Operating in a Pandemic: Securities Litigation Risk and Navigating Disclosure Concerns

J. Timothy Mast is a partner at Troutman Sanders LLP; Pamela S. Palmer and Robert L. Hickok are partners at Pepper Hamilton LLP. This post is based on a joint Pepper Hamilton and Troutman Sanders memorandum by Mr. Mast, Mr. Palmer, Mr. Hickok, David I. Meyers, Alexandra S. Peurach, and Douglas D. Herrmann.

The COVID-19 pandemic has introduced new corporate disclosure issues and increased the attendant risk of securities fraud actions, as evidenced by plaintiffs’ initial filings across the country in the past few weeks. This article discusses the significance of those initial suits to public reporting companies and how companies can tailor and update their disclosures to lessen the risk of future lawsuits. We also explore potential D&O liability risk arising in the context of the pandemic, including risk in the context of insolvency that is facing many companies for the first time.

Ultimately, public companies’ best defense is to be thoughtful and diligent in updating their risk disclosures and any earnings guidance—and possibly to withdraw guidance altogether at this time—as well as to ensure close collaboration with their accountants and auditors on the accuracy of estimates, reserves, asset valuations, and other impacted financial reporting matters. Internally, companies should take steps to make sure their internal controls are sufficient to manage heightened and new risks. Risk avoidance is the last bastion in the battle for corporate health and longevity during this tumultuous time in history and in the stock markets.

I. Section 10(b) Securities Class Actions

Like many times when event-driven securities litigation thrives, the increase in stock market volatility associated with the pandemic has caused sudden drops in the prices of many companies’ securities. A drop in stock price is a pre-condition that the plaintiffs’ bar looks for in bringing a securities class action pursuant to Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. Plaintiffs typically allege the drop in stock price was the result of the stock market learning about a misstatement or omission of material information made by the company. Consequently, we expect to see increased litigation focused on disclosure and accounting issues arising out of changed operating circumstances created by the pandemic.

Past experience and logic suggest that lawsuits will likely allege that some companies overstated performance or prospects of products in the pandemic and its aftermath, while others understated or failed to disclose operational and financial challenges and risks. Lawsuits also may allege that companies have not properly accounted for the financial impact of the pandemic. Key accounting issues are likely to include subsequent events reporting, going concern issues, asset impairment issues, and the need to restructure or even default on certain payment obligations. We are now moving into earnings season when calendar year-end companies will report their first quarter 2020 results. If the stock market reacts adversely to a company’s quarterly report, that likely will trigger a closer look by the plaintiffs’ securities bar at past company disclosures, which ultimately could lead to a lawsuit. Drawing by analogy from the 2008 financial crisis, we saw a marked increase in the filing of securities class actions during that period of substantial stock market volatility for the financial sectors and mortgage-related industries in particular. Here, early indicators show higher risk profiles for companies whose business is directly affected by the pandemic, including companies in the healthcare, life sciences, pharmaceutical, airline, tourism, and energy industries.

In fact, the first securities class action lawsuits arising from the COVID-19 pandemic were filed against companies in industries immediately affected by the pandemic. Three lawsuits were filed against Norwegian Cruise Lines by shareholder plaintiffs pursuant to Section 10(b), alleging securities fraud based on allegations that the company discussed positive outlooks for the company’s cruise ship operations in its public disclosures filed with the SEC in February 2020 “in spite of the COVID-19 outbreak” which was already underway. While the company had actually discussed the risks of COVID-19 and its “current known impact” in the challenged disclosures, the plaintiffs alleged that this disclosure was not sufficient, and the company should have also disclosed certain adverse facts about its ongoing sales tactics and current business operations. Additionally, a lawsuit has been filed against Inovio Pharmaceuticals, alleging that the company’s CEO falsely claimed that the company had successfully developed a vaccine against the spread of COVID-19 and that it anticipated rapidly bringing the vaccine to market. The Inovio suit tells us that pharmaceutical companies working on medicines that might be used to treat the coronavirus should be careful to appropriately qualify their enthusiasm about medicines, devices, processes, and testing.

