For securities class actions, 2010 was a hallmark year in many ways. Thought provoking statistical swings, precedent setting Supreme Court cases, and sweeping financial legislation paint a colorful picture of a changing global litigation landscape. In truth, it is a lot to process in a very short amount of time. While the long term consequences of these changes and trends are yet unknown, a summary of the key developments may help us to gain some insight into where we are now and where securities class actions are headed in the coming years.
I. Noteworthy Securities Class Action Statistics
As previously covered by Securities Litigation Watch a few weeks ago NERA economic consulting released its year-end assessment of securities class actions (available here). Likewise, more recently, Advisen (available here) and Cornerstone Research (available here) published year-end studies analyzing trends in securities litigation and securities class actions. While both the Advisen and Cornerstone reports use different statistical methodologies, the sum of their observations provide a fairly comprehensive view of the securities class action landscape. Significantly, both reports found that, despite a strong surge in filing in the latter part of 2010, the number of securities class action suits filed in 2010 were below historical averages. Advisen, in particular, noted that securities class action suits have increasingly represented a smaller portion of the securities litigation universe, dropping from approximately 33% of all securities litigation prior to 2006 to 16% of all securities litigation in 2010.
However, despite the declining proportional numbers of securities class actions, Cornerstone reported that federal securities class actions in 2010 outpaced those filed in 2009 by 4.8%. This is made even more significant given that both Advisen and Cornerstone have found a significant drop in credit crisis related filings (Cornerstone found a 76% drop from 2009 filing numbers). Yet, with only 72 filings in the first six months of 2010, 104 were filed in the second half of the year in an unexpected surge that brought securities class action filings to 2005 levels. Cornerstone reported that this notable surge in filings was driven by class actions related to M&A transactions (discussed here and here), actions against for-profit colleges, and a number of other non-credit crisis related suits. Such non-credit crisis related filings increased 68.8% from 2009 to 2010.
What does the above mean for securities class actions in 2011 and beyond? First, regarding the observed decline in securities class actions as a percentage of all securities related suits, it is important to take a step back and look at the big picture. With ever increasing pleading standards and other challenges to prosecuting securities actions, derivative and single/joint party suits are becoming more common (Advisen found a 39% increase in derivative actions from 2009 to 2010). The expense and sophistication needed to succeed in large securities class actions may cause some law firms to turn to these other litigation alternatives. But, let's not get ahead of ourselves. Advisen notes in its report that securities class actions are still one of "the most commonly filed types of security suits," and "typically produce most of the largest settlements..." They are, as Advison states a "vital watermark" for securities litigation trends.
How do we know that securities class actions are still and will remain a vital part of the securities litigation landscape? One reason is the money involved. Advisen reports that the average securities class action settlement in 2010 was $32 million and the average breach of fiduciary suit (usually M&A related) was $17 million. In reaching its conclusion, Advisen observed that there were certain "eye-popping" settlements in 2010 to include a tentative $600 million settlement in the Countrywide Financial case and a $235 million settlement with Charles Schwab. With the potential for large settlements in such actions law firms will continue to have ample incentive to pursue such cases vigorously.
After all is said and done, federal securities class actions outpaced 2009 levels despite a notable drop in credit-crisis related actions. Overall, non-credit crisis litigation rose to fill the void of declining credit crisis filings. A significant driver of the non-credit crisis litigation was suits related to M&A, usually alleging breach of fiduciary duty. The number of factors allegedly contributing to this trend include increased bankruptcy filings, increased M&A activity in the markets, and changes in law firm behavior. Both the Advisen and Cornerstone reports agree that law firms may have shifted their emphasis away from credit-crisis related litigation against financial firms to what Advisen referred to as "new revenue opportunities in favorable state court forums." Cornerstone noted that many analysts expect a higher number of M&A transactions in 2011, which should translate into sustained if not increased numbers of securities class actions in 2011. Similarly, the large number of bank failures in 2010 could also spur increased litigation in 2011.
II. Key Supreme Court Cases:
Several commentators have observed that the Roberts' Court has shown a propensity for securities related cases in past years. 2010 was no exception. Regarding securities class actions, below are some of the most significant Supreme Court opinions of 2010 along with a few pending cases that have high impact potential.
