On March 29, the United States Supreme Court heard oral argument in Goldman Sachs Group, Inc., et al. v. Arkansas Teacher Retirement System, et al., No. 20-222. The closely-watched case raises a host of important issues concerning the substantive and procedural requirements for certifying a securities fraud class action. Most notably, the Court will clarify what evidentiary burden a defendant bears in attempting to rebut the “fraud on the market” presumption of reliance that permits claims asserted under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) to proceed as class (as opposed to individual) actions. While the Court has opined on this issue in past decisions, including in its seminal Basic v. Levinson decision in 1988, which established the doctrine, and more recently in Amgen and Halliburton I & II, the lower courts have struggled to apply those rulings consistently.

More broadly, the case implicates the challenges lower courts have faced in applying the Supreme Court’s instruction that class action plaintiffs, whether in the Section 10(b) context or otherwise, “must affirmatively demonstrate” compliance with Federal Rule of Civil Procedure 23. As the Court held in Comcast and Wal–Mart, the “Rule ‘does not set forth a mere pleading standard.’ Rather, a party must not only ‘be prepared to prove that there are in fact sufficiently numerous parties, common questions of law or fact,’ typicality of claims or defenses, and adequacy of representation, as required by Rule 23(a). The party must also satisfy through evidentiary proof at least one of the provisions of Rule 23(b),” including that “questions of law or fact common to class members predominate over any questions affecting only individual members.” Importantly, the Court made clear that “such an analysis will frequently entail ‘overlap with the merits of the plaintiff’s underlying claim.’”

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This spring marks the 20th anniversary of the beginning of the dramatic and cataclysmic demise of Enron Corp. A scandal of exceptional scope and impact, it was (at the time) the largest bankruptcy in American history. The alleged business practices of its executives led to numerous individual criminal convictions. It was also a principal impetus for the enactment of the Sarbanes-Oxley Act and the evolution of the concept of corporate responsibility. As such, it is one of the most consequential corporate governance developments in history.

Yet a new generation of corporate leaders has assumed their positions since then; for others, their recollection of the colossal scandal may have faded with the years. And a general awareness of corporate responsibility principles is no substitute for familiarity with the governance failings that reenergized, in a lasting manner, the focus on effective and responsible governance. A basic appreciation of the Enron debacle and its governance implications is essential to director engagement.

Enron was formed as a natural gas pipeline company and ultimately transformed itself, through diversification, into a trading enterprise engaged in various forms of highly complex transactions. Among these were a series of unconventional and complicated related-party transactions (remember the strangely named Raptor, Jedi and Chewco ventures) in which members of Enron’s financial leadership held lucrative financial interests. Notably, the management team was experienced, and both its board and its audit committee were composed of a diverse group of seasoned, skilled, and prominent individuals.

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On Tuesday [March 9, 2021], SEC Commissioner Caroline Crenshaw spoke to the Council of Institutional Investors. Her presentation, Moving Forward Together—Enforcement for Everyone, (discussed on the Forum here) concerned “the central role enforcement plays in fulfilling our mission, how investors and markets benefit, and how a decision made 15 years ago has taken us off course.” In her view, the SEC should revisit its approach to assessing financial penalties and should not be reluctant to impose appropriately tailored penalties that effectively deter misconduct, irrespective of the impact on the wrongdoer’s shareholders. Is this a sign of things to come?

Crenshaw observes that, generally, SEC Commissioners of all stripes believe in a strong enforcement program but differ on the effect of corporate penalties in achieving the SEC’s goals. Crenshaw believes that the SEC has overemphasized “factors beyond the actual misconduct when imposing corporate penalties—including whether the corporation’s shareholders benefited from the misconduct, or whether they will be harmed by the assessment of a penalty.” Not only is this approach “fundamentally flawed,” but, more importantly, it allows companies to profit from their own fraud and handcuffs the SEC, inhibiting it from crafting “tailored penalties that more effectively deter misconduct” and that create financial incentives to follow the rules and invest in compliance. In Crenshaw’s view, “enforcement best advances our agency’s goals when it concentrates the costs of harm with the person or entity who committed the violation. For these reasons, ensuring that the violator pays the price is key to a successful enforcement regime and to promoting fair and efficient markets more broadly.”

