Among the most visible characteristics of large public business enterprises is the separation of ownership and management, a situation which creates an almost inescapable informational dependence of the former on disclosures by the latter. Commonly characterized as agency dilemma or principal-agent problem, the investor-manager informational asymmetry can lead to conflict of interests when objectives of the two parties are misaligned. More specifically, corporate managers, a group that encompasses corporate officers entrusted with day-to-day running of a company (e.g., CEO, CFO), and corporate directors, a corporate policy and oversight body tasked with ensuring adherence to sound corporate governance practices, jointly act as shareholder agents and are thus expected to make decisions that maximize shareholder wealth. That goal, however, may at times run counter to managers’ desire to maximize their own wealth, which may compel them to make choices that suboptimize or even impair shareholder value. When shareholders have reasons to believe that management’s public disclosures did not fully, clearly, or timely communicate all pertinent and material performance-related details, and they also suffered economic harm as a direct result of those omissions or misrepresentations, they then have the right – as in legal basis – to take legal action aimed at recouping their losses. This general scenario is at the root of securities fraud litigation, a key manifestation of what is commonly known as ‘executive risk’, itself one of the most economically and reputationally damaging expressions of organizational risk.
The above implied fundamental, disclosure-related shareholder rights date back to the early 1930s and the passage of the U.S. Securities Act of 1933 and the U.S. Securities Exchange Act of 1934, and further enhanced with the more recent Sarbanes-Oxley and Dodd-Frank acts of 2002 and 2010, respectively. Jointly known as securities laws, those legal statutes require all companies traded on U.S. public exchanges to timely, accurately, and completely disclose all pertinent and material financial details; failure to meet those obligations allows economically harmed shareholders to seek legal relief, typically in the form of financial compensation. Commonly known as securities litigation, the resultant shareholder lawsuits can be pursued individually by single shareholders or as a group known as a ‘class’, the former known as securities class actions or SCAs. Given the fairly obvious efficiency of class actions where typically large groups of investors jointly pursue the same claims (investment losses) against the same company and its managers, it should not be surprising that securities fraud lawsuits commonly take the form of securities class actions (SCAs).
From the perspective of risk management, shareholder class actions fall into the low frequency—high impact threat category (for a more in-depth discussion of that idea see my 2016 book, Threat Exposure Management: Risk, Resilience, Change). On average, in a given year, only about 4% of companies traded on U.S. stock exchanges incur SCAs, but those suits can result in substantial, i.e., multi-million, even multi-billion, losses, not to mention negative publicity. Also worth noting is that the traditionally financial disclosures focused scope of what triggers SCAs is expanding, as what investors consider to be ‘pertinent’ and ‘material’ information is now beginning to encompass not only financial performance related details, but also disclosures addressing the increasingly more important environmental, social, and governance (ESG) considerations.
Another key, securities fraud litigation related consideration is that at the tail end of 1995, the U.S. Congress once again delved into securities market manipulation considerations by enacting the Private Securities Litigation Reform Act (PSLRA). Aimed at stemming frivolous securities fraud lawsuits alleging management misrepresentations, the key provisions of the Reform Act were centered on increasing the amount of required evidence. More specifically, shareholders alleging management misrepresentations are now required to point to specific fraudulent statements or disclosures, and to allege that those statements or disclosures were reckless or intentional; moreover, investors are also required to offer evidence of having suffered financial loss as a result of the alleged fraud (as opposed to general market volatility; that condition, known as loss causation, is a critical part of shareholder fraud litigation). Given the foundational nature of those changes, the enactment of PSLRA can be seen as giving rise to the ‘modern era’ of securities litigation. With that in mind, the goal of the analysis summarized here is to review post-PSLRA shareholder litigation frequency and severity patterns with an eye toward drawing forward-looking conclusions.
