Trends and developments in securities litigation
How would you summarise recent trends and developments to have emerged in securities litigation?
Securities litigation is well-established in the US, where the claimant industry has developed over the past few decades in order to bring claims against listed-entities. In recent years we've seen an increase in securities claims being brought in the UK and in other jurisdictions, mainly in response to corporate issues, such as the Tesco accounting misstatement and the Volkswagen emissions scandal.
The availability of third-party litigation funding and ‘after-the-event’ insurance in the UK mean that it's becoming increasingly attractive to bring securities claims in this jurisdiction, as it allows a class of investors to bring a claim without having to contribute to the costs.
The nature of the issues that can give rise to claims depends on the unique factors and drivers that can impact on a business’s behaviour. The retail sector, for example, had for a long time relied upon commercial income and supplier rebates to bolster profitability; the automotive sector has had to comply with increasingly stringent environmental regulation.
In the current market environment, there's an increasing volume of ESG concerns, which could lead to the next big corporate scandal. Matters such as modern-day slavery in the supply chain and regulators’ increasing focus on facilitation of money laundering by financial institutions are only likely to increase the number of potential avenues under which claims might be pursued.
Another area of increasing exposure for companies concerns potential losses arising as a result of cyber breaches. In trust-based brands, where value is inherently linked to their ability to hold data securely and confidentially, a cyber breach can cause potentially massive losses to claimants and immediate commercial and reputational harm.
There's a need for companies to have an effective response plan in place to ensure that they're able to communicate promptly and accurately to the market and demonstrate that they're on top of the potential issues. Too soon may be dangerous, and too late may be even worse! A further class of securities that's rapidly attracting litigation surrounds cryptoassets and related functions, such as smart contracts and non-fungible tokens. Valuation and evaluation of these hybrid instruments requires financial and technical arts that evolve on a daily basis.
Clearly, coronavirus (COVID-19) is likely to have consequences as western economies start to emerge from the grip of the virus. To date, much of the worst effect of the pandemic on business performance has been mitigated by unprecedented government intervention. As this support is withdrawn, companies will come under scrutiny should issues emerge which suggest that management may have been acting improperly to keep their businesses afloat.
Common types of securities claims
What are some of the common types of securities claims? How would you characterise the size and number of cases filed in your jurisdiction?
Shareholders can bring claims against listed companies to recover losses suffered as a result of a drop in the price of their shares, often caused by a corporate issue being revealed to the market. The market for securities litigation in the UK is developing and the number of claims being brought is on the increase following the RBS rights issue litigation. Securities claims are commonly brought under sections 90 and 90A (and Schedule 10A) of the Financial Services and Markets Act 2000 (FSMA).
Under section 90 of the FSMA, issuers and their directors can be found liable to pay compensation to investors who've acquired any of the company’s shares and suffered a loss in respect of them as a result of an untrue or misleading statement in, or omissions from, prospectuses or listing particulars. It's not a fraud-based liability.
Under section 90A, an issuer can be required to compensate investors where they've acquired, continued to hold, or disposed of shares in the company in reliance on public statements, typically annual reports, and suffered a loss in respect of those shares as a result of an untrue or misleading statement, or dishonest omission, by the issuer.
The RBS rights issue litigation was a claim brought by shareholders under section 90 of the FSMA against RBS and its former directors relating to its £12 billion rights issue in April 2008. The claim was based on allegations that the rights issue prospectus misstated the financial position of the bank and omitted information necessary for investors to make an informed assessment.
The case settled in 2017 shortly before trial but showed that it was possible to bring a class action under the UK’s legal framework. A group of institutional investors brought a claim against Tesco under section 90A of the FSMA in connection with the financial reporting misstatement that came to light in September 2014 when Tesco’s senior management announced that it had overstated its expected profit for the half year of 2014/15 by around £250 million. The circumstances which gave rise to the claim led the Serious Fraud Office (SFO) to pursue a criminal investigation into Tesco, which was found by the Financial Conduct Authority (FCA) to have engaged in market abuse by publishing misleading information. However, the investigation was closed in the summer of 2020.
Securities litigation is not limited to just the FSMA provisions. General common law claims in fraud or negligence are also available to claimants, as we've seen in the Lloyds case. The claim against Lloyds and five of the former directors for losses suffered as a result of their approval of the acquisition of HBOS and participation in the UK government’s recapitalisation scheme in 2008 was the first case to reach judgment in a securities class action in November 2019.
The claim alleged that, first, the recommendation given to shareholders to vote in favour of the acquisition was negligent, and second, that the shareholder circular did not contain sufficient information about the risks of the acquisition. Both allegations were dismissed in their entirety.
