The Changing Character of Securities Litigation in 2019: Why It’s Time to Draw Some Distinctions

Securities litigation is growing at a prodigious rate. Is that good or bad? This column will answer that we have to unpack this phenomenon and realize that very different things (with very different implications) are happening simultaneously. Let’s begin with the basic data: Some 403 federal securities class actions were filed in 2018, down slightly from 412 in 2017 (which was the highest year since 2001), but more than 200% of the average number for 1996 to 2016 (which was 193).[1] Viewed together, 2017 and 2018 show that the rate of securities class action filings is accelerating, and this increase is even more striking when one recognizes that the number of publicly listed companies has shrunk significantly. If we use the 2017 year-end total number of U.S. publicly traded companies (4,411), the cases filed against publicly traded companies in 2018 (some 385) imply that 8.77% of all publicly traded companies were sued in securities class actions just in 2018 — which litigation rate is the highest rate since 2006. This 8.77% rate is more than three times the average annual litigation rate over 1996-2016 (which was 2.9%).[2] As a result, public companies now face an over one in twelve chance of attracting a securities class action this year (if the 2018 rate persists).

More ominous still, the size of the alleged losses in securities litigation has also soared. Cornerstone Research finds that the alleged losses in just the first half of 2018 were substantially greater than the alleged losses in all of 2017.[3] Of course, losses do not equate with recoveries, but they do imply that defendants may feel under siege.

These trends raise two related questions: (1) Why has this litigation rate soared (particularly when stock market values were up for most of the last year), and (2) what will be the political and legal reaction to this increase and the greater damages faced? A large part of the answer to the first question comes into view when one recognizes that the 403 total number of securities class actions filed in 2018 included some 185 “merger objection” suits (representing some 46% of this total).[4]

What accounts for the high percentage that merger objection cases bear to the total of all securities class actions? Here, the answer is simple: Such cases have migrated out of Delaware as a result of its Trulia decision, which made clear that Delaware would not award significant attorneys’ fees in cases that resulted in a “disclosure only” settlement.[5] Although some of these formerly Delaware cases could have moved to other state courts, the vast majority appears to have simply shifted to federal court. Why? As usual, there are multiple reasons, but one answer is that plaintiffs in other states could not establish personal jurisdiction in state court over the defendant corporation when it was neither incorporated nor had its principal place of business in that jurisdiction.[6] Thus, they opted for federal court and federal question jurisdiction (and nationwide service of process).

Of course, merger objection cases are not the only cause of the recent increase in volume. Even if we subtract the 185 merger objection cases from the total of 403 cases in 2018, the remaining number (218) is still well above the prior average annual rate from 1996 to 2016 (i.e., 193).[7] What explains this increase? Although 2018 saw a few new types of cases (for example, cryptocurrency cases brought as securities class actions[8]), the better explanation for this increase is that the character of securities litigation has recently changed. Once, securities class actions were largely about financial disclosures (e.g., earnings, revenues, liabilities, etc.). In this world, the biggest disaster was an accounting restatement. Now, the biggest disaster may be a literal disaster: an airplane crash, a major fire, or a medical calamity that is attributed to your product. Thus, Boeing has been sued in a securities class action because of the Lion Air crash in Asia (which involved its latest model jet); Johnson & Johnson has been sued by investors on the theory that its talcum baby powder causes cancer; and Arconic has been hit with securities class actions on the ground that its aluminum cladding was responsible for the intensity of the Grenfell Tower fire in London in which many perished. The best characterization for this new type of securities litigation is that it is “event-driven” litigation. The expectation of major losses from the disaster sends the issuer’s stock price down, which in turn triggers securities litigation that essentially alleges that the issuer failed to disclose its potential vulnerability to such a disaster. Not only are the allegations different in this style of lawsuit, but so also are the plaintiff’s attorneys and the procedural pace of the litigation.[9] Today, traditional securities litigation is not filed in the immediate wake of a stock drop; rather, plaintiff’s counsel spends months interviewing potential witnesses and gathering evidence in order to be able to plead an intent to defraud with the degree of particularity that the Private Securities Litigation Reform Act (“PSLRA”) demands.[10] A different pattern prevails, however, in the case of event-driven securities litigation, which regularly follows in the immediate wake of a stock drop.

