Risky Business: More IPOs Could Lead to More Litigation

Risky Business: More IPOs Could Lead to More Litigation

 Few public entertainers have topped the showmanship of Jean François Gravelet-Blondin. The 19th-century French tightrope walker and acrobat was famous for many astounding feats, including crossing Niagara Falls numerous times—while blindfolded, pushing a wheelbarrow, on stilts and even carrying his American-born manager, Harry Colcord, on his back. (The latter stunt prompted a reporter to remark sardonically that, for once, a manager actually earned his paycheck.)

Blondin’s legacy as an extraordinary funambulist (from the Latin for “rope-walker”) is assured. Indeed, he is considered synonymous with his trade.

His name is also important given the public’s enduring fascination with high-wire acts generally. Those acts evoke such a visceral response that the expression “walking a tightrope” is used in all manner of circumstances, many of which will be familiar to the legal profession.

The endurance test of an initial public offering, for example, is one of those occasions when the analogy seems particularly apt. Like high-wire performers, the principals behind an IPO embark on a tension-filled journey that requires careful balancing of a variety of factors that can limit—or increase—the risk of failure. Moreover, there isn’t much room for error in the process.

In fact, the margin is getting smaller. As more and more companies list under provisions of the JOBS Act, the risk of securities litigation or enforcement actions could increase substantially.

The Risk of Greater Scrutiny

The many ways in which a company could find itself in deep trouble on the tightrope of an IPO are vividly highlighted in recent findings issued by PricewaterhouseCoopers LLC (PwC). Its 18th annual Securities Litigation Study, released in April 2014, comes at a time when more eyes are focused on securities law violations. Regulators are acting on new get-tough enforcement strategies, which is creating added due diligence headaches for eager securities market participants.

But those embarking on IPOs as emerging growth companies (EGCs), as defined by the JOBS Act, may be particularly vulnerable. For one thing, by taking advantage of less stringent auditing and reporting requirements, those companies could be putting themselves at risk of even greater scrutiny.

Size Does Not Matter (in Securities Litigation)

EGCs accounted for approximately 80% of all IPOs in 2013, the PwC study notes. For those that qualify to list under the category, the advantages seem self-evident: an EGC can elect to include two instead of three years of audited financial statements and data, and the requirement to have an external auditor attest to the effectiveness of a company’s internal controls over financial reporting is waived. Other ongoing disclosure and compliance requirements are also less onerous compared with typical IPOs.

Yet those benefits come with a potential increase in risk. “Given the high percentage of both accounting-related securities cases and SEC enforcement actions that cite financial reporting violations and/or internal controls deficiencies, EGCs may be ‘throwing the dice’ if deciding not to have outside specialists attest to the controls over financial reporting,” the study declares.

Nor should newly listed companies believe that they are too small to attract the attention of the plaintiff’s bar. The evidence suggests otherwise. Almost 70% of companies named in securities class-action suits in 2013 had a market cap of less than $2 billion. The numbers were slightly higher than in the previous year, “thus proving that size does not matter when it comes to class-action securities litigation,” the PwC study adds.

Sensible Precautions

A bullish JOBS-era investment market, combined with a tougher post-recession regulatory environment, makes for interesting times.

According to PwC, it means that companies considering, on the verge of or launching IPOs need to pay careful attention to several crucial points, such as ensuring that controls are put in place for financial reporting and the dissemination of information and statements to the public.

Companies should also assess whether they are being sufficiently transparent about past and current financial performance and future prospects.

“A failure to do so,” PwC adds, “may increase the likelihood of subsequent litigation or SEC enforcement actions alleging misrepresentation in publicly filed documents.”

And that’s a tightrope no one wants to walk.

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