Shareholder Litigation in the Post-PSLRA Era
Before delving into frequency and severity trends, it is instructive to expressly address the key SCA disposition outcomes. In principle, securities fraud cases that are not initially dismissed can be either tried in court (which can lead to a jury or bench verdict) or can be settled out of court. Interestingly, of the more than 6,100 individual SCAs that have been filed in the post-PSLRA era, a grand total of just 21 of those cases went to trial – of those, only 14 have been tried to a verdict, while the remaining 7 were settled out of court prior to reaching a verdict. Hence even taking into account that roughly 40% of initial securities fraud allegations are dismissed during the initial discovery (although some are amended and re-filed), a conservative estimate of a securities fraud case being tried to a verdict is trivially small, roughly 1-in-250 cases, or 0.4% (14/(6,100*.6)). In view of that, quantifying the threat of shareholder litigation is ultimately about tracking of SCA filings, which reflects the frequency dimension, and the subsequent settlements, which captures the severity dimension.
As noted earlier, SCAs are commonly thought of as low frequency—high impact events. A company publicly traded in the U.S. (to be subject to the U.S. securities laws a company does not need to be domiciled in the United States, it just needs to have securities trading in the U.S.) faces a roughly 4% chance of incurring securities litigation, and the median settlement cost is about $8,750,000; factoring-in defense costs (given the nuanced and complex nature of SCA cases, even companies with sizable in-house legal staffs tend to use specialized outside law firms), estimated to average about 40% of settlement costs, the total median SCA cost grows to about $12,250,000. Those are just the economic costs – securities litigation also carries substantial though hard to quantify reputational costs, as being accused financial fraud often brings with it waves of adverse publicity.
In the post-PSLRA period, spanning January 1, 1996, to December 31, 2021, there have been a total of 6,118 SCAs filed in federal courts; to-date (some of the more recent cases are still ongoing), those filings gave rise to 2,352 settlements, totaling more than $127.5 billion (excluding legal defense costs). Annual SCA filing counts and median SCA settlement amounts are graphically summarized below (figures 1 and 2, respectively).
Annual SCA Frequency: 1996-2021
One of the most striking informational elements of the summary of annual SCA frequencies is the exceptionally high 2001 count of 498 cases. That striking escalation in securities litigation filings was a product of a sudden influx of the so-called ‘IPO laddering’ (an illegal practice of offering a below-market price to investors prior to the IPO if those same investors agree to buy shares at a higher price after the IPO is completed) cases, which followed on the heels of the dot-com bubble of the early Internet era (between 1995 and 2000), and which were characterized by excessive speculation of Internet-related companies. Setting that single anomalous year aside, the second key takeaway is a distinct upward-sloping ebb and flow pattern, suggesting steady cross-time growth in average annual SCA frequency. Seeing such a steady growth draws attention to a possible alternative explanation: Is the normalized frequency or the underlying number of companies that are growing? It is, however, not an easy question to answer because of an interplay between two relevant yet conflicting trends. On the one hand, focusing on just the two major national stock exchanges (there are 13 stock exchanges in the U.S. in total), the New York Stock Exchange (NYSE) and NASDAQ, since peaking at around 8,000 companies (in total) sometime in the mid-to-late 1990s, the number of companies listed on those key exchanges has steadily declined; today, about 6,000 companies trade on NYSE and NASDAQ. On the other hand, the number of companies that trade on OTC (over-the-counter) markets, which is an alternative to a formal exchange trading system, is now more than 12,000, a number that more than doubled over the past 10 years. Still, a clear majority SCA filings are against companies that trade on NYSE or NASDAQ, but filings against OTC-traded companies are not unusual - all considered, the available evidence is not sufficiently analytically coherent to warrant concluding that the steady upward climb in SCA filing incidence can be explained away by the changing size of companies publicly traded in the U.S. That said, a yet another potential contributor to that gradual SCA frequency uptick might be the earlier mentioned broadening of the scope of disclosure materiality. Traditionally rooted almost exclusively in financial performance measures, the definition of what constitutes ‘material disclosure’ is now beginning to encompass non-financial ESG (environmental, social, governance) considerations, thus it is at least plausible that having to content with a broader array of potential securities litigation triggers may manifest itself in higher average frequency of SCA litigation.
