The climate for securities class-action lawsuits is as toxic today as some of the esoteric assets that took down many once high-flying Wall Street firms. Economic volatility will continue to trigger lawsuits from plaintiffs seeking to hold companies—and their officers and directors—accountable for what is adding up to trillions of dollars in shareholder losses.
Just a year ago, there were many reasons to be optimistic that the climate for securities class-action litigation might remain temperate. The stock market was steady, and courts were holding plaintiffs to higher standards in their allegations of securities fraud. William Lerach and Melvyn Weiss—public enemies number one and two to many corporate defense lawyers—pleaded guilty to crimes related to their roles in promoting litigation, and were given prison sentences they serve today. In fact, after the number of class-action securities suits filed in federal court reached an all-time high in the early part of the decade, the number had been dropping, and a clear trend toward a more moderate number of cases was developing.
Now that trend looks to be coming to an end. As of late October, plaintiffs’ firms launched a total of 172 suits, on track to easily surpass last year’s total of 177, according to the Stanford Law School Securities Class Action Clearinghouse (SCAC), which gathers data on such cases. While that number doesn’t yet reflect a drastic upturn, many experts expect to see a steep increase in the number of securities suits filed next year, perhaps testing previous records. The losses in such cases are already exploding: During the first half of 2008, the maximum dollar loss, according to SCAC, was $587 billion, compared to just $170 billion during the same period in 2007.
For corporate directors, the increase in suits means greater personal liability risk. Defense attorneys are urging board members to double check their insurance policies, while keeping a watchful eye on legal developments on multiple fronts. Like stock options backdating and accounting fraud before it, the subprime mortgage meltdown is an event that has triggered an alarming number of new class actions. Now it appears to be spreading to include non-financial companies and could conclude with criminal charges. (Already, some executives at Lehman Brothers, including former CEO Richard Fuld, have received subpoenas from a grand jury investigating the collapse of the firm.) The litigation barrage also may demand new metrics for measurement because, as Stanford Law School Professor Joseph Grundfest says, “We’ve never seen anything like this.”
Calm Before the Storm
Despite a significant uptick in federal securities class-action suits earlier this year, related mostly to new cases brought against the originators of subprime mortgages, a PricewaterhouseCoopers report released five months ago predicted that total annual filings would likely fall. That didn’t happen. Although not quite a deluge, the number of cases is expected to reach a high not seen since 2002, when the bursting of the dot-com bubble left shareholders looking for payback. “Earlier in the year, we saw a decline in the number of cases being filed,” says Grace Lamont, a partner at PwC. “Now, the numbers are increasing, and by the end of the year they’re going to be up on last year’s number overall.”
“There are lots of companies out there that are being sued for matters unrelated to subprime. Every sector is a target and that’s a result of market volatility.”
—Adam Savett, RiskMetrics
In its midyear report, NERA Economic Consulting, which studies securities class-action activity, concluded that at the current pace, there will be an estimated 280 filings, the highest level since 2002—and that was before wild swings in the stock market created volatility not witnessed since the stock market crash of 1929. In its report, NERA also analyzed the impact of market volatility on longer-term patterns of class-action filings, and found that high market volatility “is positively correlated with the number of filings: if market volatility is higher during a quarter, controlling for market returns, filings are likely to be higher in that same quarter.”
Corporate defense attorneys have long complained that securities suits are often more related to drops in stock price than to any underlying transgression. And since the stock-market plunge has been much broader than the financial services industry, we could see a widening of securities suits. Adam Savett, director of securities litigation at RiskMetrics Group, says it is already happening. “There are lots of companies out there that are being sued for matters unrelated to subprime,” Savett says. “Every sector is a target and that’s a result of market volatility.”
An annual survey by Fulbright & Jaworski of corporate law departments in the United States and the United Kingdom found most to be “bracing” for an onslaught of litigation. Following two straight years of reporting declines in the number of new lawsuits and regulatory proceedings, corporate counsel at 251 U.S. company respondents predicted that the volume of securities suits would rise. Stephen C. Dillard, who chairs Fulbright’s litigation practice, says the coming legal climate will mark an inflection point for American business from the end of a prolonged period of prosperity to the start of a period of economic challenges. “This is likely to fuel litigation over who is to blame and who should pay the consequences,” he says.
