Securities class actions soared in 2017, jumping from 271 filings in 2016 to a near record 412 filings in 2017 — well above the average of 193 per year for the years 1997 to 2016.[1] Only 2001 was comparable, although both 2001 and 2017 were inflated by special factors.[2] Now add to this growth the $3 billion settlement in the Petrobras litigation earlier this year (plus the highly favorable ruling by the Second Circuit in Petrobras last year).[3] The result may be the same as when the discovery of gold at Sutter’s Mill was announced to the world. The plaintiff’s bar may come running.

Still, the high number of cases is only one factor that made 2017 unique. Perhaps more importantly, the likelihood that a public company would be sued in a securities class action also jumped sharply in 2017 to 8.4 percent, with this rate more than doubling since 2014.[4] This is partly the product of the decline in the number of public companies, as well as the increase in the number of suits. Further, this factor of litigation intensity varies greatly by industry. If we look to the Standard Industrial Classification (“SIC”) codes , we find that SIC Code 283 (“Drugs”) saw 66 securities class actions filed in 2017.[5] If we add to that number the 16 securities class actions filed against firms in SIC Code 314 (“Medical, Surgical and Dental Instruments and Supplies”), we find that companies in the broader pharmaceutical field accounted for nearly 20 percent of all 2017 securities class actions.[6] This combination of sudden growth and high litigation intensity concentrated on a few industries means some oxen have been gored badly and raises the prospect of a political backlash. It is as predictable that “pharma” companies will lobby for litigation relief (possibly through mandatory arbitration clauses in corporate charters or bylaws) as that they will raise drug prices aggressively.

At this point, it is important to unpack these gross numbers to see what is really new. Two important and problematic trends lie just below the surface. First, the migration of “merger objection” cases from Delaware to federal court explains much (but not all) of the increase in securities class actions in 2017. Of the 412 securities class actions filed in 2017, 198 (or 48 percent) were merger objection cases.[7] The number of such class actions in federal court has grown from 13 in 2004, to 34 in 2015, to 85 in 2016, and now to 198 in 2017. The percentage that they represent of all securities class actions has similarly increased, from 31 percent in 2016 to 48 percent in 2017. The first two months of 2018 suggest that this trend is continuing.

The reasons for this migration seem clear. Delaware grew increasingly disgusted with such suits, as they tend to result in “disclosure only” settlements that do not benefit the class and may preclude meritorious cases filed in another jurisdiction. Effectively, Delaware shut down the “market for preclusion” in its Trulia decision in 2016, which made clear that attorney’s fees would not be awarded for “disclosure only” settlements.[8] Some plaintiff’s attorneys have migrated instead to New York state courts[9], but here they may be blocked by forum selection clauses that Delaware has now authorized by statute. Because these clauses cannot apply to suits in federal court, federal court has become the preferred forum, where plaintiffs can assert disclosure violations based on the federal proxy rules or Rule 10b-5.

Still, in federal court, “merger objection” cases face a bleak fate. Cornerstone Research finds that the dismissal rate for such cases ranged between 74 percent and 77 percent from 2014 to 2017, in contrast to a much lower dismissal rate for other securities class actions that ranged between 15 percent and 54 percent over the same period.[10] But some companies do settle, possibly to purchase preclusion that protects them from more meritorious actions elsewhere. Alternatively, a corporate management may be willing to pay the plaintiff’s attorney fees in order to protect its timetable in a multi-billion-dollar merger. From its perspective, a $1 million payoff to a plaintiff’s attorney to settle a “merger objection” suit is the equivalent of a rounding error when the merger is, hypothetically, for $30 billion or more.

But even if defense counsel recognize that it is often better to settle than to fight, there remains an integrity problem. For a federal judge to certify a class action, the court must find that the plaintiff and class counsel are both capable of providing “adequate representation.”[11] Further, the court must find the settlement to be fair. This is difficult when the class gets nothing other than meaningless disclosures. Thus, defense counsel who present a “disclosure only” settlement to the court should realize that they are presenting the court with an ethical challenge. Can it realistically find such an empty settlement fair, and thereby preclude other actions which might be more vigorously and competently asserted? Possibly, the judge could rationalize: “Because this case has no merit, a worthless settlement is fair.” But the judge does not actually know this; rather, the court knows only that the action, as asserted by the plaintiff’s attorney before him, seemed worthless (but other and better actions may be precluded).

For the moment, let’s move from “merger objection” suits to the other new trend: “event-driven” class actions.[12] Traditional securities class actions usually involve financial misrepresentations, but other forms of misrepresentation are certainly possible. Increasingly, an adverse event will trigger a securities class action: an explosion, a crash, a mass torts episode (such as a toxic drug with a side effect). The largest class action settlement in 2017 ($175 million) was paid by BP p.l.c., and the triggering event was the Deepwater Horizon explosion.[13] In these cases, the first suits were by injured consumers, workers, or others with tort claims, but the caboose on this train is the securities class action, which will claim that investors were injured by the defendant company’s failure to disclose its misconduct or negligence. Sometimes, this reasoning seems strained. For example, it might be doubted that BP knew that the Deepwater Horizon was likely to explode or that it acted with scienter to conceal this remote risk.

