Cornerstone Research has issued its annual report on accounting class action litigation, Accounting Class Action Filings and Settlements—2021 Review and Analysis. Cornerstone finds that, reversing the trend of recent years, class action litigation filings against public companies for alleged accounting violations declined precipitously last year to the lowest level in 10 years. The total dollar value of accounting case settlements also fell to the lowest level in the last decade. (For a summary of Cornerstone’s report on 2020 accounting class actions, see Accounting Class Actions Increase and Settlements are More Expensive, March-April 2021 Update.) Cornerstone has also recently reported that, in 2021, SEC enforcement cases involving accounting and auditing decreased and that monetary settlements in such cases fell sharply. See Accounting and Auditing Enforcement was Down in 2021, But May Now be on the Upswing, March 2022 Update.
Cornerstone found that, in 2021, 46 class actions were filed against public companies alleging accounting violations, a 34 percent decrease from the 70 filings in 2020, and the lowest number of new accounting cases since 45 cases were brought in 2012. Only 24 percent of 2021 federal securities law class actions included accounting allegations. Approximately 20 percent of accounting cases filed in 2021 involved special purpose acquisition companies. There were 33 accounting case settlements in 2021, compared to an average of 43 during 2012-2020.
Other interesting points regarding the nature, number, and magnitude of 2021 accounting class actions in Cornerstone’s report include:
Approximately 37 percent of accounting case filings in 2021 referenced reports published by short sellers. Forty-one percent involved allegations of improper revenue recognition, compared to 37 percent and 19 percent in 2020 and 2019, respectively.
In the 46 accounting cases filed in 2021, average market capitalization losses, as measured by the change in the defendant company’s market capitalization during the class period, was $29.4 billion – down from $70.9 billion in 2020, and about two-thirds of the 2012-2020 average. Only one 2021 case alleged market capitalization losses greater than $5 billion, compared to four “mega” cases in 2020.
Thirty-three accounting class actions were settled in 2021, compared to 38 settlements in 2020. The size of the companies settling accounting class actions continued to increase. The median pre-disclosure market capitalization of settling companies in 2021 was slightly over $1 billion, 35 percent higher than the average annual 2012-2020 median.
The total value of accounting case settlements in 2021 -- $755 million – was only about a fifth of the $3.7 billion in 2020. The steep decrease in settlement value in part reflects a decline the number of large settlements; there was only one settlement involving $100 million or more in 2021, compared to six in 2020. Cornerstone also notes that the decline in accounting case settlement amounts was part of a decline for all types of securities law class action settlements.
In 2021, restatements and internal control weaknesses became less popular grounds for accounting class action litigation. Only five accounting cases involving financial statement restatements were filed in 2021, a decrease of 55 from the eleven cases in 2020, and 72 percent lower than the 2012-2020 average of 18. Four of the five restatement cases brought in 2021 included an allegation of internal control weaknesses, roughly consistent with prior years. Overall, however, the number of accounting case filings containing allegations of internal control weaknesses fell to its lowest level in the last ten years; only 18 cases were filed alleging internal control violations, compared to 41 such cases in 2020. In eight of the 2021 control cases, the company had publicly disclosed an ICFR weakness (down from 16 such cases in 2020).
As to the industries that attract accounting class actions:
The greatest number of 2021 cases were filed against companies in the Technology sector (twelve cases), Consumer Non-Cyclical sector (eight cases), and the Financial Sector (seven cases). Consumer Non-Cyclical (which includes biotechnology, healthcare, and pharmaceuticals) was the most-sued sector in 2020.
The number of new accounting cases against companies in the Energy sector increased by 50 percent in 2021, from four cases in 2020 to six in 2021. On the other hand, new Financial sector cases decreased by more than 50 percent, compared to 2020 (from 15 cases to seven).
Companies in the Consumer Non-Cyclical sector settled the most accounting cases in 2021 – eleven cases out of a total of 33 settlements. By dollar amount, the Technology sector had the highest median settlement amount ($13.6 million median value of four settlements), followed by the Industrial sector ($9.4 million median value of two settlements).
Comment: The decline in accounting class actions is somewhat surprising. Two factors may help to explain it. First, as noted above, Cornerstone has also found that SEC enforcement cases involving accounting and auditing matters decreased in 2021. See Accounting and Auditing Enforcement was Down in 2021, But May Now be on the Upswing, above. Although far from universal, some securities class action suits mirror SEC enforcement cases. Therefore, to the extent that SEC enforcement is less active, the plaintiff’s class action bar may be less active as well.
Second, restatements have traditionally been fertile ground for accounting class action litigation. The number of public company restatements has declined for the past six years and fell to the lowest number since at least 2001 in 2020. The drop in restatements is, in turn, at least partly a result of company decisions (motivated perhaps by compensation claw back policies) to correct financial statement errors via lower profile revisions, rather than formal restatements. See Restatements Decline for the Sixth Straight Year, Notching a New Twenty-Year Low, November-December 2021 Update. It is also possible of course that fewer restatements are the result of improvements in financial reporting and fewer errors requiring correction.
Both of these factors may be in the process of reversing. As noted in Accounting and Auditing Enforcement was Down in 2021, But May Now be on the Upswing, above, the SEC’s Director of Enforcement has asserted that accounting cases will increase, and there is some evidence that this is already occurring. Further, the SEC’s Acting Chief Accountant recently warned that companies are treating too many errors as immaterial when they should be filing restatements and reissuing the affected financial statements. See SEC Acting Chief Accountant Warns Against Bias in Restatement Materiality Decisions, March 2022 Update. This warning may increase the frequency of restatements.
Whatever the causes of the 2021 decline in accounting class actions, litigation based on financial reporting errors has not disappeared and remains a real possibility for many public companies. As stated in several prior Updates, accounting issues are a significant line of attack for the plaintiff’s bar, and restatements and disclosure of internal control weaknesses are likely to attract litigation, if they coincide with a significant drop in stock price. The best protection against accounting class action litigation is diligence and care in overseeing the company’s financial reporting.