Is Everything Securities Fraud?

Securities litigation is a virtually inevitable fact of life for any public company. Often, investors sue because the firm’s managers engaged in fraud that directly harmed the shareholders—say, by doctoring the firm’s financials, or lying about known business prospects. However, shareholders also sue companies that engaged in conduct that more directly harms a different set of constituents. When a pharmaceutical company sells dangerously contaminated drugs, a faulty car battery bursts into flames, or an oil rig explodes, it’s difficult to say that the direct victims of the misconduct are the companies’ shareholders. Yet shareholders commonly sue under the federal securities laws based on precisely this kind of conduct, on the ground that the managers should have better disclosed the underlying facts, and investors were harmed by the resulting drop in stock price because they did not. This has led at least one notable commentator to argue that ‘everything is securities fraud.’ Objections from industry and academia to these lawsuits, dubbed ‘event-driven litigation,’ are becoming increasingly vocal. However, despite increased interest in these lawsuits, there has so far not been any comprehensive study that examines their prevalence, attributes, and outcomes.

In my article, I address this gap by conducting a comprehensive empirical analysis of event-driven securities class actions. In a sample of nearly 500 securities class actions against public firms from 2010-2015, I find that a non-trivial 16.5% of securities class actions arise from misconduct where the most direct victims are not shareholders (ending the sample in 2015 minimizes ongoing litigation; more recent trends will be the subject of future work). While these are still a minority of the lawsuits, these cases have a significantly lower dismissal rates and generate higher settlements than cases where the primary victims are shareholders. Investors have a 20% higher chance of having their lawsuit dismissed if the misconduct at issue primarily harms them. The average shareholder settlement in cases where the misconduct most directly harms other victims is more than double the average settlement for those cases where the primary victims are shareholders. Accordingly, the empirical analysis supports the notion that event-driven securities class actions are big-ticket cases; substantial money and resources are tied up in securities lawsuits where the primary victim is not a shareholder.

This success is likely due in large part to my second finding, which is that in these lawsuits, shareholder plaintiffs almost universally benefit from government investigations into the defendant firms’ misconduct against third parties. When bringing Rule 10b-5 lawsuits, class action plaintiffs must plead their claims with heightened specificity without the benefit of discovery; a government investigation can make this task far less costly by making public the facts necessary for a successful complaint. Securities plaintiffs’ lawyers may freeride on such investigations in effort to reap larger fees with less effort.

In examining the parties in event-driven securities class actions, I find that the majority of these lawsuits are brought by institutional investors (particularly pension funds), and the top-tier plaintiffs’ lawyers that serve them. I also find that defendant firms in these cases are generally much larger than those in cases where the primary harm is to shareholders. This finding further confirms that event-driven lawsuits are not a trivial phenomenon, and that the major players in securities class action litigation are behind these lawsuits.

These results, which to my knowledge are the first of their kind, can help inform the burgeoning debate over the desirability of event-driven securities litigation. A key question in this debate is whether these lawsuits are meritorious. Many of the characteristics shared by the event-driven cases in my sample—government investigations, low dismissal rates, high settlement values, and institutional lead plaintiffs—are often viewed as proxies for merit in the securities class action context. Should we then conclude that the criticism directed against these cases is misplaced? Not so fast. First, the non-SEC investigations that accompany these lawsuits may not be a good proxy for merit because the relevant regulators—the Environmental Protection Agency, Food and Drug Administration, and the like—focus on environmental protection, food and drug safety, or other mandates, rather than investor fraud. Such investigations therefore may not signal meritorious grounds for shareholder recovery. Further, the pressure to settle such cases is intense, and institutional investors may ‘cherry-pick’ these cases because they are relatively easy to bring, and generally involve deep-pocketed defendants.

A second question is whether, irrespective of their benefits to shareholders and their merits, these lawsuits play a valuable role in deterring, compensating, or monitoring firms’ externality of costs to third parties. Available data from my sample show that event-driven securities class actions may help deter firms from conduct that harms third parties; in about 20% of the event-driven cases in my sample, there is a shareholder recovery where neither the harmed third party nor any regulator recovered anything. However, it is unclear, based on the amount of these settlements, to what extent they fill a deterrence gap, and to what extent they constitute nuisance settlements. From a compensation standpoint, these lawsuits by definition do not compensate third parties who are victims of corporate misconduct, and some leading scholars have argued that they do not compensate shareholders very effectively either. Finally, these lawsuits are arguably suboptimal as monitoring mechanisms to curtail harm to third parties. Managers often externalize costs to third parties (whether by shoddy manufacturing, false advertising, or inadequate safety measures) in order to bolster their company’s share price. Thus, shareholders may actually prefer managers to pursue such misconduct as long as the odds of detection are low. The relative success of event-driven securities class actions may reinforce this preference; shareholders may figure that if the management is not caught, shares will increase in value, and if the management is caught, they will be able to recoup at least some of their losses through settlements after the fact. Furthermore, monitoring via event-driven securities class actions is suboptimal because these lawsuits occur after millions of barrels of oil flood the Gulf, the new sports car bursts into flame, or the contaminated Tylenol is in the medicine cabinet. And even as an ex post enforcement mechanism, such lawsuits are inadequate because they often do not incentivize disclosures that would be useful in monitoring a firms’ risk for harming third parties. This is because under the existing securities regime, firms can usually better escape liability either by being excessively vague about such risks, or by saying nothing at all.

Finally, I make several broad proposals relating to mandatory operational risk and ESG reporting. Enforcing the accuracy of such disclosures—and thus making investors and the public at large better aware of the risks that firms create—could be a useful role for event-driven cases. Looking forward and building on future data, these proposals could be a first step in improving the quality of these lawsuits and their effectiveness in curbing harmful practices.

Emily Strauss is a Professor of Law at Duke Law Faculty.