The appointment process

1. Complaint filed and notice published: After an initial complaint is filed, a notice must be published within 20 days to inform potential class members of the lawsuit and their right to apply for lead plaintiff status.
2. Motions for appointment: Within 60 days of the notice, interested investors must file a motion and a sworn certification to be considered for the role.
3. Presumptive lead plaintiff identified: The court presumes the applicant or group with the largest financial interest is the most adequate plaintiff, as per the PSLRA.
4. Presumption can be challenged: Other class members can challenge this presumption by showing the presumptive lead plaintiff’s claims are not typical or that they cannot adequately represent the class.
5. Court appointment: The court reviews the motions and any challenges to appoint the lead plaintiff, typically within 90 days of the initial notice.
6. Selection of lead counsel: The appointed lead plaintiff is responsible for selecting lead counsel, subject to court approval.

Why the lead plaintiff is important

• Maximizes recovery: The PSLRA encourages large investors like pension funds to take the lead, as their resources and sophistication can help increase the overall recovery for the class.
• Active oversight: The lead plaintiff oversees lead counsel, makes key decisions, and approves settlements.
• Serves a fiduciary duty: The llead plaintiff must act in the best interests of the entire class.
• Eliminates the “race to the courthouse”: The PSLRA’s process replaced the previous system where the first to file often became lead plaintiff, allowing courts to select a more suitable representative.

Primary arguments in a motion to dismiss

• Failure to plead misstatements with particularity: Under the PSLRA, plaintiffs must specifically identify each alleged false or misleading statement and explain exactly why it was misleading. They cannot simply make broad, general allegations of fraud.
• Failure to establish a “strong inference” of scienter: The complaint must provide specific facts that create a “strong inference” that the defendant acted with scienter—that is, with an intent to deceive or with extreme recklessness. The Supreme Court has clarified that this inference must be at least as compelling as any non-fraudulent explanation.
• Failure to prove loss causation: Plaintiffs must show a causal link between the alleged fraud and the investors’ economic loss. Defendants often argue that the stock price drop was caused by other factors, such as general market declines or industry-wide trends, rather than the alleged misstatement.
• “Safe harbor” for forward-looking statements: The PSLRA includes a safe harbor provision that protects companies from liability for forward-looking statements (e.g., projections or estimates) if those statements are identified as such and are accompanied by meaningful cautionary language. 

Court’s evaluation

• Motion is granted: If the judge agrees with the defendant, the case is dismissed. Depending on the judge’s ruling, the lead plaintiff and their lawyers may be given an opportunity to revise and refile their complaint with more specific evidence.
• Motion is denied: If the judge denies the motion, the case can proceed. This is a major victory for the plaintiffs and often puts significant pressure on defendants to settle rather than proceed through discovery and trial, which can reveal damaging evidence.
• Discovery is put on hold: While the motion to dismiss is pending, all discovery proceedings are typically stayed, meaning plaintiffs cannot gather more evidence until the court rules. This gives defendants an early opportunity to end the case before incurring high discovery costs.

How class actions improve corporate governance

• Deterring fraudulent behavior: The threat of a costly securities class action deters managers from engaging in fraudulent activities. The severe financial penalties and damage to a company’s reputation and stock price serve as a powerful disincentive for misconduct.
• Addressing the root cause of misconduct: Unlike simple monetary fines, class action settlements often include non-monetary relief focused on correcting the underlying governance flaws through robust corporate governance and strong investor protections. This forces companies to implement reforms that prevent similar wrongdoing in the future.
• Enhancing board oversight: Litigation frequently prompts significant changes to a company’s board of directors, including:
  • Increasing the number of independent board members.
  • Separating the roles of Chairman and CEO.
  • Creating new committees focused on compliance and risk oversight.
• Strengthening internal controls: Securities Class Action Lawsuits can reveal weaknesses in a company’s internal financial and accounting systems, forcing an overhaul of financial controls and compliance programs resulting in robust corporate governance. This was a key outcome of the post-Enron and WorldCom litigation.
• Encouraging transparency and accountability: Securities class actions push companies toward better, more honest disclosure policies and corporate governance, which in turn leads to more reliable and accurate pricing of securities. This enhances investor trust and market integrity.
• Influencing industry-wide change: High-profile settlements and corporate governance reforms can have a “spillover” or “contagion” effect, prompting competitors to proactively review and strengthen their own governance practices to avoid similar litigation.
• Enforcing fiduciary duties: The process reinforces the fiduciary duty of a board of directors to act in the best interests of the company and its shareholders. The threat of legal action for a breach of that duty encourages directors to be more vigilant in their oversight.