Turning to the severity aspect of securities class actions, Figure 2 captures the annual median SCA settlement pattern for 1998 thru 2021 (the settlement part of the analysis only reaches back to 1998 rather 1996 because that was the first year for which analytically meaningful number of settlements for post-PSLRA SCA filings was available).
Annual Median SCA Settlements: 1998-2021
A similar, ebb and flow upward trending pattern that characterized the frequency dimension can be seen in Figure 2 as well - in fact, the average SCA cost trend appears to exhibit an even steeper slope, or a more pronounced upward drift, warranting deeper examination. Can the observed steady cross-time increase in the average (median) SCA settlement cost be driven by an underlying rise in average company size, as measured by total market capitalization (i.e., the aggregate value of outstanding shares, an appropriate expression of company size within the confines of shareholder litigation)? It is intuitively obvious that larger companies – i.e., those with larger market capitalizations – can be expected to incur larger SCA settlements, simply because, everything else being equal, larger company sizes translates into potentially larger shareholder losses. To examine that important possibility, Erudite Analytics' SCA Tracker database recording post-PSLRA securities class action settlements (n = 2,372) was utilized. Zeroing-in on records for which market capitalization value was available around the time of settlement announcement, the correlation between settlement amount and market capitalization was estimated to be 0.21 (p <.01), suggesting an overall positive (i.e., larger market capitalizations tend to be associated with higher settlement amounts) and statistically significant relationship. Stated differently, the company size—SCA settlement association suggests that the year-by-year variability in size-based mix of companies may be behind the observed upward SCA settlement trend shown earlier in Figure 2; a graphical representation of that conclusion is shown below in Figure 3.
Median SCA Settlement Amount vs. Loss-to-Value Ratio
The trendline in Figure 3 depicts the relationship between the loss-to-value ratio, which captures the relationship between the magnitude of SCA restatements and the magnitude of the corresponding market capitalization values, and the annual median SCA settlement values. The early, i.e., 1998 thru about 2003, volatility can be largely attributed to a cluster of some of the most egregious, in terms of the underlying offenses as well as the resultant SCA settlements, examples of securities fraud: Enron, WorldCom, and Tyco International, all three of which came to light in 2001 and 2002 and resulted in the three largest-ever SCA settlements ($7.2 billion, $6.12 billion, and $3.2 billion, respectively). That early volatility aside, the overall conclusion that emerges from the long-term trend, and particular the most recent several years, is that there is a surprisingly stable relationship between the size of SCA settlements and the magnitude of the corresponding market capitalization, suggesting that the upward median settlement value trend depicted in Figure 2 was ultimately a manifestation of steadily increasing median market capitalizations – in other words, when corrected for the underlying company size differences, the severity of SCA settlements shows no evidence of cross-time growth.
Examination of long-term, aggregate SCA frequency and severity trends can be a source of informative topline insights, but may also obscure more nuanced effects, such as cross-industry differences. Moreover, conclusions drawn from data spanning more than a quarter of century also implicitly discount the importance of recency, or the closeness-in-time of past outcomes, which reduces the predictive power of those conclusions by blending the relatively recent developments with comparatively older ones. Motivated by those considerations, the ensuing analyses aim to disaggregate the frequency and severity trends summarized in figures 1, 2, and 3 by delving into cross-industry differences in the context of a shorter timeframe. Doing so, however, calls for expressly addressing two core issues of industry and time framings.
Industry Definition and Data Recency
As discussed in my earlier post (Hidden Handicaps of Benchmarking), the notion of ‘industry’ is surprisingly complex due to the fact that there are numerous industry classification standards – in fact, at present there are more than 10 competing taxonomically robust schemas, each producing materially different industry groupings. Simply put, what constitutes an 'industry' is a function of which classification taxonomy one elects to use, and that choice may ultimately lead to materially different conclusions. Consequently, the approach taken in this research is to instead follow the approach used by the U.S. Securities and Exchange Commission (SEC), the key U.S. securities laws enforcement agency. The SEC requires all registrants to identify a single primary SIC (Standard Industry Classification) code, following which it divides all public filings, and thus the entities submitting those filings, into seven distinct segments: Energy & Transportation, Financial Services, Life Sciences, Manufacturing, Real Estate & Construction, Technology, and Trade & Services. The resultant SIC-based groupings are analogous to sectors, which are the most aggregate company clusters (typically comprised of multiple industries) used by essentially all industry classification taxonomies; the use of sectors is also analytically appropriate in view of the relatively small average annual SCA filing counts (as shown in Figure 1, median = 213), and even smaller annual settlement counts (low 100s).