Merck v. Reynolds (statute of limitations) - The plaintiffs claimed that the company misrepresented the risk of using Vioxx. When the danger was exposed the company’s share price allegedly plummeted. The defendant, Merck, claimed that the plaintiffs could have discovered the truth about Vioxx more than two years before the filing of the case. Therefore, Merck argued, the case was barred by the statute of limitations. In April 2010 the Supreme Court surprised many commentators who had observed a string of defendant friendly opinions from the Court in recent years. The Court sided with the plaintiffs in the case and found that the two-year statute of limitations on claims under the federal securities laws does not begin to run until the plaintiff actually discovers, or a reasonably diligent plaintiff would have discovered, "the facts constituting the violation," including facts showing the defendant's "scienter"—its intent to deceive, manipulate, or defraud. The requirement that the facts showing intent be known to the plaintiff before the statute of limitations begins to run is likely to extend the statute of limitations for plaintiffs considerably.
Morrison v. National Australia Bank (securities class actions against non-U.S. issuers) - Despite all of the fireworks in 2010, Morrison v. National Australia Bank may very well be the most significant event to occur this past year. In June the Supreme Court held in Morrison that federal securities fraud laws do not apply to "transactions in securities listed on domestic exchanges, and domestic transaction in other securities." In the months that followed that decision class action plaintiffs have had a very hard time surviving motions to dismiss where they purchased or sold securities on non-U.S. exchanges (discussed at length here and here). Although plaintiff's asserting non-U.S. exchange claims under the 1933 and 1934 Acts have been met with a brick wall in U.S. federal courts, other avenues of relief, such as state common law claims and application of non-U.S. law are being explored. For example, in the Toyota securities class action the lead plaintiff has asserted Exchange Act claims in connection with securities traded on the NYSE and Japanese law claims in connection with securities traded on the Tokyo exchange.
The implications of Morrison for claims against non-U.S. issuers in U.S. courts appear to be clearer today than they were three or four months ago. At least for now, unless an alternative to federal securities law claims can be found, claims against non-U.S. issuers who trade on non-U.S. exchanges will dry up in U.S. courts. That said, Cornerstone noted in its 2010 year-end report that suits against non-U.S. issuers exceeded those filed in 2008 and 2009. However, filings against non-U.S. issuers were skewed by a spat of filings against Chinese companies that were listed on U.S. exchanges. If these filings are removed then the total filings against non-U.S. issuers drops to levels far below those in previous years (more here). Thus, it appears that the impact of Morrison, at least on U.S. class actions is already being felt.
Another significant side-effect of the Morrison opinion may very well be an expansion and acceleration of litigation in non-U.S. countries. At least one Dutch court has cited Morrison as a basis for obtaining jurisdiction in a global securities class action (see here). Similarly, at least 15 countries now allow for some form of securities collective action. That number may increase to meet shareholder demand now that the U.S. court system will likely be unavailable to investors trading on foreign exchanges.
Janus Capital Group v. First Derivative Traders (secondary actor liability in suit against fund) - In June the U.S. Supreme Court granted certiorari to review the decision of the Fourth Circuit Court of Appeals in Janus Capital Group, Inc. v. First Derivative Traders, 78 U.S.L.W. 3271 (U.S. June 28, 2010)(No. 09-525). In the Janus Capital case, investors in a collection of mutual funds sued the holding company for the funds (Janus Capital Group) and the funds' investment advisor (Janus Capital Management) alleging that the mutual funds were managed in a way that was not consistent with what was reported in their prospectuses, which resulted in a loss to investors. In May 2007, the Fourth Circuit Court of Appeals found that investors asserted a viable claim under Section 10(b) because the defendants helped to draft and disseminate prospectuses with misleading statements. The Supreme Court heard the case in December 2010 but has not yet rendered an opinion.
Pursuant to Supreme Court rulings in First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994) and Stonebridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 128 S.Ct. 761 (2008) there is no aiding and abetting liability in private actions under Section 10(b) of the Securities Exchange Act of 1934. Only "primary violators" may be sued for securities fraud, which does not include, according to Stonebridge, service providers. However, the Fourth Circuit's opinion in Janus Capital appears to take great strides to expand the scope of "primary violator" by elevating otherwise secondary actors like Janus Capital Group to the status of primary violators. Based on the oral arguments before the Supreme Court in December, it appears that the justices may be split over whether an investement manager of a fund can be subject to primary liability for securities fraud based on alleged misstatements in the fund's prospectuses. Several of the justices asked questions concerning the relationship between an investment adviser and a fund. Justices Stephen Breyer, Anthony Kennedy, and Sonia Sotomayor all asked whether an investment advisor should be viewed as the equivalent of a corporate manager who can be held liable for a corporation's misstatements. While the outcome of the Janus Capital case is still unknown, if the Court does in fact uphold the Fourth Circuit's opinion the implications could be far reaching. The question of whether there will be a significant expansion of liability under the securities fraud laws, and, therefore, a substantial expansion of the securities class action universe could be decided when the Court issues its opinion in this case.
