Securities litigation and enforcement activity often surge in times of crisis. Indeed, bedrock federal securities regulations were borne out of an extended crisis: the stock market crash of 1929 and the decade-long Great Depression that followed.
COVID-19 has already set off a wave of securities litigation. These private lawsuits and putative class actions have been based on allegedly misleading statements in securities filings and public statements. But issues surrounding proof in the COVID-19 era, including demonstrating the “price impact” of alleged misrepresentations for purposes of reliance and loss causation, limit the viability of these claims.
As public companies anticipate the next wave of securities activity they should expect limitations on private lawsuits to prompt the Securities and Exchange Commission (SEC) to ramp up civil enforcement. The Department of Justice (DOJ) may even launch related criminal investigations in high-profile cases.
We discuss below recent COVID-19-related securities litigation and enforcement trends, special issues with reliance and loss causation, and best practices to avoid the expected onslaught of SEC enforcement and DOJ investigations.
Litigation and Enforcement Trends Stemming from COVID-19
The initial wave of private securities litigation and enforcement activity stemming from COVID-19 has been based on stock price drops following a company’s pandemic-related financial disclosures and public statements, including through press releases.
Private Securities Lawsuits
On March 13, investors filed suit against a cruise line and two of its officers in the Southern District of Florida alleging the company made misleading statements in securities filings and press releases that presented a positive outlook, despite the pandemic. After the purported misstatements came to light, the company’s stock prices fell nearly 36%.
That same day, an investor filed a securities fraud class action against a pharmaceutical company and its CEO in the Eastern District of Pennsylvania. According to the complaint, the company’s CEO met with President Trump and falsely claimed that the company had developed a COVID-19 vaccine with trials scheduled to start in April, causing the company’s stock price to more than quadruple.
Most recently, on May 20, an investor in an animal health company filed a proposed class action related to a May 7 statement that the company’s revenue had declined 9% in the first quarter “due to a reduction of approximately $60 million in channel inventory driven by factors resulting from the COVID-19 pandemic,” which allegedly caused a 13% drop in stock prices. According to the complaint, the company’s statements were materially false or misleading because they failed to disclose that a non-COVID-19 issue (consolidation of distributors) had led to a backlog in inventory likely to cause a further decline in revenue.
SEC Enforcement Activity
SEC enforcement activity related to the COVID-19 crisis also has made its way into headlines. For example, on April 28, the SEC filed an enforcement action in the Southern District of Florida against a medical company and its CEO alleging the defendants falsely claimed “that [the company] was able to acquire and supply large quantities of N95 or similar masks to protect wearers from the COVID-19 virus,” causing the company’s share price to nearly double.[1]
On May 14, the SEC filed enforcement actions against two more companies for allegedly making fraudulent statements related to COVID-19. In one matter, the SEC charged a biotech company in the Southern District of New York based on the company’s claims that it was offering products to help combat COVID-19.[2]
Proof Issues in Private, Enforcement, and Criminal Proceedings
Provisions of the Securities Act of 1933 (the Securities Act) and the Securities Exchange Act of 1934 (the Exchange Act)[3] may simultaneously give rise to private securities actions, SEC enforcement activity, and criminal proceedings initiated by the DOJ. Proceedings in these three distinct contexts involve varying legal elements and require different evidentiary proof.
Elements and Proof
In a private securities lawsuit alleging a violation of Section 10(b) of the Exchange Act or the corresponding Rule 10b-5, a plaintiff must prove the following six elements:[4]
- Material misstatement or omission by the defendant;
- Scienter, i.e., intention to deceive, manipulate, or defraud;
- Purchase or sale of a security;
- Reliance upon the material misstatement or omission;
- Economic loss or damages; and
- Loss causation, i.e., a causal connection between a misrepresentation and loss.
SEC enforcement activity also is civil in nature with penalties, including enjoining an individual from further violations of the securities laws, disgorgement of any money obtained from violations, and civil fines. In an enforcement proceeding, the SEC does not have to prove reliance, loss causation, or economic loss; but materiality and the defendant’s scienter remain elements of enforcement actions.
DOJ and individual US Attorney’s Offices may also pursue criminal prosecution for securities fraud, which subjects a defendant to criminal fines and supervision, and in the case of an individual defendant, potential imprisonment. In a criminal prosecution under Section 10(b) or Rule 10b-5,[5] the government must prove willful conduct in addition to the elements necessary for an SEC enforcement action. All elements must be proven beyond a reasonable doubt in a criminal case.
Special Considerations Involving Reliance and Loss Causation
The critical difference between private securities litigation and an enforcement action brought by the SEC is the role of reliance and loss causation. Private securities fraud claims require both, while enforcement actions do not.