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Notwithstanding a year of unprecedented economic and societal change amidst a global pandemic, non-U.S. issuers continued to be targets of securities class actions filed in the United States. Indeed, despite widespread court closures due to the coronavirus pandemic, 2020 continued to see an uptick in the number of securities class action lawsuits brought against non-U.S. issuers. It is therefore imperative that, regardless of the economic climate, non-U.S. issuers stay vigilant of filing trends and take proactive measures to mitigate their risks.

In 2020, plaintiffs filed a total of 88 securities class action lawsuits against non-U.S. issuers.

• As was the case in 2019, the Second Circuit continues to be the jurisdiction of choice for plaintiffs to bring securities claims against non-U.S. issuers. More than 50% of these 88 lawsuits (49)3 were filed in courts in the Second Circuit. A clear majority (35) of these 49 lawsuits were filed in the Southern District of New York. The next most popular circuit was the Third Circuit, with 22 lawsuits initiated in courts there. The Ninth and Tenth Circuits followed with 15 and two complaints, respectively.
• Of the 88 non-U.S. issuer lawsuits filed in 2020, 28 were filed against non-U.S. issuers with a headquarters and/ or principal place of business in China, and 12 were filed against non-U.S. issuers with a headquarters and/or principal place of business in Canada.
• As was the case in 2018 and 2019, the Rosen Law Firm P.A. continued to be the most active plaintiff law firm in this space, leading with most first-in-court filings against non-U.S. issuers in 2020 (25). However, departing from the trend of the last several years, Pomerantz LLP was appointed lead counsel in the most cases in 2020 (14); the Rosen Law Firm closely followed with 13 appointments as lead counsel.
• Remarkably, the majority of the suits (28) were filed in the 2nd quarter, at the height of the coronavirus pandemic for most areas throughout the United States, particularly in the Southern District of New York.
• While the suits cover a diverse range of industries, the majority of the suits involved the biotechnology and medical equipment industry (14), followed by the software and programming industry (9), the consumer and financial services industry (7), and the communications services industry (7).
• Of the 22 lawsuits brought against European-headquartered companies, five were filed against firms headquartered in the United Kingdom and four were filed against firms headquartered in Germany.

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Corporate accounting fraud has a significant negative impact on the economy and investors, so academic research on factors that make accounting fraud more or less likely to occur has substantial real-world and public policy implications. However, conducting such research is difficult because researchers cannot observe the incidence of fraud for most firms, corporate admissions of fraud are rare, and trials proving fraud are almost nonexistent. Thus, researchers are forced to rely on proxies for fraud to conduct empirical analysis. Our recent paper examines the use of both public and private accounting enforcement with appropriate screening to proxy for accounting fraud and demonstrates how this combined proxy improves research inferences.

The current dominant proxy for accounting fraud in research is public enforcement through the Securities and Exchange Commission (SEC). In contrast, relatively few papers, particularly in the accounting literature, use private enforcement via securities class actions (SCAs). However, we argue that the use of only public or private enforcement excludes credible fraud firm observations as the SEC lacks a sufficient budget to pursue all possible fraud and private litigants lack the incentive to pursue such cases if their expected costs exceed expected recoveries. Critically, the use of either enforcement regime does not only reduce statistical power but can also bias regression estimates.

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I want to thank the Council of Institutional Investors for inviting me today [March 9, 2021]. You are tireless advocates for investors and staunch proponents of good corporate governance. The agenda for this year’s meeting covers a number of timely topics that are top of mind for me as well—from the impact of COVID-19 on members, to drivers behind the SPAC boom, to diversity and inclusion at U.S. companies. I’m pleased you are also talking about sustainable finance, proxy voting issues and ESG ratings. Further, I share CII’s prioritization of clawbacks and transparency as to executive pay, stock trades and share buybacks. Today I have been asked to speak about what’s next for the SEC. Before I do that, I will make the usual disclaimer that the views I express today are my own, and do not necessarily reflect those of staff, my fellow commissioners, or the agency.