Role of institutional investors

• Stronger incentives: With a significant financial stake, these investors have stronger incentives to vigorously oversee the litigation and negotiate for meaningful governance reforms that benefit all shareholders, not just seek a quick cash settlement.
• Leverage for non-monetary relief: The resources and influence of institutional investors give them significant leverage in settlement negotiations to demand and enforce non-monetary changes.

Corporate Governance Reforms That Are Common in Securities Class Action Settlements

Common corporate governance reforms

Board independence and structure

• Independent directors: Mandating an increase in the number of independent directors on the board is a frequent reform. An independent director has no material relationship with the company or its management, which reduces the risk of conflicts of interest.
• Separation of roles: Many settlements require the company to separate the roles of Chief Executive Officer (CEO) and Chairman of the Board. This division of power allows a designated independent chairman to lead the board’s oversight function, while the CEO focuses on day-to-day operations.
• Term limits: Some settlements introduce term limits for directors to prevent them from becoming too entrenched, which can sometimes compromise objectivity over time.
  • New or revised committees: Securities class action lawsuitscan lead to the creation of new board committees or revisions to the charters of existing ones, such as the audit, compensation, or disclosure committees. For example, the Sarbanes-Oxley Act (SOX), which was influenced by major accounting scandals, requires audit committees to be composed entirely of independent directors.

Financial reporting and internal controls

• Enhanced internal controls: Settlements often require a review and strengthening of internal financial reporting systems, especially after accounting fraud allegations.
• CEO and CFO certification: Mirroring SOX, some settlements mandate that the CEO and CFO personally certify financial reports, increasing executive accountability.
• Real-time disclosure: Requirements for timely disclosure of material changes may be included.

Compliance and ethics

• Improved compliance programs: Companies may be required to strengthen compliance and ethics programs through enhanced training and oversight.
• Whistleblower policies: Settlements often include better protections for employees who report wrongdoing.
• Compensation clawbacks: Some settlements mandate or enhance rules allowing companies to recover executive compensation in cases of fraud.

Case study: Enron securities litigation

Examples of Enhanced Internal Controls Implemented After Settlements

Financial reporting and accounting controls

• Enhanced reconciliation procedures: After accounting scandals involving inaccurate expense reporting or improper revenue recognition, settlements often mandate stricter reconciliation processes of internal controls. This includes requiring management to regularly compare the company’s records with external bank statements and transaction activity to ensure accuracy.
• Strengthened revenue recognition policies: For companies accused of inflating revenues, new controls are established to ensure that sales are recognized only when earned and that significant rebate programs are accounted for correctly a improvement t internal controls.
• Improved financial statement close process: Settlements can force companies to overhaul the process for closing their books. This might include stricter timelines, additional review layers, and greater oversight by the audit committee to prevent financial misstatements from slipping through.  This a good example of enhancment to internal control.
• Expanded internal audit function: Many settlements require the internal audit department to be expanded or to hire an independent consultant to review controls as part of interna contral enhancements. This strengthens the audit process to better detect inconsistencies and fraud before they affect public filings.

Oversight and authorization controls

• Segregation of duties: In cases where fraud was committed by one person or a small group, settlements commonly require implementing and enforcing segregation of duties. This means that no single employee has control over all aspects of a financial transaction, such as authorizing, recording, and reconciling payments.
• Enhanced authorization workflows: Another internal control enhancement is to prevent unauthorized transactions, companies often implement clearer authorization hierarchies for significant purchases, journal entries, or other transactions. This creates a documented trail of approvals and increases accountability.
• Stronger access controls: This involves limiting access to sensitive financial information, systems, and physical assets to only authorized personnel. Examples include restricted access to accounting software, password protection, and physical security for valuable assets. A recent SEC action also targeted a company for poor cybersecurity access controls.