While certainly specific industries will be more directly and severely impacted by COVID-19, one of the unique circumstances we face is that the pandemic is impacting almost all industries in one way or another. Consequently, we are already seeing COVID-19 related securities class action lawsuits filed against companies with more tangential connections to the pandemic. Most recently, two lawsuits alleging violations of Section 10(b) were filed against iAnthus Capital Holdings (“iAnthus”), a cannabis company incorporated in Canada with shares trading on the OTCQX. According to the complaints, iAnthus received millions from Gotham Green Partners in a debenture financing that called for withholding and escrow of one year’s interest to assure payment in the event iAnthus defaulted. On April 6, 2020, iAnthus announced that it did not make the required interest payment because of the “decline in the overall public equity cannabis markets, coupled with the extraordinary market conditions that began in Q1 2020 due to the novel coronavirus known as COVID-19 pandemic,” which caused liquidity constraints for iAnthus. iAnthus’ stock price dropped upon news of the default and the securities class action complaints followed. The complaints allege that iAnthus failed to disclose why it did not use the escrowed funds under the debenture agreement to make the interest payment.

Investors have also filed suits under Section 10(b) against Zoom Video Communications (“Zoom”) based on allegations that the surge in use of Zoom’s video-conferencing services following the coronavirus outbreak revealed previously undisclosed weaknesses in the company’s security and privacy—including lack of end-to-end encryption—allegedly contrary to the company’s existing disclosures. The plaintiffs alleged the truth did not emerge—for purposes of establishing loss causation—until, on March 26, 2020, reports began to surface in the press detailing apparent breaches in the company’s privacy policies, data collection practices, and alleged transfers of user data or accessibility of user data arising during heavy usage amid pandemic and shelter-in-place orders. On March 30, 2020, the New York Times reported an investigation by the New York Attorney General. News outlets reported on March 30, 2020 that the FBI had issued a warning about “Zoombombing,” where hackers took over video-conferencing on the Zoom app. On April 1, 2020, Zoom allegedly corrected the record by acknowledging in a public statement to users that the company had “fallen short of the community’s . . . privacy and security expectations” and, on April 4, 2020, the Wall Street Journal reported that in an interview the CEO admitted “if we mess up again, it’s done” and that “[he] really messed up as CEO.” Following these and related disclosures, Zoom’s stock experienced what the plaintiffs claim was a “precipitous decline” in market value.

The securities complaints against iAnthus and Zoom illustrate a form of pandemic stress-test from which other companies can gain valuable insight. The iAnthus lawsuit raised questions about the company’s decision to default on payment obligations and the Zoom lawsuit raised questions about hidden deficiencies in products and services. Future securities lawsuits may allege failure to disclose weaknesses in a company’s financial statements, products, services, or supply chain that come to light in the stress of operations due to the pandemic. In this upcoming reporting period, disclosures that may be seen in hindsight to mitigate or soften negative impacts of the pandemic—or to strongly tout competitive advantages—could lead to litigation down the road if the disclosures are later shown to be inaccurate with the benefit of hindsight.

Given the volatile and depressed stock market, we believe a strong defense for companies will be to challenge the presumption of market efficiency on which Section 10(b) actions rely as a substitute for pleading and proof of actual investor reliance on the alleged misstatements or omissions. Plaintiffs typically seek to satisfy the reliance requirement of a 10b-5 fraud claim by alleging a presumption of reliance under the Basic, Inc. v. Levinson standard because the company’s securities trade in an efficient market that responds rapidly to material information. With all of the volatility and disruptions in the market, including trading suspensions in some instances, we expect greater opportunities for companies to argue that their stock was not actually trading in an efficient market and, therefore, price gains and drops do not reflect efficient market reaction to revealing disclosures, thereby rebutting the presumption of reliance under Basic.

