In a significant holding for plaintiffs arguing scienter in shareholder lawsuits, the Tenth U.S. Circuit Court of Appeals said a lower court had erred when it found that Pluralsight, Inc. Defendants’ use of a predetermined trading plan automatically removed their motive to manipulate the company’s stock price. In its August 23, 2022 opinion reversing the District Court’s dismissal of the shareholder lawsuit1 , the Tenth Circuit held, among other things, that the existence of a 10b5-1 trading plan does “not per se rebut an inference of scienter where … a defendant was allegedly motivated to misrepresent or withhold material information to affect a stock price.”
Pluralsight is a startup software company that offers a cloud-based technology skills platform and sells subscriptions to its products and services. At the start of the class period in January 2019, the complaint alleged that Defendants misrepresented the size of the company’s salesforce—the primary driver of Pluralsight’s quarter-over-quarter billings growth, which was the key business metric by which Pluralsight attracted investors. In addition, the complaint alleged that the company and its CEO and CFO knew that Pluralsight misrepresented the size of the salesforce and intentionally withheld this pertinent information from investors. The Lead Plaintiffs appealed to the Tenth Circuit after the U.S. District Court for the District of Utah dismissed the amended complaint on August 2, 2021.
The Tenth Circuit reversed the dismissal in part, holding that the two Lead Plaintiffs—the Indiana Public Retirement System and the Public School Teachers’ Pension and Retirement Fund of Chicago—had plausibly alleged that Defendants made a false and misleading statement at the start of the class period. At that time, Pluralsight CFO James Budge had stated that the company had “about 250” quota-bearing sales representatives; however, it was later revealed that Pluralsight actually only had only “about 200” quota-bearing sales representatives at the time. The Tenth Circuit stated that this “strongly suggests Pluralsight could not have had ‘about 250′ quota-bearing sales representatives on January 16, 2019” and found that the information was “objectively verifiable.” The misstatement marked the beginning of the class period and was a key misrepresentation, the falsity of which was revealed in the third quarter of 2019, when the Company reported a dramatically decreased billings rate of growth, shocking analysts and investors alike. The stock price dropped nearly 40 percent.
In ruling for Lead Plaintiffs on the scienter element of a 10b-5 securities fraud claim, the Tenth Circuit found that Lead Plaintiffs had pled a compelling inference that Defendants knew overstating Pluralsight’s number of quotabearing sales representatives was likely to mislead investors. The Tenth Circuit performed a holistic review in reaching this conclusion, looking to multiple allegations. To begin with, the panel cited Defendants’ statements to analysts and investors on July 31, 2019 and in January 2020, which supported the inference that the CFO knew of the capacity gap but failed to admit it. The appellate court’s finding was bolstered by the fact that the CFO had repeatedly emphasized to analysts and investors that Pluralsight carefully monitored the data surrounding Pluralsight’s billing growth and that the size of the sales force was at the core of Defendants business model.
Moreover, the Tenth Circuit held that the CEO’s and CFO’s suspicious trading within the Class Period, both inside and outside of their 10b-5-1 trading plans, supported scienter. Importantly, the Tenth Circuit agreed with Lead Plaintiffs’ argument, supported by an Amici Curiae brief by former SEC Commissioners Robert J. Jackson and Luis A. Aguilar, former SEC Chief Accountant Lynn Turner and Columbia Law Professor Joshua Mitts, along with other prominent academics, that the “text and history of Rule 10b5-1 shows that such plans can be manipulated easily for personal financial gain and thus cannot rebut the inference that personal financial gain was a motive for Defendants’ material misrepresentations.” The Court noted that these plans do not prevent officers from “making false statements to artificially inflate the stock price to trigger those automatic trades—and that is what plaintiffs allege occurred here.” The Court then found that Lead Plaintiffs’ allegations raised a strong inference of scienter because the CEO and CFO allegedly profited from their stock sales, sold a significant portion of their holdings, and the volumes of sales were higher than outside the class period.
The Tenth Circuit also revived Plaintiffs’ claims under Section 20A of the Exchange Act, which provides a private right of action to contemporaneous purchasers against corporate insiders who purchase or sell a security while in possession of material inside information.
This case is an important holding for investors. It demonstrates that affirmatively misrepresenting facts or data that a company and it officers continuously report on and that form a “key metric” in attracting investor interest, presents a danger of misleading investors and will support a finding of scienter. Significantly, the Tenth Circuit’s holding also shows that 10b5-1 trading plans are not an automatic shield to fraud claims, or a “get out of jail free card.” Courts recognize that, regardless of when the plan is created, Defendants with a 10b5-1 plan could be motivated to make material misrepresentations affecting the stock price to their benefit before a scheduled sale or to trigger a sale at a particular price.
