Class action lawsuits fueled by regulators, says PwC study
Increased enforcement actions by the SEC and other regulatory agencies will likely fuel a rise in securities class action lawsuits in the coming year, according to the 2014 Securities Litigation Study recently released by PwC.
The public outcry to eliminate financial fraud that emerged after the 2008 financial crisis has regulatory agencies across the globe paying special attention to detecting and prosecuting various forms of improper financial reporting, non-compliance with accounting rules and money laundering regulations. As a result, the SEC has reaffirmed its ‘broken windows’ approach to enforcement, which targets minor offenses that historically may have been overlooked in hopes of uncovering larger issues that could result in major fraud prosecutions. The US Department of Justice has also placed an emphasis on making sure companies are in greater compliance with the FCPA.
The report shows that no company is too big or small to be the focus of an investigation. Two-thirds of the companies named as defendants in federal securities class action lawsuits last year were small-caps (market capitalization of up to $2 billion) or less — including 24 percent that were micro-caps (market capitalization under $300 million), the report says.
In light of this environment of higher scrutiny, the report says, ‘Companies would be wise, therefore, to enhance their internal controls over financial reporting and pay special attention to the estimates and judgments upon which they base their financial reporting and disclosures — and to carefully document the underlying basis for such estimates — because when irregularities arise, these judgments are often the point of entry for external scrutiny.’
Neil Keenan, a partner in PwC’s forensic services practice who specializes in enforcement investigations, sees the SEC’s enforcement actions as the catalyst for many of these lawsuits. The agency launched the Financial Reporting and Audit Task Force in July 2013 and ‘they are already reporting a 46 percent increase in the number of accounting-related cases that they are investigating,’ he says. ‘At least 200 companies are currently on the list of entities they are pursuing for matters involving potential accounting-related fraud.’
The SEC also has access to powerful data analytics tools that allows it to detect irregularities in financial reports. The agency also gets tips about possible wrongdoing from the Office of the Whistleblower. The SEC’s emphasis on financial reporting and financial fraud ‘has made securities litigation very attractive to plaintiffs’ counsel trying to bring cases,’ says Keenan. ‘Although these cases are complex, they can result in some pretty harsh settlements if what is deemed to be financial fraud results in a decline in stock price.’
Shareholder groups are also contributing to the increase in securities litigation, especially since the market for mergers and acquisitions has improved. Historically shareholders have filed class action lawsuits when they’ve felt that the price of a merger or acquisition was undervalued. When they feel they’ve suffered a loss through an undervalued sale or a drop in stock price due to bad publicity connected to an investigation, they hope a settlement of the lawsuit will compensate them for their loss. These types of lawsuits could potentially increase as the number of mergers and acquisitions and other types of investigations increases.
Additionally, Keenan says shareholders are looking at other issues to initiate class action lawsuits. He says the study uncovers at least six securities class action lawsuits brought by shareholders that question whether allegations of breach of corruption laws, the FCPA and other international regulations have had a negative effect on share price.
‘Shareholders are very mindful of any investigation by any regulator, and they are choosing to initiate a class action if news of that investigation results in a decline in the stock market,’ says Keenan.
The report indicates that auditing irregularities and compliance issues around cyber-security will drive many of the securities lawsuits in the future. Investigations stemming from revenue-related fraud such as fake contracts or bogus sales reports, and failure to implement compliance programs to prevent cyber-security breaches will likely be the next focus of regulators.
Keenan expects companies will start improving their compliance programs to better defend against cyber-security breaches and auditing irregularities.
‘I would anticipate lots of companies and their boards looking at the accuracy of their reporting and starting to ask more questions of company officers,’ he says. ‘What are you doing to look for fraud? What are you doing to look for trends in our international operations that are early indicators of potentially inappropriate accounting?’
The report suggests companies work to enhance compliance programs in this environment of higher scrutiny. ‘A strong compliance program now necessitates controls that are modified and enhanced as the business changes, in addition to the use of technology as a compliance tool. Companies should ensure that their internal controls over financial reporting and disclosure are robust — and use their own data analytics to detect accounting fraud and to monitor trends in their operations (especially in any emerging-market businesses or subsidiaries, where practices may vary) and, perhaps even more importantly, among their peers.’