Is Everything Securities Fraud?

Securities litigation is almost inevitable for any public company.  Often, investors sue because the firm’s managers engaged in fraud that directly harmed the shareholders – say, by doctoring the firm’s financials or lying about known business prospects.  However, shareholders also sue their companies when those companies engage in conduct that more directly harms a different set of constituents.  When a pharmaceutical company sells dangerously contaminated drugs, a faulty car battery bursts into flames, or an oil rig explodes, it’s difficult to say that the direct victims of the misconduct are the companies’ shareholders.  Yet shareholders commonly base lawsuits under the federal securities laws on precisely this kind of conduct, arguing that the managers did not adequately disclose the underlying facts, and investors were harmed by the resulting drop in stock price.  This has led at least one notable commentator to argue that “everything is securities fraud.”[1]  Objections from industry and academia to these lawsuits, dubbed “event-driven litigation,” are increasingly vocal.  However, despite greater interest in these lawsuits,[2] there has so far not been a comprehensive study of their prevalence, attributes, and outcomes.

In my article, Is Everything Securities Fraud?, I address this gap by conducting a comprehensive empirical analysis of event-driven securities class actions.  In a sample of nearly 500 securities class actions against public firms from 2010-2015, I find that a non-trivial 16.5 percent of securities class actions arise from misconduct where the most direct victims are not shareholders.[3]  While still a minority of the lawsuits, these cases have a significantly lower dismissal rate and generate higher settlements than cases where the primary victims are shareholders.  Investors are 20 percent more likely to have their lawsuit dismissed if the misconduct at issue primarily harms them. The average shareholder settlement is more than double in cases where the misconduct most directly harms other victims than in cases where the primary victims are shareholders.  Accordingly, the empirical analysis supports the notion that event-driven securities class actions are big-ticket cases; substantial money and resources are tied up in securities lawsuits where the primary victim is not a shareholder.

This situation is likely due in large part to my second finding, which is that, in these lawsuits, shareholder plaintiffs almost universally benefit from government investigations into the defendant firms’ misconduct, usually by agencies other than the SEC.  When bringing Rule 10b-5 lawsuits, class action plaintiffs must plead their claims with heightened specificity but without the benefit of discovery; a government investigation can make this task far less costly by making public the facts necessary for a successful complaint.  Securities plaintiffs’ lawyers may freeride on such investigations  to reap larger fees with less effort.[4]

In examining the parties to event-driven securities class actions, I find that the majority of these lawsuits are brought by institutional investors (particularly pension funds), and the top-tier plaintiffs’ lawyers that serve them.  I also find that defendant firms in these cases are generally much larger than those in cases where the primary harm is to shareholders.  This finding further confirms that event-driven lawsuits are a significant phenomenon, and that the major players in securities class action litigation are behind these lawsuits.

These results, which to my knowledge are the first of their kind, can help inform the burgeoning debate over the desirability of event-driven securities litigation.  A key question in this debate is whether these lawsuits are meritorious.  Many of the characteristics shared by the event-driven cases in my sample – government investigations, low dismissal rates, high settlement values, and institutional lead plaintiffs – are often viewed as proxies for merit in the securities class action context.  Should we then conclude that the criticism directed against these cases is misplaced?  Not so fast. First, the non-SEC investigations that accompany these lawsuits may not be a good proxy for merit because the relevant regulators – the Environmental Protection Agency, Food and Drug Administration, and the like – focus on environmental protection, food and drug safety, or other matters unrelated to investor fraud. Such investigations therefore may not signal meritorious grounds for shareholder recovery.   Further, the pressure to settle such cases is intense, and institutional investors may cherry pick these cases because they are relatively easy to bring and generally involve deep-pocketed defendants.