1. Indiana Public Retirement System, et. al. v. Pluralsight, Inc., 45 F.4th 1236 (10th Cir. 2022).
Ernst & Young’s move to split up its auditing and consulting businesses will help the firm more easily avoid conflicts of interests—and the inevitable problems they lead to—says Cohen Milstein Sellers & Toll’s Laura H. Posner.
Earlier this month, Ernst & Young LLP announced an industry-first split of their auditing and consulting functions, dubbed “Project Everest,” a radical move that could completely transform the business model for accounting firms. The split still needs final approval from EY Partners, with a vote slated for later this year.
The announcement has ignited a fiery debate from the global accounting and business community, with many praising EY for its bold, first-mover split and the potential windfall for EY’s advisory businesses. Others speculate that Everest may be too ambitious a climb and harm EY’s brand.
If it becomes official, the division will separate EY’s accountants who audit companies such as Amazon.com Inc., Salesforce.com Inc., Alphabet, Inc. and more, from its faster-rising—and typically more profitable—consulting business. The company’s split would also mark the biggest shake-up in the sector since the 2002 collapse of Arthur Andersen, the auditor that was mired in the Enron scandal and whose downfall reduced the Big Five to the Big Four.
The Big Four accounting firms—EY, Deloitte LLP, KPMG LLP, and PricewaterhouseCoopers LLC—have been under regulatory scrutiny for years over concerns that their advisory services undermine their ability to conduct independent reviews. As reported in the Wall Street Journal in March, the SEC sent letters to them and other accounting firms in late 2021 seeking information about its audit clients and auditor practices. UK auditing and accounting regulator, the Financial Reporting Council, went a step further and asked the Big Four in 2020 to separate auditing as a standalone business in Britain by June 2024.
While details are still being hammered out, accounting insiders speculate that the move to separate the two operations will, in effect, stop newer EY recruits from pursuing cross-practice advancement of audit, tax, and advisory work as their more experienced colleagues have.
Nevertheless, from an investor protection perspective, the move should be a big win. Over the years, serious conflicts of interests have arisen due to accounting firms conducting both audit and consulting work for the same or related companies. Such conflicts frequently lead to corporate misstatements, breaches of fiduciary duties, and in some cases, fraud—which inevitably erodes investor confidence and results in securities class actions and regulatory actions.
By splitting the two businesses, these conflicts of interest, and the inevitable problems they lead to, could more easily be avoided. For example, EY recently agreed to pay the SEC $10 million for their work with Sealed Air—a packaging company known for its brands, Cryovac food packaging, and bubble wrap cushioning packaging—related to charges of auditor independence misconduct perpetrated by several partners to secure Sealed Air as a client.
This past April, in the UK, EY was hit with a $2.5 billion suit for its auditor negligence in NMC Health, which filed for bankruptcy in 2020 after billions of dollars of undisclosed debt was unearthed.
All eyes are watching. As if sending a warning shot across EY’s bow, the SEC’s acting chief accountant, Paul Munter, issued a statement in August reminding accounting firms that “it is paramount that the accounting firm fully understands its responsibility for maintaining auditor independence and it discloses such requirements to the non-accounting firm investors involved” while exploring audit firm restructurings and other complex transactions.
Although EY’s proposal will continue to spark heated debates across the industry, the move will most likely limit conflicts of interest and better protect investors moving forward, meaning EY could avoid some costly securities litigation and SEC regulatory actions in the future as well.
EY’s first-mover split is bold. Hopefully, Deloitte, KPMG, and PwC will take note as they consider the future of splitting up their own consulting and auditing arms and keeping the interests and protection of their auditing clients’ investors top of mind.
Author Information
Laura H. Posner is a partner in Cohen Milstein Sellers & Toll PLLC’s securities litigation and investor protection practice, as well as its ethics and fiduciary counseling practice. Prior to joining the firm in 2017, she was the bureau chief for the New Jersey Bureau of Securities.
Read the article on Bloomberg Tax. (Subscription required.)
Amy Miller authored the “Second Circuit” chapter for the American Bar Association’s 2022 Survey of Federal Class Action Law: United States Supreme Court and Circuit-by-Circuit Analysis. The book, produced by the ABA Litigation Section’s Class Actions and Derivative Suits Committee and edited by Elizabeth J Cabraser and Fabrice N Vincent, provides up-to-date analysis of class action law in each federal circuit.