Still, in other cases, the Supreme Court has upheld the materiality of the omission. For example, in 2011 in Matrixx Initiatives, Inc. v. Siracusano,[14] the claim was that the defendant knew that there had been credible reports that its best-selling medicine (Zicam Cold Remedy) could cause the loss of the sense of smell. Even though there had not been enough adverse events to satisfy the standard of statistical significance, the Court found the possible association to be material, because independent medical researchers had begun to sound the alarm. Statistical significance, it emphasized, was not the test of materiality.

Similarly, in 2015, in Omnicare, Inc. v. Laborers Dist. Council Constr. Indus. Pension Fund,[15] the Court found that a statement of opinion that the company “believed” itself to be in compliance with the law could be materially misleading if investors assumed that this statement implied that the company had made a procedurally adequate investigation to support its views. Thus, when Omnicare’s stock price fell after a federal raid on the company to seize evidence, the earlier statement of opinion as to law compliance could be used by plaintiffs to show a misleading statement or omission.

These cases establish only that an adverse event (whether a criminal misdeed or a harmful side effect) can be the basis for a securities fraud class action. But the cases filed in 2017 push the envelope on this principle to the limit. For example, a class action was filed against Arconic in the Southern District of New York. (and then later refiled in the Eastern District of Pennsylvania) based on the Grenfell Tower fire in London.[16] That building was clad in Reynobond, a lightweight building material produced by Arconic that may have been especially flammable. Still, major skyscraper fires have been rare events, and thus the facts in this case are more debatable than in Matrixx Initiatives. Even more troubling is Hall v. Johnson & Johnson, now pending in federal court in New Jersey.[17] Here, the claim is that Johnson & Johnson “knew for decades” that cancer-causing asbestos “was present in the talc in its Johnson’s Baby Powder.” How does one plead this allegation with sufficient particularity to survive a motion to dismiss? Answer: The complaint quotes from a press release issued by the personal injury lawyers suing Johnson & Johnson.[18] (I would as soon rely on “facts” stated on the editorial page of the New York Post). Finally, a securities class action has been filed in the Southern District of New York in 2018 against RYB Education, a Chinese company that did an IPO in the U.S. last year, alleging that RYB knew of pervasive child abuse at its schools in China.[19]

The trend in “event-driven” litigation appears to be to file early, soon after the stock drop, and without the more elaborate investigation that the larger established plaintiff’s firms today employ in securities litigation. Here, we get to the nub of the matter. Securities litigation has recently seen a number of new plaintiff’s firms enter the field. These new entrants have little hope of wresting control of a major securities class action involving financial irregularities (such as a Petrobras), because they do not have relationships with the major institutional investors who could serve as lead plaintiff. Thus, they need to focus on smaller cases or cases involving factual claims (such as that Johnson’s Baby Powder causes cancer) that larger institutional investors might feel uncomfortable asserting. In this light, the Private Securities Litigation Return Act (and its lead plaintiff provisions) has had an unintended consequence, erecting a high barrier to new entrants, because the new entrant will not have a relationship with the major public pension funds (possibly because they cannot afford to “pay to play”). Thus, the newer entrant must fear that an established plaintiff’s firm will wrestle control of a case from it (through its association with large institutional clients). As a result, the new entrant needs to move quickly and generally focus on smaller defendants.

The upshot, then, is that a two-tier plaintiff’s bar is emerging, in which the older tier will continue to focus on financial irregularity cases, because they can win control of these cases. The new entrants are likely to focus on “event-driven” cases because that is what is left to them. Here, they may have an advantage in that they can free ride on discovery conducted by personal injury and similar plaintiff’s lawyers who sued ahead of them, and this may sometimes allow them to write an adequately particularized complaint. But, when the action moves on to later stages, issues such as loss causation loom that could be fatal to their action (unless they settle cheaply).

Still, this scope of “event-driven” litigation could expand rapidly. If corporate boards have two nightmares today for which they have no adequate answers, those two nightmares are: (1) cybersecurity and (2) Harvey Weinstein-style sexual harassment allegations. Imagine that a skilled hacker penetrates security at a major bank and gains access to data on millions of its customers. Predictably, this will generate bad feelings and customer litigation against the bank, and if its stock price drops, securities litigation will follow close on the heels of the initial litigation. Correspondingly, suppose that a Steve Wynn did not resign as CEO of Wynn Resorts, and its stock price dropped in light of the charges of sexual harassment against him. These may be the “event-driven” cases of the future.