Pursuant to Supreme Court rulings in First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994) and Stonebridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 128 S.Ct. 761 (2008) there is no aiding and abetting liability in private actions under Section 10(b) of the Securities Exchange Act of 1934. Only "primary violators" may be sued for securities fraud, which does not include, according to Stonebridge, service providers. However, the Fourth Circuit's opinion in Janus Capital appears to take great strides to expand the scope of "primary violator" by elevating otherwise secondary actors like Janus Capital Group to the status of primary violators.
Based on the oral arguments before the Supreme Court in December, it appears that the justices may be split over whether an investement manager of a fund can be subject to primary liability for securities fraud based on alleged misstatements in the fund's prospectuses. Several of the justices asked questions concerning the relationship between an investment adviser and a fund. Justices Stephen Breyer, Anthony Kennedy, and Sonia Sotomayor all asked whether an investment advisor should be viewed as the equivalent of a corporate manager who can be held liable for a corporation's misstatements. While the outcome of the Janus Capital case is still unknown, if the Court does in fact uphold the Fourth Circuit's opinion the implications could be far reaching. The question of whether there will be a significant expansion of liability under the securities fraud laws, and, therefore, a substantial expansion of the securities class action universe could be decided when the Court issues its opinion in this case.
Matrixx Initiatives, Inc. v. Siracusano (materiality standard) - The Supreme Court heard oral argument in the Mattrixx case in January. The case addresses whether a drug company violates federal securities laws by failing to disclose reports of patients having adverse reactions to its drugs when the number of incidents is not statistically significant. There is currently a split in the circuit courts on the issue of the need to plead "statistical significance" in order to establish the materiality of a securities fraud claim. The Court's opinion in this case could resolve the split and may, therefore, have a "statistically significant" impact on the securities class action landscape. The extent to which minimal product defects and the like can serve as the basis to assert securities fraud claims could expand or contract the number of securities fraud cases involving facts similar to Mattrix.
Haliburton (loss causation) - On January 7, 2011, the Supreme Court agreed to hear the Halliburton case. The Court will consider the extent to which the plaintiff has the burden of proving “loss causation” at the class certification stage. The issue of loss causation asks whether the alleged fraud actually caused a company’s stock price to decline thereby causing investors to suffer losses. The Court’s decision could have significant implications for defendants as their ability to end meritless cases early in the litigation will increase if they can address the issue of loss causation as an element of the certification process. The Supreme Court is expected to hear argument in Halliburton in April 2011, with a decision likely by the end of June.
III. Sweeping Legislation - Dodd-Frank Reform Act
By far the most noteworthy legislative action of 2010 is the passage of the Wall Street Reform and Consumer Protection Act (the “Act”) on July 21, 2010. The following summarizes the key takaways impacting securities class actions.
Whistleblower Bounty - The Act provides that where whistleblower information leads to subsequent enforcement action resulting in sanctions greater than $1,000,000, whistleblowers are entitled to recover 10 to 30 percent of the monetary sanctions. Such awards will be funded by the SEC Investor Protection Fund, which itself will be funded by the sanctions collected by the SEC. The SEC has reported that the Investor Protection Fund is already fully funded at just under $452 million.
In addition to allowing whistleblowers who qualify potential recovery from SEC sanctions, the Act creates for them a private right of action against retaliation from employers. The remedy has a six year statute of limitations and the action can be brought directly in federal court. No longer will whistleblowers be required to file a complaint with the Secretary of Labor prior to filing in federal court. The remedies available are broad and include reinstatement, double back-pay, with interest, and compensation for litigation costs and attorneys fees.
