April 11, 2019 / 2:44 PM / 2 months ago

Breakingviews - Holding: Investors ignore law of “stuff happens”

The logo of Chipotle Mexican Grill is seen at a restaurant in Paris, March 7, 2016. REUTERS/Charles Platiau

NEW YORK (Reuters Breakingviews) - “Stuff happens” is a legal principle worth preserving. Shareholders are increasingly using fiascos like tainted burritos sold by Chipotle Mexican Grill and BP’s oil-well blowout in the Gulf of Mexico to claim stock fraud. That’s misguided, because securities laws were designed to punish lies about significant financial risks, not failures to warn of unforeseen mishaps.

The impact of so-called “event-driven” securities suits has been dramatic. Even as the number of U.S. public companies has dropped by more than half since 1996, the number of federal cases in which shareholders band together to sue for securities fraud has risen to near-record highs. Last year, almost 9 percent of such companies were sued – more than three times the average from 1996 to 2016, according to Cornerstone Research. More than a quarter were event-driven suits, which were relatively rare before 2017.

That kind of case has risen as traditional ones like suits over dodgy accounting and other types of financial finagling have waned. Those cases were remarkably effective – financial-report restatements have dropped a dozen years in a row, according to Audit Analytics, and left shareholders’ lawyers casting about for business. An adventurous few pushed suits claiming that calamities such as plane crashes or fires were known risks that companies should have disclosed. Most cases flopped.

In 2011, though, the U.S. Supreme Court cut the lawyers a break. In a case involving Matrixx Initiatives, the justices ruled that the drugmaker should have warned investors about a statistically insignificant number of people who claimed they lost their sense of smell after using the company’s nose spray. In legal terms, the decision expanded the definition of a risk important enough to disclose to shareholders. The floodgates opened.

Take BP. Investors who had claimed BP knew its Deepwater Horizon drilling rig would probably explode – and thus deliberately concealed the risk – found support in the Matrixx case, and won a $175 million settlement in 2017. Since then, other lawsuits have pushed the concept of possible hazards requiring disclosure even further. Arconic, for example, faces a suit for not telling shareholders that the aluminum cladding it supplied to London’s Grenfell Tower might contribute to a fire at the skyscraper and cause the company’s stock to drop – as later happened.

Most of these sorts of cases are, in fact, long shots, as evidenced by their dismissal rate of about 60 percent, according to Cornerstone Research. Just last month, for example, a federal judge in Colorado dumped a suit against Chipotle. After disease outbreaks in 2015, the fast-food outfit set out to make its food safer. When reports of illness later emerged at a Virginia restaurant, shareholders claimed they should have been told Chipotle’s efforts might not be entirely successful, an argument the judge found absurd.

A few days earlier, a New York federal judge dismissed a case against mattress maker Tempur Sealy for not disclosing that one of its retailers – Mattress Firm – might get taken over and terminate its contract to buy mattresses. Shareholders “simply assert” Tempur Sealy “would have known these things - presumably via clairvoyance and a secret window into the corporate thinking and workings of Mattress Firm - and disclosed them,” wrote Judge Lewis Kaplan.

Further evidence that this type of case might be far-fetched comes from the lawyers who file it. Though there are exceptions, they tend to be in newer firms that don’t represent the institutional investors that bring major – and stronger – shareholder suits involving financial wrongdoing. These lawyers are left with the riskier cases and try to save time and money by piggybacking on the fact-finding of personal injury attorneys who generally sue first.

Not that companies should duck accountability for the harm they cause. The victims of the Gulf of Mexico oil spill, the Grenfell Tower fire and even rotten Chipotle food suffered sometimes horrific consequences and are entitled to allege corporate misconduct. When companies and executives foul up, both should be punished. That’s what laws addressing personal injury, crime and a host of other matters are designed to do. Securities laws are a much harder case. If shareholders were lied to about foreseeable risks to the business, then fraud class actions can make sense. But too often those cases seem to demand, as Judge Kaplan put it, clairvoyance – and a quick settlement. That costs the company, and the current owners of its shares. As usual, only the lawyers come out ahead.

Breakingviews

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