"Why do public companies in the U.S. get sued by shareholders so often?" is a question often raised by management and directors of Asian companies which have listed in the U.S. or are considering such a listing. The answer is simple: a unique practice in the U.S. known as class action litigation. Class action litigation allows shareholders to cost-effectively aggregate their claims and recoup a portion of their losses resulting from a violation of the U.S. securities laws by the issuer.
What is not simple, however, is avoiding these claims and dealing with the consequences if litigation is initiated.
This issue is becoming increasingly important in Asia as the number and cost of class action securities lawsuits in the U.S. continue to rise. 224 such cases were filed in 2003, as opposed to only 163 a decade earlier -- before legislation was passed which was intended to deter such cases! More recent changes in both U.S. statutes and case law are making it harder to dismiss these claims at an early stage of the case. And the average settlement of such a case was $19.8 million in 2003, as opposed to $10.7 million in 1993.[1] As more China-based companies list their shares on U.S. stock exchanges, they too will be increasingly subject to such lawsuits.
Class Action Litigation — A Basic Primer
In a nutshell, class action litigation allows the claims of multiple shareholders, any one of which would often be too small to justify the time and expense of a lawsuit, to be aggregated into a single action. Unsurprisingly, it is the prospect of large cash awards from these aggregated claims which drives the class action litigation industry in the U.S. However, the primary movers of these lawsuits are not usually the individual shareholders who lost money in an issuer's shares but specialist "plaintiffs' law firms" which bring the lawsuits. The court awards these firms a percentage – often 25% or more – out of any proceeds obtained for the class in the lawsuits.
This work is so lucrative that these firms sometimes have their own in-house teams of researchers who scour public filings, press releases and other sources for information regarding potential problems within public companies. In addition, in order to get named as the attorneys for the lead plaintiff -- and thereby receive a larger slice of the fees -- plaintiffs’ law firms now actively solicit large pension funds and other institutional investors to be their clients in these cases because they usually suffer the largest losses.
While these firms serve a function by creating pressure on companies to quickly address any corporate problems they may be experiencing, it is important to understand that their immediate motivation is to get cash damages from the issuer (or its insurer) in as quick and efficient a manner as possible. Thus, plaintiffs' law firms will typically seek a settlement in lieu of a trial. In fact, it has been estimated that more than 80% of all class action securities law claims are settled, between 10% and 20% are dismissed by the court and far less than 1% go to trial.
Bases for Class Action Securities Law Claims
The U.S. securities laws are complex and provide numerous grounds to assert claims against companies and related parties. By far the most commonly relied upon basis for securities law claims is the general anti-fraud provision contained in Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 adopted thereunder. The basic elements of a Rule 10b-5 claim are:
- a claim by a purchaser of securities
- on behalf of a class of purchasers
- alleging that the issuer through a misstatement or omission of a material fact
- intentionally or recklessly
- caused harm which affected the price of the shares.
No bright line test exists for determining what constitutes a material misstatement or omission. Rather, the standard is whether there is a substantial likelihood that a reasonable shareholder would consider the misstatement or omission important in making an investment decision. The highly fact-sensitive, subjective nature of this key concept directly contributes to issuers' willingness to settle what they might consider to be weak claims.
It is important to note that Rule 10b-5 claims can be, and often are, made against not only the issuer, but also against its officers and directors, any person who controls the issuer and the issuer's underwriters.
Jurisdiction and Enforcement
One fundamental issue in the context of Asian companies is whether a court in the U.S. has jurisdiction over the company and its officers and directors. Jurisdiction depends on what contacts the defendants have with the United States. For a securities fraud claim against an issuer, it may be enough that it lists its shares on a U.S. market. Indeed, the exchanges require consent to U.S. jurisdiction over securities claims as a condition to listing the issuer’s shares. For individuals, the court must consider what their contacts with the U.S. are in connection with the charges in the suit. Signing an SEC filing, such as a prospectus or annual report, which is alleged to be false may be enough to establish jurisdiction over the individual signer. Frequent trips to the U.S. to work on the company’s business or to negotiate the particular transaction at issue may also be sufficient. Once a defendant has sufficient contacts with the U.S., the defendant can be sued for federal securities fraud in any federal court in the U.S.