In thinking about what I wanted to discuss today, of course I considered policy matters that I would like to see the Commission prioritize in the near term: Regulation Best Interest, the improvements needed in the proxy process, the need to finish implementing Dodd-Frank, and continuing updates to our market infrastructure. But I kept coming back to something even more foundational: our enforcement program. I want to talk about the central role enforcement plays in fulfilling our mission, how investors and markets benefit, and how a decision made 15 years ago has taken us off course. And I’ll explain how changing tack now will yield better outcomes in all these areas.

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On January 11, 2021, the Supreme Court vacated the Second Circuit’s controversial decision in United States v. Blaszczak, which held that proof of a benefit to the tipper is not a required element for criminal insider trading claims brought under Title 18 of the U.S. Code. Although the Supreme Court ordered reconsideration on other grounds— whether certain government information may be considered “property” for the purpose of a scheme to defraud—the impact on the insider trading decision may be the more significant consequence. 

The Second Circuit’s Decision in United States v. Blaszczak

As we discussed in a past client memorandum, in 2019 the Second Circuit in United States v. Blaszczak expanded insider trading liability by affirming the convictions of four individuals of wire fraud, securities fraud, and conversion charges under Title 18. The government charged the defendants—a government employee, a consultant, and two hedge fund analysts—with violating both Title 15 and Title 18 of the U.S. Code. The jury acquitted the defendants under Title 15, which is the traditional basis to charge insider trading, but convicted on certain Title 18 counts. [1] On appeal, one of the defendants’ arguments was that the District Court wrongly instructed the jury that an element that applied under Title 15 did not apply under Title 18: that the tipper disclosed information for a “personal benefit” that was known to the recipients of the tip.

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As the COVID-19 pandemic continues, the whistleblower environment is changing in ways that should have the focused attention of compliance executives across industries. Three converging factors are at work here:

1) a significant increase in fraud and whistleblower activity; 2) disruptions stemming from remote work; and, 3) new Department of Justice (DOJ)/Security Exchange Commission (SEC) guidance on corporate compliance programs. This post offers insights on what’s driving the new environment and strategic actions you can take to adapt.

5 insights you should know

Economic uncertainty and COVID-19-related instability have real consequences. Rapid, unprecedented economic turmoil has created record unemployment and layoffs. Organizations are under significant cost-reduction pressure. According to a recent ACFE survey, 79 percent of member companies have observed an increase in fraud, and 90 percent expect further fraud increases in the next 12 months. [1]

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Our recent paper uses the Wall Street Journal’s coverage of the stock option backdating scandal to examine whether media coverage causes meritorious shareholder litigation. While the media has a prominent role in covering corporate scandals, it is unclear whether the media coverage itself causes any subsequent litigation because the underlying corporate misconduct and firm characteristics may cause both the litigation and attract media coverage. Thus, meritorious litigation may have eventually occurred even in the absence of media coverage. Evidence on the causal relation between media coverage and meritorious litigation is timely due to growing concerns about the precipitous decline in newspapers nationwide and whether it will result in a significant decrease in corporate accountability (Grieco 2020; Knight Foundation 2019). The findings further have a number of important implications for the media, firms, and others.

We predict that media coverage will increase the likelihood of meritorious litigation because such coverage may increase the expected payoff of such litigation to plaintiffs’ lawyers. Specifically, the expected payoff is a function of the settlement probability, expected settlement amount, and expected litigation costs, and media coverage may affect each of these components. That is, media coverage can provide new “expert witness” information or increase the credibility of existing information, increasing both the probability of settlement and expected settlement amount. Additionally, negative media coverage may contribute to an abnormal price decrease, which may increase the settlement probability by establishing loss causation and increase settlement amounts by increasing shareholder damages. Finally, media coverage may lower investigation costs. That is, plaintiffs’ lawyers may rely on experts cited by the media, and coordination costs may be lowered by making it easier to assemble a class of affected plaintiffs.

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In the midst of a global pandemic, securities class action cases continue to provide investors with critical recoveries from companies accused of various fraudulent activities. In fact, the dollar amount of settlements in 2020 totaled $5.84 billion… an increase of 61% over the $3.62 billion in settlements during 2019.

