August 7, 2019

Voluntary Disclosures of SEC Investigations: No Good Deed Goes Unpunished?

Here’s something from Dan Goelzer’s latest newsletter: A challenge faced by a company under non-public SEC investigation is whether to publicly disclose the investigation before the company knows whether it will result in any charges. There are no firm rules on whether investigations must be disclosed. The decision is inherently a judgment call and depends on an assessment of materiality after considering the costs and consequences of the investigation, the issues underlying the inquiry, the likelihood and potential impact of any eventual SEC enforcement proceeding, and other factors. It is frequently assumed that transparency is the more conservative approach and that, in the long run, the market rewards candor.

Dan goes on to say that a recent paper by David H. Solomon, of Boston College’s Carroll School of Management, and Eugene Soltes, of Harvard Business School, casts doubt on these assumptions. Professors Solomon and Soltes conclude:

– Even if no charges are ultimately filed, companies that voluntarily disclose an SEC financial fraud investigation have “significant negative returns, underperforming non-sanctioned firms that stayed silent by 12.7% for a year after the investigation begins.”

– Disclosing in a “more prominent manner” (e.g., in a press release as distinguished from an SEC filing) is associated with worse returns.

– A CEO whose company discloses an investigation is 14 percent more likely to “experience turnover” within two years than a CEO whose company opts to remain silent, regardless of the outcome of the SEC investigation.

These findings won’t come as a surprise to anyone who’s been involved in responding to fraud allegations. Even if the SEC ultimately drops their inquiry, a years-long investigation can tear apart the company and make it pretty hard for management to stay focused on their day jobs. But in his newsletter, Dan notes that:

The circumstances which lead to SEC financial fraud investigations vary widely, as do the pros and cons of voluntary disclosure. The Solomon and Soltes research, while intriguing, should not be a factor in deciding whether to disclose an investigation. The paper does, however, underscore how seriously the markets are likely to take news of a financial fraud investigation. The audit committee needs to treat such a matter equally seriously.

Securities Class Actions: M&A Filings Down, But Plaintiffs Still Loving Disclosure Fraud

Last week, Cornerstone Research published its midyear assessment of securities class action filings. Here’s a few takeaways from the press release:

– Plaintiffs filed 126 “core” class actions (excluding M&A claims) – that’s just one shy of the record set in the first half of 2017 – due to delayed market volatility in late 2018 and an uptick in filings against consumer-focused and tech companies

– Plaintiffs have filed more than 1,000 securities class actions in the last 2.5 years – accounting for more than 20% of the total number of filings since 1997

– M&A-related filings declined more than 20% since last year – to 72 – and dropped below 90 for the first time since the second half of 2016

– Six mega-dollar disclosure loss (DDL) filings (at least $5 billion) and 11 mega maximum dollar loss (MDL) filings (at least $10 billion) propelled aggregate market capitalization losses to the highest and fourth-highest levels on record, respectively

– Due to the Supreme Court’s 2018 Cyan decision, plaintiffs continue to shift securities fraud claims against IPOs from federal to state court – 61 new 1933 Act filings have appeared post-Cyan, which consists of 23 parallel filings, 12 filings in federal courts only, and 26 filings in state courts only

’33 Act Class Actions: NY State May Not Be So Plaintiff-Friendly After All

People have been predicting that SCOTUS’s 2018 Cyan decision – which held that class actions alleging claims under the Securities Act of 1933 may be heard in state court – would be a boon for the plaintiffs’ bar…and a big problem for IPO companies & their D&O carriers. Cornerstone’s midyear assessment of securities class action filings certainly suggests that plaintiffs have found the decision encouraging.

But this D&O Diary blog points to a glimmer of hope in New York – where many post-Cyan suits are being filed because the state’s pleading standards are less onerous than at the federal level. The blog explains that a New York State trial judge recently dismissed a case brought against an IPO company & its underwriters under Sections 11 and 12(a)(2) of the Securities Act. Here’s an excerpt (and here’s a call for reform):

To the extent that the plaintiffs’ lawyers were motivated to file in state court based on perceived advantages at the motion to dismiss stage, Judge Borrok’s decision represents something of a reality check. Judge Borrok’s opinion is thorough, sure-handed, and shows no discomfort in working with the federal securities laws and relevant case law. (In that regard, Judge Borrok’s reliance on the Omnicare decision underscores the importance of that ruling in opinion cases.) The state court pleading standard does not seem to have been a factor in the ruling. And no one would mistake Judge Borrok’s opinion as plaintiff friendly.

The decision in the Netshoes case is of course just one ruling by one trial court judge. It has no precedential value and may have only limited value as an indicator of how New York state courts generally may deal with the new influx of securities cases. Moreover, Judge Borrok’s dismissal of the Netshoes case was without prejudice; the plaintiffs will have an opportunity to try to cure the shortcomings Judge Borrok noted in his decision. For all we know, the plaintiffs might well succeed in amending their complaint and in surviving the next round of dismissal motions.

However, one can hope that Judge Borrok’s ruling may help send a message that the plaintiffs may need to reconsider whatever perceived advantages they may think they have in proceeding in state court rather than federal court.

Liz Dunshee