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Further reading: is everything securities fraud?

US research questions whether shareholders fare better in court when they are not the primary victims of a public company incident
March 4, 2021
  • Clinical professor of law Emily Strauss has questioned whether all corporate incidents should be considered securities fraud
  • Evidence suggests that size matters when making a claim

A 'circular economy' – which aims to eliminate waste through the continual use of resources – is a well-worn phrase and one that also applies to financial commentary. Readers of Bloomberg writer Matt Levine’s daily newsletter will recognise the statement "everything is securities fraud". It’s one of his classics, alongside "people are worried about bond market liquidity" and "blockchain blockchain blockchain", which are both fairly self-explanatory subjects. 

Now Emily Strauss, a clinical professor of law who teaches securities litigation at Duke University in the US, has tested Levine’s hypothesis in the draft paper 'Is Everything Securities Fraud?' prompting this publication to cover her research. We can only hope Levine comments on this article in his popular newsletter to complete the circle of commentary.

The premise of Levine’s question is whether companies that do things that hurt shareholders should be considered securities fraud, even if they don't seem fraudulent in the first place. He argues that it is not only more obviously fraudulent incidents such as the collapse of NMC Health or Wirecard (optimistically called mismanagement) that should fall under the legislation. Events such as the Deepwater Horizon spill or the launch of unsafe pharmaceutical products should also be considered to be securities fraud because management did not disclose that they were doing something wrong, and therefore misled investors. 

 

Who’s the victim? 

In her paper originally published in 2020 and updated last month, Strauss looked at 500 class actions against public companies between 2010 and 2015, using data from Stanford Law School. Her aim was to investigate the prevalence and attributes of the lawsuits brought by shareholders who were not the primary victims of the incident. An example might be BP (BP.) shareholders suing the company over Deepwater Horizon rather than the families of those who died in the tragedy. 

Strauss is hardly convinced shareholders should be on top of the list for compensation. “The empirical analysis supports the notion that event-driven securities class actions are big-ticket cases; substantial money and resources are tied up in securities lawsuits where the primary victim is not a shareholder,” she says. 

The big finding in the research here is that it is better to be a shareholder suing for compensation after the big event than an actual victim: “These cases have significantly lower dismissal rates and generate higher settlements than cases where the primary victims are shareholders.” A class action brought by the primary victims is 20 per cent more likely to be dismissed than one brought by shareholders, from that 500 case sample size. 

This is shocking at first, but when Strauss looks at the actual investors bringing these cases it makes sense. They are not retail shareholders trying to get £10,000 back. Sixty per cent of the cases she looked at had a pension fund as lead plaintiff, and they hired “top-tier” law firms to get them compensation. 

 

Head of the class

Unfortunately, many IC readers will have owned shares in a company that has suffered a life- or value-destroying catastrophe, and this will happen again in the future, but the UK does not have an established ‘everything is securities fraud’ legal framework for compensation. 

Law firm DAC Beachcroft says UK laws are restrictive in what can be considered securities fraud. A successful claim under section 90A of the Financial Markets and Securities Act "requires a claimant to show that they relied on the defective disclosure when making their investment decision and that they have suffered a loss as a result”. One example is the suit against Tesco (TSCO) by Omers Administration Corporation and Manning & Napier Fund, which was settled out of court last year after a multi-year battle. Tesco had overstated its interim profits in 2014 by £250m and this had hit its share price. 

Even for US shareholders, there are a few barriers to any significant loss being linked to securities fraud. Management has to know about the risk and not disclose it, but it can’t be a “black swan” event.  “Even if the risk ultimately was material, managers may not have perceived it to be so, and therefore did not disclose the risk not because they thought they had anything to hide, but because they honestly and un-recklessly misjudged the likelihood that the disaster would occur,” Strauss says. She also warns of “hindsight bias”, in which a bad outcome alone leads people to believe securities fraud happened. 

So is everything securities fraud? Perhaps in the US, if you’re a pension fund with hefty financial firepower and what Strauss says is a 'sheriff of Wall Street attitude'. In the UK, as a retail investor, only securities fraud is securities fraud and sometimes – if you're a private investor – even that isn't enough.  

‘Is Everything Securities Fraud?’ can be read in full at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3664132