The history of securities litigation is marked by particular types of cases that come in waves:
- the IPO laddering cases, which involved more than 300 issuers and their underwriters;
- the Sarbanes-Oxley era “corporate scandal” cases, which involved massive litigation against Enron, WorldCom, Tyco, Adelphia, HealthSouth, and others;
- the mutual fund market timing cases;
- the stock options backdating cases, most of which were actually derivative cases, but many plaintiffs’ firms devoted class action resources to them;
- the credit crisis cases; and
- the Chinese reverse-merger cases.
In fact, the out-of-the-ordinary type of securities case has become ordinary; we have been in a series of waves for the past 20 years.
But we are not in one now, and I’m often asked, “What’s next?”
Although I don’t know if we’re about to enter a period of quirky cases, like stock options backdating, I’m confident that we’re going to experience a storm of non-M&A securities class actions caused by a convergence of factors: an increasing number of SEC whistleblower tips, a drumbeat for more aggressive securities regulation, a stock market poised for a drop, and an expanded group of plaintiffs’ firms that initiate securities class actions.
The SEC’s Whistleblower Program
The Dodd-Frank Wall Street Reform and Consumer Protection Act directed the SEC to give bounties to certain whistleblowers. With awards in the range of 10 percent to 30 percent of monetary sanctions over $1 million, the bounties were designed to attract meaningful tips.
The program caused a stir. Plaintiffs’ law firms established whistleblower practice groups and hired former SEC enforcement officials. The SEC created the Office of the Whistleblower, increased staffing, set up a website and hotline system, etc. Corporate firms published myriad client alerts and held hundreds of seminars—and braced for their own bounties, in the form of new work caused by more internal and SEC investigations, and resulting securities class actions. I told my family that I’d see them when I retired.
Yet it took a while for the whistleblower program to get rolling. The number and amount of the early awards were surprisingly low. But, as featured on the SEC’s website, they have increased steadily, and are now at significant levels. In total, the SEC has paid out more than $100 million in bounties. The number of tips has increased from 3,000 in the program’s first fiscal year to 4,000 last year. SEC Chair Mary Jo White calls the bounty program a “game changer” and Director of Enforcement Andrew Ceresney says it has had a “transformative impact on the agency.” Indeed, last year, the SEC filed 868 enforcement actions, a single-year high.
Calls for Increased Government Enforcement
Just as the bounty program is hitting its stride, the political environment again seems to be turning against corporations due to the perceived failure of the government’s securities enforcement efforts in the aftermath of the credit crisis and the recent Wells Fargo scandal, among other factors. And, of course, this election season has been marked by widespread anti-establishment sentiment.
During my nearly 25 years as a securities defense lawyer, I have seen the pendulum swing back and forth, from outrage against corporations, to outrage against the unfairness of SEC enforcement and the ethics of plaintiffs’ lawyers. Although I don’t think anti-corporate sentiment significantly changes the rate of government enforcement—they do the most they can with their resources, and are constrained by burdens of proof—I do strongly believe that anti-corporate sentiment increases the number and severity of private securities class actions.
We evaluate the state of the securities class action litigation environment primarily by reference to the rate at which cases are dismissed. Over the history of securities litigation, the biggest driver of the rate of dismissal is not any legal standard, but instead is the overall public attitude toward the value of private securities litigation. Whether facts are “particularized,” or an inference of scienter is “strong,” are subjective judgments that give judges wide latitude to dismiss a complaint, or not. Judges are people. They read the news. They talk to friends. They have children who are Millennials. They have seen people they thought were good do bad things. When public sentiment is anti-corporation, the judicial environment is inevitably influenced.
When the judicial environment changes, plaintiffs’ lawyers increase their investment in securities litigation—both in the number of cases they file, and how hard they litigate cases. Two waves of cases provide examples:
- In the Chinese reverse merger cases, plaintiffs’ firms filed securities class actions against virtually every Chinese company about which there was a report of a problem. Plaintiffs defeated nearly every motion to dismiss, especially in the Central District of California. Although the economic recoveries in those cases weren’t substantial due to a lack of company and insurance resources, several smaller plaintiffs’ firms went all in.