The significance of this distinction has evolved near-full circle in the private securities litigation context. Prior to the Supreme Court’s decision in Basic v. Levinson,[6] several courts required individual class members in putative securities class actions to affirmatively prove they relied on a material misrepresentation in connection with purchasing or selling a security. This generally rendered proposed securities class actions ineligible for class certification under Rule 23 given the myriad different factual circumstances underlying an investor’s decision to execute a securities transaction.
In a watershed change, the Supreme Court in Basic accepted a presumption of reliance based on a “fraud-on-the-market” (FOTM) theory. The FOTM premise is that the price of a security traded in an efficient market will reflect all publicly available information about a company; accordingly, a buyer of the security may be presumed to have relied on that information in purchasing the security.
As Basic recognized that the presumption of reliance may be rebutted, the central issue underlying the FOTM theory is whether allegedly fraudulent statements have in fact affected stock price. “In the absence of price impact, Basic’s fraud-on-the-market theory and presumption of reliance collapse.”[7]
Price impact – i.e., whether an alleged misrepresentation affected market price in the first place – also is a component of loss causation. Loss causation requires investors to demonstrate that the defendant’s deceptive conduct caused their claimed economic loss. More specifically, investors must prove that the corrected truth of a former falsehood actually caused the stock price to fall, rather than “changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions, or other events.”[8]
Analyzing price impact for both reliance and loss causation is no easy task even in periods of market stability. Stock prices fluctuate continuously in response to a variety of issuer and market developments, as well as “noise” trading based on irrational or emotional investor responses. “Because of the need to distinguish between the fraud-related and non-fraud related influences of the stock’s price behavior[,]” modern securities litigation relies heavily on use of event studies, a statistical tool to identify significant price changes adjusted for market volatility or industry specific factors.[9]
Event studies in securities litigation typically start with determining the market-adjusted change in a company’s share price when a triggering corrective disclosure becomes public. This prediction is based on the historical relationship – usually over a one-year observation period ending shortly before the corrective disclosure – between price changes in the overall market and price changes of the issuer’s stock. The market adjustment attempts to remove the influence of news and events that affect the price of all companies in the market or industry from the individual company’s stock price. What remains might be the portion of the observed price change that could be due to issuer-specific news and “noise” trading.
This methodology makes event studies uniquely challenging in times of crisis.[10] The functional and practical limitations of event studies in this context directly implicates the ability to demonstrate price impact. Because price impact is a critical component of reliance and loss causation, limitations on event studies may impede private securities frauds claims arising out of economic crisis.
Tips to Avoid Securities Litigation and Enforcement Activity in the COVID-19 Era
As plaintiffs may face significant challenges establishing reliance and loss causation in shareholder class actions, companies experiencing stock declines concurrent with COVID-19’s negative impact on markets may be able to dismiss securities claims at the pleading or certification stage.
However, plaintiffs are not the only ones combing through public company disclosures. In the wake of the pandemic, the SEC and DOJ each have signaled an intention to focus on misconduct specifically related to disclosures concerning COVID-19. That focus, combined with limitations on demonstrating the “price impact” of alleged misrepresentations, may result in the SEC, and possibly even the DOJ, stepping in to fill the void.
While SEC Chairman Jay Clayton has acknowledged that the effects of COVID-19 may be difficult for a company to assess with precision, the chairman has likewise cautioned that “how issuers plan for that uncertainty and how they choose to respond to events as they unfold can nevertheless be material to an investment decision.”[11]
The SEC and its key officials have continued to issue guidance and public statements: (a) reminding “all companies to provide investors with insight regarding their assessment of, and plans for addressing, material risks to their business and operations resulting from the coronavirus to the fullest extent practicable to keep investors and markets informed of material developments;”[12] (b) cautioning that “a number of existing rules and regulations require disclosure about the known or reasonably likely effects of and the types of risks presented by COVID-19;”[13] (c) urging public companies to provide forward-looking guidance in their quarterly earnings statements and calls;[14] and (d) clarifying that the SEC’s response to COVID-19 is focused on “maintaining…enforcement and investor protection efforts, particularly with regard to the protection of…critical market systems and…vulnerable investors.”[15]
Attorney General William Barr has likewise directed all US Attorneys to “prioritize the detection, investigation, and prosecution of all criminal conduct related to the current pandemic.”[16] It is reasonable to expect that federal prosecutors will be focused on false or materially incomplete public statements related to the impact of COVID-19, such as schemes to conceal the current or anticipated impact of the outbreak or to use the outbreak to conceal misconduct and other negative information.