The 2022 Survey of Federal Class Action Law: A U.S. Supreme Court and Circuit-by-Circuit Analysis is a valuable tool for both in-house and outside counsel who confront the prospect of litigating class actions in federal circuits with which they may have little or no experience and must make informed recommendations on removal. Succinct summaries are prepared by litigators from each of the respective circuits and address changes in rules and statutes as well as significant case law.
The federal False Claims Act and similar state anti-fraud statutes authorize private citizens to redress government fraud by filing a legal action on behalf of the United States, as well as for certain states, to recover for the government the funds that wrongdoers unlawfully obtained, along with substantial penalties. These lawsuits are referred to as qui tam actions, and the private citizens, known as whistleblowers, who successfully prosecute these suits may receive a portion of the recovery. Because the United States and individual states are the real parties in interest to qui tam actions, they have the right to take over, or intervene in, the whistleblower’s action. For a variety of reasons, however, the federal and state governments often opt not to take over qui tam cases even though the whistleblowers’ allegations are meritorious.
When the government declines to intervene in a filed False Claims Act lawsuit, the whistleblower can still pursue the action on the government’s behalf. Numerous whistleblowers who have continued pursuing their False Claim Act cases following a government declination have gone on to successfully recover substantial sums for the government and taxpayers. According to data published by the U.S. Department of Justice, between 2010 and 2021, whistleblowers secured more than $3 billion in judgments and settlements for the government in cases in which the government declined to intervene.
Whistleblowers’ perseverance and success in securing significant recoveries for the government in declined False Claims Act cases continues in 2022. On July 20th, whistleblower Michael Bawduniak announced that pharmaceutical company Biogen agreed to pay $900 million to resolve his qui tam action alleging that Biogen provided kickbacks to induce physicians to prescribe its drugs to Medicare and Medicaid patients. Mr. Bawduniak pursued his case even though the United States and several states declined to intervene. And on August 3rd, a jury sided with whistleblower Ronald Streck and entered a $61 million verdict against Eli Lilly after determining that the drug company deliberately reported false pricing to state Medicaid programs in order to lower rebates that it owed to the states. If upheld, the verdict will be trebled under the False Claims Act. Here again, Mr. Streck pursued his qui tam action and prevailed despite the United States’ and several states’ decisions not to intervene.
For many qui tam cases, a decision by the government not to intervene does not mean that the whistleblower’s allegations lack merit and should not be pursued. Whistleblowers’ continued litigation of meritorious cases after a government declination brings accountability to corporations that defraud the government while returning large sums to our nation’s treasury and deterring future fraud.
Boeing will revise bylaws that a Seventh Circuit panel said improperly barred federal derivative claims, ending a dispute with shareholders over alleged proxy misstatements regarding its 737 Max jet that spawned suits in both Illinois federal court and the Delaware Court of Chancery.
If the settlement deal disclosed Wednesday is approved in both Delaware and Illinois, Boeing’s executive and board director insurance will pay the company $6.25 million. Attorneys for Seafarers Pension Plan, which sued on the company’s behalf, will seek up to $4.25 million of that settlement fund in fees and expenses, according to the preliminary approval motion.
Full court approval will also require Boeing’s board of directors to amend its forum-selection bylaw to allow exclusively federal derivative claims from stockholders in either the District of Delaware or the District of Virginia. Boeing announced in May it was moving its headquarters from Chicago to Arlington, Virginia.
That part of the deal is important, the plan said, because it will do away with the company’s current bylaw, which had only allowed such suits in the Delaware Chancery court. That “prevented the federal derivative claims at issue in this case, or any other exclusively federal derivative claim, from being brought,” according to the filing.
. . .
Seafarers is represented in both suits by Cohen Milstein Sellers & Toll PLLC, with Offit Kurman PA serving as local counsel in Delaware.
The health of the US financial markets and investors is dependent on auditors fulfilling their critical gatekeeping function. While the Sarbanes-Oxley Act led to great improvement in financial reporting, it didn’t go far enough to ensure auditor independence, says Laura H. Posner, a partner in Cohen Milstein’s Securities Litigation & Investor Protection and Ethics and Fiduciary Counseling practices. Prior to joining Cohen Milstein in 2017, Posner was the Bureau Chief for the New Jersey Bureau of Securities.
Last month, the Sarbanes-Oxley Act turned 20 years old. Sarbanes-Oxley, a landmark piece of legislation that transformed auditing and financial reporting in the wake of the Enron and Arthur Andersen scandal, has proven to be one of the most effective pieces of financial legislation passed since the enactment of the Securities Act of 1933 and the Securities Exchange Act of 1934.