Companies in China which do not have assets in the U.S. may also ask themselves why should they be concerned about being sued in that country? It is a fair question. As many China-based companies warn in their prospectuses, it may be difficult to collect on a judgment in a U.S. securities action against assets in China and the temptation to simply ignore the U.S. case, default and let the plaintiffs try to collect in China may be great. However, having to defend against enforcement proceedings in China based on a U.S. securities judgment is not the only risk a defaulting defendant might face. For example, U.S. regulatory authorities such as the SEC or the body supervising the stock exchange where the China-based company’s stock is traded might take a dim view of companies which ignore U.S. court proceedings, especially when they have consented to the jurisdiction of the U.S. courts, as all listed companies must do. Delisting proceedings or other government sanctions could follow. Also, even if a company has no assets in the U.S. at the time of the suit, if it acquires such assets later or even opens a bank account with a U.S. bank, those assets might be seized to satisfy a judgment. Accounts receivable or other monies owing by U.S. companies to a defaulting defendant might also be attached and used to pay the judgment. If the company has insurance and it ignores the case or does not cooperate in its defense, it could also lose its insurance coverage. In short, any non-U.S. company should think very carefully before it decides, in effect, to thumb its nose at a U.S. securities litigation complaint. [2]
What if Class Action Litigation Arises — A Hypothetical Case Study
Class action litigation is a complicated, multi-step process. The following is a hypothetical case study highlighting some of the more common issues that can arise.
1. The problem: A junior employee of Company A, which is listed on the New York Stock Exchange, contacts a director of Company A to voice concerns that Company A may be significantly under-counting its inventory of obsolete products to enhance its financial statements.
Lesson to be learned:Issuers and their management and board are often judged in hindsight by courts (and by U.S. stock exchanges and the SEC if they commence investigations, as discussed below) on how promptly and comprehensively a company begins an investigation into alleged wrongdoing. A potential problem at this stage is that many Asian companies have an ingrained culture which is not conducive to the implementation of a flexible, targeted internal inquiry. Accordingly, directors and top management must make a conscious effort to explicitly identify what steps are reasonable to confirm the substance of any allegations.
2. The investigation: After an initial preliminary inquiry, the board determines that problems exist with inventory counting which have not yet been fully identified. The board appoints an independent committee to investigate further (in most cases, it is the audit committee that oversees such investigations). The committee hires independent counsel and forensic accountants to assist it in its work.
Lesson to be learned: Maintaining the attorney-client privilege over all documents produced in connection with the investigation is extremely important so that plaintiff's law firms do not have unfettered access to this sensitive information. However, issuers may be pressured by the SEC or other governmental agencies to share documents, which would make them available in any action litigation.
3. The results of the investigation: Following the investigation, the independent committee concludes that there is a problem with inventory counting in the prior year, which necessitates a restatement of Company A's previously publicly disclosed financial statements for the year.
Lesson to be learned: When faced with action litigation or even rumors in the press of improper conduct, Asian issuers often have an instinctive reaction to put out a press release to announce they are innocent before the facts are known. For obvious reasons, such releases can compound the issuer's liability if material problems later surface. A related concern is when issuers should put the public on notice once they discover a problem. It is often the case that, because this information is arguably material to a shareholder's investment decision, issuers make an announcement when it is definitely decided that a material problem exists, even if the quantitative or qualitative scope of the problem has not been definitively determined.
4. The restatement: Company A publicly releases its restated financial statements and files them with the SEC. Company A's stock price drops significantly in reaction to the restatement.
5. The class action claims: A plaintiffs' law firm files a complaint in a U.S. court against Company A and its directors and officers, alleging that the restatement violated Rule 10b-5 and various other securities laws. On the advice of counsel, Company A's board also determines whether Company A can or should under applicable law indemnify its officers and directors in connection with the lawsuit.
Lesson to be learned: As soon as an issuer learns of a suit, issuers should immediately notify any insurers which provide them with directors and officers insurance (known as D&O insurance) or similar insurance coverage. The failure to notify in an accurate and timely manner may result in the issuer or its directors and officers not being able to assert rights or obtain coverage under the insurance policies.
6. The preliminary discovery period: If a motion to dismiss is denied, Company A produces non-privileged documents related to the inventory problem to the plaintiffs' law firms at their request and regarding the claims in the complaint.
Lesson to be learned: Unlike many jurisdictions elsewhere, in U.S. lawsuits plaintiffs generally have broad "discovery" rights. As a result, this phase can be time-consuming and expensive. Asian issuers are often shocked at the very idea of sharing any of their corporate documents with third parties, even if they are not related to strategic, operational or financial matters. This underscores the importance of maintaining attorney-client privilege over as many documents as possible and implementing a coherent document retention policy, which is discussed below. Issuers must also understand that delaying production of documents or producing incomplete sets will only drag out the litigation and increase their legal and other fees.