Companies that proactively address concerns related to COVID-19, both in their public disclosures and in their boardrooms, will be best positioned to ward off securities litigation or enforcement actions. Recent SEC guidance offers best practices for disclosing the evolving impact of COVID-19:
- Do not place sole reliance on “generic, or boilerplate, disclosures” concerning the general risks of COVID-19.[17]
- Do not overstate preparedness to handle the crisis or downplay the material impact of the pandemic.[18]
- Exercise caution in disclosing reliable, methodologically sound, and meaningful forward-looking guidance explaining how the pandemic may affect operations and financial conditions. In addition to appropriate forward-looking cautionary language about the uncertainties posed by COVID-19 and identifying the statement as the opinion of management, issuers should identify the basis for the opinion, potentially including known material information that may contradict the opinion.[19]
- Be particularly mindful of using or selectively disclosing material nonpublic information during the COVID-19 pandemic.[20] This would include corporate insiders engaging in securities-related transactions based on material information that has not yet been publicly disclosed.
Conclusion
In these unprecedented times, it will be particularly important for companies to adhere to their communications and securities trading policies, to stringently enforce internal controls and procedure, and to be mindful of their disclosure obligations. If a company nonetheless finds itself on the receiving end of a securities claim or the subject of an enforcement investigation related to COVID-19 disclosures, counsel should be involved early and often to maximize strategic (and privileged) advice.
[1] Complaint, Sec. Exch. Comm’n v. Praxsyn Corp., No. 20-cv-80706 (S.D. Fla. Apr. 28, 2020).
[2] Complaint, Sec. Exch. Comm’n v. Applied BioSciences Corp., No. 1:20-cv-03729 (S.D.N.Y. May 14, 2020).
[3] The Securities Act generally regulates an initial sale of securities. The Exchange Act governs securities on the secondary market.
[4] Dura Pharm., Inc. v. Broudo, 544 U.S. 336, 341–342 (2005).
[5] The government may also prosecute fraudulent conduct under the property fraud statutes, including the relatively new securities fraud statute (18 U.S.C. § 1348). Compared to Section 10(b) and Rule 10b-5 prosecutions, Section 1348 has a lower scienter requirement (knowingly rather than willfully), does not require an actual purchase or sale of a security, and has a longer maximum sentence (25 years).
[6] 485 U.S. 224 (1988).
[7] Halliburton Co. v. Erica P. John Fund, Inc., 573 U.S. 258, 278 (2014).
[8] Dura, 544 U.S. at 343.
[9] Jill E. Fisch et al., The Logic and Limits of Event Studies in Securities Fraud Litigation, 96 Tex. L. Rev. 553, 564 (2018).
[10] See Edward G. Fox et al., Economic Crisis and the Integration of Law and Finance: The Impact of Volatility Spikes, 116 Colum. L. Rev. 325, 358–68 (2016).
[11] US Sec. and Exch. Comm’n, Proposed Amendments to Modernize and Enhance Financial Disclosures; Other Ongoing Disclosure Modernization Initiatives; Impact of the Coronavirus; Environmental and Climate-Related Disclosure (Jan. 30, 2020), https://www.sec.gov/news/public-statement/clayton-mda-2020-01-30.
[12] See Press Release, US Sec. & Exch. Comm’n, SEC Provides Conditional Regulatory Relief and Assistance for Companies Affected by the Coronavirus Disease 2019 (COVID-19) at 2 (Mar. 4, 2020), https://www.sec.gov/news/press-release/2020-53 (“March 4 Press Release”).
[13] See Guidance, US Sec. & Exch. Comm’n Div. of Corp. Fin., CF Disclosure Guidance: Topic No. 9 – Coronavirus (COVID-19) at 1–2 (Mar. 25, 2020), https://www.sec.gov/corpfin/coronavirus-covid-19 (“March 25 Guidance”).
[14] See Public Statement, US Sec. & Exch. Comm’n, The Importance of Disclosure – For Investors, Markets and Our Fight Against COVID-19 at 1 n.i (Apr. 8, 2020), https://www.sec.gov/news/public-statement/statement-clayton-hinman (“April 8 Joint Statement”). The joint public statement represents Chairman Clayton and Director Hinman’s views, not the official position of the SEC. Id.
[15] See US Sec. & Exch. Comm’n, SEC Coronavirus (COVID-19) Response, https://www.sec.gov/sec-coronavirus-covid-19-response (last visited May 25, 2020).
[16] Press Release, US Dep’t of Justice, Attorney General William P. Barr Urges American Public to Report COVID-19 Fraud (Mar. 20, 2020), https://www.justice.gov/opa/pr/attorney-general-william-p-barr-urges-american-public-report-covid-19-fraud.
[17] April 8 Joint Statement.
[18] March 4 Press Release at 2. The SEC’s press release cautions public companies to “take steps to prevent directors and officers from exaggerating the company’s preparedness to handle COVID-19.” Id.
[19] See Omnicare Inc. v. Laborers District Council Construction Industry Pension Fund, 575 U.S. 175 (2015) (setting forth standard for Section 11 liability in the context of opinion-based statements); see also March 25 Guidance.
[20] March 25 Guidance.