Written by John Durrant
As of May 5, 2020, the COVID-19 pandemic has accompanied a precipitous descent in the domestic securities markets, followed by a surprisingly sharp rebound. Such volatility may well give rise to several different types of potential liability against companies and their officers and directors, including:
- Securities fraud claims under the Exchange Act of 1934 (the “Exchange Act”).
- Claims related to offerings of securities under the Securities Act of 1933 (“Securities Act”).
- Claims under the various state securities claims, i.e., the “Blue Sky” laws.
- Derivative suits arising under state law.
Business leaders may well say, “Wait, we didn’t cause COVID-19; we didn’t shut down the economy; how can we be held liable?”
While there is undoubted merit to that frustration, this article explains where potential liability lies and gives some general ideas about how to mitigate that risk.
First, it should be noted that recent years have seen an increase in securities fraud claims. In this growth, “event-driven” private securities litigation has played an outsized role. Event-driven lawsuits arise from the occurrence of negative exogenous events and the failure to warn of the risks posed by such events. While a publicly-traded corporation may have no responsibly for the bankruptcy of a key business partner, a hurricane that floods a warehouse, or indeed a global pandemic that results in the shutdown of much of the economy, a plaintiff may base claims on a failure to disclose underlying infirmities and vulnerabilities that such exogenous events reveal.
But, while history has shown that just about any decline in stock prices can conceivably give rise to securities litigation, there are good reasons to expect that capable plaintiff’s lawyers will carefully select who to sue and how to sue them this time around.
Unlike, say, bad weather, a pandemic has not been generally imagined by companies (or indeed most of the public) to be likely or probable. Very few companies therefore had specific cautionary language in their SEC filings related to risks caused by pandemics. A prior failure to disclose the risk of a pandemic to a particular business is unlikely to trigger a colorable securities claim. The securities laws require the transparent disclosure of risk, not clairvoyance.
There remain avenues to bring more credible claims, however. For instance, COVID-19 may expose general business vulnerabilities (e.g., supply chain issues, reliance on particular vendors, weaknesses in customer base, reliance on key employees, failures to institute succession planning, or changed macroeconomic circumstances). So, while it would be tough for a plaintiff to argue credibly that an issuer should have anticipated a pandemic and disclosed that risk, it would be less so for a plaintiff to argue that the COVID-19 happened to reveal the truth about a general vulnerability in a business that the business failed to disclose fully prior to the pandemic.
For instance, if a hypothetical business were reliant on one thinly-capitalized supplier, which went out of business during the pandemic shutdown, a failure to disclose the vulnerability regarding the reliance on one supplier could give rise to securities fraud claims, even if previously undisclosed risk of the pandemic itself could not.
Moreover, after the pandemic and shutdown have become known, companies have to be careful and thorough about explaining how they expect these unusual circumstances to impact their business. Again, the law does not require a perfect or exhaustive prediction about the future, but a candid, good faith assessment of headwinds.
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The pleading and proof of federal securities claims is rigorous. Under the Exchange Act, a plaintiff bringing claims will have to plead and prove a strong inference of scienter (i.e., intent to defraud) that is “cogent and compelling” and at least as compelling as other inferences. In addition, a plaintiff will have to establish loss causation, which is nearly always a challenge, but will be more so for claims arising from drops in the price of securities around the time of COVID-19. It will be important for such plaintiffs to disaggregate the effects of alleged fraud from other factors causing price changes, such as the pandemic itself. One very interesting recent article suggested that the collapse in oil prices may have been the primary factor in the declines in stock prices in early 2020, even though it was attributed in the financial press mainly to COVID-19. So, in addition to the impacts of COVID-19, plaintiffs will also need to separate out consider the effects of the collapse in oil prices (which also related to the pandemic, but had other major causes).
In addition to claims under the Exchange Act, there is the potential for claims related to offerings of securities. For publicly traded companies, claims regarding offerings typically arise under Section 11 and 12(a)(2) of the Securities Act. Such lawsuits do not typically require pleading or proof of fraudulent intent, but have roughly analogous causation requirements, because the absence of causation (“negative causation”) is an affirmative defense to such claims.
Going forward, the SEC Chairman Jay Clayton has stated the Commission’s expectation that issuers reexamine prior disclosures and issue revised guidance that fully describes all material risks posed by COVID-19. Among other applicable regulations, Item 105 of Regulation S-K – requires disclosure in the Risk Factor sections of their filings of the “most significant factors that make an investment in the registrant of offering speculative or risky.” And, Item 303 of Regulation S-K requires disclosure in the management discussion and analysis (“MD&A”) portion of annual or quarterly filings of “known trends of uncertainties” expected to have a “material favorable or unfavorable impact on net sales or revenues, or income from continuing operations.”
Issuers should make use of the “Safe Harbor” in Section 21E of the Exchange Act, and update forward-looking statements. While the implications of COVID-19 to a business will vary widely across industries and particular companies, issuers should think through the actual and potential impacts, preferably with the assistance of knowledgeable counsel and auditors, and disclose them forthrightly. It will not be sufficient to warn generically that COVID-19 may impact operations, if more specific facts about the impact are known but not disclosed or if the risks have already manifested themselves as actual impacts on a business. It is this reason that many issuers have withdrawn guidance for part or all of 2020 – while it is important to qualitatively describe business risks with particularity, it may be too uncertain to reasonably forecast earnings and the like at this juncture and honestly acknowledging that uncertainty should not be problematic from a regulatory or litigation perspective.
Finally, we note that, in addition to private securities litigation under the Securities Act and Exchange Act, there is the potential for derivative suits arising after COVID-19, alleging breaches of duty related to the preparation and response to the pandemic. Such lawsuits can be more easily defended if boards document their governance decisions in a way that demonstrates sound business judgment. In addition there is a potential for claims under the Blue Sky laws, or state securities laws for certain types of securities.
It is still early and the shutdown may be impacting the filing of new lawsuits, but thus far there has not been a marked increase in securities cases, arising from COVID-19 or the accompanying market volatility. The few cases that have emerged have concerned specific misstatements regarding operations during the pandemic – e.g., a company allegedly exaggerating its progress on a vaccine, a cruise line allegedly failing to disclose the business risks from the virus and misleading sales practices, or a Chinese issuer failing to disclose risks caused exposure to the Wuhan apartment rental market. Those are sui generis claims that do not point to a broader uptick in COVD-19 claims.
That may well change as circumstances evolve and courts around the country open up. But successful plaintiffs will have to rigorously plead and prove impacts attributable to wrongdoing by businesses or management (as opposed to COVID-19). Successful defendants will have carefully and completely disclosed business impacts in good faith in a timely manner. Such issues obviously have a number of permutations in different industries and organizations that will require the assistance of knowledgeable counsel and accountants.