Among other things, Sarbanes-Oxley led corporations to adopt and implement significantly more robust financial controls, leading to fewer and smaller restatements. But since it was enacted, both the financial markets and the Big Four accounting firms have transformed dramatically. Audit firms have expansive consulting arms, and financial products are significantly more complex. Legal developments have also made it increasingly difficult to hold fraudsters accountable when they run afoul of auditing rules and the securities laws. Perhaps most alarming is the dangerous pattern of auditors lacking independence from their clients, creating conflicts of interest that we must not ignore.
While Sarbanes-Oxley led to great improvement in financial reporting, it didn’t go far enough to ensure auditor independence. Hopefully, the necessary changes will be made before the next auditing scandal rocks the markets and harms investors.
“Independent” Auditors
Sarbanes-Oxley attempted to ensure auditor independence, requiring engagement partners to rotate off clients every five years and audit firms to bar certain consulting work for audit clients. But the concept of the independent auditor in the US has blurred as accounting firms have become increasingly ensconced in their clients, leading to erosion of investor confidence and opening the door to corporate misstatements, breaches of fiduciary duties, or worse—fraud.
An illustration of this is the recent report that Ernst & Young devised elaborate—and what federal authorities now claim were sham—tax shelters that allowed Perrigo, a leading maker of nonprescription drugs, to avoid more than $100 million in federal taxes. When Perrigo’s outside auditor, BDO, questioned the legality of the tax shelters, Perrigo replaced BDO with Ernst & Young, which then blessed the transactions its consulting arm helped create. This is a prime example of why there must be a bright line defining what it means to be an independent auditor and proscribing what activities are permitted and which run afoul of auditor independence rules.
While the Securities Exchange Commission has released some guidance on what kinds of relationships accounting firms and their auditing divisions can and cannot have with clients, it is not surprising that this activity still takes place. The client, after all, is the one who pays the bills.
Role of Litigation
Auditor independence issues often play an important role in private litigation, too. For example, investors recently settled securities litigation against Mattel Inc. and its auditor, PwC, for $98 million. According to Mattel’s own audit committee, PwC’s lead audit partner for the engagement violated auditor independence rules by providing recommendations on candidates for Mattel’s senior finance positions. A Mattel whistleblower referenced in the complaint also alleged that PwC then helped cover up Mattel’s valuation allowance misstatement that ultimately led to the need for a restatement. Mattel had improperly understated its net loss by approximately $109 million, effectively overstating earnings by $0.32 per share.
While Sarbanes-Oxley attempted to prevent such compromises of independence, the Mattel/PwC case demonstrates that the legislation did not go far enough and that further regulatory action and civil litigation is necessary to protect investors.
Call for Regulators to Get Tough
In the US, accounting firms are regulated by both the SEC and the Public Company Accounting Oversight Board, a quasi-public agency created by Sarbanes-Oxley. SEC and PCAOB rules require audit firms to keep an arms-length relationship with the companies they oversee. In 2020, the SEC clarified the auditor independence rule under then-SEC Chairman Jay Clayton. Under the revised rules, companies are required to limit the number of services they provide to a single client to ensure objectivity and impartiality in their audit work.
Unfortunately, since the fall of Arthur Anderson in the wake of the Enron scandal, the SEC and PCAOB have often failed to go after auditors playing fast and loose with the rules. The death knell of Arthur Andersen—which was one of the “Big Five” auditing firms—was a massive blow to the accounting industry and gave many regulators cold feet in bringing claims against audit firms. When the Supreme Court later overturned the government’s obstruction of justice case against Arthur Andersen, it further dampened enforcement efforts.
The SEC recently rolled out a new enforcement initiative aimed at investigating conflicts of interest in nation’s largest accounting firms—a key step to ensure auditors are acting as the independent gatekeepers. One suggestion is for the SEC and PCAOB to look across the pond at the Competition and Markets Authority and Financial Reporting Council’s recent hardline efforts to regulate the separation of the audit and non-audit practices of the UK’s largest auditing firms—the same Big Four as in the US—as a part of the UK’s “Restoring Trust in Audit and Corporate Governance.”
In addition to the Big Four establishing a separate regulatory audit board, FRC’s April 2022 proposed revisions to the Audit Firm Governance Code stipulates a maximum tenure of nine years to guard against threats to independence and requires an independent non-executive to participate in the auditing process alongside the audit board. The INE would be entirely independent from the auditor and audited entities. It also would be meant to represent the public interest and act for the benefit of the common good, including that of the shareholder and other stakeholders.