The second key trend disaggregation consideration is recency of data, or the closeness-in-time of SCA filings and settlements. The long-term trends captured in figures 1, 2, and 3 obscure numerous legal developments in the form of legislative acts (e.g., the Sarbanes-Oxley Act of 2002) and the U.S. Supreme Court rulings (e.g., 2005 Dura Pharmaceuticals or 2007 Tellabs Inc) with broad economic events, such as the 2007-2008 global financial crisis, no to mention more general societal trends, such as the relatively recent intensification of interest in the impact of ESG considerations. Moreover, long-time horizons also dilute micro trend changes – for instance, while it is well-established that median based estimates are unaffected by outliers, it might be less obvious that data time horizon choices can also have a pronounced impact on statistical estimates. For example, as shown in Figure 1, the median number of SCA filings for the full 1996-2021 period is 213, whereas the median number of SCAs for just the most recent 10 years (2012 thru 2021) is 249. But what, exactly, should be the line of demarcation between data that are deemed recent and those that are not? While it is not always easy to arrive at a truly objective answer to that important question, analyses of legal trends are commonly tied to statutes of limitations of applicable laws, which offers a convenient basis for objectively delimiting between ‘recent’ and ‘old’ SCA filings and settlement data. For securities laws, the applicable statutes of limitations applicable were set by the U.S. Supreme Court (2013 Gabelli v. SEC ruling) to be 5 years from the date of the underlying violation. Using that as the basis for data recency, the ensuing analysis zeros-in on 2017-2021 SCA filings trends across the seven SEC-framed sectors.
2017-2021 Patterns and Relationships
Based on the above outlined reasoning, the ensuing analyses focus on 2017-2021 patterns of SCA filings and settlements; more specifically, the analyses aim to address a combination of cross-sector and cross-time differences. Starting with SCA filings, Figure 4 offers a summary of the trends.
Sector-Specific 2017-2021 SCA Filing Frequency
As shown by the 5-Year Moving Average along with the low and high 5-year frequency values, the incidence of securities fraud litigation varies considerably across industry sectors, with Life Sciences exhibiting the highest overall incidence rate, and Real Estate & Construction the lowest. It is also worth noting that the within-segment annual incidence rates fluctuate noticeably, which underscores the importance of interpreting the reported 5-Year Moving Averages as averaged approximations. Still, the empirical evidence presented in Figure 4 suggests that based on the most recent trends, as a group, Life Sciences firms face the greatest probability of incurring shareholder litigation.
During the 5-year stretch between 2017 and 2021, the average aggregate (i.e., across all seven sectors delineated in Figure 4) annual number of settlements was 126 – while sufficiently large to support robust aggregate (i.e., all sectors combined) cross-time conclusions, that count is nonetheless too low to allow statistically sound cross-time and cross-industry comparisons (the average annual number of SCA filings during the same period was 352, which was large enough to support a combination of cross-sector and cross-time SCA frequency analysis). Consequently, the severity part of the deep dive analyses summarized in figures 5 and 6 is focused only on cross-time contrasts, or more specifically, on a comparison of annual median settlement values for all sectors combined.