- In the stock option backdating cases, plaintiffs’ firms filed against nearly every company that had a potential backdating problem. Plaintiffs defeated motions to dismiss at a high rate, and settled cases for relatively large amounts. The backdating cases greatly raised the level of derivative settlements, established several smaller plaintiffs’ derivative firms as players in shareholder litigation, and were incredibly lucrative for larger plaintiffs’ firms.
Expansion of Plaintiffs’ Securities Class Action Firms
The stock-options backdating cases and the Chinese reverse merger cases have another thing in common: they have fueled an expansion of the plaintiffs’ bar.
The Reform Act’s lead plaintiff process incentivized plaintiffs’ firms to recruit institutional investors to serve as plaintiffs. For the most part, institutional investors, whether smaller unions or large funds, have retained a handful of prominent plaintiffs’ firms, and smaller plaintiffs’ firms have been left with individual investor clients who usually can’t beat out institutions for the lead-plaintiff role. At the same time, securities class action economics tightened in all but the largest cases. Dismissal rates under the Reform Act are pretty high, and defeating a motion to dismiss often requires significant investigative costs and intensive legal work. And the median settlement amount for cases that survive dismissal motions is fairly low.
These dynamics placed a premium on experience, efficiency, and scale. Larger firms thus filed the lion’s share of the cases, and smaller plaintiffs’ firms were unable to compete effectively for the lead plaintiff role, or make much money on their litigation investments.
This started to change with the wave of cases against Chinese issuers in 2010. Smaller plaintiffs’ firms initiated the lion’s share of them, as the larger firms were swamped with credit-crisis cases and likely were deterred by the relatively small damages, potentially high discovery costs, and uncertain insurance and company financial resources. Moreover, these cases fit smaller firms’ capabilities well; nearly all of the cases had “lawsuit blueprints” such as auditor resignations and/or short-seller reports, thereby reducing the smaller firms’ investigative costs and increasing their likelihood of surviving a motion to dismiss. The dismissal rate has indeed been low, and limited insurance and company resources have prompted early settlements for amounts that, while on the low side, appear to have yielded good outcomes for the smaller plaintiffs’ firms.
These outcomes built on gains smaller plaintiffs’ firms made during the stock options backdating cases, in which several smaller plaintiffs’ firms did quite well picking up matters in which the larger plaintiffs’ firms didn’t win the lead role, or working with the larger firms as co-counsel. Fueled by their economic and lead-plaintiff successes, these smaller firms have built up a head of steam that has kept them going, even after the wave of China cases subsided. For the last several years, following almost every “lawsuit blueprint” announcement, a smaller firm has launched an “investigation” of the company, and they have initiated an increasing number of cases. Like the China cases, these cases tend to be against smaller companies. Thus, smaller plaintiffs’ firms have discovered a class of cases—cases against smaller companies that have suffered well-publicized problems that reduce the plaintiffs’ firms’ investigative costs—for which they can win the lead plaintiff role and that they can prosecute at a sufficient profit margin.
Although it isn’t possible for me to know for sure, I strongly believe that there is a very large amount of capacity among the larger and smaller plaintiffs’ firms to increase securities class action filings. Larger plaintiffs’ firms have only recently finished working through the bulge of the credit crisis cases, and employ a large number of securities class action specialists who have time for more cases. And the smaller firms are aggressively filing cases and pursuing lead-plaintiff roles.
One of my mentors used to say that “nature abhors a vacuum,” when predicting that there would always be a steady supply of securities litigation. In a twist on this maxim, I like to say that plaintiffs’ securities class action specialists aren’t going to become doctors or dentists—or even derivative litigation lawyers. Instead, this large group of lawyers will always file as many securities class actions as they can. And now, with smaller plaintiffs’ firms hitting their stride, the supply of plaintiffs’ securities class action lawyers is very large, and is looking for more work.
Is There a Securities-Litigation Storm on the Horizon?
I believe that the convergence of these factors, as well as the predicted drop in the stock market, will significantly increase the number of securities class actions. Indeed, the next big wave in securities litigation may well not be a type of case caused by a unique event, such as options backdating, but instead a perfect storm of cases caused by a competitive blitz by plaintiffs’ firms, as companies report bad earnings results as the economy and stock market decline, and as whistleblower bounties and other SEC enforcement tools unearth disclosure problems. And throw in other lawsuit-drivers, such as short-seller hit-pieces, and we could see an unprecedented storm of securities class actions.