Compliance and training controls

• Compliance program overhaul: Following a lawsuit, a company’s entire compliance program may be restructured to include more robust training and monitoring to prevent future wrongdoing by enhance internal controls.
• Ongoing ethics training: Regular, mandatory training for all employees on anti-fraud policies and ethics is a common settlement provision. This helps to foster a strong ethical culture and ensures staff are aware of the controls in place.
• Whistleblower protections: Some settlements introduce or strengthen policies that encourage and protect employees who report internal misconduct, leading to more transparent practices.

Executive accountability

• Executive certifications: Settlements can reinforce or expand upon the Sarbanes-Oxley (SOX) requirement that the CEO and CFO personally certify the accuracy of financial reports. This is meant to ensure executives are personally invested in the integrity of the company’s financial statements.
• Compensation clawback policies: In cases involving executive fraud, settlements sometimes include or enhance policies that allow the company to recover incentive-based compensation paid to executives who contributed to or failed to prevent the misconduct.

Example: Monsanto settlement

Mandatory reforms from Sarbanes-Oxley (SOX) to Protect Shareholder Rights and Enhance Corporate Governance

• CEO and CFO certification: The act requires the CEO and CFO to personally certify the accuracy and completeness of financial reports, holding them personally liable for fraudulent statements.
• Independent audit committees: SOX requires that all members of a company’s audit committee be independent directors. It also mandates that the audit committee be responsible for hiring and overseeing the external auditor.
• Separation of audit and non-audit services: To prevent conflicts of interest, the act prohibits accounting firms from providing certain non-audit consulting services to the companies they audit.
• Internal controls: SOX introduced Section 404, which requires management to establish, maintain, and assess the effectiveness of the company’s internal controls over financial reporting.
• Public Company Accounting Oversight Board (PCAOB): The act created the PCAOB to oversee the audits of public companies, an authority that previously fell to the accounting industry itself ensure better corporate governance practices. 

Companies That Improved Internal Controls After Settlements

Wells Fargo

• Sales practices reform: Abandoned the aggressive, cross-selling business model and overhauled its compensation structure to reduce incentives for fraudulent behavior.
• Enhanced oversight: Implemented new leadership, including a new CEO, and strengthened the bank’s governance and risk management framework to prevent misconduct from persisting.
• Independent review: Committed to an independent review of all customer accounts to identify and remedy unauthorized activity, including offering reimbursements for fees. 

Monsanto

• Revenue recognition policies: The company had to correct its revenue recognition policies after failing to properly account for millions of dollars in rebates offered to retailers.
• Enhanced financial controls: Monsanto was compelled to hire an independent compliance consultant to strengthen its internal accounting controls and ensure accurate financial reporting.

Enron

• CEO/CFO certification: SOX, in response to Enron and other scandals, now requires CEOs and CFOs to personally certify the accuracy of financial statements.
• Independent audit committees: Companies must establish independent audit committees with financial experts to review their financial reporting, which Enron’s board failed to do effectively.
• Auditor independence: To prevent conflicts of interest, SOX banned accounting firms like Arthur Andersen, Enron’s auditor, from providing both auditing and consulting services to the same company.

WorldCom

• Training and education: As part of its settlement, WorldCom was required to establish a training and education program for employees and officers on federal securities laws to minimize the possibility of future violations.
• Improved financial reporting processes: The settlement forced the company to undertake an extensive review of its corporate governance and internal controls to prevent such fraudulent activities from reoccurring.

Peloton

• Enhanced oversight: The resulting settlement included governance reforms aimed at increasing board accountability for oversight.
• Inventory management: The company was forced to address the internal control failures that led to a “material weakness” in its financial reporting, which contributed to holding over $1 billion in excess inventory. 

