Attorney: Matthew C. Moehlman
Pomerantz Monitor May/June 2018
Corporate fraud comes to light by different routes. The Securities Exchange Act’s reporting requirements are designed to compel disclosure and transparency by public companies. Even so, investors cannot always count on bad corporate actors to blow the whistle on themselves.
When a third party reports an event that calls in to question the truth of a company’s statements to the market, some commentators refer to the resulting litigation as “event-driven.” These types of cases have become more common in recent years, as companies have found ways to avoid obvious admissions that their previous statements were wrong. In some quarters, particularly the defense bar, event-driven cases are criticized as applying 20/20 hindsight to an unprecedented bad event. But in our view, this ignores the many cases in which a company knows but conceals a risk that just such an event will occur. When the event then does occur and investors suffer losses due to the market’s reaction to the materialization of the concealed risk, we believe that the company should be held accountable.
RESTATEMENT CASES – A DWINDLING CATEGORY OF SECURITIES SUIT
Fifteen years ago, securities fraud often came to light when a company restated its past financial results. For example, if a company had engaged in several large, pre-arranged, round-trip transactions with no economic purpose, in order to inflate its reported revenue and cash flow, it might announce that it was restating its financial results to correct them. If the stock then plunged, shareholders suing to recoup their losses could invoke the restatement as an admission that the company’s earlier financials were materially misstated. Since materiality and falsity are two elements of a securities claim, therestatement would significantly strengthen the shareholders’ case.
Times have changed. Litigation analysts report that in the ten years since the Enron securities litigation wrapped up, the number of reissuance restatements filed by public companies has steadily declined—from nearly one thousand in 2006 to just over a hundred in 2016. Regulatory reforms aimed at deterring accounting fraud may account for the downturn, or corporations may simply have learned that restatements increase litigation risk and learned not to lead with their chins.
In any event, astute shareholders should stay attuned to multiple non-company sources for revelations that damage their investment portfolio. Let’s look then at several examples of recent cases in which news reported by third parties prompted shareholder litigation.
EVENT-DRIVEN CORRUPTION CASE— IN RE PETROBRAS SECURITIES LITIGATION
A case prosecuted by this firm, the securities litigation relating to the Brazilian state-owned energy giant Petróleo Brasileiro S.A.-Petrobras, shows how investors may first learn of a fraud from external sources and events rather than a company announcement.
Reports of corruption had dogged Petrobras for years. The endgame began in early 2014, when newspapers reported that the Brazilian federal police had arrested a retired Petrobras executive as part of a crackdown on black-market money-laundering.
Petrobras did not mention the incident explicitly in its annual report filed the following month, saying only that it was conducting routine internal investigations into certain issues.
Petrobras had still not disclosed the findings of those investigations when, months later, the police released sworn affidavits in which the executive testified to orchestrating a decades-long kickback and bid-rigging scheme along with other top Petrobras executives, over a dozen large construction companies, and many of Brazil’s leading political figures.
In addition to not divulging the scheme, Petrobras never restated its financials, despite having overvalued its fixed assets by, according to its own estimates, $30 billion.
Petrobras wrote off $2.5 billion as kickback-related overpayments, and took a $16 billion asset impairment. Petrobras argued in its motion to dismiss that $2.5 billion was immaterial to its financial results under SEC guidance regarding materiality from a legal and accounting standpoint. In denying Petrobras’ motion, the district court observed that materiality is not limited to a purely quantitative assessment but can also include qualitative factors, such as concealment of an unlawful transaction. In that regard, the court noted that Petrobras’ misstated financials concealed an illegal kickback scheme that, when revealed, called into question the integrity of the company as a whole. The court also found that Petrobras’ assertions of integrity and high ethical standards were actionable because they were alleged to have been made to reassure the market, and the market may have relied on their truth.
EVENT-DRIVEN PRODUCT CASE— MATRIXX INITIATIVES, INC. V. SIRACUSANO
Some events that lead to actionable claims implicate a company’s representations about its products. Matrixx Initiatives, Inc. v. Siracusano involved a drug manufacturer that failed to disclose that its popular cold remedy had caused a small number of users to lose their sense of smell. When a morning television show revealed this potential side effect, the stock plummeted. On appeal to the Supreme Court of the United States, Matrixx argued that the possibility of loss of smell was so minute as to be immaterial. The Court disagreed. It found that misstatements need not be statistically significant to be material, and held that Matrixx’s press releases touting the safety and efficacy of the cold drug were actionable.
EVENT-DRIVEN OPERATIONS CASE— IN RE VALE S.A. SECURITIES LITIGATION
An event may also reveal a company’s statements about its operations to have been materially false and misleading. In November 2015, it was reported that the Fundão dam in Minas Gerais, Brazil had collapsed, releasing tons of toxic sludge on the village below and leading to the worst environmental disaster in Brazil’s history. The dam was jointly owned by Vale S.A., a multi-national mining concern whose securities trade on NASDAQ.
The dam collapse shattered Vale’s carefully-crafted image as a good corporate citizen. While some economists say that the only social responsibility of business is to increase profits, socially responsible investing has become a major force across global markets, with over $23 trillion in responsibly invested assets reported to be under management. Vale, like a number of large industrial companies, published a detailed annual “Sustainability Report” in order to win inclusion in the Dow Jones Sustainability Index. Vale stated in one sustainability report that it would “prevent, control or compensate for [environmental] impacts,” and that it had “policies, systematic requirements and procedures designed to prevent and minimize risks and protect lives.” The district court found that these statements were actionable. The court, moreover, found that Vale’s executives had been privy to studies showing that the dam was structurally unsound for years before the foreseeable risk of its collapse became a reality.