Conclusion
The health of the US financial markets and investors is dependent on auditors fulfilling their critical gatekeeping function. To do so, accounting firms must be truly independent from the companies they are auditing.
Delaware Chancery Court Vice Chancellor Travis Laster broke new ground recently by ruling that a board of directors’ failure to address an obvious “red flag” constituted a sufficient breach of fiduciary duty of oversight under the court’s Caremark1 standard to overcome a motion to dismiss, even though the board learned about it through a litigation demand.
The alleged misconduct in Garfield v. Allen2 involved a violation of an equity compensation plan approved by the ODP Corporation Board of Directors. Although Vice Chancellor Laster accepted “with trepidation” the “novel theory” of a Caremark claim advanced by plaintiff, he found that “the logic of the … theory is sound.” Vice Chancellor Laster noted that “from an analytical perspective … the source of the directors’ knowledge should not make a difference.” In short, a litigation demand by itself can now serve as a “red flag” triggering a potential Caremark claim. What remains to be seen is whether this new theory of liability becomes a viable approach to challenging a board’s breach of its fiduciary duty of oversight beyond the factual circumstances of this case.
The Garfield case arose in the context of the grant of equity awards by the directors of ODP under an existing executive compensation plan previously approved by its stockholders. The plan contained a limit on the number of shares that could be awarded to an individual in any given year. Plaintiff challenged the award granted to ODP’s CEO, claiming that the board had violated the plan by awarding him an excessive number of shares. Plaintiff made a demand on the ODP board to amend the award to comply with the terms of the plan.
In response to the demand, the board’s compensation committee chose to interpret the plan differently and applied another limitation found in the plan—one that was higher and ostensibly permitted the award to stand. Because the board denied the stockholder’s demand without taking any action, plaintiff brought a direct claim for a breach of contract based on the terms of the plan and a derivative claim for breach of fiduciary duties. Defendants moved to dismiss the claims relying on their different interpretation of the plan as the basis for not taking the action plaintiff demanded.
In denying the motion to dismiss, Vice Chancellor Laster ruled that the directors on the compensation committee breached the contractual terms of the plan and their fiduciary duties by approving the award, that the CEO breached his fiduciary duties by accepting the award, and that all the directors breached their fiduciary duty by not fixing the awards after receiving notice of the violation in the demand.
The underlying theory on the board’s failure to amend the award after receiving notice of the violation was premised on a Caremark type claim and rests on the notion that directors can be held liable for consciously not addressing “red flags” brought to their attention. Vice Chancellor Laster ruled that just because a “red flag” is raised in a litigation demand, it does not absolve directors from potential liability. Thus, the ODP directors who approved an improper award in the face of a “plain and unambiguous” contractual restriction in the plan face liability both for approving the improper award and for failing to address the issue once they were advised of the problem by a stockholder demand. Significantly, here all directors breached their fiduciary duties by failing to amend the award after being put on notice of the violation when they received plaintiff’s demand. As Vice Chancellor Laster noted: “[w]hen directors grant awards that exceed an express limitation in an equity compensation plan, the allegations support an inference that the directors acted knowingly and intentionally,” supporting a claim for breach of “fiduciary duty of loyalty by failing to act in good faith.”
Recognizing that this approach to Caremark claims was novel and without precedent, Vice Chancellor Laster cautioned against how this doctrine should be applied in future cases. His concern centered on other plaintiffs who might attempt to manufacture whistleblower-type claims as a basis for a demand and then sue directors who failed to act “because the directors did not respond to the whistle.” While this might be a concern, however, there now appears to be a pathway for stockholders to assert a Caremark claim where directors are advised of an otherwise unknown serious problem or “red flag” and fail to address the issue when given notice through a litigation demand.
1. In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959, 971 (Del. Ch. 1996) (Allen, C.)
2. Garfield v. Allen, et al., C.A. No. 2021-0420-JTL (Del. Ch. May 24, 2022)
To say that federal securities regulators are expanding oversight of cryptocurrencies at an opportune time would be an understatement. In fact, some industry experts say the increased attention is overdue.
