ATTORNEY: MARC I. GROSS
POMERANTZ MONITOR MARCH/APRIL 2017
To paraphrase Tolstoy, while all good companies may be alike, all frauds are not. Corporate frauds usually involve lies about financial information, such as historic results or future prospects. The financial impact of these frauds on the company’s stock price is foreseeable and easily measured. However, the effects of lies that reflect the lack of management integrity or ineffectiveness of corporate governance controls are arguably less readily measured. These lies often have only a small direct impact on the bottom line; but when the truth is revealed, the effect on the company’s stock price can be substantial. Such stock price effects, sometimes referred to as “reputational losses” or “collateral damage,” are attributable to the market’s reassessment of investor risks, including possible management turnover, or the possibility that problems lieahead. Nonetheless, the ability to recover the damages in these instances is disputed by some corporations and academics.
A textbook example of reputational losses is what happened at Wells Fargo. At the beginning of September 2016, the bank had surpassed its rivals to become the largest financial institution measured by stock market capitalization, with assets exceeding $100 billion. It had distinguished itself from peers through its “cross-selling” policy, i.e., marketing a menu of products (such as savings accounts and insurances policies) to checking account customers. Wells Fargo touted its cross-selling successes in shareholder reports, which were closely followed by analysts.
However, on September 8, 2016, investors were shocked to learn that the bank had agreed to pay $190 million to regulators to settle claims arising out of abusive cross-selling practices. Senior management’s pressure to meet astronomical cross selling “goals” – which was actually a euphemism for quotas – had pushed branch bank officers to engage in abusive and illegal practices in order to meet those quotas. Without informing their customers, much less obtaining their consent, bank officers withdrew funds from customers’ checking accounts near the end of the quarter, placed the funds in a new savings account for the customers, and then reversed the transactions at the beginning of the next quarter. Such schemes allowed bank officers to meet their quotas, while customers often found themselves paying overdraft fees when their checks unexpectedly bounced.
Senior Wells Fargo officials were aware of the illegal practices, having fired over 5,000 bank employees over several years for doing this. However, management continued to pressure bankers to meet cross-selling quotas, and awarded multi-million dollar bonuses to the Executive Vice President responsible for implementing the practices, making further illegal acts by many employees inevitable.
These illegal practices had virtually no effect at all on Wells Fargo’s bottom line. They resulted in only $2 million of additional revenues for the bank over a multi-year period, and even the $190 million regulatory settlement was like a drop in the bucket to such a giant company. Most telling, none of the financial data or cross-selling metrics were materially false. Nonetheless, concern about the adverse publicity, potential investigations and management shake-up caused Wells Fargo’s share price to tumble 6% within days of the September 8, 2016 disclosure. Declines continued as pressure mounted for the resignation of the bank’s CEO, John Stumpf. By the time Stumpf appeared to testify before a Congressional panel, Wells Fargo shares had fallen 16% -- although Wells Fargo’s financial condition and prospects had not significantly changed.
Another example of pure reputational losses arose last year with Lending Club, a leader of the newly minted “online” lending services. LendingClub focuses on sub-prime customers whose credit ratings are too low to qualify for loans from regular banks. Once the loans were made, Lending Club bundled them and sold them to funders.
On May 9, 2016, Lending Club’s CEO, Renaud Laplanche, was forced to resign following findings by an internal investigation that $22 million in loans had been improperly sold to the Jeffries Group (one of its funders), in contravention to Jeffries’ express instruction. There were also indications that Laplanche had undisclosed interests in one of the company’s potential funders. The size of the improperly sold loans paled in comparison to the billions that Lending Club lent over the last several years.
Again, nothing indicated that Lending Club’s historic performance had been inflated, nor that its operating model was flawed. However, once these infractions were disclosed, investors immediately drove the stock price down 30%.
Reputational Losses Are the Rule, Not the Exception.