How Securities Class Action Lawsuits Deter Fraud

Deterrence mechanisms

• Financial liability and penalties: The most direct deterrent is the massive financial liability that a securities class action lawsuit can impose. Settlements often total hundreds of millions or even billions of dollars, and while these are often covered by the company’s insurance, the costs still impact the company and its shareholders. This economic threat discourages fraudulent activities by making them prohibitively expensive.
• Reputational damage: A securities fraud lawsuit, especially a high-profile one, can severely damage a company’s public reputation. This can lead to a loss of investor and customer confidence, decreased market share, and long-term financial harm. The fear of this reputational fallout incentivizes companies to prioritize ethical behavior.
• Improved corporate governance: Securities class actions can force companies to overhaul their internal corporate governance structures. These reforms may include:
  • Strengthening internal controls and compliance programs.
  • Restructuring the board of directors.
  • Increasing oversight of financial reporting.
• Executive accountability: While financial penalties often fall on the company, executives and directors can face personal liability and reputational damage. The threat of being named in a lawsuit and being held accountable can deter senior leadership from engaging in or enabling misconduct.
• Empowering small investors: The class action mechanism allows investors with small financial interests to collectively pursue legal action against large, powerful corporations. Without this ability to pool resources, it would be economically unfeasible for most individuals to sue a company, which would significantly reduce the risk of litigation for corporations. 

Examples of Shareholder Rights

Shareholder rights and the right to information

• Inspecting books and records: Shareholders can inspect corporate books and records, including meeting minutes, bylaws, and financial reports.
• Receiving annual reports: Companies must provide shareholders with regular reports and audited financial statements.
• Requesting information for a legal purpose: Shareholders can request information for a specific purpose related to their investment, which companies must comply with unless the request is improper. 

Shareholder rights and the right to transfer ownership

• Liquidity: This right provides liquidity, especially for publicly traded stocks, allowing investors to sell their shares for cash on an exchange.
• Private company restrictions: In private companies, this right may be restricted by a shareholder agreement that dictates how shares are sold and to whom.

Financial rights

• Receive dividends: Shareholders are entitled to receive dividends when the board of directors declares them, as a share of the company’s profits.
• Claim remaining assets in liquidation: If a company liquidates, shareholders have a claim on the remaining assets after creditors and bondholders have been paid.
• Appraisal rights: In certain corporate actions, like a merger, a dissenting shareholder may demand a judicial appraisal of their shares to ensure fair value.

Voting rights

• Electing directors: Shareholders elect the members of the board of directors who oversee the company’s management.
• Approving major actions: They vote on fundamental changes such as mergers and acquisitions, amendments to the articles of incorporation, and company dissolution.
• Say-on-pay: At publicly traded companies, shareholders have a non-binding advisory vote on executive compensation.

Shareholder rights and legal rights

• Class action lawsuits: Shareholders can participate in class action lawsuits when they suffer harm as a group due to securities fraud or other illegal acts.
• Derivative lawsuits: Shareholders can bring a derivative lawsuit on behalf of the corporation when directors or officers commit misconduct, like breach of fiduciary duty.
• Petitioning for dissolution: In extreme cases of fraud, mismanagement, or oppression, a shareholder may petition a court to dissolve the business.

Special shareholder rights for certain shareholders

• Preemptive rights: In some cases, shareholders have the right to buy newly issued shares before they are offered to the public, protecting their ownership percentage from being diluted.
• Minority protections: Legal protections are in place to prevent majority shareholders from unfairly oppressing or freezing out minority shareholders.
• Right to call special meetings: In some companies, shareholders holding a certain percentage of stock can demand a special meeting to address specific issues.

Better Investor Protection from Securities Class Actions

1. Overhauling the “fraud on the market” theory

• The problem: The “fraud on the market” theory, which presumes investors rely on the integrity of the market price, can lead to lawsuits that are not based on actual investor reliance. This can result in settlements where diversified investors, who were not genuinely harmed, receive payouts at the expense of other investors.
• A possible solution: Scholars have argued that a derivative action framework, where any recovery would go directly to the company, would be a better fit, as it focuses on internal corporate misconduct rather than assumed external harm. 