The number of worldwide settlements in 2020 where a monetary amount was agreed to totaled 133… an increase of 13% above the 118 settlements finalized during 2019.

The primary difference between 2019 and 2020 were with the mega settlements… typically considered cases settling for $100 million or greater. While the quantity of these cases were similar during the last two calendar years, the largest settlements in 2020 were incredibly higher in dollar amounts. The two largest settlements in 2019 were Cobalt International Energy at $389.6 million and Alibaba Group Holding at $250 million… while the top 2020 settlements were the following:

• Valeant Pharmaceuticals – $1,210,000,000
• American Realty Capital –$1,025,000,000
• First Solar – $350,000,000
• Signet Jewelers – $240,000,000
• SCANA Corporation – $192,500,000

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In our Summer 2018 update, we discussed a number of recent district court decisions in securities cases premised on the theory that the company failed to disclose, in alleged violation of the securities laws, that it was engaged in underlying anti-competitive conduct. In each of those cases, the court held that the heightened pleading standard imposed by the Private Securities Litigation Reform Act of 1995 (“PSLRA”)—which requires that fraud be pleaded with particularity—applied not only to the allegations that the securities laws had been breached, but also in determining whether the plaintiff had adequately pleaded the existence of the alleged underlying anti-competitive conduct.

In Gamm v. Sanderson Farms, Inc., 944 F.3d 455 (2d Cir. 2019), that issue came before the Second Circuit. Consistent with the district court decisions discussed in our Summer 2018 update, the Second Circuit held that “when a securities fraud complaint claims that statements were rendered false or misleading through the nondisclosure of illegal activity, the facts of the underlying illegal acts must be pleaded with particularity in accordance with the requirements of Rule 9 and the PSLRA.” Id. at 466-67.

Background

In Gamm, a series of antitrust lawsuits were filed against chicken producer Sanderson Farms and a number of its competitors. The lawsuits alleged that Sanderson Farms colluded with those competitors to manipulate the price of chicken by monitoring supply and suppressing its own supply at times when the price of chicken was high. Among the allegations were claims that Sanderson reduced supply by destroying breeder hens and eggs, exporting eggs from the U.S., and dumping excess chicken inventories in foreign markets where they sold for a fraction of the U.S. market price. This was alleged to have been accomplished, in part, through the manipulation of one of three chicken price indices, the Georgia Dock, which was alleged to have a less rigorous verification process as compared to the other indices.

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Social and environmental disasters, such as the #MeToo movement, the Deepwater Horizon oil spill, the opioid crisis, data privacy breaches with a vast number of companies such as Yahoo! Inc., Equifax, Inc., are well covered events in the news. These events impact peoples’ lives and many perceive a correlation between these events and civil litigation on the part of the injured or affected persons. However, it may not occur to the average person that these and other similar events have driven many securities class actions since 2016 onward. In fact, the trend of event-driven litigation is rising each year, while the more traditional accounting-based allegations are on the decline. No one can foresee a catastrophic event occurring or witness what goes on behind the closed doors of a publicly traded company or know that a data breach is occurring until after the event has occurred and been exposed. That exposure, sometimes a result of negligence or potentially outright fraud, can often lead to a sharp decline in the stock price and as such, impacts the investors in that stock negatively. Hence, the new trend of event-driven securities class action litigation is on the rise and resulting in more and more recoveries for shareholders, despite more tenuous arguments being the basis of the lawsuits.

When referencing securities litigation, it generally brings to mind well publicized accounting scandals, such as WorldCom, Inc. or Enron Corporation which delivered billions in investor recoveries. These cases hinged on schemes to inflate earnings or cooking up fake holdings and hiding debt through the use of special purpose vehicles or special purposes entities. The accounting fraud for both companies was eventually discovered by internal audits or SEC probes and are examples of the more traditional path leading to a securities class action being brought against any company. The nature of securities class actions for many decades has rested on traditional accounting-based allegations related to revenue recognition, improper allowance for losses, delayed asset impairment, or other violations of generally accepted accounting principles.