A closely related issue is that market volatility also may interfere with the plaintiff’s ability to plead and prove that a company-specific misstatement or omission caused the plaintiff’s loss—known as the element of “loss causation.” When a market-wide event causes losses to nearly all companies, including by sector, and there is unprecedented volatility, it is more difficult for plaintiffs to prove loss causation. Working with forensic economists, defense counsel often use statistical methodologies, such as event studies, to show that a drop in the stock price was caused by general economic or market factors, and not by company-specific information, in order to defeat loss causation on a class-wide basis. Techniques that plaintiffs use to show allegedly fraudulent inflation in a company’s stock price following a positive disclosure, and cast this alleged inflation back through the class period to prove loss causation and damages, simply may not be valid when the effects of market or industry forces on the price, such as the ongoing COVID-19 pandemic, cannot be separated from the effects of any company-specific information.

In the 2008 financial crisis, some defendants were able to obtain dismissal at the pleading stage by arguing that plaintiffs failed to adequately plead loss causation where a company’s stock lost significant value but the price drop at the time of the alleged corrective disclosure tracked declines across its industry peers. A lesson for investors is that the securities laws are not an insurance policy for unexpected market-wide events.

II. SEC Disclosures

While the ongoing COVID-19 pandemic has had a significant impact on businesses around the globe, the full extent of this impact remains unclear and related SEC disclosures will be subject to scrutiny—both by regulators and by investors. Public companies will be forced to grapple with disclosure of the material impact the COVID-19 pandemic has had and is expected to have on their business.

To assist in this formidable endeavor, the SEC not only has provided public companies a 45-day extension for filing disclosure reports, but also has issued extensive disclosure guidance regarding COVID-19. On March 25, 2020, the SEC Division of Corporation Finance issued “CF Disclosure Guidance: Topic No. 9,” clarifying the Agency’s position on what public companies must disclose during this unprecedented earnings season. This guidance asks companies to assess “the effects COVID-19 has had on [the] 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” when determining what pandemic-related corporate information will be material to shareholders and, thus, subject to mandatory disclosure in the firm’s SEC filings.

When reviewing the SEC’s disclosure guidance, companies should revisit disclosed risk factors and any forward-looking statements in light of the pandemic. The SEC requires public companies to disclose any material risks bearing on the company and its securities, with the failure to disclose these risks exposing companies to potential government investigations, SEC enforcement actions, and private securities actions. To diminish the litigation risk associated with allegedly inadequate disclosures, the Private Securities Litigation Reform Act of 1995 (“PSLRA”) includes a “safe harbor” provision, immunizing from liability any forward-looking statement—such as revenue projections or earnings guidance—provided that (1) the statement is identified as such and accompanied by meaningful cautionary language; (2) the statement is immaterial; or (3) the plaintiff fails to show the statement was made with actual knowledge of its falsehood. To benefit from the PSLRA’s safe harbor provision, then, material forward-looking statements must be accompanied by disclosure of any specific risks faced by the company that could render any of its forward-looking statements untrue.

The SEC has specifically requested that forward-looking disclosure by companies include “as much information as is practicable.” Many companies likely will determine to include a specific pandemic risk factor in future SEC filings. Companies should, however, be cautious when revising their risk factors in response to COVID-19. Prior to the current crisis, very few companies had specific risk factor disclosures regarding the result of a pandemic on their business. Disclosures made now may be scrutinized as potentially revealing a prior material omission.