Pursued remedies in securities litigation
What remedies are typically pursued in securities litigation? How do plaintiffs generally go about calculating damages?
In the UK, no securities litigation case has yet resulted in damages being awarded and, therefore, the way in which damages are to be calculated will need to be resolved by the English courts in due course. Under section 90 of the FSMA, an investor is entitled to recover its full loss on the securities in question, and this is likely to be calculated as the difference between the true value of the securities and the actual price paid. The true value would be the price of the shares had the inaccuracy or omission not been made and questions arise as to how this true value should be identified and at what date.
In certain circumstances investors may argue that the shares wouldn't have been purchased at all. In which case damages would be calculated as the total purchase price less any value that may have been achieved following discovery of the defect. For section 90A claims, the difference between the price paid or received and the true value of the security in question or the price realised on its sale is likely to be the appropriate measure for calculating quantum.
It may be possible to argue that funds invested in shares would instead have been invested elsewhere and therefore that there is a lost profits claim, particularly for institutional investors who would be able to demonstrate how else those funds would have been invested and what return would have been generated. However, such compensation may not be available under section 90 of the FSMA and an investor may have to bring a claim in the alternative in fraudulent misrepresentation to recover damages on that basis.
It's worth noting that for securities litigation cases the English system does not recognise a class as a claimant, but recognises each individual claim, and therefore damages are calculated on a per-claimant basis.
In order to evidence loss from a financial perspective, a claimant would need to demonstrate when shares were purchased or sold and at what price, as well as requiring information regarding the actual and expected performance of the company, such as share price, financial statements, press releases, and profit forecasts. They would also need information regarding the performance of the market, including share price and other available financial information for competitors, such as the performance of industry indices.
If a lost profits claim is going to be made, then information regarding alternative investments that would have been made, supporting evidence for that counterfactual, and information regarding the performance of the alternative investments would be required.
Notable cases and lessons learned
Could you highlight any recent securities litigation cases which have been particularly notable in terms of showcasing available remedies? What lessons can firms draw from their outcome?
The claims against Lloyds and Tesco give an indication of how damages can be calculated for a securities claim, however the claims against Lloyds were dismissed in their entirety and the Tesco case was dropped. In the Lloyds litigation the claimants proposed two measures of loss. First, the loss per Lloyds share caused by the dilution arising from the acquisition of HBOS at an overvaluation. And second, the loss per Lloyds share had the transaction not gone ahead, adjusted to exclude any general decline in bank shares and any element of reflective loss.
In the Lloyds case, claimants didn't manage to establish that they suffered loss as a result of the breaches of the information duty and the judge did not accept any of the three alternatives put forward for what would have happened had the acquisition not completed had the funding disclosures been made.
In any event, the claimants would have failed to establish the quantum of loss that they had allegedly suffered. The judge rejected the methodology that had been adopted by the claimants’ expert to identify what would have happened to the Lloyds’ share price following any of the events that it was argued would have led the deal to fail. The judge commented that a useful reference point in assessing the diminution in value of Lloyds’ shares may be to assess the value of a Lloyds share, adjusted by reference to an index of UK banking shares and making allowances for what may have happened if the HBOS acquisition had not gone ahead, which likely would have impacted the whole index.
In the summer of 2020, a FSMA 90A case against Tesco had reached the pre-trial review stage and we note that the MLB claimants’ primary claim for damages was calculated by reference to the difference between the purchase price of the Tesco shares and the value of those shares on 23 October 2014 – when Tesco disclosed the ‘expected impact’ of the £263 million overstatement in its previous profits guidance statements.
In addition, the MLB claimants’ claimed for the loss of profits they alleged they would or might have made had their money not been invested in Tesco. Ultimately, this particular case was dropped, so there remains uncertainty about the application of the legislation.
Looking further afield, and talking generally, where securities claims are raised, we can see that defendants are frequently keen to settle. The potential ramifications of an adverse finding in a court can lead to further claims. By settling early, questions of liability may be avoided, and the potential for additional claims by other parties mitigated.
Securities litigation success by jurisdiction
How would you gauge the success of securities litigation in your jurisdiction, in terms of promoting truthfulness and disclosure in capital markets?
Liability for a corporate issuer will turn on the extent of directors’ knowledge of untrue or misleading statements made by the company in its public statements. This puts directors’ conduct under the spotlight and potentially exposes them to personal liability. This is consistent with a general trend to find culpable individuals and management should be aware of the risks and consider what actions can be taken to mitigate them. This is likely to have a positive impact on the truthfulness of corporate disclosures to the market.