Why? One can debate this point at length, but it may be that some plaintiff’s counsel are less concerned about surviving a motion to dismiss because they expect an early (and cheap) settlement.

In any event, the key point here is that the contemporary securities litigation playing field is dominated by three very different categories of cases: (1) traditional securities cases, which have grown both in number and even more in size; (2) merger objection cases, which characteristically have low merit but nonetheless give plaintiffs some leverage because of the defendants’ fear of any disruption in the timing of their merger; and (3) event-driven cases, where the legal standards are not yet clear because few of these cases have yet produced an appellate decision. One can feel very differently about these three categories. In all candor, this author would like to encourage the first category (where the PSLRA stands guard against frivolous suits), but probably would prefer to chill the latter two. Let’s take each one at a time:

A. Merger Objection Cases. Defendants are hoping that the Supreme Court’s decision earlier this month to grant certiorari in Varjabedian v. Emulex Corp.[11] will produce a decision that slows the spread of merger objection cases. In that case, the Ninth Circuit panel held that because Section 14(e) of the Securities Exchange Act authorizes the SEC to prohibit acts not themselves fraudulent under the common law or Section 10(b) (at least if the prohibition was reasonably designed to prevent acts and practices that were fraudulent), the plaintiff in such a case need not allege scienter, but only negligence. Although this position is arguable, every other circuit that has ruled has decided to the contrary, and the Ninth Circuit has not done well in the Supreme Court when it is the lone dissenter among the circuits. More importantly, some hope that the Supreme Court will rule (as some amici have requested it to do) that there is no implied private cause of action under Section 14(e). Although this is possible, the issue was not discussed in any detail in Emulex. Thus, the court is more likely to insist on scienter, while noting in a parenthesis or footnote that “for purposes of this case we have assumed with the parties that a private cause of action exists under Section 14(e), which issue we reserve for a future day.”

Still, assume that the court either says that there is no private cause of action under Section 14(e) or mandates that scienter must be plead. What will the impact be? Either decision will, of course, provoke hundreds of law firm memos to clients, but the real world impact may be very modest. Plaintiffs could simply assert the same allegations under Section 10(b) and Rule 10b-5. Or, if a merger vote by a publicly listed corporation is involved, a cause of action might also be plead under the proxy rules and Section 14(a) (and such a suit in some circuits requires no allegation of scienter). The false premise in expecting Emulex to restrict the flood of merger objection cases is the assumption that plaintiffs want to take their cause of action to trial. In the vast majority of such cases, however, they do not. Rather, they are either (a) exploiting the lawsuit’s potential ability to disrupt the merger’s timetable or (b) selling preclusion to the defendant because settling the current frivolous suit may prevent other litigation with greater merit. Hence, the fact that plaintiffs must base their cause of action on Rule 10b-5 (where they cannot satisfy the pleading requirements) is not prohibitive because they plan to settle, not fight.

So if Emulex will not preclude or seriously chill merger objection litigation, what might? Delaware, of course, did successfully discourage such suits by denying lucrative fees for worthless, disclosure only settlements. Could federal courts do the same?  Here is the difference: The Delaware Chancery Court is a concentrated group of sophisticated judges who collectively bore the impact of a multitude of merger objection cases. Ultimately, they realized their time was being wasted — and they responded collectively. In contrast, federal judges are dispersed, and each federal district judge sees only a few such cases. Moreover, with all respect to federal judges, they can be characterized as “Lone Rangers” who do not typically act collectively. Hence, a joint response is less likely.

Still, federal judges do have two important weapons at their disposal if they wanted to curb merger objection cases. First, Section 21D(c) of the Securities Exchange Act instructs the court, upon final adjudication of the action, to make findings as to whether the complaint (and certain other pleadings) complied with Rule 11(b) of the Federal Rules of Civil Procedure. My estimate is that a high percentage of the complaints in merger objection cases would not satisfy Rule 11’s requirements, and thus mandatory sanctions would be required by Section 21D(c)(2) of the 1934 Act. The problem, of course, is that if the case settles, defendants will not raise this issue, but a strong court could do so on its own.