They occur whenever financial missteps are disclosed, whether the effects on the bottom line are material or not. Studies have shown that when a company restates prior performance or future prospects, only a portion of the declines in stock price can be explained by the resulting recalibration of likely future cash flows, a primary factor in stock valuation. Significant, if not larger, portions of those declines arise from the market’s reassessment of management’s reliability or integrity. One study actually concluded that “[f]or each dollar that a firm misleadingly inflates its market value, on average, it loses this dollar when its misconduct is revealed, plus an additional $2.71, due to reputation loss.”
Market perceptions of managerial competence and integrity are a distinct and critical factor in determining the stock price. Disclosure of fraud, as it reflects a lack of corporate integrity, augments any stock price reaction triggered by revising reported results. When the reliability and credibility of statements issued by management is called into question, it increases the perceived information asymmetry between management and stockholders.
The SEC has embraced the view that management integrity is critical to shareholder valuation: “[t]he tone set by top management––the corporate environment or culture within which financial reporting occurs––is the most significant factor contributing to the integrity of the financial reporting process.” So too has the Public Company Accounting Oversight Board. Courts have also recognized the impact of management integrity on stock valuations, deciding that investors may base their investment decisions, at least in part, on factors such as management ethics and accountability.
Perhaps because these effects are undeniable and substantial, defendants in securities fraud actions increasingly argue that stock declines caused by revelations of integrity issues are not recoverable. The case for denying such recovery was made forcefully in a law review article by Cornell and Rutten in 2009, entitled Collateral Damage and Securities Litigation (“Cornell/Rutten”). The authors defined collateral damage as “the valuation impact of a corrective disclosure that does not correspond to the original inflation.” They explained that, if the original misconduct did not materially affect the company’s bottom line, it could not have inflated the company’s market price at the time of purchase; therefore, “because the original misstatement could not have inflated the stock price in an efficient market, the decline following the corrective disclosure must be due to collateral damage.” They concluded that “while collateral damage can have a material impact on securities prices, declines associated with collateral damage are not, and should not be, recoverable under section 10(b) of the Securities Exchange Act of 1934.”
Presumably this analysis could apply even when the underlying misconduct did have a material effect on the company’s bottom line, but the post-disclosure price drop is viewed as “disproportionate” to the specific financial impact of the fraud. Experts would then be called upon to parse out how much of the post-disclosure price drop was “proportional” and how much represents “collateral damage” caused by the realization that management was incompetent or corrupt.
It is true that, in assessing “loss causation,” a fundamental element of any securities fraud claim, courts have started with the precept that the underlying fraud must have inflated the purchase price of the stock, and that revelation of the fraud removed that inflation, injuring investors. Cornell/ Rutten’s fundamental assumption is that stock price inflation can be caused only by misstatements of financial information, such as revenue or cash flows. They fail to attribute any possible inflation to investors’ mistaken assumption of management integrity, and thus the reliability of statements regarding performance and outlook. But perceptions of competence and integrity are as critical as profits and losses in determining and maintaining the market price of a company’s stock. That is why, when such perceptions are shaken, the market price drops dramatically.
Public policy objectives also support recovery of such reputational losses. As noted by the Second Circuit in Gould v. Winstar Communs, Inc.:
The argument is one of culpability and foreseeability. When a defendant violates section 10(b) by making a false statement to investors with scienter, the defendant in many cases should be able to foresee that when the falsity is revealed, collateral damage may result. As between the culpable defendant—who could foresee that investors would suffer the collateral damage—and the innocent investors, it would seem entirely appropriate to require the defendant to be the one to bear that loss.
Thus, when a company makes affirmative misrepresentations concerning its managerial competence and integrity, there can be no doubt that those statements help inflate the market price of its stock. But it is just as true that, in the absence of any representations on this subject, investors should be entitled to assume that management has the basic integrity necessary to guiding a modern public corporation. Just as it is reasonable to recognize that investors are entitled to presume the “integrity of the market” (untainted by fraud), so too should investors be entitled to presume the “integrity of management” (untainted by a propensity to commit fraud). Recovery of such additional “reputational” damages is consistent with policies intended to curb securities fraud.