Young University Law School, “[c]ourts have not uniformly concluded whether short sellers can prove loss causation,” and they conclude that “short sellers should not benefit from the Basic presumption; therefore, their inclusion in any prospective class of typical traders should jeopardize class certification.”
Hurt and Stancil propose that “Congress could make statutory changes to ensure that the class that is certified has only typical investors and that only those net losses caused by the false statement in questions are calculated as damages.”
They advocate for stricter scrutiny of class composition through congressional reform that may place notable limitations on the federal judiciary’s ability to evaluate market reliance:
Acknowledging that the judicial creation of classwide reliance rests on shaky ground, Congress should amend Section 21D of the Exchange Act to allow for classwide reliance regardless of the efficiency of the U.S. capital markets. Reliance on market prices is at best a legal fiction, and a statutory provision could eliminate the adherence to an outdated presumption. Instead, Section 21D could merely not require a showing of reliance by certain types of investors in certain types of cases.
This proposal may restrain the federal judiciary’s power and hamper its independence to scrutinize the strength of fraud-on-the-market claims through empirical analysis of price impact, either at the time when the alleged misrepresentation was made or when the alleged fraud-related information was disclosed.
In our current state of severe political polarization, it is unlikely that Congress will muster the will to unitedly propose marked limitations on the power and independence that the federal judiciary relies on to execute justice in mass tort claims.
According to Chief Justice John Roberts’ 2021 year-end report on the federal judiciary:
Chief Justice Taft was prescient in recognizing the need for the Judiciary to manage its internal affairs, both to promote informed administration and to ensure independence of the Branch. He understood that criticism of the courts is inevitable, and he lived through an era when federal courts faced strident calls for reform, some warranted and some not.
The U.S. Court of Appeals for the Second Circuit has been given the opportunity to reevaluate class certification issues of reliance for the third time in In re: Goldman Sachs Group Inc. Securities Litigation. Undoubtedly, the Second Circuit has greater knowledge and specialized expertise in attaining consensus on these highly technical issues than Congress.
Goldman Sachs firmly contests that U.S. District Court for the Southern District of New York failed to evaluate the informational connection between the allegedly misleading generic statements and the corrective disclosures in accordance with new guidance penned by Justice Amy Coney Barrett in the U.S. Supreme Court this past summer, in the salient case.
According to the defendants’ petition to the Second Circuit, if the Southern District of New York does not exercise its duty “to compare the contents of any of the challenged statements with the ‘corrective disclosures’,” then “[p]rice impact will be nearly automatic in inflation-maintenance cases because plaintiffs can simply point to a back-end stock drop following news of any discrete failure to comply with a company’s aspirational principles or internal controls.”
The court’s absence from evaluating the informational connection between any alleged misleading or generic statement or disclosure, and any alleged corrective event or truth- revealing disclosure may incentivize plaintiffs to increase their reliance on short-seller research for a de facto win against directors and officers that face activists’ threats.
Short-seller reliance is not the only piggybacking scheme in plaintiffs’ arsenal. A follow-on strategy on investigations initiated by the U.S. Securities and Exchange Commission or the DOJ also helps plaintiffs close the gap on evidentiary requirements to validate securities claims.
According to professor Emily Strauss of the Duke School of Law, “private plaintiffs seize on government investigations in order to capitalize on the government’s factfinding.” According to Strauss:
There is, in general, a robust debate over the merits of these lawsuits; some commentators argue that piggyback litigation extends the benefits of public enforcement and protects against under-deterrence, while other scholars decry such lawsuits as solely “multiplying wrongdoers’ penalties: [a plaintiffs’ lawyer] provides no independent search skills, no special litigation savvy, and no nonpoliticized incentives. She simply piles on and runs up the tab.”
Strauss states that “[i]rrespective of whether piggyback litigation is desirable in the securities context, the existing literature suggest that it is often quite successful.”
According to Professor Alexander Platt of the University of Kansas School of Law, “research has shown that securities class actions are less likely to be dismissed, settle faster, and for more money, and are more likely to have an institutional lead plaintiff, when there is a parallel SEC enforcement action.”
Our data and analysis indicate that plaintiffs’ short-seller piggybacking scheme creates measurable litigation exposure for directors and officers and burdens insurance carriers with defense and cost containment expenses, in addition to settlement losses that erode directors and officers liability insurance profitability.
