Cornerstone Research has released two reports on class action litigation under the securities laws. Together, the reports suggest that, while the number of cases is rapidly growing, the quality and size is falling – more cases are being dismissed and settlement amounts are declining. And, as the over-all number of filed cases increases, the percentage involving GAAP violations, restatements, and internal control weaknesses, is decreasing, as is the number of settled GAAP violation cases.
2017 Securities Law Class Actions Filed
As reported in Securities Class Action Filings—2017 Year in Review, 412 securities class actions were filed in 2017 – an increase of more than 50 percent over 2016, which set a record with 271 filings. M&A cases were the primary cause of the up-swing in filings. Almost half of the 2017 cases – 198 – involved merger and acquisition activity.
Another way of looking at these numbers is as a measure of the risk that a public company will become a defendant in a securities law class action. In 2017, more than 8 percent of companies listed on U.S. exchanges were the subject of a class action filing. Larger companies face a slightly smaller risk; about one out of every fifteen S&P 500 companies was sued. By comparison, in 2016, 3.9 percent of U.S. exchange-listed securities were subject to class action filings. See Do You Feel Lucky? ExchangeTraded Companies Have a 1-in-26 chance of being Targeted in a Federal Securities Law Class Action, January-February 2017 Update. (The 2017 increase in the odds of being sued resulted from both more class action filings and a smaller universe of public companies.)
The report, which was prepared by Cornerstone and the Stanford Law School Securities Class Action Clearing House, also found that, of those complaints alleging securities fraud (Rule 10b-5), false Securities Act registration statements (Section 11), or false securities sales material (Section 12(2)), 100 percent included allegation of misrepresentations in “financial documents.” However, allegations relating specifically to accounting and internal control are declining sharply. Twenty-two percent of new cases alleged GAAP violations (down from 30 percent in 2016), six percent involved announced restatements (down from 10 percent in 2016), and 14 percent alleged internal control weaknesses (down from 21 percent).
Other highlights of the 2017 class action filings report, include:
- The number of filings against non-U.S. issuers continued to increase. As a percentage of total cases, complaints against nonU.S. issuers were filed at the highest rate since 2011.
- For the S&P 500, the lowest rate of filings was against companies in the Financial/Real Estate sector (1.6 percent). The highest filing rate was against companies in the Industrial sector (22.3 percent). Last year’s most-frequently sued sector, Energy/Materials fell to second from last (a decline from 19.8 percent in 2016 to 2.3 percent in 2017).
Cornerstone and Stanford also studied the rate at which cases are dismissed within the first three years after filing. Over half (54 percent) of cases filed in 2015 were dismissed before three years had passed from the date the case was filed; this was the highest three-year dismissal rate since Cornerstone began compiling data. This trend appears likely to continue. The report states that early “dismissal rates for filings in cohort years 2016 and 2017 are comparable to the record high dismissal rate of the 2015 filing cohort” and that 2017 cases may turn out to be thrown out of court at a rate in excess of 2015. In the press release announcing the 2017 report, Professor Joseph Grundfest, director of the Stanford Law School Securities Class Action Clearinghouse, observed that, while legislation enacted in 1995 “was designed to deter plaintiffs from filing low-quality complaints, * * * this surge in complaints that are dismissed with greater frequency suggests that the law is no longer having its intended quality-enhancing effect.”
2017 Securities Law Class Actions Settled
In Securities Class Action Settlements—2017 Review and Analysis, Cornerstone looks at class actions that were settled last year. (According to the 2017 filings report, for cases filed between 1997 and 2016, 50 percent were settled, 43 percent were dismissed, 1 percent ended with a trial, and 6 percent are still pending.) Cornerstone finds that the dollar value of settlements “dipped dramatically” in 2017. Specifically –
- Eighty-one securities class actions were settled in 2017, a decrease of 4 from the 85 settlements approved by courts in 2016.
- The total value of the 81 settlements was $1.5 billion, compared to $6.1 billion in 2016. Therefore, while the number of 2017 settlements was 95 percent of the 2016 count, the aggregate value was only 25 percent.
- The median amount for which cases settled in 2017 was $5 million, 40 percent of the 2016 median of $8.7 million. The average settlement declined 75 percent to $18.2 million.
The percentage of settled cases involving accounting allegations continued to decline. In the press release announcing the settlement report, Cornerstone states: “The proportion of settled cases alleging GAAP violations in 2017 was 53 percent, continuing a three-year decline from a high of 67 percent in 2014. Of cases with accounting allegations settling in the preceding nine years, 23 percent involved named auditor codefendants. In 2017, this dropped to 13 percent.”
Comment: Clearly, the risk that a public company will be named in a securities law class action is increasing, particularly for companies engaged in M&A activity. While the risk that a class action suit will raise accounting issues seems to be declining, financial reporting and disclosure continue to be significant lines of attack for the plaintiff’s bar. The best protection against litigation is diligence and care in overseeing the company’s financial reporting. Audit committees may also want to be especially sensitive to issues arising in the areas that have traditionally attracted the attention of the plaintiffs bar and the SEC, particularly revenue recognition.