Event-Driven Securities Litigation: an Interview with Marc I. Gross
Whether you’re an influencer, a politician, or a corporation, reputation impacts your livelihood. In the Spring 2024 issue of The Business Lawyer, Marc I. Gross published a paper rebutting Columbia Law Professors Merritt Fox and Joshua Mitts’ “Event Driven Suits and the Rethinking of Securities Litigation,” published in the Winter 2022-2023 issue of the same journal. Marc met with Brett Lazer of the Monitor to discuss why a company’s reputation is a key factor often missed by the courts when assessing the impact of misleading statements on stock prices, and the consequences thereof for measuring damages in securities fraud class actions.
The Pomerantz Monitor
Your article focuses on “event-driven securities litigation.” Perhaps you can explain what that is and the debate surrounding it.
Marc I. Gross
It’s a term Professor John Coffee of Columbia coined about 10 years ago to describe cases filed following major catastrophes, such as BP’s Deepwater Horizon oil rig explosion. The debate is whether the same rules should apply to these cases as to financial misstatement cases, because event-driven cases deal with an undisclosed, not a misstated, result. For example, in a case that Pomerantz successfully pursued against BP, the company had a series of catastrophes prior to the oil rig explosion. BP asserted it had implemented a remedial program, but failed to disclose that the program did not apply to high-risk offshore drilling. The court found that BP’s prior pattern of misconduct, combined with its failure to disclose the degree of risk investors actually faced, supported a securities fraud claim. In recent years, event-driven litigation has expanded from similar catastrophes to cases where a company was suddenly found to have engaged in other types of misconduct. Such as the dark pool trading platform at issue in Pomerantz’s case against Barclays, or the ABACUS transactions that John Paulson engaged in with Goldman Sachs, which were referenced in the film The Big Short.
In their article, Fox and Mitts argue that event-driven cases should be categorized separately and analyzed under a different set of rules, including imposition of much higher pleading burdens on plaintiffs. Frankly, I don't think they want to limit such rules to catastrophes. I think they see their proposals as a means to recast what they think is wrong in securities fraud litigation.
Monitor
What is the argument of the Fox and Mitts’ piece?
MIG
They say that in event-driven cases, if not most securities cases, the court should not focus on how stock prices reacted when the wrongdoing was disclosed, but on the price impact had the company said nothing at the outset. In other words, to determine damages, the court should focus on stock prices at the time the misconduct first occurred, not when the misconduct was revealed. In the Barclays case, the bank had serious prior violations related to certain trading platforms, and they said, “For our new ‘dark pool’ trading, we've now taken remedial measures to ensure customers are protected and there are no abuses,” which, in fact, they hadn’t. Fox and Mitts’ thesis is that in assessing price impact, the court shouldn't look at what happened when investors learned that Barclays’ statements were misleading, but how the market would have reacted had there been no statements about the dark pool trading at the outset, on the assumption that the company did not have to volunteer such information.
Monitor
You say this misses a key function of these kinds of corporate utterances.
MIG
These statements are made to burnish a company’s reputation and assure investors that past misconduct has been remediated. My argument is that courts fail to give sufficient weight to the degree to which a company's reputation impacts the stock price at the time misstatements are made. There's empirical evidence showing that a significant portion of any stock price is attributable to reputation. Marty Lipton [a founding partner of law firm Wachtell, Lipton, Rosen & Katz] suggests it’s 50%. That makes sense because companies are essentially brand names. Their value is based on what investors think their profitability will be, but also on perceptions of the management’s integrity. Investors don't like surprises, so they will invest in stocks based upon an assumption of reliability and truthfulness. We have this whole theory of fraud on the market - what else is the market doing but presuming a degree of credibility and reliability of management? Investors assume such factors are baked into the stock price. So when a company discloses misconduct, or incurs a catastrophic event, and the stock price plummets, studies have shown that the size of the decline is often disproportionate to the amount that the stock would have fallen had the company simply been truthful in the first instance. If a company says, “Instead of earning $1 we only earned $0.75,” you might expect a 25% decline based on historic price/earnings ratios. In fact, studies show that stock will actually fall over 50%. What accounts for that additional decline? As cited in my article, Professor Karpov and others have empirically shown the additional decline is attributable to the market reassessing the reputational risk of the company.
Monitor
One of the examples you use to illustrate this effect is Wells Fargo. Can you take us through what happened in that case?
MIG
Wells Fargo had a sterling reputation, selling at a higher price-to-earnings ratio than its competitors. The bank touted its “synergy” practices, such as getting checking account customers to invest in other types of accounts. These “synergies” helped the bank distinguish itself from its competitors. Then suddenly investors learned that Wells Fargo’s bankers were engaging in abusive practices to meet “goals”: at the end of the quarter, transferring money from customers’ accounts into others, and then reversing the transactions. Sometimes customers lost money due to overcharge fees, sometimes they didn’t. It didn't add much to profits or revenues. This wasn’t Enron, where earnings were being faked. Wells Fargo was still making billions of dollars in profits. Indeed, when these abusive practices were disclosed, it paid only a $185 million fine, a drop in the bucket for the bank. Nonetheless, the stock price cratered by $30 billion within a month. That's an indication that the market reassessed the reliability of management. The market was prescient because it turned out that Wells Fargo was doing this with car loans, insurance and other products. Boeing currently is an extreme example of such misconduct. It didn’t cook the books like Enron, but it cratered its own planes by pushing profits before safety.
Monitor
This gets back to the issue of a company’s statements. One supposes Boeing couldn’t come out and say it was skimping on safety to maximize profits.
MIG
It’s a good question, because the courts have asserted, and properly so, that a company doesn't have to accuse itself of criminal misconduct. At the end of the day, it's not about merely saying that you’re taking action to improve safety as Boeing did, it’s whether you are actually doing it, which it was not. For Fox and Mitts, these situations don’t constitute securities fraud because there was no requirement to volunteer information about safety practices. Rather, the professors categorize this as only a breach of a fiduciary duty of care for which derivative claims exist as a remedy. In a sense this is correct, because directors have a fiduciary duty, under the Caremark case in Delaware, to make sure remedial measures are, in fact, being implemented. We could certainly bring a derivative case against Boeing. The problem with derivative cases is that they take money from the directors and put it back into the company without necessarily helping shareholders who lost millions when they sold shares following disclosure of the wrongdoing.
Monitor
Fox and Mitts suggest that any function served by private securities litigation would be better addressed by derivative cases, regulatory criminal prosecutions, or SEC enforcement, but you claim these remedies are insufficient. Why?
MIG
Historically, the SEC's recoveries are limited to collecting fines, not damages incurred by investors. In fact, studies by John Coffee and others show that private litigants recover 10 times the amount that the SEC gets in their cases. So first, it’s a matter of compensation. Second, the SEC simply doesn't have the resources to pursue all these claims. The SEC and the Supreme Court have long recognized that securities litigation firms function as private attorneys general. We play a complementary role. With better resources, could the SEC actions one day be sufficient? I’m not convinced. At a certain point it becomes political. Congress has a vested interest in this system, and so without private actors there will always be political concerns that interfere with justice being carried out.