2018 is the first year the S&P 500 experienced a negative total return since 2008 (yes, you read that right). Stock market volatility spiked in the fourth quarter of 2018 and remains elevated today. One might suspect this means we are in for an increase in shareholder litigation in 2019. The reality, though, is a bit more nuanced.
Market Performance as a Factor in Predicting Securities Litigation Trends
It is true that, historically, there has been a loose correlation between market downturns and increased shareholder litigation. As shown in the following graph based on data provided by the Stanford Law School Securities Class Action Clearinghouse, class action filings in federal court spiked following the dotcom crash in 2000 and jumped again after the 2007–2008 financial crisis.
The primary driver, though, of the more recent spike in federal securities class actions in 2017 (the largest spike since 2001) was a shift in where mergers-and-acquisitions (M&A) actions were filed: from state to federal court. That shift continued in 2018. Roughly 46 percent of federal securities actions filed in 2018 concerned merger disputes. In market downturns, M&A activity tends to stall, which can lead to a decrease in such cases.
Keep in mind that, because the figures depicted in the graph above are limited to federal securities suits and fail to account for a recent increase in state securities suits, they may understate the overall trends in securities litigation.
Taken together, what this means for 2019 is uncertain. What was it that President Truman said about one-handed economists? (Answer: “Give me a one-handed economist! All my economists say ‘on the one hand . . . , but on the other. . . .’”)
Despite uncertainty over the direction of the stock market in 2019 and the number of securities case filings, there are several trends in the types of recent filings worth noting.
The Shift Toward Opt-Out Litigation
A U.S. Supreme Court opinion from June 2017 served, in effect, to encourage potential class members of a securities class action class to file their own, individual actions within three years of the securities offering in order to preserve their ability to pursue opt-out claims. See Cal. Pub. Emps. Ret. Sys. v. ANZ Sec., No. 16-373, slip op. (2017) (addressing whether section 13 of the Securities Act permits the filing of an individual complaint more than three years after the relevant securities offering, when a class action complaint was timely filed and the plaintiff filing the individual complaint would have been a member of the class but for opting out of it). The Court held that the petitioner’s filing of its individual complaint more than three years after the relevant securities offering was ground for dismissal because section 13’s three-year time limit is a statute of repose not subject to equitable tolling. Id. at 2 (syllabus). The Court rejected the petitioner’s argument that “dismissal of its individual suit as untimely would eviscerate its ability to opt out,” because “it does not follow from any privilege to opt out that an ensuing suit can be filed without regard to mandatory time limits.” Id. at 3 (syllabus). That ruling appears to have launched a sustained and meaningful increase in opt-out cases by major institutional investors.
A notable series of opt-out cases involving a real estate investment trust, American Realty Capital Partners (ARCP, now known as VEREIT), was initiated by a major class action filed in the Southern District of New York in October 2014 against ARCP and certain executives based on alleged accounting misrepresentations. In November 2017, ARCP’s former chief financial officer was sentenced to 18 months in prison for accounting fraud. With this factual background against ARCP and its executives, large institutional investors leveraged their substantial equity positions in the company, as well as their substantial resources, to litigate outside the class. To date, those efforts have resulted in settlements with several large institutional investors totaling more than $200 million. In its press release announcing a $90 million settlement with one of the opt-out investors (Vanguard), VEREIT noted that “Vanguard’s holdings accounted for approximately 13 percent of VEREIT’s outstanding shares of common stock held at the end of the period covered by the various pending shareholder actions.” The press release further stated that, “[i]n light of the fact that the Vanguard lawsuit was proceeding in a different federal district court [in the District of Arizona] than the other related cases pending against VEREIT, VEREIT believes that if the Vanguard lawsuit continued, it could find itself facing successive trials on similar factual and legal issues that could have subjected VEREIT to increased legal risk.”
Given the considerable success by these opt-out plaintiffs, there undoubtedly will be more opt-out suits filed by major investors with the means to litigate separately from a class in other securities matters. Venue selection may also be an important consideration by potential opt-out plaintiffs, who strategically may select alternative venues to those selected by the class action plaintiffs. In sum: If large institutional investors determine that litigating on behalf of themselves, outside the class action, leads routinely to higher settlement outcomes, this could fundamentally change the scope and size of class actions.
