If Matt Levine has a mantra in his "Money Stuff" column on Bloomberg, it's this: everything is securities fraud. "You know the basic idea," he often says in his most acerbic voice,
"A company does something bad, or something bad happens to it. Its stock price goes down, because of the bad thing. Shareholders sue: Doing the bad thing and not immediately telling shareholders about it, the shareholders say, is securities fraud. Even if the company does immediately tell shareholders about the bad thing, which is not particularly common, the shareholders might sue, claiming that the company failed to disclose the conditions and vulnerabilities that allowed the bad thing to happen. And so contributing to global warming is securities fraud, and sexual harassment by executives is securities fraud, and customer data breaches are securities fraud, and mistreating killer whales is securities fraud, and whatever else you've got. Securities fraud is a universal regulatory regime; anything bad that is done by or happens to a public company is also securities fraud, and it is often easier to punish the bad thing as securities fraud than it is to regulate it directly." (Money Stuff, 6/26/19)
In this rulemaking petition filed by the U.S. Chamber Institute for Legal Reform and the Center for Capital Markets Competitiveness of the U.S. Chamber of Commerce, petitioners ask the SEC to take on one aspect of this type of securities litigation—event-driven securities litigation arising out of the COVID-19 pandemic. Will the SEC take action?
Petitioners contend that, while the Private Securities Litigation Reform Act was enacted to prevent "frivolous 'strike' suits alleging violations of the Federal securities laws," it has not corrected all of the imbalances: in recent years, there has been "an explosion of securities class action filings," driven in part by the "advent of event-driven lawsuits that are filed when a public company's stock declines after a negative event." For example, securities litigation has been predicated on "wildfires, oil spills, product recalls, a plane crash, and a dam collapse." Petitioners consider these cases to often be of "dubious merit," filed to "extract a quick settlement." Petitioners report that securities class actions based on the disastrous COVID-19 pandemic have already been filed, and predict that "pandemic-related events will be seized upon as the basis for additional securities litigation."
But, petitioners maintain, the SEC has the authority to address this issue: the PSLRA provides authority for the SEC "to expand the PSLRA's statutory safe harbors and create additional exemptions from liability when appropriate. The Commission should exercise that authority and act without delay to place reasonable limits on securities litigation arising out of the COVID-19 pandemic."
According to Cornerstone Research, "[p]laintiffs filed 428 new securities class actions across federal and state courts, the highest number on record and nearly double the 1997-2018 average [of 215 cases]." Moreover, "[e]ach of the last three years—2017 through 2019—has been more active than any previous year." Petitioners consider the increase to be driven in large part by the growth of event-driven claims, citing in support Professor John Coffee of Columbia Law School:
"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.... 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."
In these cases, Coffee argues, plaintiff's counsel do not spend months building a case to plead scienter with particularity; rather, these cases are filed quickly, and "that may be because 'some plaintiff's counsel are less concerned about surviving a motion to dismiss because they expect an early (and cheap) settlement.'" The characteristics of this event-driven litigation, petitioners argue, are just like the those that led Congress to pass the PSLRA. Although the "legitimacy of these lawsuits is highly suspect," the litigation creates "a large potential exposure. The defense costs are high, and few companies want to risk the reputational damage that could result from prolonging the litigation of such claims."
This type of litigation, petitioners contend, is likely to be repeated in connection with the pandemic: "[i]f past history provides any lessons, the pandemic itself, which has already wreaked havoc on the stock market, has resulted in and will continue to cause significant securities litigation activity, including frivolous claims." Suits could potentially be based on pre- and post-pandemic statements about preparations, prospects for resumption of business, business interruptions and misstatements in the financial statements. For example, they suggest that numerous elements in the financial statements are, as a result of the pandemic, "tremendously uncertain" and therefore "highly susceptible to second-guessing in litigation if things don't turn out in accordance with the estimates embodied in the financial statements." Petitioners report that 20 COVID-related cases have already been filed and consider these cases just "the tip of a much larger iceberg," especially as the pandemic continues and companies face more uncertainty.
According to petitioners, the PSLRA is no longer providing the type of protection that was envisioned. Petitioners identify a number of holes in the PSLRA that they argue should be addressed, including financial statements prepared according to GAAP, IPOs, tender offers and other transactions, as well as "statements that are not forward-looking—or even potentially the parts of otherwise forward-looking statements that refer to present or historical facts." And, under the PSLRA, petitioners contend, the SEC is authorized to adopt new exemptions: the statutory safe harbors regarding forward-looking information "were meant to be a 'starting point.'"
Although in CF Disclosure Topics Nos. 9 and 9A (see this PubCo post and this PubCo post), Corp Fin provided useful guidance, more help is needed to "limit unjustified COVID-19 lawsuits—meaning lawsuits that turn on disclosures related to COVID-19 or its impacts, or allegations that the enormous changes wrought by COVID-19 made pre-pandemic statements untrue or misleading."
SideBar
From the get-go, SEC Commissioner Jay Clayton and other SEC officials repeatedly urged companies to be as forthcoming as possible about the impact of the pandemic, taking advantage of the safe harbor for forward-looking information where available, and assured companies that the SEC did "not expect to second guess good faith attempts" to provide "appropriately framed forward-looking information," or to object to "well-reasoned judgments." Apparently, the petition indicates, plaintiffs' attorneys are not similarly restrained.
