Joni S. Jacobsen
Chicago +1 312 646 5813
New York +1 212 698 3500
The spread of the coronavirus continues to impact the global economy, with many companies experiencing severe disruptions in their ability to manufacture, distribute and sell their products, as well as disruptions to the productivity and mobility of their workforce. As COVID-19 continues to impact corporations’ operations and financial results, as well as markets in general, we anticipate an increase in securities and derivative litigation. Public companies should understand how the uncertainties created by the coronavirus may increase the risk of securities and derivative litigation, and steps that can be taken to minimize such risks.
Alleged Violations of Section 10(b) and 20(a)
As COVID-19 causes market uncertainty, companies must remain candid and develop disclosure strategies that are conscious of increasing investor sensitivity. Alleged misrepresentations have already served as the basis for several COVID-19–related securities suits and future suits related to COVID-19 are a certainty. Going forward, issuers should expect securities litigation caused by COVID-19 under a myriad of theories, especially as the pandemic’s consequences continue to mature: cases related to supply-chain disruptions, liquidity disclosures, solvency, and possible long-term effects of the pandemic.
Several suits involve alleged misrepresentations to consumers and investors relating to potential risks posed by COVID-19. Norwegian Cruise Lines (“NCL”) was one of the first companies hit with a securities fraud suit arising out of the pandemic. In Norwegian Cruise Lines Sec. Litig., 1 plaintiff alleges that NCL provided misleading information and had a systematic practice of denying COVID-19’s severity in order to encourage customers to continue to book cruises, and that these misstatements, once revealed, caused an actionable decline in stock value.
On May 27, 2020, a similar suit was filed against Carnival Cruise Lines. The complaint against Carnival alleged the company made false and misleading statements and omitted information about its adherence to its health and safety protocols in the wake of the pandemic, its role in the transmission of COVID-19, and purported violations of port-of-call regulations, and asserts a putative class period of January 28, 2020 through May 1, 2020. According to plaintiff, although defendants knew of the risk posed by the virus, they still allowed the ships to set sail. When the truth about the outbreak aboard Carnival’s ships was revealed, the stock price plummeted and plaintiffs filed suit.
Whereas other securities fraud suits have arisen from overstatements relating to a company’s products or position in this unprecedented environment.
Several other securities fraud actions were filed as a result of companies’ allegedly misleading statements regarding the handling of PPP loans and the likelihood of an announced acquisition being consummated. For example, on June 4, 2020, a securities class action was filed in the Northern District of California against Wells Fargo, its CEO and CFO alleging violations of Sections 10(b) and 20(a) arising out of Wells Fargo’s handling of PPP loans.4 Specifically, plaintiff alleges the defendants made misleading statements or failed to disclose that: (i) Wells Fargo improperly allocated government-backed loans under PPP, and/or had inadequate controls in place to prevent such misallocation; (ii) the misallocation and inadequate controls increased the Company’s litigation risk with respect to PPP allocation, as well as increased its regulatory scrutiny; and (iii) as a result, the Company’s public statements were materially false and misleading at all relevant times.
On June 10, 2020, a securities class action was filed in the Northern District of California against Forescout, its CEO and its CFO alleging violations of Sections 10(b) and 20(a). The lawsuit arises out of a potential merger between Advent International Corp., which was set to acquire Forescout, but is now subject to litigation in Delaware Chancery Court. The complaint is filed on behalf of investors who purchased Forescout securities between February 6, 2020, the date the acquisition was announced, and May 15, 2020, the day Forescout announced that Advent “would not be proceeding” with the acquisition. The complaint alleges that when Forescout announced the merger, it “knew that its business had begun to suffer a dramatic and undisclosed downturn,” including in its Asia Pacific and Japan region “that was impacted by COVID-19 starting in January,” and that its revenues were inflated through a “channel stuffing scheme.” As a result, “Forescout knew that the consummation of the [Merger] was exceptionally risky at the time it announced the Merger Agreement.”
M&A Litigation and Securities Act Claims
Plaintiffs’ attempts to pursue securities fraud claims have also arisen from M&A deals and offerings. For example, in Comtech Telecommunications Corp. Sec. Litig.,5 plaintiff alleged the proxy issued in connection with a merger between Comtech and Gilat Satellite Networks Ltd. was materially incomplete and misleading and violated Section 14, particularly concerning Comtech’s material financial projections and the impact of COVID-19 on the “macroeconomic environment” in relation to the projections. In Wolfe v. Stemline Therapeutics, Inc.,6 plaintiff brought claims for violations of Sections 14 and 20(a) alleging that defendants failed to disclose material information in the company’s financial projections relating to proposed corporate acquisition. Plaintiffs request included “pre-COVID-19” and “post-COVID-19” financial information, and questioned why a certain company was selected by the financial advisor as a comparable given that entity’s unique situation due to the pandemic.
If history is our guide, we also expect plaintiffs to look for opportunities to file Securities Act claims which imposes a more lenient pleading burden in that plaintiffs are not required to plead scienter. Phoenix Tree Holdings Limited: American Depositary Shares Sec. Litigation7 is an example of a case alleging that defendants violated Sections 11, 12 and 15 of the Securities Act by issuing offering materials that omitted or otherwise misrepresented information relating to COVID-19. Specifically, plaintiffs alleged that defendants omitted (i) the level of renter complaints the company received before and as of the January 22, 2020 IPO, (ii) the demand in Chinese residential rental market, and (iii) the Company’s exposure to significant adverse developments resulting from the onset of the coronavirus in China, particularly in Wuhan, at the time of the IPO.
To date, the SEC has filed several complaints alleging securities fraud violations arising out of alleged misstatements companies made relating to products in demand as a result of the pandemic, namely, N95 masks, finger-prick tests for COVID-19 and thermal scanning equipment to detect individuals with fevers. Another suit was filed alleging a pump and dump scheme.