With market volatility on deck for U.S. equities in 2022, plaintiffs’ continued reliance on short-seller research may catalyze frequency and compound severity of fraud-on-the- market suits.
Nessim Mezrahi is co-founder and CEO, Stephen Sigrist is vice president of data science and Carolina Doherty is vice president of business development at SAR LLC.
 SAR SCA Rule 10b-5 Exposure Report – 4Q 2021.
 Id., see, Appendix-1 in SAR SCA Rule 10b-5 Exposure Report – 4Q 2021. There are 41 SCAs filed in 2021 that allege violations of the Exchange Act and Rule 10b-5 that SAR reviewed but did not analyze due to insufficient pricing data and/or the securities claims that allege novel theories of liability.
 SAR SCA Platform Database, as of December 31, 2021.
 “U.S. Justice Dept launches expansive probe into short-selling – sources,” Svea Herbst-Bayliss, Reuters, December 10, 2021.
 SAR SCA Platform Database, as of December 31, 2021. 239 alleged corrective disclosures against U.S. and non-U.S. issuers analyzed indicate that 34 are linked to short- seller reports and 13 of the corresponding drops do not exhibit a statistically significant single-day residual return at the 95% confidence standard.
 Order Granting Defendants’ Motion to Dismiss Third Amended Complaint Without Leave to Amend, In re Facebook, Inc. Securities Litigation, Case No. 5:18-cv-01725.
 “Shareholders Sue Post-SPAC-Merger Biotech Firm After Short Seller Attack,” Kevin LaCroix, The D&O Diary, November 21, 2021.
 See, In re Tal Education Group Securities Litigation, Case No. 1:18-cv-05480, Docket Entry No. 93: “ORDER APPROVING PLAN OF ALLOCATION OF NET SETTLEMENT FUND”, November 30, 2021.
 See, “Guest Post: Second Circuit Ruling Exposes D&Os to Exchange Act Claims Based on Biased Short-Seller Research,” Nessim Mezrahi, The D&O Diary, December 3, 2020.
 Jed D. Melnick, “The Mediation of Securities Class Action Suits – A Panel Discussion Hosted by the Benjamin N. Cardozo School of Law,” Cardozo Journal of Conflict Resolution, Vol. 9:397, 2008.
 “2021 Is in the Record Books: A Year of Memes, Crypto, and Stock All-Time Highs,” Connor Smith, Barron’s, December 31, 2021.
 “Fed Rate-Setting Panel Gets New Members in 2022 Amid Rate-Rise Expectations,” Michael S. Derby, The Wall Street Journal, December 31, 2021.
 Antonis Kartapanis, “Activist Short-Sellers and Accounting Fraud Allegations,” McCombs School of Business, The University of Texas at Austin.
 Christine Hunt and Paul Stancil, “Short Sellers, Short Squeezes, and Securities Fraud,” BYU Law Research Paper No. 21-05.
 “Much like an overexploited ecosystem, the increasingly polarized political landscape in the United States – and much of the world – is experiencing a catastrophic loss of diversity that threatens the resilience not only of democracy, but also of society, according to a series of new studies that examine political polarization as a collection of complex ever-evolving systems.” See, “Political polarization and its echo chambers: Surprising new, cross- disciplinary perspectives from Princeton,” Morgan Kelly, High Meadows Environmental Institute, December 9, 2021.
 2021 Year-End Report on the Federal Judiciary, Chief Justice G. Roberts, December 31, 2021.
 “Goldman Takes 3rd Shot At Nixing Cert. For Investor Class,” Dean Seal, Law360, December 22, 2021.
 Defendant’s Petition for Permission to Appeal Pursuant to Federal Rule of Civil Procedure 23(f), In re Goldman Sachs Group, Inc. Securities Litigation, Case No. 1:10-cv- 03461.
 Emily Strauss, “Is Everything Securities Fraud?” UC Irvine Law Review (forthcoming),Duke Law School Public Law & Legal Theory Series No. 2021-04, February 6, 2021.
 Alexander I. Platt, “Gatekeeping in the Dark: SEC Control over Private Securities Litigation Revisited,” 72 Administrative Law Review, Harvard Public Law Working Paper 20-02., January 8, 2020.