Recovery from the pandemic also brings its own set of uncertainties. When will the recovery occur? What will be its ongoing impact on the company’s business? These are specific risks that should be identified in discussing forward-looking statements regarding the company’s business. The SEC, for its part, has “encourage[d] companies that respond to [its] call for forward-looking disclosure to avail themselves of the safe-harbors for such statements,” with SEC Chairman Jay Clayton and Director of the Division of Corporation Finance William Hinman giving comfort that the Agency “[will] not expect good faith attempts to provide appropriately framed forward-looking language to be second guessed by the SEC.” Companies should nevertheless ensure that they are both documenting the rationale for decisions related to accounting and disclosure judgments and continuing to provide as robust internal control over financial reporting as possible given the current circumstances. Companies that previously disclosed a hypothetical risk of pandemic or public health crisis should update their filings to reflect current events.

Plaintiffs bringing COVID-19 disclosure-related litigation against public companies also may allege that an issuer has failed to comply with the disclosure requirements of Item 303 of SEC Regulation S-K, requiring the disclosure of known trends or uncertainties that might reasonably be expected to have a material impact on sales or revenues. Although the case law generally requires actual knowledge of the known trend or uncertainty for liability to attach, companies nevertheless will need to be careful in making their Item 303 disclosures. Further, companies making new or secondary offerings of securities face potential liability under sections 11 and 12 of the Securities Act of 1933 for any misstatements or omissions in a registration statement. In short, public companies should seek counsel from not just their disclosure counsel but also their litigation counsel in order to ensure that complete attention is given when drafting any and all public disclosures relating to the effect of the pandemic on the company’s business.

III. Derivative Suits

In addition to class actions alleging violations of Rule 10b-5, we expect to see a rise in shareholder derivative suits filed on behalf of companies against directors and officers, likely alleging that corporate officers and directors breached their fiduciary duties to shareholders and caused harm to the corporation by failing to adequately prepare for, manage, or oversee corporate operations during the pandemic.

The performance of boards and management in governing through the pandemic will be subject to shareholder scrutiny and criticism in hindsight, especially for public companies in industries hard-hit by COVID-19, including the travel, food, and hospitality sectors. Derivative suits are brought by shareholders or, if the company is insolvent, by bankruptcy trustees, receivers, and creditor’s committees. The basic claim is that the board and officers breached their fiduciary duties to the company, resulting in corporate harm. The risk of shareholder suits against the board and management team goes hand-in-hand with declines in corporate performance, with these suits often being filed alongside 10b-5 actions. For example, in Beheshti v. Inovio Pharmaceuticals, Inc. et al., No. 20-01962 (E.D. Pa. Apr. 20, 2020), a derivative action filed on the heels of the Inovio 10b-5 class action discussed above, the shareholder plaintiffs have alleged that the corporate defendants breached their fiduciary duties to the company by, among other things, misrepresenting the status of the company’s COVID-19 vaccine.

What kinds of duties do directors and officers owe to the company during the current crisis? Directors and officers owe fiduciary duties of care and loyalty to the company and, in some instances, directly to the shareholders. The liability of directors and officers for breach of fiduciary duties owed to the corporation or its shareholders is governed by state law, usually the law of the state of incorporation. In Delaware, for instance, the duty of care is violated by gross negligence, but the standard of care varies from state to state. The duty of loyalty is defined generally as acting in good faith and refraining from conscious wrongdoing and self-dealing at the expense of the company or its shareholders. As a practical matter, directors are more likely to face liability in derivative suits for breach of the duty of loyalty, rather than breach of due care. Most companies have included “exculpation” provisions in their articles of incorporation protecting directors from monetary liability to the company or its shareholders for breach of the duty of care, but not for breach of the duty of loyalty. Further, business decisions are generally reviewed under the “business judgment rule” standard, which is highly deferential to the good faith business judgments of disinterested, independent directors and officers—even when those decisions lead to corporate losses. The adequacy of board oversight, even in the absence of specific business decision-making, is reviewed for breach of the duty of loyalty—a standard requiring pleading and proof of conscious failure to take in relevant information and exercise oversight.