7. Settlement: If the complaint is not dismissed on a motion (and sometimes even when such a motion is pending), Company A, aided by its counsel, and the plaintiffs' law firms often negotiate at some point during the lengthy discovery process to see if the case can be settled for a cash payment. If no settlement is reached, Company A must defend the case in a trial. Even if a settlement is approved, individual shareholders may “opt out” and continue to litigate their own claims -- but not claims for other shareholders -- at their own cost and risk.
Lesson to be learned: There are companies that specialize in estimating the likely amount of a court judgment for a particular class action lawsuit, based on the nature of the claim, the market capitalization of the issuer, the fluctuations in the issuer's stock price during the relevant period and other factors and comparing them against the results of prior lawsuits. These statistical analyses can be very useful tools for an issuer's board and legal counsel as a kind of bench-mark when negotiating the settlement.
8. SEC and other governmental and regulatory issues: While a full discussion of actions that the SEC, other governmental authorities and a U.S. stock exchange can take in this regard is beyond the scope of this article, issuers should be aware that the same circumstances which lead to class action securities law claims can also result in civil or criminal investigations, claims against the issuer and related parties by the SEC, and administrative actions by the stock exchange to delist the issuer's shares.
Avoiding Litigation
While there is no fool-proof method for avoiding securities class action litigation in all cases, the following principles should help a company’s management and board of directors to minimize the likelihood of a securities law violation that could trigger such claims:
• Tight IPO prospectus and road show. One of the leading bases for class action securities law claims is that an issuer's IPO prospectus turns out to contain a material misstatement or omission which causes the stock price to decline after the IPO when the problem is revealed. As many securities law practitioners in Asia know, this in turn creates tension with the perception of many Asian issuers that any cautionary language in the prospectus, such as customary risk factors, is a personal criticism of management's abilities.
In addition, claims have also been based on comments made by management during its "road show" when it sells its IPO to institutional investors. The traditional assumption that institutional investors are less likely to initiate class action litigation and that no one outside of the road show would learn of these statements are increasingly ill-founded. Plaintiffs have been known to even quote specific statements made by senior management during closed-door road show presentations in their complaints, such as the complaints in the class action litigation recently initiated against China Life.
• Careful, consistent public disclosure. Press releases or statements to reporters in Asia or the U.S. which are overly optimistic or, equally importantly, inconsistent with prior public statements can also lead to stock price movement and class action claims. Accordingly, building and retaining a seasoned, international-caliber management team that can — with support from experienced counsel — implement meaningful disclosure controls as mandated under the Sarbanes-Oxley Act, and consistently communicate the company's message to analysts, institutional investors and the public, is essential to long-term success as a public company in the U.S.
• Effective internal controls and procedures. All public companies in the U.S. should implement clear written internal controls and procedures, particularly with respect to financial and accounting matters which constitute the most common source of class action securities law litigation.
• Allocate sufficient time and resources to ongoing periodic disclosure. One effective defense in class action litigation is to demonstrate that management, the board and key board committees, in particular the audit committee, have allocated significant time and worked with their outside legal counsel and auditors to ensure that the issuer's periodic public disclosure filed with the SEC is complete and accurate.
Conclusion
The ultimate long-term effect of class action litigation on a particular issuer, whether in Asia or elsewhere, not unsurprisingly depends on how quickly and cost-effectively the litigation can be resolved and on the underlying problems within the issuer that led to the litigation. Issuers that fully address the litigation and their problems in a timely manner will have a better chance of salvaging their stock price and reputation among investors. Some issuers can even prosper after litigation, such as our client NetEase.com, a Nasdaq-quoted company which provides Internet and wireless services in China. In 2003, NetEase settled class action securities litigation relating to an accounting restatement, and saw its stock price increase dramatically thereafter.
More recently, plaintiffs' law firms have shown their boundless creativity by making claims against China Life, a state-owned enterprise which listed on the New York Stock Exchange at the end of 2003, for alleged irregularities at its parent company. It remains to be seen whether the increasing number of class actions brought against Asian companies will deter them from listing in the U.S.
Jack C. Auspitz is a senior partner in Morrison & Foerster LLP's New York office and is a member of its U.S. securities litigation group. Charles C. Comey is managing partner of Morrison & Foerster LLP's Shanghai office, specializing in private equity, M&A and capital markets transactions. Paul W. Boltz is an associate in Morrison & Foerster LLP's Hong Kong office, specializing in corporate and capital markets transactions.
[1]Recent Trends in Securities Class Action Litigation: 2003 Early Update, National Economic Consulting (February 2004). Median settlements were lower. There were six settlements in 2003 for over $100 million each, including three for over $300 million each, which drove the average higher.
[2] Individuals who are named as defendants in such complaints also run the risk of having their present or future U.S. assets seized, losing insurance coverage and perhaps even having their travel to or through the U.S. interfered with.