In Corp Fin Disclosure Guidance 9, the staff recognized that the uncertainties associated with COVID-19 made its effect on specific companies difficult to predict and, in many circumstances, the impact was beyond a company's control and knowledge. Still, "the effects COVID-19 has had on a company, what management expects its future impact will be, how management is responding to evolving events, and how it is planning for COVID-19-related uncertainties can be material to investment and voting decisions."
In addition to the Corp Fin guidance, Clayton observed that investors were thirsting for information and urged companies to "continue to provide material information to investors, including information related to the current and expected effects of COVID-19, as promptly as practicable." In a statement to a meeting of the SEC's Investor Advisory Committee, Clayton stressed the importance of providing information to investors, particularly "in times of economic shock and uncertainty." The increased investor demand for information fueled by the uncertainties associated with COVID-19, together with the fact that, as a result of COVID-19, companies may not be able to file required periodic reports on a timely basis, has created "a challenge." Even if earnings releases and 8-Ks are the vehicles, he stressed that the importance of companies' providing "as much information as is practicable" cannot "be overstated." (See this PubCo post.)
In April, Clayton and Corp Fin Director Bill Hinman urged companies, as they issued earnings releases and conduct analyst and investor calls, to again provide as much information as practicable, focusing their disclosure less on historical information and more on "current financial and operating status, as well as future operational and financial planning" under "various COVID-19-related mitigation conditions." In addition, they advised, notwithstanding advice from many legal counsel cautioning companies to limit forward-looking disclosures to reduce legal risk and even though it seemed likely that "actual financial and operational results may differ substantially from what would now appear to be reasonable estimates," they encouraged companies to go for it and just take advantage of the safe harbors for forward-looking statements. "Given the uncertainty in our current business environment," they observed, they "would not expect to second guess good faith attempts to provide investors and other market participants appropriately framed forward-looking information." (See this PubCo post and this PubCo post.)
Also in April, SEC Chief Accountant Sagar Teotia issued a Statement on the Importance of High-Quality Financial Reporting in Light of the Significant Impacts of COVID-19, which addressed the challenge of making significant judgments and estimates in light of the acute uncertainty resulting from COVID-19. Consistent with OCA's historic positions, Teotia confirmed that OCA has "not objected to well-reasoned judgments that entities have made, and we will continue to apply this perspective." Teotia identified many accounting areas that may involve significant judgments and estimates in light of the evolving status of COVID-19, and stressed the importance of providing the required disclosures for estimates and judgments. (See this PubCo post.)
In their rulemaking petition, petitioners request that the SEC take the following actions:
1. Use its authority under the PSLRA
"to bar liability for statements about a company's plans or prospects for getting back to business, resuming sales or profitability, or other statements about the impacts of COVID-19, whether forward-looking or not—as long as suitable warnings were attached. Such warnings will remind investors of the tremendous uncertainty inherent in the ongoing pandemic, which has led to fastmoving changes to the health and business environment—while at the same time protecting companies already facing economic hardship and uncertainty from Monday-morning quarterbacking by plaintiffs' lawyers seeking to bring securities class actions just because the company's stock price dropped post-pandemic."
2. Alternatively, consider limiting liability for these types of statements to "circumstances in which the plaintiff can prove that the speaker had actual (subjective) knowledge of its falsity," effectively treating these statements as equivalent to statements of opinion for purposes of securities fraud claims. (See this PubCo post.) The petitioners maintain that, given the uncertainty created by COVID-19 on business operations and profitability,
"any statement necessarily incorporates a subjective assessment that should not be actionable unless this heightened scienter standard is satisfied. That approach would have the benefit of eliminating, or at least limiting, the ability of plaintiffs' lawyers to seize upon generalized pre-pandemic statements of emergency preparedness to argue that the company misrepresented its readiness and therefore is liable for stock price drops post-pandemic. Even in the early stages of the pandemic, there was a lack of consensus about the projected severity and duration of COVID-19—with scientists and government officials providing widely varying assessments. Requiring actual knowledge of the falsity of pre-pandemic statements will help ensure that the focus properly remains on the issuer's knowledge at the time the statement was made, not how well the statement holds up after-the-fact."
3. Require that financial statements (which are not protected under the PSLRA) include "a statement reminding financial statement users that a number of the elements of financial statements are determined on the basis of projections of future business or market conditions or by applying 'mark to market' standards and stating that due to the tremendous uncertainties flowing from the pandemic and its effect on the economy, there is a greater possibility of variation than in the past." The petitioners argue that many items in the financial statements are based on "current market conditions and projections, all of which are tremendously uncertain due to the pandemic and therefore are highly susceptible to second-guessing in litigation if things do not turn out in accordance with the estimates embodied in the financial statements." Accordingly, the petitioners advocate that the SEC
"bar liability for claims based on statements that satisfy these warnings, or alternatively, treat them as the equivalent of opinions that require proof of subjective knowledge of falsity in order to be actionable. This limitation on liability would not necessarily preclude all litigation, but it would address unjustified financial statement-based liability by limiting circumstances in which a lawsuit could be filed. Such warnings would also make it somewhat more difficult to establish reliance as well as impact on the market price for these types of securities lawsuits."
Originally Published by Cooley, November 2020
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