The Rise of Shareholder Class Actions in Response to Corporate Misconduct

Shareholder class actions in response to corporate misconduct, particularly in the U.S., are on the rise. According to the Securities Class Action Clearinghouse, 403 federal securities class actions were filed in 2018; a dramatic rise from the 165 filed in 2013, just five years ago. Not all of these class actions necessarily relate to corporate misconduct, but the overall trend is clear. The rise of these actions underscores the damage bribery can do to a business beyond scrutiny and enforcement from government authorities.

Just last week it was reported that oil services provider Petrofac is facing a GBP 400 million lawsuit after one of its former executives pleaded guilty to bribery and corruption charges. The lawsuit is being brought by a litigation funder representing several large UK and US pension funds claiming they suffered substantial losses because of the company’s involvement in bribery, corruption, and money-laundering. However, the Petrofac suit is nothing new; as aforementioned, shareholder class actions have been on the rise for years.

Although settlements for corporate misconduct with the authorities usually grab the headlines, the true cost of a bribery scandal can be much higher for companies, once the costs of litigation and derivative lawsuits have been accounted for. For that reason, it’s important to examine the bases upon which shareholder class actions are brought, what you need to know about the recent increase, and what you can do to shield your organizations.

The Bases For Shareholder Class Actions

It is not entirely clear if the U.S. Congress intended for the Foreign Corrupt Practices Act (FCPA) to have a private cause of action, but various courts have held that the FCPA does not create a private cause of action. Regardless, shareholders are still able to bring claims based on other causes. Broadly, there are two categories:

1) Derivative Claims against directors or officers of a company

In broad terms, derivative claims usually allege that a director undertook an action, or failed to undertake action, relating to the misconduct that led to shareholder losses. A director’s fiduciary duty includes the obligation to, in good faith, assure that a reporting or information system or controls exist. Moreover, a director has oversight liability to oversee or monitor the company’s controls and systems once implemented. If it can be shown that a director knew that he or she was not discharging these fiduciary obligations in good faith, liability may arise.

In practical terms, shareholders often allege participation in, covering up of, or a failure to prevent FCPA violations. Such a claim can take many forms. For example, shareholders may claim that the director failed to implement internal controls, failed to monitor the implementation of such controls, failed to remedy misconduct once detected, and so on. In practice, derivative claims based on FCPA violations are rarely litigated as the standard for proving that a director knew he or she was not discharging their fiduciary obligations is high. Derivate claims are frequently dismissed, although companies sometimes feel compelled to settle claims out-of-court.

2) Securities Fraud Class Action Claims

Claims of securities fraud by shareholders are common following FCPA scrutiny as it can have large impacts on a company’s share price.

In securities fraud class action claims, a class of shareholders generally allege that the company’s disclosures in regard to (potential) FCPA violations and enforcement actions brought by the DOJ and SEC were misleading or constitute proof of material misstatements in previous statements publicly released by the company. As a reminder, the general principle behind securities laws is the requirement that issuers (i.e. companies issuing shares) must make full and complete disclosures of all pertinent information relevant to an investor's decision to buy, sell, or hold shares in the company. Such claims are thus often argued on the basis that, among others, the company misstated the quality of its internal controls, its compliance with its own policies and the FCPA (or other laws), or its projections about risks and costs associated with an FCPA enforcement action.

On the bases mentioned above, the plaintiffs in a class action typically claim that these misstatements or omissions artificially inflated and maintained the company’s share price and that they suffered losses when the stocks fell in price following the revelation of the concealed information. Successfully pleading such claims can be difficult however, as the plaintiffs would have to prove specific knowledge and intent to deceive on behalf of individuals making the misstatements.

However, in practice, many shareholder class actions based on securities fraud claims are rarely litigated, as many companies prefer to settle them quickly as they are backed by insurance and wish to avoid drawn-out litigation. Indeed, there a number of prominent examples of this trend.

Why You Should Be Paying Attention To This Trend

The Petrofac class action announced last week is part of a wider trend over the last couple of years of shareholders bringing lawsuits following allegations of alleged corporate wrongdoing. These actions may not succeed on their merits if litigated, but companies often see themselves forced to settle these cases regardless of business reasons. Yet, these shareholder class actions can be enormously costly; they are often more expensive than the fines levied by regulators.

A prominent example of this trend is the USD 2.95 billion settlement beleaguered Brazilian state-owned oil company Petrobras struck with shareholders in 2018; the largest ever settlement involving a foreign issuer in the U.S. Following the revelations of widespread bribery, the company’s shares fell to a low of USD 3 per shares in January 2016 from a high of USD 72 in May 2008.

A shareholder class action was subsequently launched that claimed that investors suffered large losses due to material misstatements in the company’s filings with the SEC. The case was ultimately settled out of court, with Petrobras denying liability for the losses as it claims to be the victim of the actions of individual executives. The total size of the settlement far surpasses the total fines levied on the company by regulators; U.S. and Brazilian authorities levied a total of USD 853.2 million of penalties on Petrobras. Remarkably, the USD 2.95 billion settlement was at the lower end of analyst estimates of the size of the deal; analysts expected a settlement between USD 5 and 10 billion. Petrobras is also still facing additional pending shareholder suits in Europe. The Petrobras case clearly illustrates that the costs of these shareholder class actions can be enormous.

In another example, Walmart settled one of several shareholder class actions in October 2018 over allegations that the company paid bribes in Mexico - the FCPA scrutiny related to that action has been pending since 2011. Walmart paid out USD 160 million to the investor class without admitting or denying the allegations.

Beyond the large sums involved in these settlements, another reason to pay attention to this trend is that shareholder class actions typically strain businesses by the cost of litigation and crucially, the distraction it forms from business operations. In the Petrobras case, the pending settlement got in the way of a restructuring plan, which the company recognized in a statement emphasizing that the settlement “puts an end to the uncertainties, burdens, and costs of protracted litigation”. It is apparent that shareholder class actions have the potential to significantly increase the pain and drag out the headaches associated with a bribery enforcement action.

Shielding Your Company

All of this begs the question: How can I shield my company from these types of shareholder class actions? As the Petrofac, Petrobras, and Walmart examples show, these settlements are enormously costly. The obvious answer is thus for companies to assess the total exposure to liability stemming from bribery and corporate misconduct, beyond the fines and disgorgement possibly imposed by regulators when assessing the cost of their compliance programs.

Having a strong compliance program with appropriate internal controls in place may avoid this type of misconduct in the first place or mitigate the severity of the fallout by detecting it early. Lastly, a solid compliance program may even constitute a competitive advantage, as investors are increasingly looking for companies displaying a strong commitment to ethics and compliance as a marker of a good investment. The old idiom of “prevention is better than cure” certainly applies here.

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