Not surprisingly, the financial-services industry has been the feeding ground of security suits litigators. With 63 new cases this year, nearly every large financial institution has been sued, according to Grundfest. A former commissioner of the Securities and Exchange Commission, who founded SCAC to track the origins and developments of every federal securities class-action case filed, Grundfest says the plaintiffs’ lawyers are running short on financial services targets. “There has been an ‘easing up’ in the number of new companies being sued. But that’s not because the credit crunch is over—it’s because the plaintiffs are running out of people to sue.”
Grundfest also suggests that new metrics may be needed to measure the severity of the cases and the size of the awards. Each year, Cornerstone and the SCAC publish a study that measures the size of class-action filings by tracking market capitalization losses for defendant firms during and at the end of the class period. The study uses the Disclosure Dollar Loss (DDL) figure to measure the total sum of losses incurred for all class-action lawsuits. For the first half of 2008, DDL totaled $106 billion, well above the semi-annual average of $65 billion over the 11 years the study has run. If this level persists to year’s end, the 2008 DDL would be about 40 percent higher than in 2007, and almost 65 percent higher than the annual average over 11 years. “We need an even more detailed examination of the dollar disclosure and maximum dollar loss as estimated by Cornerstone,” Grundfest says, “because this is well outside the historic norms.”
Follow the Money
While investor losses are the most important factor affecting settlement values, NERA notes that there are other case characteristics correlated with settlement amounts. Settlement values rise dramatically with the inclusion in a settlement of securities other than common stock (bonds or options, for example). Because NERA’s measure of investor losses is based on common stock only, losses claimed by investors in other securities are likely much higher. Settlements also increase with the potential depth of defendants’ pockets. For each 1 percent increase in the defendant company’s market capitalization on the day after the end of the class period, the settlement is expected to increase by 0.2 percent.
On the other hand, if the defendant firm has declared bankruptcy or has a stock price of less than $1 per share at the time of settlement, the settlement is expected to be approximately 20 percent lower.
The industry breakout for companies sued during 2007 was more or less in line with that of prior years, except for the financial-services industry, which saw a rise in cases, primarily as a result of subprime-related filings. Technology remained the most sued industry sector for yet another year, although the percentage of all cases that were filed against tech companies decreased slightly, from 30 percent to 25 percent.
Federal class actions directed at foreign filers almost doubled last year, and are expected to continue rising. Twenty-seven cases were filed in 2007, compared to 14 cases in 2006. More cases were filed against Chinese foreign private issuers (FPIs) than any other geographic group.
Scope Widens
The first subprime-related case was filed in February by shareholders alleging securities violations in California against New Century Financial before the lender filed for bankruptcy; after state regulators revoked its lending licenses, federal officials started two investigations into the firm, and shareholders filed more than 25 lawsuits claiming securities violations.
One of the more recent trends in securities litigation is an increase in the frequency in which the plaintiffs’ bar pursues related companies with deep pockets. That point is underscored in a case brought by shareholders of Freddie Mac, in which Freddie itself is not a defendant. The suit, filed by investors who bought Freddie Mac shares, names only Goldman Sachs, JPMorgan Chase, and Citigroup. The suit alleges that the investment firms, which underwrote a Freddie Mac stock offering, did not disclose the company’s “massive exposure to mortgage-related losses.” (JPMorgan Chase didn’t underwrite the offering, but it acquired Bear Sterns, which did.)
Cases with an accounting firm as a co-defendant are associated with settlements almost two times larger than those without, and cases with an institutional investor as lead plaintiff typically generate settlements that are one-third larger than those without.
For example, a settlement was reached in late summer in a case charging officers and directors of General Motors and Deloitte & Touche, GM’s outside auditor during the period of time covered by the action. GM agreed to a cash payment of $277 million and Deloitte agreed to contribute an additional $26 million in cash, bringing the total settlement to $303 million.