Crypto assets have gone mainstream. Over the last year, several large pension funds have announced allocations to crypto or its underlying blockchain technology, while asset managers like Fidelity Investments have enabled 401(k) retirement savings plan participants to invest directly in Bitcoin1 and celebrities like Tom Brady and Larry David pitch crypto on TV to retail investors. Meanwhile, cryptocurrencies have been hit particularly hard during Wall Street’s recent downturn, losing two-thirds of their value since their November 2021 peak market capitalization of $3 trillion.2
Enter the U.S. Securities and Exchange Commission’s (SEC). On May 3, 2022, the SEC’s Division of Enforcement announced the expansion of its crypto group from 30 to 50 people and renamed it the Crypto Assets and Cyber Unit. “By nearly doubling the size of this key unit, the SEC will be better equipped to police wrongdoing in the crypto markets,” SEC Chair Gary Gensler said in a statement accompanying the announcement. The SEC said the Crypto Assets and Cyber Unit would focus on investigating securities fraud violations related to crypto asset offerings, crypto asset exchanges, crypto asset lending and staking products, decentralized finance (DeFi) platforms, non-fungible tokens (NFTs), and stablecoins. Division of Enforcement Director Gurbir S. Grewal added that the unit “will be at the forefront of protecting investors and ensuring fair and orderly markets in the face of these critical challenges.”
Formerly known as the Cyber Unit, the group began investigating crypto in 2017, around the time Bitcoin reached $10,000 per coin and several new cryptocurrencies launched Initial Coin Offerings (ICOs)3. At the time, the SEC warned investors that, due to the limited oversight, “ICOs could easily be scams or ponzi [sic] schemes disguised as legitimate investments.”4 In the past five years, the unit has brought more than 80 enforcement actions related to fraudulent and unregistered crypto asset offerings and platforms, leading the SEC to recover more than $2 billion for swindled investors.
The SEC’s enforcement expansion comes amid other proposed SEC initiatives to regulate the crypto markets and legislative activity in the U.S. Congress focusing on the best way to regulate issuers of stablecoins, which are cryptocurrencies pegged to a fiat currency like the U.S. dollar.5 The SEC’s regulatory initiatives to broaden investor protections in the crypto markets, announced on April 4, 2022 by Chair Gensler, included registering and regulating crypto exchanges, potentially separating out asset custody to minimize investor risk, and partnering with the Commodity Futures Trading Commission (CFTC) to address trading platforms for crypto-based security tokens and commodity tokens.6 The SEC’s proposed initiatives are in line with President Biden’s March 2022 Executive Order, which directed federal agencies to implement a strategy for policies and regulations on digital assets, including cryptocurrencies.7 Although Biden’s Executive Order was well received by crypto market experts —they described it as “extremely positive,” “long overdue,” and an “acknowledgment that cryptocurrency is here to stay” —it did nothing to quell the uncertainty as to which federal agency will serve as the primary regulatory of the crypto markets.8
Judging from its expansion of the Crypto Assets and Cyber Unit and proposed regulatory initiatives, the SEC views itself as the primary regulator of the crypto markets. But a bipartisan bill introduced on June 7, 2022 by U.S. Senators Cynthia Lummis (R-Wyoming) and Kirsten Gillibrand (D-New York) allocates primary oversight to the CFTC, reasoning that crypto products operate more like commodities than securities.9 Senators Lummis and Gillibrand’s bill has received a fair amount of criticism from investor protection and consumer advocacy groups, who say it indulges cryptoindustry-led efforts to marginalize the SEC.10 That criticism aside, U.S. Senators Debbie Stabenow (D-Michigan) and John Boozman (R-Arkansas) are in the process of drafting crypto legislation that also designates the CFTC as the primary regulator of the crypto markets.11
Congress will likely not act until after the midterm elections and there is no indication whether it will agree with Chair Gensler that the SEC already has the tools to properly and effectively police crypto markets. “We already have robust ways to protect investors trading on platforms. And we have robust ways to protect investors when entrepreneurs want to raise money from the public. We ought to apply these same protections in the crypto markets,” Chair Gensler said. “Let’s not risk undermining 90 years of securities laws and create some regulatory arbitrage or loopholes.”
On July 8, 2022, Federal Reserve Vice Chair Lael Brainard echoed Gensler’s comments while reflecting on the recent crypto turbulence and massive losses. “It is important that the foundations for sound regulation of the crypto financial system be established now before the crypto ecosystem becomes so large or interconnected that it might pose risks to the stability of the broader financial system,” she said.12
Securities Litigation 101
When it comes time to determine which plaintiffs will act as representatives for all class members, lawsuits brought under the U.S. federal securities laws are unlike any others. That’s because securities class actions are subject to the Private Securities Litigation Reform Act of 1995 (the PSLRA), a law that created a process to select the lead plaintiffs based on objective criteria including the size of their financial interest in the case.
Under the law, the lead plaintiff is a key player in a securities class action, acting as a fiduciary on behalf of the entire class and responsible for selecting lead counsel, signing off on litigation strategy and tactics, approving proposed settlements, and negotiating attorneys’ fees.
