Dr. David Tabak of NERA Economic Consulting has written a working paper on the relationship between risk disclosures and damages in securities class actions. CFO.com has an article discussing the paper.
Quote of note (CFO.com): "Given the increasing potential for shareholder lawsuits, Tabak believes that top managers should give greater weight to the option of revealing the possibility of bad news before it becomes a certainty. The realization of such perils as an adverse interest-rate movement, a product failure, or an impending government probe 'could easily lead to a large decline in a company's stock price' — a greater decline, he asserts, than what would have occurred earlier if the company had merely disclosed the probability that an event would take place."
HealthSouth Corp. (OTC Pink Sheet: HLSH), the largest provider of physical rehabilitation services in the U.S., announced last week the preliminary settlement of the securities class action pending against the company in the N.D. of Alabama. The settlement also covers related derivative suits. The cases stem from the massive accounting improprieties at the company revealed in 2003.
The settlement is for $445 million, including a cash payment from HealthSouth's insurance carriers of $230 million and HealthSouth common stock and warrants valued at $215 million. Interestingly, "the federal securities class action plaintiffs will receive 25% of any net recoveries from future judgments obtained by or on behalf of HealthSouth with respect to claims against Richard Scrushy, the company's former chief executive officer, Ernst & Young, the company's former auditors, and UBS, the company's former primary investment bank, each of which remains a defendant in the derivative actions as well as the federal securities class actions." Bloomberg has this report.
An interesting appellate decision from late last year illustrates the double-edged nature of the efficient market hypothesis for securities fraud litigants. In In re Merck & Co. Sec. Litig., 432 F.3d 261 (3rd Cir. 2005), the Third Circuit addressed whether Merck's failure to disclose certain accounting practices of a wholly-owned subsidiary was a material omission.
On April 17, 2002, in connection with the initial public offering of the subsidiary, Merck filed a Form S-1 that disclosed for the first time that the subsidiary had recognized as revenue the co-payments paid by consumers. The Form S-1 did not disclose, however, the total amount of co-payments recognized. On the day the Form S-1 was filed, Merck's stock price went up. Two months later, the Wall Street Journal reported that the subsidiary had been recognizing the co-payments as revenue and estimated the total amount of this revenue in 2001 at over $4 billion. Merck's stock price dropped two dollars.
On appeal, the Third Circuit held that in an efficient market the materiality of disclosed information may be measured by looking at the movement of the company's stock price immediately following the disclosure. Since Merck's stock price did not decline when the Form S-1 was filed, the court found that the revenue recognition information was immaterial as a matter of law. In response to the plaintiffs' argument that the real disclosure took place when the Wall Street Journal made public the estimated magnitude of the co-payment recognition, the court found that the "minimal, arithmetic complexity of the calculation" made by the reporter "hardly undermines faith in an efficient market." The court noted that this was especially true given how closely Merck was followed by analysts.
Holding: Dismissal affirmed.
Quote of note: "[Plaintiff] is trying to have it both ways: the market understood all the good news that Merck said about its revenue but was not smart enough to understand the co-payment disclosure. An efficient market for good news is an efficient market for bad news. The Journal reporter simply did the math on June 21; the efficient market hypothesis suggests that the market made these basic calculations months earlier."
Addition: One of the panel judges was Samuel Alito, who has since become Justice Alito.
Business Week has an article on the increasing number of institutional investors who are opting out of securities class actions and filing their own suits. The article discusses the Time Warner and WorldCom litigations.
Merrill Lynch has announced the preliminary settlement of 23 securities class actions related to its research coverage of Internet stocks. The cases allege that Merrill Lynch disseminated overly optimistic research and investment recommendations to garner investment banking business. The settlement is for $164 million.
As discussed in this Los Angeles Times article, the settlements surprised some experts because of Merrill Lynch's apparently strong legal position. Many of the cases had already been dismissed, although appeals were pending. (The dismissals are discussed here and in a number of other posts.)
As a result of these settlements and prior actions, only 2 of 41 class actions related to Merrill Lynch's research coverage remain pending. Notably, one of those suits is the Dabit case currently before the U.S. Supreme Court.
For readers interested in more analysis of the Securities Litigation Uniform Standards Act (SLUSA) issues before the U.S. Supreme Court this term, the New York Law Journal (via law.com - regist. req'd) has two recent columns on the cases. The column on Dabit (Feb. 15) can be found here; the column on Kircher (Feb. 8) can be found here.
The Wall Street Journal has an op-ed (subscrip. req'd) today discussing the effectiveness of the PSLRA. The author is Kenneth Lehn, a professor and former chief economist for the SEC.
The op-ed argues that the PSLRA has not discouraged the bringing of securities class actions. To the contrary, the percentage of listed companies subject to suit has increased and settlement values are up. The author summarizes the results of a number of recent studies.
