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June 19, 2015

“RoboCop” isn’t the only factor driving new securities class actions

by: William S. Norton

Despite the anticipatory lull in case filings just prior to the 2014 Supreme Court decision on Halliburton Co. v. Erica P. John Fund—a decision that could have changed modern securities fraud litigation as we know it but instead simply reaffirmed the fraud-on-the-market presumption—securities fraud class action litigation continues to play an active and growing role in protecting the integrity of the capital markets. And this trend is likely to continue.

The recent increase in securities litigation is in part due to the natural countercyclical nature of the stock market in relation to class action filings, but also because of several emerging factors, including increased regulatory attention to financial fraud, advances in regulator technology, increased whistleblower activity, and groundbreaking litigation to rein in the emerging field of high frequency trading.

Securities litigation tends to be countercyclical

A study conducted by PricewaterhouseCoopers in April 2015 found a countercyclical relationship between the growth rate of the stock market and the number of new securities class action lawsuits filed. According to the study, in years the growth rate declined, the number of filings increased; conversely, in years where growth increased, filings decreased.

Thus, after the Crash of 2008, securities class action filings spiked. In 2009, the S&P 500 rebounded and filings fell.  From 2009 to 2011, growth rates declined and filings again increased.  From 2011 to 2012, growth increased as filings declined.  And, as 2013 turned to 2014, growth declined and filings slightly increased.

What does this mean for the future? After six years of stock market growth (albeit at varying rates), and with the S&P 500 at record highs, regulators such as Federal Reserve Chair Janet Yellen and investors such as Warren Buffet agree that stocks are at historically high valuations. While attempting to make prophesies about markets is fraught with peril, when the anticipated market correction comes, history teaches that increased securities litigation filings will follow.

SEC investigations and enforcement actions are increasing

Increased government enforcement activity is one driver of private securities litigation. In that regard, 2014 was a record year for the U.S. Securities and Exchange Commission. In 2014, the SEC filed a record 755 enforcement actions—up from 686 in 2013. Similarly, the SEC recently reported 1,612 ongoing and 995 new investigations in 2014— up from 1,444 ongoing and 908 new investigations in 2013. The SEC has predicted to Congress that this trend will continue in 2015 and 2016.

Whistleblowers are getting louder

Thanks mainly to the creation of the SEC’s Office of the Whistleblower in mid-2010, whistleblower actions are also starting to make a significant impact on the Commission’s fraud reduction efforts. For instance, tips to the SEC rose from 334 in 2011 to 3,620 in 2014—the most tips received by the department to date, with most of those allegations falling into the categories of “corporate disclosures and financials,” “offering fraud” and “manipulation.” And since investigations into relevant tips often take a few years to complete, awards resulting from these enforcement actions will likely continue to rise for the next several years.

In fact, of the 14 awards that the Whistleblower program has granted since 2011, nine were made in 2014, including one award of more than $30 million to a whistleblower outside of the United States, emphasizing the international reach of the program. According to Office of the Whistleblower Chief Sean McKessy, “The Commission issued whistleblower awards to more individuals in Fiscal Year 2014 than in all previous years combined.”

In 2015, this growth in the number and proportion of awards has continued. For example, in April, the SEC announced that it had awarded a whistleblower $600,000, which represented the statutory maximum award of 30 percent of the funds it had recovered in connection with the SEC’s first anti-retaliation case. Payouts to SEC whistleblowers now total over $50 million.

“RoboCop” – the SEC’s data-driven police officer

While the SEC’s relatively new data analytics tool is technically called an Accounting Quality Model, this innovative corporate filings trawler was dubbed “RoboCop” by the press shortly after its release in 2013 for its advanced approach to cleaning up the dirty streets of earnings management. Created by the SEC’s Financial Reporting and Audit Task Force, the AQM is designed to analyze earnings disclosures against a company’s industry peer group and to determine if any risk indicators or inducers are detected. It then rates the company according to how likely it is that fraudulent activities are taking place, typically within 24 hours of the company’s filing. Among other things, these scores help SEC reviewers prioritize investigations and concentrate on specific sections of reports that the AQM flags as suspicious.

Putting the brakes on high frequency trading

For securities litigation, the rapidly evolving world of high frequency trading, or HFT, is a fascinatingly complex subject. In HFT, complex mathematical algorithms are used to trade stock at speeds of millionths of seconds. This speed, for example, can allow HFT algorithms to take advantage of newly released data, such as the monthly unemployment report, and profit from it by selling stock the instant these numbers are announced and buying it back at reduced prices in a matter of microseconds.

While this speed may seem like an unfair advantage to the average day trader, even more troubling are the alleged perks offered to high frequency traders by the stock exchanges themselves, such as co-location for picosecond time advantages on trades, proprietary data feeds and access to non-public complex order types typically only available to the exchanges’ clients.

HFT can be seen as a form of “front running” or “penny jumping” that has long been illegal for brokers and constitutes illegal market manipulation as practiced today. In the end, I am inclined to agree with Charlie Munger, Vice Chairman of Berkshire Hathaway, in his description of high frequency traders as “a bunch of short-term people trying to get information one-millionth of a nano-second ahead of somebody else” and HFT as “basically evil and it should never have been able to reach the size that it did.”

In an ongoing effort to address this alleged manipulation, Motley Rice currently serves as one of three lead counsel in a federal securities class action lawsuit that seeks to hold numerous securities exchanges accountable for their roles in these allegedly unlawful actions.

These and many other factors have led to increased demand for securities litigation, which will continue to keep pace with rapidly evolving attempts to defraud investors, with the ultimate goal of remedying and deterring securities fraud.