Prior to the PSLRA’s enactment in 1996, judges often assigned the role of lead plaintiff to the first party to file a securities lawsuit in their court or based on their knowledge of the law firm representing the plaintiff. This created a perceived “race to the courthouse,” in which specialized attorneys filed complaints soon after stock drops, sometimes relying on a stable of clients with small stock holdings in many publicly traded companies. These practices also raised criticisms that too many shareholder lawsuits were “lawyer driven,” since plaintiffs’ attorneys usually had far larger stakes in the outcome than the small investors who often brought the lawsuits.
To remove any advantage for early filers, the PSLRA1 directs judges to apply a rebuttable presumption to appoint the movant with the largest financial interest in the litigation, if the movant is also “typical” and “adequate” as defined in Rule 23 of the Federal Rules of Civil Procedure.2 When naming the lead plaintiff, the court also approves lead plaintiffs’ choice of lead counsel.
To help potentially harmed investors learn about new lawsuits and give them time to step forward, the law requires plaintiffs who filed the shareholder lawsuit to publish within 20 days a public notice containing certain information, including the claims asserted, the purported class period, the court where it was filed, the fact that any class member can serve as lead plaintiff, and the deadline for filing lead plaintiff motions. With the growth of the internet, these “PSLRA notices” have evolved from newspaper advertisements to online news releases beamed instantly around the world. Purported class members have 60 days from the first PSLRA notice to file a lead plaintiff motion with the court.
Though the PSLRA is mute on how to calculate financial interest, courts generally have looked at total class period purchases, net class period purchases, net class period expenditures, and most importantly losses, as calculated on a last-in-first-out (LIFO) or first-in-first-out (FIFO) basis. Since movants sometimes group together to file joint lead plaintiff petitions, the courts often consider whether to allow such a group to aggregate its losses in a single motion. The courts typically decide whether to permit such aggregations on a case-by-case basis. While the PSLRA does not provide any guidance about groups, the courts have considered factors such as the group’s size, whether group members knew each other before filing the motion, whether they have discussed how they plan to work together on the case, their experience as lead plaintiffs, and their choice of counsel.
When Congress enacted the PSLRA, it sought to empower institutional investors, reasoning that they would have larger losses—more “skin in the game”—and that their size, staffing, levels, and sophistication would give them better tools to fulfill their fiduciary duties to absent class members, including oversight of the attorneys. In that respect, the law certainly worked. Institutional investors, rarely involved in shareholder lawsuits prior to 1996, now are appointed lead plaintiffs in roughly half of all newly filed federal securities class actions; even in smaller cases where individual investors act as lead plaintiffs, the PSLRA’s lead plaintiff mechanism ensures an orderly, fact-based selection process. The increased involvement of institutional investors has in turn benefited all shareholders. Numerous academic studies have shown that shareholder class actions led by institutional investors are more likely to succeed than those led by individuals. Cases with institutional lead plaintiffs settle for more money and pay lower attorneys’ fees than other cases, even when controlling for the fact that institutions tend to file larger cases.
1. The PSLRA has provisions dealing with many aspects of securities litigation, notably creating an automatic stay of discovery designed to protect defendant companies from documentary “fishing expeditions” until a judge decides whether the case is properly pled; raising pleading standards to require plaintiffs to show a strong inference that defendants had knowingly acted wrongly; and providing defendants with a “safe harbor” against liability for forward-looking statements. We will leave those for a future installment of Securities Litigation 101.
2. Rule 23 requires that the lead plaintiff’s legal claims are typical of the class, broadly meaning that they arise from the same event and are based on the same legal theory, and that the movant is adequate, meaning its interests do not conflict with those of the class and it has enough experience and resources to vigorously represent the class and oversee counsel.
Fiduciary Focus
Shareholder Advocate Summer 2022
I recently had the pleasure of moderating a session at the legal education conference of the National Association of Public Pension Attorneys (NAPPA) titled “The ABC’s of DE&I: Public Pension Plans Spell It Out”. The program was specifically designed to assist public pension attorneys in thinking about how to advise their clients regarding diversity, equity and inclusion (DE&I) consistent with the exercise of their fiduciary duties, including the exclusive benefit rule and the duties of loyalty and prudence.
In brief, as readers of this column know, fiduciaries must carry out their functions acting solely in the interest of the members and beneficiaries and for the exclusive purpose of providing benefits and defraying reasonable expenses incurred in performing such duties. They must act with the care, skill, prudence and diligence in light of the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.