2. Encouraging derivative actions for investor protection

• The problem: For certain types of internal fraud where the financial harm is primarily to the company itself, a traditional class action may not be the most effective remedy.
• A possible solution: Reframing certain securities lawsuits as derivative actions would allow shareholders to sue on behalf of the company, with any recovered funds being returned to the company’s balance sheet. This ensures that the compensation directly benefits the company and all its shareholders, including those who were not part of the initial class.

3. Enhancing the lead plaintiff process for investor protection

• The problem: While the PSLRA encourages institutional investors to act as lead plaintiffs, the process is not always as transparent or competitive as intended. Concerns about attorneys recruiting institutional investors and potentially self-serving settlements persist.
• A possible solution: Increased transparency in the lead plaintiff selection process, including the disclosure of how legal fees are determined and a more robust competitive process for appointing lead counsel, could ensure better alignment of interests between the lead plaintiff and the broader class.

4. Reevaluating the scienter requirement

• The problem: The heightened pleading standard for scienter (fraudulent intent) can sometimes make it difficult for plaintiffs to bring legitimate cases.
• A possible solution: Some have argued for a reassessment of the scienter requirement, suggesting a more balanced standard that does not unduly restrict the ability of investors to hold corporate wrongdoers accountable.

5. Increased use of technology in litigation

• The problem: Securities class actions are often protracted and costly due to complex evidence gathering.
• A possible solution: The use of technology like AI and data analytics could streamline the litigation process, allowing for more efficient case management and potentially leading to better outcomes for investors. These tools can also help in the early identification and monitoring of corporate risks, preventing fraud before it occurs.

6. Promoting a culture of compliance

• The problem: Settlements often focus on addressing specific governance failures rather than the broader cultural issues that enabled misconduct.
• A possible solution: Settlements could incorporate more stringent, long-term requirements for building and maintaining a strong ethical culture. This could include a focus on “tone at the top,” anonymous reporting channels, and tying executive compensation to compliance metrics, which can mitigate the risk of fraud recurring.

Conclusion

The ‘Fraud on the Market’ Theory

How it works

1. Public misstatement: The company made a public, material misrepresentation.
2. Efficient market: The stock was traded on an efficient market, meaning its price was influenced by public information.
3. Timing: The plaintiff bought or sold the stock between the time of the misstatement and when the “truth” was revealed.
4. Price impact: The misstatement caused the market price to be artificially inflated or deflated.

Rebuttal of the presumption

Debate and criticism

• Congressional intent: Critics argue that Congress never explicitly endorsed the theory when passing securities laws.
• Market efficiency: Doubts exist about the accuracy of the efficient capital market hypothesis, with behavioral economists pointing to irrational investor behavior and cognitive biases that influence stock prices.
• Actual reliance: Critics suggest that the theory wrongly assumes all investors believe stock prices are accurate, when many investors may not.

Examples of Successful Rebuttals of The Presumption of Reliance

Goldman Sachs Group, Inc. v. Arkansas Teacher Retirement System (2021)

• The context: Plaintiffs alleged that Goldman Sachs’s generic statements about its business principles and client focus were misleading, as the company had undisclosed conflicts of interest.
• The rebuttal: Goldman Sachs argued that its statements were too generic to have an impact on its stock price. The Supreme Court agreed that courts must consider the generic nature of a misstatement when evaluating price impact. It clarified that defendants carry the burden of proving that the misrepresentation did not affect the stock price by a preponderance of the evidence.
• The outcome: The Supreme Court vacated the class certification and remanded the case, holding that the lower courts did not adequately consider the generic nature of the statements and whether they could have had a price impact.

Halliburton Co. v. Erica P. John Fund, Inc. (Halliburton II) (2014)

• The context: Halliburton was accused of making misleading statements about its financial performance and asbestos litigation exposure.
• The rebuttal: Halliburton successfully argued that defendants should be allowed to introduce evidence of “price impact” at the class certification stage. If a defendant can show that an alleged misrepresentation did not actually cause a change in the stock’s market price, then the presumption of reliance can be rebutted.
• The outcome: The Court held that defendants could use evidence of a lack of price impact to defeat class certification. This made it a far more powerful tool for defendants to challenge class actions early in the litigation.