Broadly speaking, securities litigation typically arises from two types of alleged financial misrepresentations. Accounting fraud, or “cooking the books,” may arise when a company’s actual financial performance is below expectations or targets and executives manipulate the company’s financial disclosures (either through material misstatements or omissions) to conceal the company’s true value. Event-driven claims typically arise when a company discloses—or market participants discover—that some external shock has affected the company’s performance. Oftentimes the claims surrounding these types of events focus on a company’s failure to make adequate and timely disclosures of the known risks associated with certain events. For example (and as discussed further below), claims of a company’s failure to prevent and remedy security breaches and the company’s subsequent failure to disclose the scope of those breaches to the market may constitute a basis for a securities case.
I consider two examples of event-driven causes of securities cases in which the events are alleged to have materially affected the performance and prospects of companies: (1) data security breaches and (2) manmade disasters, such as the California wildfires.
Data security breaches. In the last few years, a number of high-profile incidents of security breaches have occurred. A number of publicly traded companies, such as Yahoo! Inc. and Equifax, Inc., experienced declines in their company’s stock prices when data breaches were disclosed to market participants, and the corresponding securities cases have not been inconsequential.
For example, in September 2016, Yahoo announced that 500 million users’ data had been breached in 2014. Among the information accessed were names, email addresses, dates of birth, phone numbers, and passwords. In a second announcement a few months later, Yahoo announced that one billion users’ information had been stolen in August 2013 and that an unspecified number of user accounts were accessed throughout 2015 and 2016 in a separate cyberattack involving forged cookies. As a result of these data breach incidents, multiple court actions were filed against Yahoo, including a 2017 securities class action complaint (In re Yahoo! Inc. Securities Litigation, No. 17-CV-00373-LHK (N.D. Cal. filed Jan. 24, 2017)) alleging that Yahoo and three of its officers made false and misleading statements or materially misleading omissions concerning the adequacy of Yahoo’s user data security and the existence of data security breaches. That action resulted in an $80 million settlement in 2018, approved by the district court on September 7, 2018.
A second, $29 million settlement was reached in January 2019 to resolve related shareholder and derivative class actions (In re Yahoo! Inc. Shareholder Derivative Litigation) filed in California state court (Lead Case No. 17-CV-307054), Delaware state court (C.A. No. 2017-0133-SG), and the U.S. District Court for the Northern District of California (Lead Case No. 17-cv-0787-LHK). The Superior Court of California for the County of Santa Clara granted final approval of that settlement on January 9, 2019—believed to be the first monetary award to a company in a derivative action related to a data breach.
A third, multidistrict class action against Yahoo related to the above-described data breaches (In re Yahoo! Inc. Customer Data Security Breach Litigation, No. 16-MD–02752-LHK (N.D. Cal.)) could result in yet another large monetary settlement. In 2018, the parties to that action proposed a settlement fund of up to $50 million, with an additional potential award of up to $35 million in attorney fees. That proposal was, however, denied by the court on January 28, 2019. Among the reasons for this denial was the court’s stated concern that “the settlement may allow for unreasonably high attorneys’ fees, and therefore any unawarded attorneys’ fee may improperly revert to Defendants.” The parties presumably will pursue a revised settlement proposal and re-petition for court approval.
These types of data breach claims are not unique to Yahoo. Marriott, for example, incurred similar litigation when, in November 2018, it disclosed that its personal network had been compromised since 2014. As a result of the breach, personal data for 500 million Starwood guests potentially was exposed to the invading hackers. Upon disclosure of this news, the company’s stock price declined over 5.5 percent, and a federal class action securities case was filed the next day.
Data breach risks are high as companies face a complex cat-and-mouse game with sophisticated hackers who can adapt their strategies to overcome security measures taken by companies. It therefore is reasonable to expect that companies will continue to face data breaches and related litigation in the coming year.
Manmade disasters. In October 2017, northern California faced the worst set of wildfires in its history, which led to devastating destruction of property. Authorities quickly suggested that the wildfires may have been caused by downed power lines operated by a subsidiary of Pacific Gas and Electric Company (PG&E). By June 2018, the California Department of Forestry and Fire Protection concluded that a number of California wildfires in 2017 and 2018 had been started by downed PG&E power lines or other PG&E equipment. This prompted the filing of a class action complaint in federal court in the Northern District of California. The complaint alleges that throughout the defined class period, PG&E and its parent company made false and/or misleading statements and/or failed to disclose PG&E’s role in the wildfires and failed to comply with safety regulations. As a result, the company’s communications regarding its business and operations were materially false and misleading. PG&E is estimated to be facing more than $30 billion in potential liabilities and recently initiated bankruptcy proceedings as a result of the disaster.
