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Securities Litigation in 2019: Predictions and Speculations
ALM Media
John C. Coffee Jr.
The results are now in for 2018, and, in terms of securities class actions, it was another near-record year with a bumper crop of lawsuits. 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 percent above the average number for 1996 to 2016 (which was 193). (This data comes from Kevin M. LaCroix, “Securities Suit Filings Continued at Heightened Pace in 2018,” The D&O Diary, (Jan. 6, 2019) at pp 1-2.) Viewed together, 2017 and 2018 show a significant inflation in the rate of securities class action filings, particularly when one recognizes that the number of publicly listed companies has shrunk significantly (chiefly because of mergers and bankruptcies). 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 percent 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 percent rate is more than three times the average annual litigation rate over 1996-2016 (which was 2.9 percent). (Id. at p. 3. The litigation rate in 2017 was also a record at the time—8.4 percent.) As a result, public companies now face an over 1 in 12 chance this year of attracting a securities class action (if the 2018 rate persists).
More ominous still, the size of the alleged losses in securities litigation has also soared according to Cornerstone Research. Indeed, they find that the alleged losses in just the first half of 2018 were substantially greater than the alleged losses in all of 2017. (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).) Although the size of the alleged losses does not necessarily determine the size of the settlement (if any), it does make it impossible to characterize securities class actions as merely “nuisance litigation” when a loss could bankrupt even a sizeable company.
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, in 2018, the 403 total number of securities class actions filed in that year included some 185 “merger objection” suits (representing some 46 percent of this total). (See LaCroix at p 2.)
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 fees in cases that resulted in a “disclosure only” settlement. (See In re Trulia Stockholders Litigation, 129 A.2d 884, 898-99 (Del. Ch. 2016). The decision further made clear that “disclosure only” settlements were disfavored.) Although some of these formerly Delaware cases could have moved to other state courts, the vast majority appear to have simply shifted to federal court. Why? Although there are multiple reasons, one answer is that plaintiffs in other states could not establish personal jurisdiction over the defendant corporation where it was neither incorporated nor had its principal place of business in that jurisdiction. (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. This still does not explain why Delaware cases have not migrated in large numbers to New York state courts (which to date have not followed Trulia).)
Still, merger objection cases are not the only cause of the recent increase in volume. Indeed, even if we subtract away the 185 merger objection cases from the total of 403 cases, the remaining number (218) is still well above the prior average annual rate (193). (See LaCroix at p. 2.) What explains this increase? Although 2018 saw a few new types of cases (e.g., some seven cryptocurrency cases were filed as securities class actions in the first half of 2018 (see Cornerstone Research at p.2)), the better explanation 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 Lions 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 action on the ground that its aluminum cladding was responsible for the intensity of the Grenfell Towers 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. (The plaintiff’s law firm probably most closely associated with “event-driven” litigation is the Rosen Law Firm. The largest securities plaintiffs law firms are less frequently involved in this type of litigation.) 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 PSLRA demands. (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”).) 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 interested in preparing to survive a motion to dismiss because they expect an early (and cheap) settlement.
As just described, 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. What may happen in 2019 in each of these categories? Let’s take each one at a time:
Merger Objection Cases
Defendants are hoping that the Supreme Court’s decision earlier this month to grant certiorari in Varjabedian v. Emulex, 888 F.3d 399 (9th Cir. 2017), cert. granted, 2019 U.S. LEXIS 8 (Jan. 4, 2019) 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 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 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, what if the court either says that there is no private cause of action 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 just 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 fact, at least in the vast majority of such cases, they do not. Rather, they are either (1) exploiting the lawsuit’s potential ability to disrupt the merger’s timetable or (2) selling preclusion because the frivolous suit may prevent other litigation with greater merit. Hence, the fact that they 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 many complaints in “merger objection” cases would not satisfy Rule 11’s requirements, and thus mandatory sanctions are 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, “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.
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. 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. Saltzberg, 2018 Del. Ch. LEXIS 578 (Del. Ch. Dec. 19, 2018), 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 v. Beaver County Employees Retirement Fund, 138 S. Ct. 1061 (2018), 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. Saltzberg 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 interest groups to adopt such a bylaw mandating arbitration. (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, Dec. 14, 2018 at B10. J&J has asked the SEC to permit it to omit the proposal.) Now, in the wake of Sciabucucchi, 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.” (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).)
Event-Driven Class Actions
How skeptically should federal courts view “event-driven” securities class actions? Where 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 v. Siracusano, 131 S. Ct. 1309 (2011). Essentially, it found that plaintiff’s allegations that defendants’ failure to disclose warnings that it had received from doctors and hospitals that its cold remedy (Xicam) caused many patients to lose their sense of smell satisfied both the materiality and scienter standards for Rule 10b-5. The facts in Matrixx Initiatives were extreme, but often it will be the case that the defendant has received some warnings. Moreover, 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.
The bottom line is that there is no obvious reason why the number of securities class actions should 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. Still, 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 actions volume will continue to grow, and that something like 95 percent of all mergers will be challenged by non-meritorious suits that tax shareholders pointlessly.
John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.