The discussion began by noting that there certainly is no shortage of attention to issues of diversity, equity and inclusion these days. For example, lawyers may have noticed that the topic of DE&I recently graced the covers of both the New York State Bar Journal and the Washington Lawyer publication of the DC Bar Association. Similarly, investment professionals are likely aware that the CFA Institute recently issued a Diversity, Equity & Inclusion Code— a voluntary code developed with the recognition, as articulated by the CFA Institute, that a diversity of perspectives leads to better investor outcomes, that an inclusive investment industry better serves our diverse society, and that an organization with an inclusive culture and effective working relationships is a better place to work.
NAPPA conference attendees were very fortunate to have panelist Kellie Sauls, Director of Diversity, Equity, and Inclusion for the Teacher Retirement System of Texas, to help them think about how to address DE&I in their work advising fiduciaries. Ms. Sauls displayed a wealth of knowledge, gained through not only many years of experience in the DE&I field but also practical, concrete experience in advising a public pension plan. She presented important information and tips relevant for a range of pension plans, from those organizations with established programs to those just beginning to focus on DE&I. Here are some of my key takeaways from her presentation.
One Size Doesn’t Fit All
What diversity looks like in one area of the country is not necessarily the same as what diversity is in another part of the country. For example, certain groups that may be underrepresented in a large California city may not be the same as those underrepresented in a small Midwestern town. Likewise, people who are members of an underrepresented group in one industry— nursing, for example—may not be underrepresented in another industry, such as information technology. This requires clarity in understanding existing circumstances and developing approaches in strategic planning around DE&I.
Take this quote about diversity: “The inability to envision a certain kind of person doing a certain kind of thing because you’ve never seen someone who looks like him do it before is not just a vice. It’s a luxury. What begins as a failure of imagination ends as a market inefficiency; when you rule out an entire class of people from doing a job simply by their appearance, you are less likely to find the best person for the job.” While a reader might think this was a 2022 quote talking about racial or gender diversity, equity and inclusion, it actually comes from Moneyball, the 2003 book by business writer Michael Lewis and concerns Oakland Athletics executive Billy Beane’s recruitment of baseball players.
It’s About Risk Mitigation and Compliance
DE&I belongs in the risk management and legal compliance program. In a 2021 survey, over 50% of employers reported lack of DE&I as an enterprise risk.
For example, Ms. Sauls noted that, for many employers, the so-called “Great Resignation” resulted in female employees leaving in greater numbers than men. The business risk created when talented individuals are leaving the workforce in large numbers is something every employer must pay attention to. DE&I can mitigate risk by helping an employer recruit and retain talent critical to the effective operation of the organization. DE&I, as an integral part of onboarding, employee development, performance management, career development, and succession planning, supports an organization in acquiring and retaining talent, as well as avoiding equal opportunity challenges, thus mitigating business risk, reputational risk, and legal compliance risk.
Reiterate the Business Case
Recognizing that commitment to DE&I is consistent with the strategic objectives of the organization means that every DE&I program must emanate from leadership as part of the institutional plan. Support from the top means communication to, from, and among the board and that senior staff leadership must reiterate the business case each and every time DE&I is discussed. Identifying and communicating appropriate metrics and benchmarks are crucial to developing a culture of continuous improvement, and support from the top cannot be overstated.
Everyone Has a Role to Play
Experience shows that about 10% of employees may be characterized as overly enthusiastic or energetic, passionate, and zealous with regard to DE&I. Another 10% or so likely will not be on board and may even try to sabotage DE&I efforts. The remaining 80% or so of the workforce is the so-called “sweet spot” open to growth and learning. But it is critical to note that everyone in an organization plays a part in DE&I and it is important that people see themselves as participants. Input should and can be obtained from all. It is important to invite people with contrary viewpoints into the discussion; even (and perhaps especially) individuals who are not “on board” can provide valuable feedback. Challenges are to be expected and addressing them can assist in formulating the role of DE&I in organizational culture and how it factors into the organization’s core values.
It is important that employees see themselves as a part of the DE&I work, and one tool for consideration is the creation of affinity or employee resource groups. Some organizations have a wide range of such groups, such as Black and Latinx, LBGTQA, women in investment, caregivers, and military families. It was also noted that many affinity and resource groups include allies within the group’s membership—for example, a women in investment group may include men who support DE&I efforts in this area.
Practical Applications Appreciated
Attendees reported that the panel was a relatable conversation, with a discussion of trends in the area as well as risk mitigation and the interplay with legal and compliance systems and processes. They appreciated the discussion of practical applications, quickly attainable successes, expected challenges, and motivating imperatives for those engaged in DE&I work, and they left the program better able to advise their clients regarding DE&I and the exercise of fiduciary duties.