John C. Coffee Jr.

Securities litigation is now near an all-time high. Why? It seems to be the product of multiple factors, but two stand out: (1) the migration of “merger objection” cases from Delaware to federal court, and (2) the appearance of a new style of securities litigation that is increasingly called “event-driven” litigation. In “event-driven” securities litigation, the issuer’s financial statements are not challenged; rather, there is usually an “event” (a fire or explosion, an airplane crash, a product recall, or a law enforcement action) and a consequent stock price fall. Plaintiffs then seek to relate this “event” to prior statements by the issuer that assured the public that it was in full regulatory compliance or that attested to the high quality of its product. For example, the issuer asserts in a series of periodic filings that it is in full regulatory compliance and then is subjected to regulatory action that surprises the market and drives down its stock price. For example, in Omnicare v. Laborers Dist. Council Construction Indus. Pension Fund, 135 S. Ct. 1318 (2015), the issuer stated:

“We believe our contract arrangements with other healthcare providers, our pharmaceutical suppliers and our pharmacy practices are in compliance with federal and state laws.” (Id. at 1323).

In fact, the practices were unlawful, and the Federal Government sued Omnicare. Although the Court recognized that Omnicare’s statement was an “opinion” statement, subject only to a lesser standard of liability, the Court still remanded for further proceedings to determine if Omnicare had omitted material facts about how it had formed its belief. Had it investigated adequately? Did it recognize that there were serious questions about the legality of its practices? If so, omission-based liability, Justice Kagan said, was possible.

Similarly, a few years earlier in Matrixx Initiatives v. Siracusano, 563 U.S. 27 (2011), the Court held that plaintiffs state a claim under Rule 10b-5 when the corporate defendant fails to disclose reports it has received about adverse effects associated with its product (even though no statistically significant association had been shown). In Siracusano, the defendant sold a cold remedy, called “Zicam,” whose active ingredient, zinc gluconate, is now believed to cause anosmia, or loss of the sense of smell.

These two decisions within the last decade may have convinced the plaintiff’s bar that “event-driven” securities litigation offered profitable new opportunities. After all, plaintiffs could sue with the benefit of 20/20 hindsight in cases where subsequent events showed that the product was dangerous or the practice unlawful.

If that was the hope, the Second Circuit’s decision this month in Singh v. Cigna, 2019 U.S. App. LEXIS 6637, must have been a major disappointment for the plaintiff’s bar. In Singh, defendant Cigna made fairly general statements about its regulatory compliance. Specifically, in its Form 10-K for 2013, it asserted that it had “established policies and procedures to comply with applicable requirements” and that it “expect[s] to continue to allocate significant resources” to its compliance efforts. Later in 2014, it also adopted a “Code of Ethics and Principles of Conduct,” which stressed the need for compliance and integrity by everyone.

As it turned out, its compliance efforts fell considerably short of what was needed, and it was cited for regulatory violations by the Center for Medicare and Medicaid Services (CMS), which is the regulatory body that oversees Medicare services. When CMS audited Cigna and announced sanctions, Cigna’s stock price fell over the next four days from $140.13 to $135.85—or slightly less than 3 percent. Based on this, several pension funds, represented by Labaton Sucharow, brought suit in 2016 under Rule 10b-5.

It should be obvious that these facts do not amount to John Dillinger robbing a bank at gun point or Bernie Madoff pulling off a Ponzi scheme. Indeed, the district court granted defendant’s motion to dismiss, finding neither materiality nor scienter to have been shown. Nonetheless, plaintiffs appealed (and may today regret this error in judgment).

At the Second Circuit, the panel left no doubt how they viewed this case. Their first two sentences put it bluntly:

“This case presents us with a creative attempt to recast corporate mismanagement as securities fraud. The attempt relies on a simple equation: first, point to banal and vague corporate statements affirming the importance of regulatory compliance; next, point to significant regulatory violations; and voila, you have alleged a prima facie case of securities fraud.”

Interestingly, the panel threw out the case on the grounds that these statements were not materially misleading, and it did not discuss scienter. Usually, it is easier to do it the other way around because the Private Securities Litigation Reform Act (PSLRA) requires special pleading of scienter, with Section 21D(b)(2)(A) of the Exchange Act requiring that the plaintiff “state with particularity facts giving rise to a strong inference” of fraud. Plaintiffs thus lost on the issue of materiality, which was exactly the issue that Siracusano and Omnicare had seemed to relax.

How broadly should Singh be read? A minimally careful statement of its holding is that generalized statements about regulatory compliance cannot be materially misleading, at least in the absence of knowledge of information suggesting the issuer knew of its noncompliance. But even here, one must be more exact. The Second Circuit noted that “Cigna’s Medicare operations experienced a series of compliance failures” during the period in which it released its statements. But Cigna’s statements said only that it had “established policies and procedures to comply with applicable requirements” and that compliance was “important for every employee.” No claim was made by Cigna that it was in compliance or (as in Omnicare) that it believed it was complying. That would present a different case.

Thus, predictions of the death of event-driven securities litigation are still premature. Nonetheless, the case hints skepticism of such litigation and is at least one straw in the wind.

Let’s now move from regulatory compliance cases to product failure cases. Boeing has recently experienced two major crashes of its new jet, the 737 Max 8 (one off Indonesia in October, another in Ethiopia in good weather this March). Its stock price has suffered, and securities litigation is a certainty. A class action filed after the second crash will face the difficulty that the market already knew of the first crash, which elicited a great deal of commentary about the possibility that Boeing’s aircraft either had some inherent problem or that pilots had not been adequately trained to handle it. Thus, those purchasing Boeing stock after the first crash are subject to a strong “truth on the market” defense, as they had notice of the problem.

But what about class actions brought on behalf of purchasers after the first crash? Such actions have in fact been filed, alleging that Boeing failed to disclose that “the company’s new 737 Max automated stall-prevention system was susceptible to deadly malfunctions.” See “Bragar Eagel & Squire, P.C. Reminds Investors That Class Action Lawsuits Have Been Filed Against PPDAI, Boeing, Ternium and Aphria and Encourages Investors to Contact the Firm” (Jan. 21, 2019) (available on LEXIS). This is a classic example of event-driven securities litigation.

Here, scienter probably provides a stronger defense than materiality. Unless plaintiffs can plead with particularity that Boeing hid a risk or risks known to it that caused the crash, they cannot even obtain discovery under the PSLRA. This author does not pretend to know what the evidence will show (if discovery is even available), but this is a formidable obstacle.

Why then is “event-driven” securities litigation increasingly brought? It may be that some plaintiff firms overread Siracusano and Omnicare and concluded that all disasters would be material. Or, it may be that this litigation tends to settle cheaply (or at least that some plaintiff firms are willing to so settle). It may be cheaper to settle than to litigate to victory (and some defendants may fear what discovery might reveal).

For defendants, however, the lesson from Singh is that issuers can safely stress the need for, and importance of, regulatory compliance. But going further and expressing the belief that one is in full compliance (or that the company “believes” it complies with all applicable laws and regulations) may be more dangerous and invites an Omnicare attack. Although the defense bar hopes that Omnicare can be confined to Section 11 cases, the probability is otherwise. Predictably, Omnicare will leak over into Rule 10b-5 cases.

We are, however, beginning to see the courts confront (with skepticism) this new pattern of event-driven securities litigation. Stay tuned. More developments will follow.

John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.