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A class securities fraud suit is more likely to make it past the pleading stage when the targeted company restated its financials.
Judges between 2007 and 2016 dismissed roughly 28 percent of traditional class securities cases involving restatements compared to almost 40 percent of those not involving a restatement, Cornerstone Research senior adviser Laura Simmons told Bloomberg BNA. Traditional securities cases are those alleging violations of 1934 Securities Exchange Rule 10b-5 and/or 1933 Securities Act Section 11or Section 12(a)(2).
Courts take a dim view of corporations that enhance their balance sheets at investors’ expense, securities lawyers said. In addition, the fact of a restatement makes it hard to deny that the misstated numbers weren’t material—or that they weren’t misstated in the first place.
“If the restatement shows that the company was falsely trying to dress up its balance sheet, those are cases where investors are likely to recover and courts are likely to come down hard on companies,” New York securities arbitration attorney Jacob Zamansky, Zamansky LLC, told Bloomberg BNA.
An issuer that restates its financials is admitting two important elements of a securities fraud claim: materiality and falsity, Washington securities lawyer Daniel Sommers, Cohen Milstein Sellers & Toll PLLC, said. For investors alleging securities law violations that don’t require fraudulent intent, “a restatement is an even more powerful ally,” Sommers said. In those cases, a restatement may provide all the facts needed to state a claim, he said.
The increased likelihood of having to defend a shareholder class action isn’t the only problem for companies that restate their financials. Such companies “often find themselves at the wrong end” of an SEC enforcement action as well, New York securities litigator Michael Young, Willkie Farr & Gallagher LLP, told Bloomberg BNA.
Despite the risk of a civil class action, “sophisticated companies” facing a possible restatement “will often decide that it makes sense to reach out to the SEC to position themselves for cooperation credit,” Young said. Doing the right thing without government prompting is the best scenario, he said. “What it really boils down to is whether the company is acting like a good corporate citizen or not.”
Restating questionable financials may help a company mitigate the impact of an SEC lawsuit or avoid one altogether, but the courts nevertheless hold companies accountable, especially when intentional misconduct may be involved.
The U.S. District Court for the Southern District of New York, for instance, recently concluded that digital analytics concern comScore Inc. and several top comScore officials must face class claims they misled investors by grossly inflating the company’s revenues ( Fresno Cty. Emples. Ret. Ass’n v. comScore, Inc. , 2017 BL 264744, S.D.N.Y., No. 16-cv-01820, 7/28/17 ).
Investors said comScore improperly recognized $43.2 million in revenue for certain nonmonetary transactions in order to inflate its performance-based metrics. After a press report questioned the company’s recognition practices, comScore’s stock price plummeted. Shortly thereafter, comScore admitted that it shouldn’t have recognized any revenue from the deals.
The company and its officers moved to dismiss the complaint, but the court allowed the suit to proceed. It said that by admitting its financial statements were inaccurate, comScore left no dispute that the complaint pleaded numerous false and misleading misstatements with respect to revenue and compliance with generally accepted accounting principles.
While some companies consider class lawsuits and/or enforcement proceedings a cost of doing business, Zamansky argues against that approach. “There really should be some penalties by the SEC,” he said. “Businesses shouldn’t be restating financials in the first place.”
In the comScore case, “it appeared that the company wasn’t candid with its audit committee. That’s a huge red flag,” Zamansky said.
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