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On the eve of the U.S. presidential election last week, the SEC Enforcement Division released its annual report for fiscal year 2020 (the “Report”), providing an overview of the Division’s enforcement figures, developments, and areas of focus in what Director Stephanie Avakian described as “the most challenging year in recent memory.” [1] This past year has marked, together with the longest shutdown in government history the year prior, a challenging but reasonably productive time for the SEC’s enforcement program. Just as last year’s report highlighted the Division’s struggles during the fiscal shutdown, the final annual report of the Clayton-led SEC focuses on the significant disruption the COVID-19 pandemic has caused to the Division’s operations, investigations, and priorities, including the suspension of testimony for several months, establishment of a Coronavirus Steering Committee, and redirection of resources toward COVID-related fraud. This time around, however, the Division could not avoid a drop-off in the number of enforcement cases, which seems attributable at least in part to the pandemic and its profound impact on the SEC’s operations.

More fundamentally, the Division’s stated enforcement and operational priorities remain largely consistent with recent annual reports, with no significant signals of a change in emphasis during the lame-duck session. And while the election of President-elect Joseph Biden and the wind down of the Clayton era marks the opportunity for new leadership to begin crafting priorities from a clean slate, any significant shifts will likely take time to be expressed to the market. Meanwhile, in the intervening months and even years, a number of the hundreds of ongoing investigations relating to the Division’s current priorities (including many in their early stages) will continue to materialize through enforcement actions. Market participants should thus take note of the Division’s stated areas of focus, which themselves may color any new priorities of the new administration.

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Introduction

The Division of Enforcement’s efforts to deter misconduct and punish securities law violators are critical to protecting millions of investors and instilling confidence in the U.S. securities markets. Each year, the Division recommends, and the Commission brings, hundreds of enforcement actions against individuals and entities for fraud and other misconduct and secures remedies that protect investors by punishing misconduct, deterring wrongdoing, removing bad actors from our markets, and, where possible, compensating harmed investors. This report summarizes some of the major accomplishments and key priorities of the Division over the last fiscal year.

Focus on Financial Fraud and Issuer Disclosure

Integrity and accuracy in financial statements and issuer disclosures are critical to the functioning of our capital markets. During the last fiscal year, the Division maintained its ongoing focus on identifying and investigating securities laws violations involving different components of the financial reporting process.

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[On October 15, 2020], the SEC announced a settled enforcement action against a public company in connection with the company’s initiation of a stock buyback program while in possession of material, nonpublic information (“MNPI”). [1] The Commission charged the company with violating Section 13(b)(2)(B) of the Exchange Act, which requires reporting companies to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that transactions are executed, and access to company assets is permitted, only in accordance with management’s authorizations.

Specifically, the SEC found that the company’s decision–approved by its legal department–to enter into a Rule 10b5-1 trading plan to repurchase the company’s shares on the same day that the company resumed previously suspended, CEO-to-CEO merger discussions violated the company’s own securities trading policy, and therefore fell outside the board’s repurchase authorization. Without admitting or denying the SEC’s findings, the company agreed to the entry of a cease and desist order and to pay a $20 million penalty to settle the action.

The SEC’s order highlights a number of important matters for public companies:

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Special purpose acquisition companies or “SPACs” are an increasingly popular way for an existing private company to become publicly traded without undergoing a traditional initial public offering, and for investors in public markets to invest in growth-stage companies. There can be generous returns for SPAC sponsors, but they should be aware of the liability risk in connection with their role. Indeed, litigation arising from several recent SPAC acquisitions, most prominently against Nikola Corporation, underscores the risks for SPAC sponsors. They therefore should be mindful of steps they can take to mitigate these risks in the reverse merger process.

Key Takeaways

• In the “de-SPAC” transaction, when a SPAC acquires its target, the SPAC and its sponsors are potentially liable under Sections 10(b) and 14(a) of the Securities Exchange Act of 1934 for misleading statements included in a proxy statement or in other public statements. The SPAC and its sponsors may also be liable under Section 11 of the Securities Act of 1933 if that de-SPAC transaction includes a registered offering.
• Investors have sought to hold SPACs and their sponsors liable for a variety of alleged misstatements, including about the financial outlook of the target companies and the level of due diligence performed by the SPAC.
• The best ways for a SPAC sponsor to mitigate these risks are to perform sufficient due diligence on the target and to be cautious with language in the proxy statement.

