Where have all the lawsuits gone?

The bubble has burst,’ pronounces David Robinson, senior manager of key accounts for CT Summation, a San Francisco-based developer of litigation support and e-discovery tools. He sighs as he says it, because he remembers much, much better days for his industry – a time just a few years ago, when lawsuits flew thick and fast. Robinson is only the first in a lengthy line of lamenters who, increasingly, say they do not expect a quick return to those golden days.

‘I am increasingly realistic that this industry’ – the level of shareholder suits of nearly all varieties, including those filed over so-called 10b5 accounting irregularities – ‘is greatly diminished from what it was 10 years ago,’ says Charles Lichtman, a shareholder at Berger Singerman and a specialist in fraud and shareholder cases.

‘Many securities class action lawyers have simply stopped filing because they have come to believe they have no chance of success,’ says Randy Johnston, a Dallas-based attorney and also the author of Robbed at pen point.

Death to tradition
The proof is in the numbers, and what they vividly show is that there has been a monumental collapse in traditional, accounting-driven filings against publicly held corporations. Securities lawsuits are down, a lot, in the traditional sectors. Per Stanford Law School’s Securities Class Action Clearinghouse, the average number of filings each year has been 192, in the period 1997-2007, but in 2008 there were 210 filings. Wait – isn’t that up? Indeed, but Stanford further parses the numbers to reveal that a staggering 97 of those 2008  filings are attributed to the global financial meltdown. Just 109 are traditional, accounting-based filings, compared to 128 in 2007, 175 in 2005 and 215 in 2004; the recent high was 242 in 1998.

Over at PricewaterhouseCoopers, Grace Lamont, principal and US securities litigation practice leader, reports that ‘the percentage of traditional accounting cases fell in 2008 to the lowest level since we’ve been keeping numbers.’

Joe Grundfest, a Stanford professor of law at the Securities Class Action Clearinghouse, has crunched the numbers another way, and what he sees is that total case filings dipped in 2005 (178 total) and 2006 (116 filing), but – due to the subprime crisis – numbers started to pick up in 2007 and have stayed high. ‘There was a remarkable decline in filings,’ says Grundfest, who pinpoints the questions that matter: why did filings start falling in 2005, and what predictions can be made about future levels?

For his part, Grundfest cautiously offers that some studies have shown sharp improvements in accounting quality at big corporations – thus providing fewer grounds for suits – but he adds that other studies see no real improvement in accounting. Either way, the one conclusion that seems clear, suggests Grundfest, is that there has not been a deterioration in accounting. ‘No studies have found that,’ he says.

Another argument is that, just maybe, Sarbanes-Oxley has had its desired effect and resulted in putting into place activist, intelligent boards of directors that are taking steps to ensure that corporate books keep getting better. Talk to lawyers around the country and, while there is a profound unwillingness to go on the record about this issue, there is broad agreement that boards are indeed getting more diligent – but at every public company? And so diligent that they are sniffing out possible fraud before it can trigger litigation? There is not wide support for this thesis; indeed, there is little support for it at all.

Betting on a losing game
This brings us back to the question: why have filings rooted in traditional accounting issues (income restatement, for instance) dropped? ‘Lawyers are scratching their heads over this,’ says Michael Schaalman, an attorney with Quarles & Brady.

Lawyers do have their explanatory arguments, however. Will Prickett, the Boston-based chair of Seyfarth Shaw’s national securities and financial litigation practice group, says a big reason is that, going back 10 years, it has simply gotten much easier to win dismissal of a case at a very early stage and that, increasingly, judges are employing this option. Every such case that is dismissed, however, represents substantial losses for a plaintiff law firm – hundreds of thousands of dollars of time and out-of-pocket expenses go into preparing a case, and no law firm wants to drop that kind of bet on a game of chance that looks to favor the other side. This means that a kind of Darwinism plays out with case filings – only the strongest actually make it to court, because prudent economics encourage dumping weak cases early or, increasingly, not pursuing them at all. Attorneys whisper about intra-law-firm belt tightening – associates are getting fired, partners are retiring early and everywhere the recession is forcing even the biggest firms to eyeball expenses closely. All of this activity may be translating into the preparing and filing of substantially fewer securities cases.

Either way, the unmistakable reality is that ‘the court has more tools for getting rid of cases early, at the class certification stage, and this is impacting the number of cases that get filed,’ says Christopher Davies, a Washington, DC-based attorney in the securities department at WilmerHale.
‘I see many, many cases that 10 years ago were certain winners, and now they are dismissed early or never get filed,’ says Lichtman. ‘Fewer cases survive the motion to dismiss stage.’