Finally, let’s return to “merger objection” cases. These also tend to be brought by a specialized segment of the plaintiff’s bar. Usually characterized as “bottom fishers,” these law firms do not bring (or work on) the major financial irregularities cases; nor are they nimble enough to bring “event-driven” litigation. Instead, they simply challenge every merger and are content to settle apparently only a quarter of the cases they bring. In so doing, they impose an unjustifiable tax on shareholders and mergers.

How should they be dealt with? It would be disappointing if “merger objection” suits were expelled from Delaware only to find a safe haven in federal court. Federal courts have several options open to them: (1) they could refuse to certify the class; (2) they could refuse to approve the settlement; (3) they could refuse to award fees; or (4) they could award sanctions on their own motion (because defendants cannot credibly settle and then seek sanctions).[20] Of these options, the simplest is probably to refuse approval of the settlement. Over the intermediate to long term, this approval may convince defense counsel not to expect federal courts to bless collusive deals.

Once upon a time, courts might wink and nod at “merger objection” cases and cooperate in their settlement. But with these cases now approaching 50 percent of all securities class actions, this “business-as-usual” approach cannot (and should not) continue. As a result, the immediate future may prove to be the best of times for the established plaintiff’s bar in securities class actions and the worst of times for the others.

ENDNOTES

[1] This data comes from Cornerstone Research and is available online. They show the number of class action filings for the last five years as: 2012: 151; 2013: 165; 2014: 168; 2015: 207; 2016: 271; and 2017: 412.

[2] 2001 had a higher number, but that year was uniquely affected by “IPO laddering” cases. 2017, as discussed below, had a unique number of “merger objection” cases.

[3] See In re Petrobras Sec. Litigation, 862 F.3d 250 (2^nd Cir. 2017) (simplifying proof of ascertainability and evidence needed to establish “fraud on the market”).

[4] Cornerstone Research shows the percentage of U.S. listed companies subject to securities class action filings for the years 2012 to 2017 as: 2012: 2.8%; 2013: 3.4%; 2014: 3.5%; 2015: 4.3%; 2016: 5.6%; and 2017: 8.4%. This increase was substantially (but not entirely) caused by the hyperbolic increase in “merger objection” cases.

[5] See Kevin La Croix, “Securities Suit Filings at Historically High Levels During 2017,” The D&O Diary, January 1, 2018. This comes to 16% of the 412 securities class action filings reported by Cornerstone.

[6] Id. The exact percentage (based on 412 class actions) is 19.9%.

[7] See Cornerstone Research, supra note 1.

[8] See In re Trulia Inc. Stockholder Litigation, 129 A.3d 884 (Del. Ch. 2016) (fee award justified in “disclosure only” suit only when revised disclosure is “plainly material”).

[9] See Gordon v. Verizon Commc’ns, Inc., 148 App. Div. 3d 146, 46 N.Y.S. 557 (1^st Dept. 2017). Still, lower court judges in New York state are properly refusing to grant fee awards for worthless settlements. See City Trading Fund v. NYC, 2018 WL 792283 (N.Y. Sup. Ct Feb 8, 2018). This decision by Judge Shirley Werner Kornreich may be a bellwether.

[10] See Cornerstone Research, supra note 1.

[11] See Rule 23(a)(4) of the Federal Rules of Civil Procedure.

[12] The term “event-driven” appears to have been coined by Kevin La Croix. See Kevin La Croix, “Turning Events into Securities Suits,” The D&O Diary, July 17, 2017. Still, they have been around for some time. ISS Securities Class Action Services lists the $265 million paid to settle the Massey Energy Company class action in 2010 as the 64^th largest class action settlement. It followed a mine explosion that killed many and later produced a criminal conviction of Massey’s CEO.

[13] ISS Securities Class Action Services lists the BP case, which was settled for $175 million, as the 88^th largest securities class action settlement.

[14] 133 S. Ct. 1309 (2011).

[15] 135 S. Ct. 1318 (2015).

[16] For a discussion of this case, see Kevin La Croix, supra note 12. Lead counsel is the Pomerantz Law Firm.

[17] This case was filed on February 8, 2018 in federal court in New Jersey. As with much “events-driven” litigation, it uses an individual (and not an institutional) plaintiff and was filed by a new entrant into securities litigation (although a very active one): The Rosen Law Firm.

[18] See Hall v. Johnson & Johnson, Complaint at paragraph 65 (citing and relying on press release by the Beasley Allen Law Firm).

[19] See Kevin La Croix, “Chinese Preschools’ Child Abuse Reports Lead to U.S. Securities Suit Against Recent IPO Company,” The D&O Diary, November 28, 2017.

[20] Under Section 21 D(c) of the Securities Exchange Act of 1934, the court “upon final adjudication of the action” must “include in the record specific findings regarding compliance” with Rule 11(b) of the Federal Rules of Civil Procedure. In the case of “merger objection” litigation, many, if not most, complaints would flunk the standard required by Rule II. I make no similar claim about “event-driven” litigation, which is far more variable.

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.