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Is Everything Really Securities Fraud?

This article addresses the perception that every corporate trauma constitutes securities fraud, and that U.S. companies have been overwhelmed by securities actions in recent years. We don’t think the evidence supports that conclusion.

Readers of Bloomberg’s Money Stuff column will undoubtedly recognize the phrase “everything is securities fraud,” which was coined by Matt Levine under this general theory:

  1. A public company does a bad thing;
  2. The company does not immediately disclose the bad thing, because generally when you are doing a bad thing you are trying to be sneaky about it;
  3. Eventually the bad thing comes out and the stock drops; and
  4. Shareholders sue, saying that the company defrauded them by not disclosing the bad thing.

Thus, Levine writes, “contributing to global warming is securities fraud, and sexual harassment by executives is securities fraud, and customer data breaches are securities fraud, and mistreating killer whales is securities fraud, and whatever else you’ve got.”

This is tongue and cheek, of course, and Levine acknowledges that this is not “literally the law.”  But is there a kernel of truth here?

We agree that there’s a kernel, but perhaps not much more.  While there have certainly been securities lawsuits in recent years that have pushed the envelope on the traditional concept of a securities lawsuit, their prominence has been overblown.

As an initial matter, here’s what we mean by a traditional securities claim: imagine, perhaps as the most classic example, an accounting fraud like Enron, where the company hid billions of dollars in debt and fabricated billions of dollars in revenue to prop up its stock price and pay out enormous salaries and bonuses to executives.  Another example: a number of biotech and pharmaceutical companies have been sued in recent years when statements about the efficacy of a drug or device prove to be overstated or simply false.  In these scenarios, federal securities laws allow investors to sue companies (and their officers and directors) for making false statements that inflated the stock price and caused losses for investors when the truth came out.

In contrast, the new breed of “everything is securities fraud” cases typically hinge on less fundamental aspects of a company’s business that are particularly embarrassing and public, like, as Levine suggests, the treatment of killer whales by Seaworld or the inadvertent disclosure of customer data by Equifax, both of which resulted in significant settlements for stockholders.  In such cases, plaintiffs’ lawyers typically focus on statements outside of a company’s regular financial disclosures or a company’s aspirational statements about the standard of conduct to which it adheres.  For example, in the Seaworld case, the plaintiff targeted statements by executives that downplayed the importance of the movie Blackfish, which revealed mistreatment of the whales at Seaworld, to the park’s attendance and sales expectations.  In the Equifax case, the plaintiffs targeted statements that the company was “a trusted steward of consumer and business information” and that data security is “a top priority” before a data breach disclosed the personal information of more than 148 million people. 

Whether or not you believe that these cases stretch the federal securities laws too far (for what it’s worth, we don’t believe the examples above are problematic), the frequency of such cases suggests that the effect on the market is minimal.

First, only around 5% of public companies are exposed to securities litigation of any kind each year, according to Cornerstone Research, an economic consulting firm.  The vast majority of companies are not sued.

Second, even companies that have experienced large stock drops are still unlikely to be sued.  At worst, the very largest companies (with greater than $2.8 billion in market cap) that have been subject to the very largest stock drops (greater than 20%) historically have only a 40% chance of being sued under the federal securities laws.  Midsize and smaller companies have less than a 20% chance even with large stock drops, and only a 5-10% chance or less for smaller stock drops, depending on the size of the company and drop.

Third, of the federal securities cases that are filed, roughly half are dismissed at the earliest available procedural stage based on a technical failure in the claims (we suspect, anecdotally, that an even higher percentage of “everything is securities fraud” cases are dismissed early).  In such scenarios, companies avoid the vast majority of expenses and disruption caused by securities litigation.

This leaves the cases that are filed and survive dismissal: around 70 cases or so per year that result in settlements and recoveries for investors in the companies at issue.  In recent years, these cases have delivered between $2 and $6 billion dollars annually for investors.  Given that these cases have been filtered by the legal system to include only the most meritorious claims—and that the market capitalization of public companies in the U.S. exceeds $49 trillion—we see little cause for concern that securities litigation may be hamstringing corporate growth and development.  

Rather, we view meritorious securities litigation as a cornerstone of the U.S. economy (not all countries protect investors to the extent that the U.S. does) and a vital component of market regulation.  

In our view, it turns out that very little actually is securities fraud, but that the legal system rightly provides an avenue for investors to recover value when they have been defrauded or misled by public companies and their managers.