|September 25, 2012|
Previously published on Fall 2012
Virtually unheard of five years ago, securities class actions against private investment fund sponsors are now a growing risk. This development is the result of a combination of factors, including:
- a challenging economic and investment environment;
- disappointing returns at some funds;
- the Madoff fraud;
- the efforts of the plaintiffs’ securities class action bar to cultivate relationships with certain institutional investors; and
- increased regulation of the private funds industry.
Despite these factors, the plaintiffs’ securities class action bar still faces substantial challenges in pursuing private investment funds. The class action structure does not necessarily fit neatly within the private investment funds context, and the plaintiffs’ bar will have to adapt. In addition, compared to the extensive body of case law involving securities class actions against publicly listed companies, there are few reported decisions involving securities class actions against private investment fund sponsors. Finally, conscientious private investment fund sponsors can take a few careful steps today to reduce their risk of defending a class action in the future.
A Brief History
Historically, the plaintiffs’ bar has been extraordinarily successful - based purely on the number of suits filed and settlements achieved - in targeting various industries and challenging accepted practices within those industries. For example, over the last 30 years, the plaintiffs’ bar has targeted, at various times, the information technology, biotech/pharma, medical device and financial services industries. Ten years ago, the plaintiffs’ bar focused on large scandals at firms such as WorldCom and Tyco, as well as various financial market irregularities such as market timing at mutual funds and the IPO “laddering” and “spinning” cases. Following the financial crisis in 2008, the plaintiffs’ bar focused on claims arising out of the securitization of subprime mortgages, the collapse of the auction rate securities market and various Ponzi schemes, including the Madoff fraud. Even more recently, the plaintiffs’ bar has filed numerous claims in connection with M&A transactions, on the theory that the purchase price was inadequate, even in situations where the price was at a substantial premium to the pre-announcement closing price.
Despite this success, the securities class action industry has undergone material changes over the last two decades. Perhaps the most important changes were implemented as part of the Private Securities Litigation Reform Act of 1995 (the Act) which made it more difficult, as a practical matter, to bring a securities class action.
Among the most radical of the reforms that the Act imposed were the so-called lead plaintiff provisions. The lead plaintiff provisions were intended, in part, to impose investor control over the litigation and eliminate the perceived abuse of lawyer-driven litigation by giving control to the investor or group of investors with the largest financial interest. These provisions create a rebuttable presumption that the person or group of persons with the largest financial stake in the relief sought constitutes the most adequate plaintiff. Under the Act, the court appoints the most adequate plaintiff as lead plaintiff and the lead plaintiff then selects counsel.
In response to the lead plaintiff provisions, the plaintiffs’ bar developed strong relationships with a variety of institutional investors, including public pension plans. Over the last 17 years, a variety of these institutional investors have been appointed as a lead plaintiff in dozens of securities class actions. These institutional investors have become highly sophisticated in litigation and securities matters. Many of these same institutional investors hold investments in private investment funds.
Learning from History
If the cases that have been brought so far against private investment fund sponsors are any indication, the plaintiffs’ bar will draw heavily on their strategies and theories in dealing with publicly traded companies. Therefore, fund sponsors have a good roadmap for the securities law-based claims that may lie ahead, including:
- Section 10(b) of the Securities Exchange Act of 1934 (the Exchange Act) and corresponding Rule 10b-5, which relate to fraud in connection with the purchase or sale of a security and require proof of causation, reliance and knowledge or intent;
- Section 12(a)(2) of the Securities Act of 1933 (the Securities Act), which creates liability for any person who offers or sells a security through a prospectus or an oral communication containing a material misstatement or omission; and
- Section 15 of the Securities Act, which creates liability for those persons who control an issuer for misinformation in a registration statement, prospectus or distribution of securities, and helps investors collect damages when the issuer does not have enough money to pay the investors.
The Class Action: Leverage for Lawyers
A fundamental purpose of the class action structure is to create economies of scale and promote fairness, for both plaintiffs and defendants. For the plaintiffs’ bar, class actions are also the litigation equivalent of “leverage” in a transaction. A lawyer who represents one client can bring a class action on behalf of all persons who are similarly situated. In doing so, the lawyer has an opportunity for significantly greater fees based on a contingency fee agreement and obtains greater bargaining power with the defendants. The prospect of having to defend a class action is oftentimes sufficient to bring companies to the settlement table. As the U.S. Court of Appeals for the Fifth Circuit has observed, “class certification may be the backbreaking decision that places ‘insurmountable pressure’ on a defendant to settle, even where the defendant has a good chance of succeeding on the merits.”