Securities litigation could also play a part in the M&A landscape, as potential buyers weigh the value of the target against the potential for ongoing securities litigation. For example, Bank of America, which is the target of a securities suit, will also have to defend cases against Countrywide* and Merrill Lynch, both of which it has acquired. “If you buy the whole enchilada, you get the good and the bad,” says RiskMetrics’ Savett.
Other examples of suits that Savett describes as more like “six degrees of separation” include those against Toll Bros., MoneyGram International, and Constellation Energy. Even though the defendants have no apparent direct connection to the subprime mortgage crisis, they too are being drawn in. “Most of the allegations that are related to these cases are aligned in valuation or disclosure areas,” Savett explains. “Shareholders allege that the risks of the investments [leading to a drop in valuation] weren’t properly disclosed, and that’s what we’re seeing in cases filed against companies that aren’t lenders, loan originators, or issuers. The profile of the defendant is changing.”
“There has been an ‘easing up’ in the number of new companies being sued. But that’s not because the credit crunch is over—it’s because the plaintiffs are running out of people to sue.”
—Joseph Grundfest, Stanford Law School
Complicating the picture is the flurry of bankruptcies that make it difficult for shareholders to win awards. However, bankruptcy doesn’t end the angst for corporate officers and directors at financial firms pushed to collapse or near collapse by the credit crisis. For a growing number of directors and officers, there’s a bigger worry: the criminal investigation. In addition to investigations led by federal agencies such as the SEC, the Federal Bureau of Investigation, and the Department of Justice, more assertive state attorney generals in California, Connecticut, Massachusetts, and elsewhere are launching their own investigations. Even municipalities, such as the City of Springfield, Mass., are seeking to recover lost value for their employee pension funds. Specifically, Springfield is seeking to recover damages from Merrill-Lynch, which admitted that two brokers in a regional office had mistakenly invested funds in mortgage-backed securities, even though the Commonwealth of Massachusetts prohibits such risky investments. The top federal prosecutor in Los Angeles said charges will be filed in the coming months in a sweeping investigation of banks and subprime lenders for their role in the nation’s mortgage crisis. “I think we are going to see some fairly dramatic results in the near future,” U.S. Attorney Thomas O’Brien told The Associated Press. “There are people who have made many millions of dollars preying on unsuspecting people. That’s wrong. That’s fraud in a tremendous amount.”
U.S. and state attorney generals are reportedly investigating mortgage lenders and investment banks, including Bank of America, Countrywide, Deutsche Bank, IndyMac Bancorp, Lehman Brothers, Merrill Lynch, Morgan Stanley, New Century, UBS, Wachovia, and Wells Fargo, to determine whether mortgage fraud and other white-collar crimes were committed. The FBI is said to have launched a fraud investigation into the activities of Fannie Mae, Freddie Mac, Lehman Brothers, and the American International Group (AIG). A new layer of complexity is added to the litigation mix now that there is government involvement to consider. Now a stakeholder in AIG, Fannie Mae, Freddie Mac, and other banks that opt to participate in the federal bailout program, the government’s role as defendant or litigant remains unclear. “Some commentators have gone back to the 1980s when the Resolution Trust Corp. was suing everyone trying to recoup money from the fallen savings and loans…I don’t see that happening yet,” says Savett, a former securities litigator. “I think we’re still so early in this nationalization bailout plan that the government hasn’t yet stepped in and taken the reins.”
Beyond Subprime
While so much focus is being placed on lawsuits stemming from the economic crisis related to subprime and shareholder losses, there are other areas that bear watching. Kevin Lacroix, who writes “The D&O Diary,” an online journal of directors’ and officers’ liability, points out that a majority of filings in the month of September were unrelated to subprime. “Although the plaintiffs’ lawyers have been quick to pursue claims from the credit crisis, they have not done so to the exclusion of all other activities,” Lacroix writes. “Indeed, the plaintiffs’ bar continues to pursue other kinds of claims, and so merely because a company has not been directly affected by the credit crisis does not by itself mean that the company is free from securities litigation exposure in the current environment.”
Savett agrees: “Every sector is still being sued and that’s a result of market volatility. It’s the exact same story across the board. I don’t see anything that is going to make this market take its Maalox and calm down. I think we will continue to see large volumes for some time to come.”