A similarly positive effect is likely to come from regulator-driven public, rather than private, securities litigation. You can't underestimate the impact of public securities litigation and the prospect of criminal action against individuals with management accountability as a significant deterrent – not just for the immediate impact of criminal sanctions but also the lasting reputational damage that such a judgment can cause to a business’s long term value.
The corporate response to these threats should also increase the reliability of information being disclosed. Leading companies are frequently implementing robust and comprehensive internal procedures for the preparation of public disclosures, maintaining records of the steps taken to review and verify the statements being made, and directors are actively challenging the disclosures.
The risk of a misstatement increases in geographically diversified groups where management may be decentralised, and these procedures would be particularly important in this instance. Management may also like to consider carrying out forensic due diligence when approaching new markets or operations, which should assist in identifying potential issues before a transaction goes ahead.
Given the risk of ESG-disclosure related litigation, companies are increasingly treating public disclosures in relation to ESG matters similarly to those they make in respect of financial disclosures and adopting processes such as independent auditing of annual reporting, where such reporting is mandatory. This is likely to have a positive impact on the trust that users have in such disclosures.
Advice on remedies and measuring damages
What advice would you offer to parties on assessing the merits of available remedies and measuring damages? How should this assessment inform the approach taken to litigation?
A claim brought under section 90A of the FSMA or under common law requires the claimants to establish that there was a defect in the disclosures made, that the claimants relied on the alleged defect and suffered a loss, and that the loss was caused by the defect. Therefore, we would advise parties to carefully consider the extent to which any fall in the share price on the misstatement or omission becoming public knowledge can be attributed to the issue in question, as opposed to general market movements, the performance of competitors, or otherwise.
Parties should also think about how to deal with share price rebounds and consider whether a flawed disclosure by management has led to a sustained structural loss in the value of the business, or whether the impact was in fact temporary, with no effect on the true underlying value. Claimants also need to be able to prove that they relied on the alleged defect, which is likely to be a significant hurdle for investors in most cases.
In the absence of detailed guidance in FSMA on this point, in the recent 'Summary of conclusions' judgment on the HP/Autonomy v Lynch & Hussain case, the court discussed extensively the meaning of ‘reliance’ under Schedule 10A of FSMA and included an informative analysis of cases on misrepresentation and deceit. Records of investment committee decision making and considerations should be collated at an early stage. Evidence that alternative investments may have been considered, but were rejected for issues which are analogous to the apparent cause of the misstatement would be helpful.
In the event that a prospective claimant is seeking litigation funding to pursue a claim, they should think carefully about how best to ‘pitch’ the merits of their case to a funder. A substantial majority of prospective claims that litigation funders see are declined, either on the basis of legal merit, an insufficiently substantiated quantification of loss, or a potential defendant which may not have the financial capability to actually pay an amount awarded against it.
From a claimant’s perspective, or for lawyers managing a claimant group, a decision on how to best utilise forensic technology should be an important first step in establishing liability and quantum. In particular, where there are multiple potential claimants, relevant information may be held on disparate systems and the data may be held inconsistently.
Capturing this information early and aligning data sets so that you are comparing apples with apples across the group, helps ensure that you're applying a consistent approach to the calculation of losses suffered. From a defendant’s perspective, liability – particularly who knew what, when with regard to potentially erroneous disclosures or errors in financial reporting – should be an early focus of any forensic review of the evidence.
Future predictions for securities litigation
Looking ahead, what are your predictions for securities litigation? What issues are likely to influence the way damages are calculated going forward?
Due to the fact that investors are increasingly considering the ESG credentials of the entities they are investing in, and the increase in funds with specific ESG mandates, we consider this is a specific area where securities claims may be brought in the future as more reliance is placed on ESG disclosures. There's inherently more subjectivity and complexity in any damages claim when an ESG claim is being considered, rather than a relatively straightforward financial mis-reporting claim. The impact on value of such esoteric concepts is harder to establish as it cuts to less readily quantifiable aspects of brand value.
The way damages are calculated going forward may depend on the type of claimant. Sophisticated institutional investors are more likely to be able to substantiate a consequential loss and evidence what the funds would have been invested in in a ‘but for’ scenario, whereas individual investors will find this much harder and may be limited to a claim which is just the simple loss in the value of the shares held.
The litigation funding market is buoyant at the moment and there's a lot of capital looking for deployment. Securities litigation is a focus area for many funders. When coupled with the potential likelihood of increased misreporting claims and issues which may have gone undiscovered during the pandemic, I would anticipate a significant rise in the number of securities claims being brought in the short to medium term.
As corporate awareness of the risks of securities litigation evolves, we're likely to see more caution being built into their disclosures. By avoiding providing assurances or caveating projections of future results, many securities litigation claims might be prevented from the outset.
For more insight and guidance, get in touch with our team.