Certifying a Class: Easier Pled Than Done
Filing a putative securities class action lawsuit is one thing; establishing that a class should be certified is another matter entirely. To achieve class certification, plaintiffs must meet a variety of requirements. One of the key requirements, commonly referred to as the predominance requirement, places the burden on plaintiffs to show the court that questions of law or fact common to the members of the class predominate over any questions affecting only individual members of the class.
Demonstrating predominance can be particularly difficult in a securities fraud suit. To establish a claim of securities fraud under Section 10(b) of the Exchange Act, a plaintiff must prove six elements, including reliance on a material misstatement or omission of fact at the time of purchasing or selling a security. According to the U.S. Supreme Court, proving reliance provides the requisite causal connection between a defendant’s misrepresentation and a plaintiff’s injury. For class certification, plaintiffs must demonstrate that each member of the entire class relied on the alleged misstatement or omission in making the investment decision.
In a securities fraud suit, plaintiffs regularly rely on the “fraud on the market” theory to establish reliance. The fraud on the market theory stands for the proposition that, in an efficient market, information that is available to the public is rapidly absorbed by the market and reflected in the price of a security, even though individual market participants may be unaware of the information. The U.S. Supreme Court accepted the fraud on the market theory in 1988 in Basic v. Levinson.
In Basic, the Court held that when an investor purchases a security at a price that has been inflated by false or misleading information, and when the investor reasonably believes that the market price reflects all available information, a court can presume that the investor relied on the false or misleading information. As a result, in instances where the fraud on the market theory applies, plaintiffs do not have to prove individual reliance on the alleged misstatement or omission, as the court presumes such reliance. Absent the fraud on the market presumption, plaintiffs face a substantial challenge in achieving class certification because individual issues of reliance generally preclude a finding that common issues predominate.
In a putative class action alleging securities fraud against a private investment fund sponsor, it will be difficult - if not impossible - for a plaintiff to utilize the fraud on the market theory because investment interests in a private investment fund do not trade in an efficient market. Indeed, the Basic Court focused heavily on the concept of an impersonal, well-developed market for securities in adopting the fraud on the market theory. The Basic Court distinguished between the modern securities markets, which involve literally millions of shares changing hands daily, and face-to-face transactions where the inquiry into an investor’s reliance upon information relates to the subjective pricing of that information by that investor. In a private investment fund context, there is generally nothing remotely approaching an impersonal, well-developed market for interests in a private investment fund.
How to Reduce the Risk of a Securities Class Action
Private investment fund sponsors that are launching new funds can take steps today to reduce the risk of litigation in general, and class actions in particular, including the following:
- Note in the private placement memorandum the nature and purpose of an investment in the private investment fund, the differences between an investment in a private investment fund and an investment in public equity, and the fact that the interests in the private fund are illiquid and not traded in any market;
- Consider whether a mandatory arbitration provision that precludes class actions in the arbitration context, as part of the standard form subscription agreement for the fund, is right for the particular sponsor’s situation. The business case and the legal case for mandatory arbitration provisions is highly fact-specific, and the benefits of any such provision may be outweighed by the detriments. In addition, the enforceability of such provisions varies among the states and federal courts;
- Prohibit the transfer of interests in the fund without the prior written consent of the general partner or management company, as is typically the case;
- Carefully adhere to the rules and regulations concerning private offerings of securities, and consider thoroughly the ramifications of general advertising and solicitation under the recently enacted Jumpstart Our Business Startups Act (JOBS Act);
- Expressly avoid or limit duties of disclosure in the fund documents; and
- Make extensive disclosure of risks in order to take advantage of the “bespeaks caution” doctrine, which states that if soft information in a prospectus (including forecasts, opinions, estimates and projections about future performance) is accompanied by cautionary language that warns the investors about the actual results or events that may affect performance, then the soft information may not be substantially misleading to investors.
Securities class actions are a nascent risk for private investment fund sponsors. While the law in this area is still developing, sponsors can and should take steps to reduce their future risks.
 Courts typically consider five factors in determining whether a security trades in an efficient market. These include: (1) the security’s average weekly trading volume expressed as a percentage of total outstanding shares; (2) the number of securities analysts reporting on the security; (3) the extent to which market makers and arbitrageurs trade in the security; (4) the issuer’s eligibility to file SEC Form S-3 (a short form registration statement that is reserved for companies that have $75 million in common equity held by non-affiliates of the registrant and have filed reports with the SEC for 12 consecutive months); and (5) facts demonstrating a cause and effect relationship between unpredicted corporate events or releases of financial data and an immediate reaction in the security’s price.