Second, Section 21D(a)(6) of the 1934 Act instructs the court in a securities class action that the “total attorneys’ fees and expenses awarded by the court to counsel for the plaintiff class shall not exceed a reasonable percentage of the amount of any damages…actually paid to the class.” In the typical merger objection case, the settlement is a disclosure only one with no monetary fund being created. Read strictly, Section 21D(a)(6) would preclude any attorney fee award in such a case, because it is not “reasonable” that the fee award exceed the recovery. If this line of reasoning were followed, the rule in federal courts would be the same as that in Delaware: namely, a disclosure only settlement would not justify a fee award. Still, some courts have concluded that they can award a fee on a lodestar basis in an injunctive case. This misreads Section 21D(a)(6), which is addressing the maximum fee permitted, not the fee award formula. Nonetheless, more than a few courts will strain the law to encourage settlements. Thus, in the last analysis, federal courts are partly responsible for the plague of merger objection cases that now burdens them.

B. The Traditional Class Action. If one believes securities class actions have become too numerous or too large, one conceivable answer is the insertion of a mandatory arbitration clause in the corporation’s charter, which would purport to bar securities class actions (or possibly all securities litigation) in favor of an arbitration remedy (and IPO issuers could easily utilize it). At times over the last two years, there have been hints that the SEC was open to this approach. But in December 2018 the Delaware Chancery Court issued its decision in Sciabacucchi v. Salzberg[12], which held that a corporate charter provision mandating a specific forum selection is invalid and unenforceable in the context of securities fraud actions because these suits are not matters of internal corporate governance. At issue in this case was a charter provision specifically mandating that actions asserting a cause of action based on Section 11 of the Securities Act of 1933 could only be brought in federal court. This was a response to the Supreme Court’s decision in Cyan, Inc. v. Beaver County Employees Retirement Fund, [13] which held in 2018 that Section 11 actions could be brought in state court (as the 1933 Act expressly provides). The logic of Sciabacucchi v. Salzberg suggests that attempts to provide in a corporate charter provision that Rule 10b-5 claims could only be brought in an arbitration proceeding would be similarly rejected in Delaware.

Although few corporate managements appeared interested in adopting such a provision, there have been recent attempts by opponents of securities litigation to adopt such a bylaw mandating arbitration.[14] Now, in the wake of Sciabacucchi, it appears more likely that the SEC would reject such a bylaw proposal under SEC Rule 14a-8(i) on the ground that it was “not a proper subject for action by shareholders under the laws of the jurisdiction of the company’s organization.”[15]

C. Event-Driven Class Actions. How skeptically should federal courts view event-driven securities class actions? When the risk seemed remote at the time the corporate issuer made its disclosures, both the materiality of the issuer’s omission and its alleged scienter would seem open to serious challenge. But the problem for defendants is the Supreme Court’s decision in Matrixx Initiatives, Inc. v. Siracusano.[16] Essentially, it found that plaintiffs had adequately alleged the materiality of defendant’s failure to disclose warnings that it had received from doctors and hospitals that its cold remedy (“Zicam”) caused many patients to lose their sense of smell, and that plaintiffs had also satisfied the scienter standard for Rule 10b-5. The facts in Matrixx Initiatives were extreme, but the case does seem to relax and expand the definition of materiality and to simplify the pleading of scienter.[17] Moreover, we must realistically assume that it will often be the case that the defendant has received some warnings. Further, Matrixx Initiatives makes very clear that materiality does not require that the defendant be in possession of statistically significant adverse information before it is required to provide some warning to investors. Thus, although many cases should and will be dismissed, this category of cases may remain viable because the potential damages are often very high. This will be the area that deserves the closest scrutiny in 2019.

To give an example, suppose a hypothetical company called IntelADP has its headquarters and main plant destroyed by a quake a little off the main line of the San Andreas Fault. Its production line will be closed for nearly a year, and its stock price falls by 50%. Of course, it knew it was near the San Andreas Fault, but it never disclosed this because all Silicon Valley companies were near the fault and none had suffered (over the eyewink that 50 years is in geological time). Materiality is debatable here, but scienter should not be (particularly when several high-ranking executives died in the quake). Possibly unwisely, no one recognized the danger. Will courts agree with me? We will see — because this is the kind of case likely to arise in the near future.