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Many predicted a wave of securities litigation would follow the stock market plunge during the early days of the pandemic in March 2020, just as it did in the wake of the 2008 economic downturn. But in the months since the onset of pandemic- related economic hardship, only a few cases have been pursued by private plaintiffs, with a roughly equal number of enforcement actions filed by the U.S. Securities & Exchange Commission.

The trend in shareholder litigation is beginning to shift. We are now seeing an uptick in claims challenging public statements made regarding protective measures and financial condition. The SEC has encouraged companies to keep shareholders informed about Covid-19 developments relevant to their businesses throughout the crisis. While this guidance is meant to improve transparency, public companies should not overlook the risk of future shareholder litigation as they adjust to new restrictions on business operations, implement new workplace safety measures, and attempt to best position themselves for success in a period of virtually unprecedented economic uncertainty.

In this post, we examine current securities litigation uniquely associated with the pandemic, predict litigation risks and trends going forward, and offer a summary of best practices for avoiding them.

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Companies should ensure that their clearance systems are properly designed to identify any MNPI that would preclude share repurchases.

Most stock buyback programs garner attention when the board authorization of a program is announced and when the company provides a quarterly update on its buyback progress during its earnings call or 10-Q filing. However, a recent SEC settled enforcement proceeding highlights that neither of those dates is relevant to the analysis of insider trading risk associated with stock repurchases. Instead, the question of whether the company possesses material non-public information (MNPI), and therefore should not be trading in its own securities, needs to be analyzed at the date of each purchase or, if relevant, the initiation of a 10b5-1 plan to facilitate automated repurchases.

In this case, the SEC alleged that the legal department authorized entering into a 10b5-1 plan for future repurchases at a time when the company’s CEO had just recently reinitiated discussions relating to a potential material M&A transaction.

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Introduction

This post provides guidance covering key questions that your organization may face as a result of a regulatory and enforcement inquiry during COVID-19, including a checklist to aid your response. Considering and approving these best practices is good; mastering and implementing them so that you may reflexively employ them is ideal. And a critical component of this is identifying outside counsel that you trust, that knows you and your business, and that can respond quickly to assist you in this high-stakes and fast-moving context.

For additional updates regarding COVID-19, see Market Trends 2019/20: COVID-19 from a Securities Law Perspective, COVID-19 Update: SEC and Nasdaq Response and Updated SEC C&DIs, SEC’s Conditional Reporting Relief and COVID-19 Disclosure Guidance: First Analysis, SEC Reporting Companies: Considering the Impact of the Coronavirus on Public Disclosure and Other Obligations: First Analysis, and COVID-19 Ramifications for Public Companies—SEC Disclosures, SEC Filings and Shareholder Meeting Logistics: First Analysis. For an overview of practical guidance on COVID-19 covering various practice areas, including securities, see Coronavirus (COVID-19) Resource Kit.

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On October 8, 2020, a new Ninth Circuit ruling deepened a circuit split over whether allegations in another civil lawsuit could constitute a corrective disclosure in a securities fraud class action. See In re BofI Holding, Inc. Sec. Litig., 2020 U.S. App. LEXIS 31938 (9th Cir. Oct. 8, 2020) (the panel was comprised of Judges Paul J. Watford, Market J. Bennett, and Kenneth K. Lee, with Lee concurring in part and dissenting in part). The Ninth Circuit joins the Sixth Circuit in declining to adhere to a categorical rule that allegations in a civil suit can never constitute corrective disclosures. Id. at *20 (citing Norfolk Cty. Ret. Sys. v. Cmty. Health Sys., 877 F.3d 687, 696 (6th Cir. 2017)). The Eleventh Circuit remains at the other end of the spectrum, holding that, as a matter of law, allegations from civil suits cannot constitute corrective disclosures, even partial. See Sapssov v. Health Mgmt. Assocs., 608 F. App’x 855, 863 (11th Cir. 2015) (noting that “a civil suit is not proof of liability”). As a reminder, a corrective disclosure occurs when “information correcting the misstatement or omission that is the basis for the action is disseminated to the market.” 15 U.S.C. § 78u-4(e)(1).

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