After this rigorous opening, however, the op-ed suggests three modest PSLRA reforms that do not really go to the identified problem. First, defendants should be allowed to appeal denials of motions to dismiss. Second, damages should not be calculated using aggregate models. Finally, investors who are fully compensated for their losses by SEC distributions pursuant to the Fair Funds program should not be allowed to collect additional damages in private litigation.
Even assuming that these proposed reforms were worthwhile, it is hard to see how they would have any significant effect on the number of filings. What is missing, one might suggest, is a proposed reform addressing the economic incentives driving plaintiffs' attorneys to bring securities class actions.
In case you missed it, which would be easy to do since it appeared in the Saturday edition of the Wall Street Journal, Professor Moin Yahya had an op-ed (subscrip. req'd) decrying the relationship between short sellers and the securities litigation plaintiffs' bar. The op-ed discusses a few cases in which short sellers appear to have profited by sponsoring securities fraud suits against companies (including the Terayon case, discussed in this post from 2004).
Quote of note: "Plaintiffs should be deemed insiders until they announce their intention to sue or commence the lawsuit. Furthermore, any hedge funds that deal with plaintiffs or their lawyers should disclose their dealings prior to any short-selling. The SEC has had no compunction in the past targeting fraudulent practices, and the short-selling plaintiffs should not be treated any differently."
Nortel Networks Corp. (NYSE: NT), the largest North American telephone equipment maker, has announced the preliminary settlement of the securities class actions pending against the company in the S.D.N.Y. The cases are related to Nortel's announcement of revised financial guidance during 2001 and its revision of its 2003 financial results and restatement of other prior periods.
The proposed settlement is for $2.4 billion in cash and stock. In particular, Nortel has agreed to pay $575 million in cash and issue stock equivalent to 14.5 percent of the company. Nortel also will contribute one-half of any recovery from its existing litigation against certain former officers who were terminated for cause. The agreement is conditioned on payments from existing insurance - an issue that has not yet been resolved.
Bloomberg reports that the proposed settlement is the fifth-largest securities class action settlement in U.S. history.
(1) Excluding the Enron and WorldCom settlements, the value of securities class action settlements was $3.5 billion in 2005, up from $2.9 billion in 2004.
(2) The settlement value increase is attributable to a 10% increase in the number of settlements (124 in 2005 vs. 113 in 2004), a $2.1 million increase in average settlement value ($28.5 million in 2005 vs. $26.4 million in 2004), and an increase in the number of settlements over $100 million (9 in 2005 vs. 7 in 2004).
(3) The median value of settlements increased 19% to $7.5 million in 2005.
The press release announcing the report can be found here.
Quote of Note (press release): "[W]hile the Cornerstone study finds a significant increase in settlement amounts in 2005, a report recently issued by the Stanford Law School Securities Class Action Clearinghouse in cooperation with Cornerstone Research found decreases in 2005 in both the number of case filings, as well as the amount of investor losses associated with case filings. Since there is a delay between case filings and case resolutions, these results suggest - along with the effects of the Dura decision - potential lower settlement values in the future."
The Cornerstone/Stanford report on securities class actions filings in 2005 has been the subject of press commentary, primarily focused on the "sharp decline" in cases. The New York Times has a Legal Beat column discussing the report in today's edition.
There are two interesting questions that arise out of the report's findings.
First, is the decline actually significant? Securities Litigation Watch has done a great job of pointing out that commentators are ignoring the actual statistical trend - perhaps because they are merely relying on the press release that accompanied the report. In the context of post-PSLRA filings (i.e., since 1996), last year's 175 filings is entirely consistent with the normal up-and-down pattern.
Second, and perhaps more interestingly, why was there no rise in the number of securities class action filings last year given the astonishing increase in financial restatements? There were an estimated 1200 financial restatements in 2005, nearly twice as many as in 2004. Although not every financial restatement brings a lawsuit, there is little doubt that the correlation is significant. The Cornerstone/Stanford report found that 89% of securities class actions filed in 2005 alleged misrepresentations in financial documents.
The New York Times column states that restatements are becoming more commonplace and may not indicate misconduct, but then quotes some experts suggesting that the real reason for the decline in filings is a combination of the PSLRA and judicial decisions (including Dura) that have made it more difficult for investors to bring cases. One missing link, however, is the relationship between restatements and stock price declines. The announcement of a restatement that is not accompanied by a significant stock price decline is unlikely to engender a securities class action (not enough damages). So it would appear that we need at least one more piece of the statistical puzzle: how many of last year's restatements led to a significant stock price decline?
Professor Elliott Weiss, a well-known securities law expert, is the author of a law review article ("Let the Money Do the Monitoring: How Institutional Investors Can Reduce Agency Costs in Securities Class Actions") that was the basis for the PSLRA's lead plaintiff provisions. In an interesting career change, Professor Weiss has joined a prominent securities class action plaintiffs' firm. Securities Litigation Watch has an interview.