‘Nowadays, a case has to be pled with great specificity,’ adds Lisa Wood, a Boston-based attorney with Foley Hoag. Various court decisions – notably the 2007 Tellabs v Makor Issues & Rights ruling – have, decision by decision, upped the rigors for the plaintiff bar. Boiled down, the Tellabs decision requires that the plaintiff argument – that this fraud caused losses x, y and z – has to be at least as likely to be true as other explanations of events. When that high level of probability does not attach, prima facie, to the plaintiff’s argument, the judge may simply dismiss the case. ‘This tree has ripened,’ says Wood, who suggests that the Supreme Court’s message is that cases should get settled earlier, even before they get to court.  

A shrinking target
This message has not gone unnoticed by the plaintiff bar and ‘has been maturing over many years,’ says Wood. Corporations are also paying close attention.

Wood also points to the early 2008 Stoneridge Investment Partners v Scientific-Atlanta decision, where the Supreme Court said that investors could not sue third-party consultants (law firms, accountants, banks) who happened to work for a company that may have perpetrated accounting fraud. Before Stoneridge, plaintiffs had been undeterred when the target company appeared to be running out of cash because there were many others to pursue (during Enron, for instance, Merrill Lynch had loomed as a prime target). Stoneridge closed the door on a lot of peripheral litigation and also set as a ground rule that if there is money to be had, it should come from the public company that committed the fraud. And that, suggests Wood, has prompted many would-be litigators to look at other kinds of cases.

Another reason for the drop is that ‘we just aren’t seeing that many restatements of earnings. They always trigger suits,’ says Bob Rapp, a partner in the securities litigation practice at Cleveland-based Calfee, Halter & Griswold. Palo Alto, CA-based David Furbush, co-head of Pillsbury Winthrop Shaw Pittman’s securities litigation team, adds that when a company restates earnings and the share price abruptly crumbles, ‘absolutely, that company will be sued. We just haven’t seen that very often in the past year.’

Falling market muddies the waters
Furbush elaborates that ‘the best single predictor of a company getting sued is a one-day stock price plunge of at least 40 percent. That brings out the lawsuits.’ And this year, in a broadly down market, big one-day drops are not occurring very often because so many shares are already far down to begin with.

Wood says there is one more factor that is depressing the number of classic securities cases: ‘To prevail, you have to show the fraud caused loss, and that has become very hard in this market.’ Even when fraud is provable, that might not be sufficient to win a sizable amount because the defense will argue that every company in the sector has suffered similar losses in the current market. ‘The inability to plead loss causation is a prime reason why there are fewer filings,’ says Wood. Schaalman, meanwhile, refers to a ‘perfect storm of factors that are dissuading plaintiffs from filing class action cases.’

The upshot of the mounting decisions going against the plaintiff bar is that there are simply fewer plaintiffs – at least, fewer that are keeping busy with case filings.

‘Plaintiffs grab the low-hanging fruit,’ says Davies. Right now, he suggests, the tempting targets are Ponzi schemes (think Madoff and the feeder funds/advisers) and offshoots of the subprime/liquidity crises. Those types of cases alone are keeping the plaintiff bar busy, according to the Stanford numbers, which show a strong spike in financial services-related activity.

Does all this mean that corporate boards can comfortably look forward to a long-term diminution in cases? John Jordak, chair of the securities litigation group within Atlanta law firm Alston + Bird, says that in his view of the history of litigation and recent trends, ‘at any given time, one sector will see many class action suits, while others see fewer. Ten years ago it was internet companies [the so-called dotcom bust], but now it is financial services companies. Overall, there are a lot of suits targeting that sector right now.’ Might emphasis eventually shift to other sectors? You bet, suggests Jordak, because eventually every sector’s luster pales.

Now, just when breaths are coming easier in the corporate boardroom, Lamont offers worrisome data: filings in Q1 2009 totaled a brisk 49, and ‘the majority of cases were accounting-related,’ she says. It is too early, she insists, to say that the 2009 story is one of the return of the classical 10b5 lawsuit. But, she says, the evidence is unmistakable for Q1 – filings are up. Yes, there are all the known reasons why now is a bad time for such filings, but Lamont says her numbers don’t lie: old-fashioned filings are up significantly.

The history of securities lawsuits is that of a pendulum swinging and, just maybe, suggests Lamont, the pendulum is about to swing again. Either way, companies need to keep a close eye on things. Right now many are escaping the gaze of the plaintiffs, but they should not rest too easy. The litigious winds can be particularly fickle.