In re Overstock Securities Litigation (2024)

• The context: A plaintiff alleged that Overstock (now Beyond) engaged in a scheme to inflate its stock price.
• The rebuttal: A plaintiff’s own deposition testimony was used to successfully rebut the presumption of reliance. The plaintiff admitted that it would have bought the shares “no matter the price”. This testimony showed that the plaintiff did not rely on the integrity of the market price, severing the link required for the presumption.
• The outcome: The court affirmed the dismissal of the plaintiff’s misrepresentation claims based on a failure to plead reliance, showing that reliance can be disproven at an early stage of litigation.

How rebuttals succeed

• Lack of price impact: By providing event studies or other economic evidence, defendants can show the alleged misrepresentation did not cause any movement in the stock price.
• Truth-on-the-market: Defendants can argue that the market was already aware of the true facts, which were either publicly available or were not material to the average investor.
• Plaintiff-specific evidence: As seen in the Overstock case, a defendant can use evidence specific to a plaintiff, such as deposition testimony, to prove that they did not rely on the integrity of the market price.

Company Enhancing Corporate Governance after Securities Litigation

Financial misconduct and accounting fraud

• Bank of America: As part of a 2012 settlement for its acquisition of Merrill Lynch, Bank of America agreed to various governance reforms. These changes included:
  • Implementing majority voting in director elections.
  • Creating an annual, non-binding shareholder vote on executive pay (“say on pay”).
  • Ensuring the independence of the compensation committee.
  • Establishing policies for a board committee to review all future acquisitions.
• Hanover Compressor Co.: Following allegations of financial misstatements, the Houston-based company agreed to corporate governance changes in its settlement. These reforms targeted the accounting practices and financial reporting that led to the lawsuit.
• TXU Corp.: This Dallas utility is another example of a company that agreed to governance changes as part of a securities class action settlement.

Executive misconduct and lack of oversight

• Alphabet (Google): Shareholder derivative litigation filed against Alphabet and its executives in 2019 alleged the company covered up sexual harassment claims and a data breach. The lawsuits claimed that Alphabet’s board engaged in a “pattern of concealment” to protect company interests at investors’ expense. The settlement involved creating a special litigation committee to investigate the claims and negotiate a resolution.
• Boeing: Following two fatal crashes of the 737 MAX, derivative lawsuits were filed alleging the board failed to properly oversee the aircraft’s development. Though a full class action settlement is complex, the litigation prompted increased scrutiny of the board and management.
• Snap Inc.: A shareholder lawsuit regarding the company’s IPO registration statement included a settlement with significant corporate governance changes. The reforms focused on the company’s board oversight and internal reporting.
• Wells Fargo: Beyond the sales practices scandal, the company has faced multiple legal challenges and a 2023 settlement with shareholders. The litigation and regulatory actions have led to ongoing governance overhauls and increased oversight of operations.

Cybersecurity and data breaches

• Facebook (now Meta): In 2018, a shareholder class action related to the Cambridge Analytica data scandal prompted extensive governance reforms. The company agreed to pay $5 billion, but the settlement also forced it to overhaul its internal policies and enhance oversight to protect user data.

Bribery and illegal activities

• Exelon (subsidiary Commonwealth Edison): A 2023 settlement resolved a class action stemming from a bribery scheme. The lawsuit and resulting criminal proceedings led to convictions of company executives and reinforced the need for strict compliance protocols and transparency in corporate governance.

Mergers and acquisitions (M&A)

• WeWork: A shareholder dispute over the company’s terminated tender offer was settled by agreeing to a new tender offer. This resolution demonstrated how litigation can impact the governance and structure of complex corporate transactions.

Implications of Settlements with Governance Changes for a Company’s Reputation and Long-Term Value

Settlements that mandate corporate governance reforms, while costly in the short term, can have significant positive implications for a company’s reputation and long-term value. By publicly committing to and implementing these changes, a company signals a shift toward a more ethical and sustainable business model, which can help restore trust with investors, regulators, and the public.