In addition to securities fraud and SEC enforcement actions, we also expect public companies and their boards of directors to face derivative actions alleging a board’s failure of oversight or inadequate responses to red flags. We believe this legal theory is likely to be pursued given the recent oversight claims that have survived a motion to dismiss in Delaware Court of Chancery, as well as the volatility in the market which may prevent plaintiffs from filing classic stock drop securities fraud claims.
Failure of oversight claims arose from the seminal Caremark decision in 1996, and involve a claim that directors caused or permitted a corporation to break the law or failed to establish or oversee a monitoring system for a corporation's compliance with the law. Caremark claims are frequently recognized by the Court of Chancery as one of the most difficult corporate law claims to plead.11 However, in the past year, several failure of oversight claims have survived motions to dismiss, practically ensuring that plaintiffs will attempt to seize this momentum and file similar suits arising out of the pandemic.12 All three cases involved fairly extreme circumstances relating to the boards’ alleged failure to oversee critical products in a highly regulated industry, or failure to implement its own monitoring system despite direct knowledge of internal issues. However, given these recent cases as well as the absence of a sustained stock drop for many companies, it is no surprise that several derivative actions have been filed in response to COVID-19, and we expect more are on the way.
To limit potential risks of securities fraud and derivative actions, companies should thoughtfully assess their consideration of and responses to this rapidly changing situation, ensure robust internal controls are in place at the management and board level, and document the board’s consideration of these issues. For example, board should consider the following:
As COVID-19 continues to cause market uncertainty, companies must remain diligent to ensure that they have robust disclosure strategies in place that are being followed, as well as a process to document the board’s careful deliberation. Companies should do their best to adhere to SEC guidance specifically outlining suggested disclosures related to COVID-19. 15
1) See Norwegian Cruise Lines Sec. Litig., No. 1:20-CV-21107-RNS (S.D. Fla. Mar. 12, 2020).
2) See Zoom Video Commc’ns. Sec. Litig., No. 3:20-CV-02353-JD (N.D. Cal. Apr. 7, 2020).
3) There have been several cases filed relating to financial issues which appear to have been revealed during the pandemic. See Hunter v. Elanco Animal Health Inc., et al., No. 1:20-cv-01460-SEB-DML (S.D. Ind. May 20, 2020) (previous statements were allegedly materially misleading and stock declined when distribution issues and impact of COVID-19 were revealed); Riback v. iAnthus Capital Holdings, Inc., et al., No. 2:20-cv-01962 (S.D.N.Y. Apr. 14, 2020) (defendants allegedly failed to make certain interest payments due under a debenture agreement ($40 million was pursuant to secured debenture offering) given “decline” in cannabis and the pandemic; but private placement offering allegedly required withholding and escrow of one year’s interest from transaction proceeds to be available in the event of default); Lee v. iQiyi, Inc., et al., No. 1:20-CV-01830-LDH-JO (E.D.N.Y. Apr. 16, 2020) (based upon report issued after pandemic began, iQIYI allegedly made false and/or misleading statements and/or failed to disclose inflated revenues, user numbers, and expenses); Wu v. GSX Techedu Inc., et al., No. 2:20-CV-04457-ES-CLW (D.N.J. Apr. 17, 2020) (based upon information revealed after pandemic began, allegedly made false and/or misleading statements and/or failed to disclose that GSX overstated its profitability, revenue, student enrollment figures, teacher qualifications, and teacher selection process, which was likely to have a material negative impact on the company’s financial results).
4) Ma v. Wells Fargo & Co., et al., No. 3:20-cv-03697-RS (N.D. Cal. Jun. 4,
5) Comtech Telecomms. Corp. Sec. Litig., No. 2:20-CV-02070-RJD-AYS (E.D.N.Y. May 6, 2020).
6) Wolfe v. Stemline Therapeutics, Inc., No. 1:20-cv-02280, 2020 WL 2568844 (E.D.N.Y. May 20, 2020).
7) Phoenix Tree Holdings Limited: American Depositary Shares Sec. Litig., No. 1:20-CV-03259-PAC (S.D.N.Y. Apr. 24, 2020).
8) SEC v. Praxsyn Corp., et al., No. 9:20-CV-80706-RAR (S.D. Fla. Apr. 28, 2020).
9) SEC v. Applied BioSciences Corp., No. 1:20-CV-03729-JMF (S.D.N.Y. May 14, 2020).
10) SEC v. Turbo Global Partners, Inc., No. 8:20-CV-01120-JSM-TGW (M.D. Fla. May 14, 2020).
11) In re Caremark Int'l Inc. Derivative Litig., 698 A.2d 959, 967 (Del. Ch. 1996).
12) See Marchand v. Barnhill, 212 A.3d 805, 822 (Del. 2019); In re Clovis Oncology, Inc. Derivative Litigation, Consolidated C.A. No. 2017-0222-JRS, 2019 WL 4850188, 2019 Del. Ch. LEXIS 1293 (Del. Ch. Oct. 1, 2019); Hughes v. Hu, C.A. No. 2019-0112-JTL, 2020 WL 1987029 (Del. Ch. Apr. 27, 2020).
13) Beheshti v. Kim, et al., No. 2:20-cv-01962 (E.D. Pa. Apr. 20, 2020).
14) See Lozano v. Schessel, et al., No. 1:20-cv-04554 (S.D.N.Y. Jun. 15, 2020).
15) See COVID-19 Coronavirus – Considerations for Boards of Directors and COVID-19 Coronavirus: SEC Disclosure Obligations for Public Companies.
The authors would like to thank Greg Noorigian for his invaluable assistance.