The success of the Act's bounty provisions in pulling would-be whistleblowers out of the woodwork is yet to be seen. Some commentators have speculated that there are many pressures on potential whistleblowers that could keep them in the closet. Ultimately, the question is whether the Act struck the necessary risk to reward ratio necessary to create substantive change in behavior. It it did 2011 and beyond could see an increase in SEC enforcement actions based in insider leaks accompanied by a flurry of spin-off class action suits.
Clawback Provision - the Act also provides new provisions for executive incentive-based compensation. The Act requires that the SEC prohibit securities exchanges from listing any company that does not disclose incentive based compensation. And, its "clawback" provision under Section 954 requires that executive incentive-based compensation based on false financial data be returned to the company. The Act's clawback provision covers all executive officers and applies to all incentive-based compensation going back three years from the date of a misstated financial filing. This is in contrast to Sarbanes Oxley, which only allowed a one year look-back and which only covered the issuer's current CEO and CFO.
In an unexpected twist, the Act does not extend the right to sue aiders and abettors to private parties. This step, which was championed by Senator Arlen Spector and Representative Maxine Waters, would have overturned the Supreme Court's Stonebridge decision barring suit against aiders and abettors in securities fraud cases. However, similar to extraterritorial reach for private parties, the Act does provide for a Government Accountability Office (GAO) study on the propriety of aiding and abetting liability as a remedy for private litigants. The GAO has a year from enactment to report its findings to Congress.
Investment Advisor Registration Changes - The Dodd-Frank Act raises the dollar threshold for registration under the Advisors Act from $25 million to $100 million of assets under management (AUM). Therefore, any advisor with AUM over $100 million will be required to register with the SEC, barring an exemption. Any advisor with AUM under that threshold amount will be prevented from registering with the SEC, unless the advisor (a) advises an investment company registered with the SEC or a firm elected as a business development company under the Advisors Act, or (b) the advisor would otherwise be required to register with 15 or more states in which case it would be allowed to register with the SEC instead.
In sum, the Dodd-Frank Act registration provisions will bring about a significant change for the investment community. Many of the larger hedge funds and private equity advisors will be required to register with the SEC. Many of the smaller advisors will be subject to state regulation, possibly in multiple states. This will almost certainly increase regulatory oversight for the investment community as a whole to include more explicit fiduciary obligations and reporting requirements for those who must now register with the SEC. The changes mentioned above will become effective July 2011. Specifically, those advisors who are required to register with the SEC will be required to do so by July 21, 2011. For more information and details about the Dodd-Frank registration provisions see here.
SEC Funding - The Dodd-Frank Act provides the SEC with more reach and authority in the financial world than it has ever had. Such authority covers a much broader spectrum of enforcement than even mentioned above. But, increased authority is one thing. Having the fiscal resources to fully exercise that authority is another. In its 2010 year-end report, Advisen observed that, in the wake of the credit crisis, regulatory authorities like the SEC, DOJ, and state enforcement officers are more likely to coordinate investigations and share information. It further noted that the Dodd-Frank Act beefed up SEC funding and that the SEC now plans to add another 800 employees on top of the 400 additional full-time employees budgeted for fiscal year 2011.
However, as also noted by Advisen, Republican control of the house may stall SEC funding, which could mean a stunting of enforcement efforts. It appears that just such a scenario is already happening. According to this press release, due to spending bill H.R. 3082 the SEC will continue to operate under its 2010 budget until April, 2011. Similarly, CNNMoney reports here that Congress projected that the SEC needed to double its budget by 2015 in order to pay for Dodd-Frank reform. Unfortunately, at least at this point, the SEC may actually be more financially strapped than they were before Dodd-Frank. The SEC, according to CNNMoney, has, among other things, had trouple hiring even one new staff position, is having to delay the creation of key offices mandated by Dodd-Frank, has had to postpone depositions in enforcement cases, and has had to divert money from other projects to fund Dodd-Frank initiatives. As reported by CNNMoney, SEC spokesperson John Nester put it best. "Operating under [the current budget] is already forcing the agency to delay or cut back enforcement and market oversight efforts," "The longer we operate under significant budgetary restrictions, the greater the impact."
2010 was one of the most exciting years in recent memory for securities class actions. There were many changes to the business, regulatory, and judicial landscape that had some immediate impact as well as long-term implications. 2011 looks to be another exciting year with M&A filings on the rise, Supreme Court opinions that have been handed down and that have yet to be issued, and the ever evolving Dodd-Frank reform initiatives.