2017-2021 Median SCA Settlement Values
Once again, considerable cross-sector variability is evident, with median settlement values ranging from a low of $8.425 million for Life Sciences companies to a high of $17.305 million for Financial Services firms. However, as noted earlier, the magnitude of SCA settlements is positively correlated with market capitalization, thus at least some of the variability depicted in Figure 5 could be due to cross-sector company size differentials. Examining company-specific market capitalization values recorded about the time individual settlements were announced yields supporting evidence: Financial Services firms boasted by far the largest median market capitalization of $3.241 billion, while Life Sciences companies recorded the lowest median market capitalization of just $446 million. Figure 6 below offers an overall SCA settlement vs. corresponding market capitalization value comparison.
SCA Settlement vs. Market Capitalization
While clearly evident, the settlement amount-market capitalization association appears to be particularly strong for Financial Services and Life Sciences organizations, which fall on the high and the low end, respectively, of the settlement amount and market capitalization continuum; that association, however, is somewhat less consistent for the remaining five sectors. For instance, Manufacturing companies boast the second highest market capitalization ($1.872 billion), but their median settlement value of $10 million is noticeably lower than the corresponding Real Estate & Construction ($14.468 million) or Trade & Services ($12.25) values, both of which exhibit significantly lower median market capitalization values ($1.182 billion and $923.6 million, respectively).
The bits of SCA frequency and severity insights captured in figures 4 thru 6 are suggestive of a need for a more comprehensive approach to assessing shareholder litigation exposure of individual sectors. Consider Table 1.
Fair Share Index
The goal of the Fair Share Index (FSI) summarized in Table 1 is to amalgamate and systematize the frequency and severity cross-sector comparisons discussed earlier, while also factoring-in important mediating considerations, such as the impact of company size on the size of settlements. FSI is rooted in the idea that, everything else being equal, a large group of similar companies, as exemplified by industry sectors, that accounts for a certain proportion of all companies, can be expected to also account for a proportional share of all SCA lawsuits (frequency) and a proportional share of total market capitalization-weighted SCA settlements (severity). For instance, given that the Life Sciences sector represents approximately 18% of companies in Erudite Analytics' SCA Tracker database (which encompasses primarily companies traded on NYSE and NASDAQ, but also a sizable cross-section of OTC traded firms), that sector can then be expected to account for about 18% of SCA filings, and also about 18% slice of the aggregate, size-weighted SCA settlement amount. If that was the case, the Life Sciences sector would be deemed to exhibit average exposure to the threat of shareholder litigation (in the context of either or both SCA dimensions). If, on the other hand, Life Sciences accounted for larger than expected share of filings or settlements, it would then be deemed to have heightened SCA incidence or severity exposure; conversely, if it accounted for a smaller than expected share of filings or settlements, it would be deemed to exhibit sub-average SCA exposure (numerically, the FSI is centered on 1.0, thus values greater than 1.0 indicate heightened and values smaller than 1.0 indicated sub-average SCA exposure). Also, given that due to random fluctuations alone the chances of any sector’s frequency or severity FSI equaling exactly 1.0 are low, the FSI estimation logic should be framed as deviation-adjusted range, computed here using the established concept of average absolute deviation, as follows:
Using the above AAD calculation and the ‘Share of’ values shown in Table 1, the average frequency deviation was estimated to be 0.21, and the average severity deviation was estimated to be 0.68. With those estimates as additional inputs, sector specific ‘Fair Share Index: Frequency’ values smaller than 0.79 or greater than 1.21 point toward sub-average or heightened, respectively, SCA frequency exposure, and ‘Fair Share Index: Severity’ values smaller that 0.32 or greater than 1.68 point toward sub-average and heightened, respectively, SCA severity exposure. The examination of sector values in Table 1 points to the Life Sciences sector as the one that exhibits clearly heightened SCA incidence and severity exposure, suggesting that, overall, Life Sciences firms are more likely than others to be sued by their shareholders, and those suits are also likely to lead to disproportionately large (vis-à-vis the company size) settlements. Also worth noting is the heightened Energy & Transportation sector’s value of the Severity FSI; when interpreted jointly with the sector’s lower than expected Frequency FSI value, the evidence in Table 1 suggests that Energy & Transportation firms are comparatively less likely to be sued by their shareholders, but when sued, those firms face considerably higher than suggested by their size settlement costs.