Another example relates to the recent tragic collapse of a dam in Brazil on January 25, 2019, which is being called the worst environmental disaster in Brazil’s history. Early reports confirmed at least 65 deaths, hundreds of missing persons, and vast property destruction to nearby villages and farms. Vale, S.A., one of the world’s largest iron-ore mining companies, owns the dam that collapsed. (This collapse followed the earlier collapse of another dam—also owned by Vale—in Brazil three years ago.) While the specific cause of the dam collapse is not yet known, the Wall Street Journal has reported that Brazil’s top prosecutor intends to pursue charges against the company’s executives.
Vale’s shares are traded on the New York Stock Exchange, and the market price experienced a significant decline from $14.85 at the close on Thursday, January 24, 2019 (the day prior to the dam collapse), to $11.20 per share at the close on Monday, January 28 (the next business day): a 25 percent decline. By that Monday (January 28, 2019), a securities class action already had been filed in the Eastern District of New York on behalf of a proposed class of investors against Vale and its executives.
Event-driven actions involving as wildly disparate causal shocks as data security breaches, wildfires, and dam collapses are similar in that they involve events that plaintiffs claim would have (and ought to have) been preventable by companies and their executives had they appropriately monitored, maintained, and managed their equipment, and had they followed adequate safety precautions and regulatory mandates. Whether or not those allegations have any merit will be the source of detailed investigations, complex and lengthy litigation, and potentially differing interpretations of facts. In any event, we are likely to see these types of adverse incidents continue to drive securities litigation.
Corporate Communications via Social Media
The Securities and Exchange Commission (SEC) provided guidance in 2014 concerning companies’ use of social media platforms to communicate material information about a public offering or business combination transaction. Using the principle that material information should be disclosed to market participants in a fair and fully accessible manner, the SEC advised that companies may use social media to convey material information so long as investors are notified in advance of the social media platform—such as Facebook or Twitter—to be used for such communications.
It would be impossible to mention corporate use of social media to communicate to investors without discussing Tesla. Tesla disclosed in 2013 that it intended for Tesla Chairman and Chief Executive Officer Elon Musk’s personal Twitter account to convey material information about the company. In fact, the company encouraged investors to follow Musk’s tweets. Whether Tesla should have pursued this strategy is debatable in light of fallout from Musk’s August 7, 2018, tweet: “Am considering taking Tesla private at $420. Funding secured.” In response to Musk’s statement, Tesla’s shares soared to an intra-day high of $387.46 per share, an increase of $45.47 over the prior closing price. A class of short-sellers filed suit in Isaacs v. Tesla, Inc., No. 3:2018cv04865 (N.D. Cal. filed Aug. 10, 2018), claiming that Musk’s tweet “artificially manipulate[d] the price of Tesla stock to completely decimate the Company’s short-sellers (and, on the way, injured all purchasers of Tesla securities).” Tesla and Musk each paid a $20 million penalty to resolve fraud charges by the SEC. As part of that settlement, Musk also was required to step down as Tesla chairman, and Tesla was required to add independent directors to its board.
Two issues arise from the Tesla incident. First, companies may be reluctant to use social media to disclose material information to investors without adequate controls and compliance in place. Tesla’s case may be unique given Musk’s previous outsized role at Tesla: He is something of a corporate celebrity who is known for his unconventional behavior. Second, securities actions on behalf of short-sellers are atypical, making for a potentially complex set of issues. One typically thinks of corporate actions as intended to increase value for common shareholders, not to “punish” short-sellers by increasing the value of the company’s stock. The outcome of the Tesla securities litigation may indicate whether short-sellers are likely to become a more prominent class of investors filing suit in securities actions.
Broader Turmoil Can Lead to Litigation
In the first month of 2019, more than 30 federal securities class action cases were filed—a pace that, if it keeps up, would result in nearly 500 cases in 2019. That number is well in excess of the number of filings observed in any prior year. Between recent stock market volatility, the trade war with China, the government shutdown, increased state and non-state hacking attempts on corporations, environmental factors, and a litany of other concerns, 2019 is already shaping up to be an eventful year in securities class actions.
Laurel C. Van Allen is a senior vice president of Coherent Economics LLC in Chicago, Illinois..
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