The bottom line is that there is no obvious reason to expect the number of securities class actions to fall in 2019. The only category of case that can be sharply reduced is merger objection cases, and here the greatest barrier to reform is that many (and maybe most) corporate defendants would prefer to settle than to fight. Nonetheless, federal courts should not be awarding fees in these cases that exceed the PSLRA’s “reasonable percentage” limitation (and a reasonable percentage of zero cannot exceed zero). The areas to watch most closely in 2019 are fee awards in merger objection cases and the analysis of scienter by district courts in event-driven class actions. Generous, permissive decisions in these areas will ensure that class action volume will continue to mushroom, and that something like 95% of all mergers will be challenged by non-meritorious suits that tax shareholders pointlessly. No claim is here made that we should discourage the traditional securities class action (which already must meet the high standards of the PSLRA), but the other two categories merit much greater judicial skepticism.

ENDNOTES

[1] These data come from Kevin M. LaCroix, “Securities Suit Filings Continued at Heightened Pace in 2018,” The D&O Diary, (January 6, 2019) at pp 1-2.

[2] Id. at 3. The litigation rate in 2017 was also a record at the time — 8.4%.

[3] See Cornerstone Research, “Securities Class Action Filings — 2018 Midyear Assessment” (2018). Loss in securities cases can be estimated in various ways, and I am here using Cornerstone’s data for the loss following the corrective disclosure (which came to $157 billion in the first half of 2018).

[4] See LaCroix, supra note 1, at 2.

[5] See In re Trulia Inc. Stockholders Litigation, 129 A. 2d 884, 898-99 (Del. Ch. 2016). The decision further made clear that disclosure only settlements were disfavored.

[6] After the Supreme Court’s decision in Bristol-Myers Squibb Co. v. Superior Court of California, 137 S. Ct. 1773 (2017), there is considerable doubt that a corporation can be sued except in states where it has its principal place of business or is incorporated. Also, many Delaware corporations have adopted forum selection bylaws under which they can only be sued in Delaware for fiduciary breach violations. Only the last factor can explain why Delaware cases have not migrated in large numbers to New York state courts (which to date have not followed Trulia).

[7] See LaCroix, supra note 1, at 2.

[8] Some seven cryptocurrency cases were filed as securities class actions in the first half of 2018. See Cornerstone Research, supra note 3, at p.2.

[9] The plaintiff’s law firm probably most closely associated with event-driven litigation is the Rosen Law Firm. The largest securities plaintiff’s law firms are less frequently involved in this type of litigation.

[10] See Section 21D(b)(2) of the Securities Exchange Act of 1934 (requiring plaintiff to “state with particularity facts giving rise to a  strong inference that the defendant acted with the required state of mind”).

[11] 888 F.3d 399 (9th Cir. 2017), cert. granted, 2019 U.S. LEXIS 8 (January 4, 2019).

[12] 2018 Del. Ch. LEXIS 578 (Del. Ch. Dec. 19, 2018).

[13] 138 S. Ct. 1061 (2018).

[14] Hal Scott, a Harvard Law professor, recently filed such a shareholder proxy proposal seeking a shareholder vote to add an arbitration clause to the corporation’s certificate of incorporation or bylaws at Johnson & Johnson. See “J&J Pulled into Court Fight,” Wall Street Journal, December 14, 2018 at B10. J&J has asked the SEC to permit it to omit the proposal.

[15] Under SEC Rule 14a-8(i), the proposal can be omitted from the corporation’s proxy statement on this basis, and corporate managements frequently seek a staff “no action” letter on this basis (as J&J has).

[16] 131 S. Ct. 1309 (2011).

[17] Some may want to argue for a change in the definition of materiality. But with a now Democratic House, this is legislatively impossible, and I greatly doubt that the Supreme Court will revisit its definition of materiality in Basic, Inc. v. Levinson, 485 U.S. 429 (1988), where it has just refused to examine another aspect of the decision in Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014). Thus, the scienter standard presents the one area where a tightening of standards seems the most feasible.

This post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.