January 10, 2011
M&A Securities Class Actions Take 2
Here is something that ISS’s Luke Green recently blogged:
Securities Litigation Watch has recently noted that securities class actions related to M&A activity have been skyrocketing since 2009. And, as Advisen’s most recent Q3 report observes, breach of fiduciary suits filed in state court are the “raging bull of the year thus far,” constituting “approximately a third of all new security suit filings in Q3 2010.” Commentators have argued that the growth of M&A breach of fidcuiary suits is largely due to plaintiff’s attorneys seeking new revenue streams as securities class action suits decline. But, a brief analysis of economic conditions relating to M&A activity seems to indicate that other significant factors may be fueling the M&A class action trend.
To understand where we are today in terms of the surging numbers of M&A class actions it may help to start first with an analysis of the supply and demand forces at play during the credit crisis. Throughout 2008 strong companies became increasingly pessimistic as the U.S. sunk into the depths of recession. Faced with a frozen credit market and plummeting consumer spending, these companies were incentivized to change their growth strategy from horizontal and vertical integration to organic growth based on their core strengths, or to rightsizing their cost structures in anticipation of reduced economic activities. Honest corporate executives aspired to make their quarterly numbers by applying traditional conservative growth strategies: efficiency through lean production and reduced staffing, focusing resources on core competencies, and cutting costs. While these companies turned their attention inward they also began storing up cash reserves and planning for the worst.
As a result, not only did a panicked lending industry freeze credit, corporate buying dwindled resulting into an all but non-existent M&A market. Private equity firms, which account for a significant portion of M&A in a normal market, generally withdrew from the deal market as well. Meanwhile, on the M&A supply side, the ranks of the less fortunate swelled as reduced revenues and lack of credit exposed weaknesses in companies that otherwise prospered during better times. Because of the broad nature of the recession, buyers were few and far between for the mounting number of distressed companies. But, even if there were potential buyers for these companies, sellers were reluctant to sell for fear of being underpriced in a hyper distressed stock market.
Fast forward to November 2010. What has changed? The aching back of a deep recession is still all too familiar. And, times are still tough for many. But, there are signs of positive change. Christopher Lisle of Acclaro Growth Partners reports that, as of September 2010, GPD growth has averaged 3.5% since mid-2009. During the same time period half a million private sector jobs were created. Furthermore, credit markets are beginning to thaw. Lisle estimates that private equity firms have as much as $450 billion in cash sitting on the sidelines that they stored up during the boom years but now must use before they have to give it back to investors. Buyer confidence in corporate stability appears to be on the rise as well. Jeremy Gaunt of Thompson Reuters reports that the price for investment grade corporate bonds is on the rise while the cost of insuring U.S. and European investment grade debt is going down. Typically, the accelerated purchase of these securities indicates investor confidence that companies will not be damaged by what Gaunt refers to as “U.S. slowdown and contagion elsewhere.”
The link between increased M&A activity and thawing credit markets, cash-rich U.S. corporations and increased investor confidence appears compelling. Thompson Reuters reports that worldwide M&A deals reached $267 billion in August, which was the most active August since 1999. The StarTribune reports that the first half of 2010 is the best half for M&A since 2007 with a 49% increase in the first half of 2010 from the same period in 2009.
With credit available to those who qualify at pre-2008 prices, companies with the ability to buy are in a position for strategic growth. And, as the economy has stabilized, buyer confidence has risen as reliable economic forecasts are becoming more realistic. In addition, many of these companies toned their infrastructure and core businesses during the darkest parts of the recession while storing up cash reserves along the way. For these fortunate shoppers the M&A store shelves are stocked with candy. Many companies suffered more than they could bear during the recession and have not yet fully recovered. Others are drawing ever closer to insolvency (Advisen observes that bankruptcies in Q1 2010 jumped significantly from the already high numbers in Q1 2009). Thus, these weaker companies are looking for an exit strategy. M&A, while not always the most attractive option, is at least an option. Now that both buyers and sellers are more confident that available credit can ensure that M&A deals will close, the scales are tipping in favor of M&A.
M&A activity seems to be surging on the coattails of a recovering economy. M&A related securities class actions are also surging. Are these trends cause and effect? It appears very likely that the same forces driving M&A activity in general are also driving M&A securities class actions. Most of the M&A suits are breach of fiduciary duty suits (Advisen reports that they accounted for 33% of all securities suits filed through the first three quarters in 2010). More often than not these types of suits involve shareholders who are upset that their board is selling at depressed prices. Allegations often include self dealing on the part of the board, especially where change in management incentives and compensation are involved. So, companies hard hit by the recession are looking for a way out. Boards and executives who have little hope of improving their numbers any time soon are looking for a way out. With limited options, M&A is an alternative, albeit one that investors whose stocks have taken a severe beating are reluctant to embrace. It is the perfect storm for breach of fiduciary suits.
The trend toward increased M&A activity and an increasing number of M&A securities class actions appears likely to continue. The rebound from low transaction volumes seems to be in full swing as credit markets improve and management/board confidence remains positive and stable. But, the true longevity of the trend is anyone’s guess. A relapse into recession would demoralize investors and restrict credit flows again, which would almost certainly tighten the noose on M&A activity. For the time being, however, slow and steady economic growth out of an economic trough seems to be the recipe for rising M&A securities class actions.