A second question is whether, irrespective of their benefits to shareholders and their merits, these lawsuits play a valuable role in deterring, compensating, or monitoring the external costs these firms impose on third parties.  Available data from my sample show that event-driven securities class actions may help deter firms from conduct that harms third parties; in about 20 percent of the event-driven cases in my sample, there is a shareholder recovery even though neither the harmed third party nor any regulator recovered anything.  However, it is unclear, based on the amount of these settlements, to what extent they fill a deterrence gap or constitute nuisance settlements.  From a compensation standpoint, these lawsuits by definition do not compensate third-party victims of corporate misconduct, and some leading scholars have argued that they do not compensate shareholders very effectively either.[5]  Finally, these lawsuits arguably fall short as monitoring mechanisms that can curtail harm to third parties.  Managers often pass costs on to third parties (whether by shoddy manufacturing, false advertising, or inadequate safety) in order to bolster their company’s share price.  Thus, shareholders may actually prefer that managers pursue such misconduct as long as the odds of detection are low.  The relative success of event-driven securities class actions may reinforce this preference; shareholders may figure that if the management is not caught, shares will increase in value, and, if the management is caught, they will be able to recoup at least some of their losses through settlements after the fact.  Furthermore, monitoring via event-driven securities class actions is suboptimal because these lawsuits occur after millions of barrels of oil flood the Gulf of Mexico, the new sports car bursts into flame, or the contaminated Tylenol has been swallowed.  And even as an ex post enforcement mechanism, such lawsuits are inadequate. They do not prevent firms from trying to avoid liability with vague or even non-existent disclosure about risks that can harm third parties rather than providing the kind of specific disclosure that would be useful in monitoring those risks.[6]

Finally, I make several broad proposals about mandatory operational risk and ESG reporting.[7]  Requiring more specific disclosures of catastrophic risks that might affect outsiders, as well as of the measures firms take to be responsible corporate citizens, would enable shareholders and the general public to better monitor these risks.  Event-drive cases could be useful in enforcing the accuracy of such disclosures.  Building on future data, these proposals could be a first step toward improving the quality of these lawsuits and their effectiveness in curbing harmful practices.

ENDNOTES

[1] Matt Levine, Opinion, Snap Earnings and Emissions Fraud, Bloomberg (May 11, 2017, 9:10 AM), https://www.bloomberg.com/opinion/articles/2017-05-11/snap-earnings-and-emissions-fraud.

[2] See, e.g., John C. Coffee, Jr., Securities Litigation in 2017: “It Was the Best of Times, It Was the Worst of Times, CLS Blue Sky Blog (Mar. 19, 2018), https://clsbluesky.law.columbia.edu/2018/03/19/securities-litigation-in-2017-it-was-the-best-of-times-it-was-the-worst-of-times/; Michael Klausner et al., Guest Post:  “Stock-Drop Lawsuits, The D&O Diary (June 28, 2020), https://www.dandodiary.com/2020/06/articles/securities-litigation/guest-post-stock-drop-lawsuits/.

[3] Ending this sample in 2015 minimizes ongoing litigation; more recent trends will be the subject of future work.

[4] Stephen Choi, Jessica Erickson & Adam C. Pritchard, Working Hard or Making Work?  Plaintiffs’ Attorney Fees in Securities Fraud Class Actions (NYU L. & Econ. Rsch. Paper Series, Working Paper No. 19-31, 2019).

[5] See, e.g., William W. Bratton & Michael L. Wachter, The Political Economy of Fraud on the Market, 160 U. Pa. L. Rev. 69 (2011); Merritt B. Fox, Why Civil Liability for Disclosure Violations When Issuers Do Not Trade?, 2009 Wis. L. Rev. 297 (2009).

[6] See Donald C. Langevoort, Disasters and Disclosures: Securities Fraud Liability in the Shadow of a Corporate Catastrophe, 107 Geo. L.J. 967 (2019).

[7] See Jill E. Fisch, Making Sustainability Disclosure Sustainable, 107 Geo. L.J. 923 (2019).

This post comes to us from Emily Strauss at the Duke University School of Law. It is based on her recent paper, “Is Everything Securities Fraud,” available here. A version of this post appeared on the Oxford Business Law Blog.

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