Shareholders seeking to sue on behalf of a company must first establish their standing to assert the company’s claims, which normally are controlled by the board. Shareholders are required by corporate law to first make a demand on the board to bring the desired action, or else establish that a demand would be futile because a majority of the directors are too conflicted to exercise valid business judgment on the demand. In response to a demand, the board must investigate and make a business decision about whether it is in the best interest of the company to take the action demanded. If the demand is refused, courts should generally defer to the board’s business judgment and dismiss the case without considering the underlying merits of the claims.

Against the backdrop of the pandemic, derivative plaintiffs can be expected to allege that corporate officers and directors mismanaged the company prior to or during the pandemic by, for instance, failing to adequately prepare for risks associated with governmental shutdowns or to take timely action to mitigate corporate losses. Directors and officers can take steps to protect themselves from the risk of personal liability exposure by ensuring that they remain cognizant of their duty of loyalty to the company by acting in good faith and refraining from corporate transactions that could be characterized as self-dealing. To take advantage of the deferential business judgment rule, boards should keep adequate records of the steps they are taking to inform themselves in a timely way with input from management and outside advisors and document the process of making good faith decisions to protect the company from loss. While the transition to remote working has disrupted the way many companies operate, it is vital that entities maintain—and perhaps, given the heightened risk of COVID-19-related litigation, strengthen—their recordkeeping practices during these challenging times.

IV. Insolvency

The COVID-19 pandemic has had a devastating effect on many businesses and is expected to take many companies over the edge and into insolvency. This, in turn, may result in heightened exposure to liability for corporate directors and officers, stemming from the litigation risks discussed above.

Under most state laws, when a company becomes insolvent, the duties of the directors and officers shift from acting in the best interest of the company and all of its shareholders, to acting in the best interest of the company and its creditors—the new “residual” owners. Until insolvency, creditor rights are contractual. Once the company is insolvent, however, the equity is generally wiped out and the creditors are first in line to recover from the company’s assets. At this point, creditors gain standing to sue derivatively in the right of the company.

Directors and officers can then become personally exposed to legal costs if the insolvent company is unable to advance defense costs. If a company becomes insolvent and cannot meet its indemnity obligations to its directors and officers, it is critically important for both public and private companies to check their insurance coverage and make sure that directors and officers have immediate access to money for defense, even if the company cannot or will not step up. This coverage is called “Side A,” which is designed to step in and start paying for defense of the individual directors and officers, often with no deductible, when the company cannot pay.

At the same time, insurers are reacting to the COVID-19 crisis and considering this new risk in underwriting all kinds of coverage, including exclusions. To ensure that the company’s insurance is adequate, including the company’s D&O coverage, it is important that companies consult with their brokers, coverage counsel, and in some instances work directly with insurance underwriters to get the best coverage possible.

Finally, the threat of COVID-19-fueled insolvency also has led many companies to make adjustments to operations, including revisiting how they are handling dividend payments. Short of tangible potential insolvency issues, most companies are still paying previously-declared dividends because of shareholder litigation risk, but many are suspending future dividend payments and revisiting dividend programs on a going-forward basis. As companies continue to respond to the heightened risk of insolvency created by pandemic shutdowns and increased governmental restrictions, directors and officers can again reduce litigation risk by maintaining careful records of the steps the company is taking to respond to any insolvency issues created by the COVID-19 pandemic.

V. Conclusion

As society continues to navigate the uncharted waters of this pandemic, we expect to see many more issues arise that will lead to new and novel theories of securities fraud and other alleged disclosure violations. We expect that those discussed above will be in the mix and, if early filings are any indication, more securities fraud suits will be forthcoming in the coming weeks and months, as plaintiffs’ attorneys and shareholders continue to review public companies’ SEC disclosures and second-guess their risk disclosures and guidance. Companies that proactively address these concerns both in their public disclosures and in their boardrooms—including with respect to ensuring appropriate reporting of guidance and projections, adequate internal control over financial reporting, and sufficient D&O liability coverage—will be best positioned to outlive this pandemic and its ensuing fallout for years to come.

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