July 25, 2023
By Christopher Lometti and Richard E. Lorant
Securities Litigation 101
Shareholder Advocate Summer 2023
In prior articles, we have mentioned the importance of enacting a policy to govern a pension fund’s approach to tracking and managing its securities litigation assets. Today we will focus on a key section of that policy: the criteria for active involvement in a securities lawsuit.
How Private Enforcement by Institutional Investors Promotes Fair and Free Markets
First, some background on what makes the federal securities class action mechanism such a vital tool to enforce transparency and accountability for publicly traded companies in U.S. markets and why active involvement by institutional investors is important to making class actions effective.
Private enforcement of U.S. securities laws through civil litigation provides an important complement to government prosecution by the Securities and Exchange Commission through its civil enforcement and administrative actions, and the Department of Justice, which is responsible for criminal enforcement. Chronically underfunded and understaffed, federal enforcement agencies necessarily focus on the largest, most egregious cases. Moreover, the SEC typically retains money it collects through civil penalties rather than returning money to shareholders. When the SEC does reimburse defrauded investors directly through its Fair Fund, its disgorgements are dwarfed by the amounts recovered through private securities class action settlements; the top 50 Fair Fund disgorgements totaled $11.5 billion, about a fifth of the $56.8 billion recovered by the 50 largest securities class action settlements.
Likewise, a class action mechanism that allows parties with similar claims to pursue damages collectively is essential because the vast bulk of individual securities losses are “negative claims” too small to pursue alone: the cost of hiring an attorney exceeds the value of the potential award or settlement. This is true even for most institutional investors, which explains why only a small number of frauds generate the kind of massive losses required for big pension funds to opt out of class actions to seek their own settlements. Without class actions—and the contingency fees that make them economically feasible for plaintiffs’ lawyers—most frauds would simply go unpunished; all but the very largest shareholders damaged by the very largest frauds would absorb their losses as part of the cost of investing in public markets. It’s noteworthy that, while most countries outside the U.S. have prioritizedsending corporate fraudsters to prison above compensating investors, that is changing. The European Union, for example, is instituting rules to facilitate collective actions in all member nations.
As further context when considering involvement, it is also important to remember that the emergence of institutional investors as lead plaintiffs following passage of the Private Securities Litigation Reform Act of 1995 (PSLRA) has benefited all shareholders. Numerous academic studies show that cases led by sophisticated institutional investors have better outcomes, bigger recoveries, and lower attorneys’ fees than those led by individual investors on average, even when controlling for case size. In fact, at least one study found that the involvement of institutional lead plaintiffs has lowered attorney fees for all shareholder lawsuits, since judges often look at similar-sized cases when deciding on fee awards. These improved results argue for pension funds to continue to selectively pursue meritorious litigation for their own benefit—and for the greater good.
Case-by-Case Factors to Consider for Active Participation as Lead Plaintiff
So, what factors do funds consider when deciding whether to file a lead plaintiff motion? As in all fiduciary and policy-related practices, one size doesn’t fit all. But what follows are some general concepts.
An analysis of whether to actively pursue a case begins with the size of a fund’s initial loss and potential damages, both as an absolute number and relative to other potential lead plaintiff movants.
Funds who have a securities litigation policy often identify a minimum dollar loss (i.e., “loss threshold”) to consider active involvement in meritorious litigation. This loss threshold, whether firm or flexible, will help fund staff determine if its loss is large enough to warrant spending time on the litigation, since class actions allow absent class members to wait until there is a recovery to file a settlement claim. Consulting with monitoring counsel will also give the fund an idea whether its loss is outsized compared to other funds that are likely movants.
The PSLRA directs judges to select the movant with the largest loss as lead plaintiff, so long as it is a typical and adequate class representative, so calculating the initial loss amount is relatively straightforward. The initial complaint will identify a purported class period based on corrective disclosures—moments the stock price was materially affected because defendants allegedly misled investors or failed to publicly disclose information they should have under the law. Movants then sum up their losses during the class period, typically using the last-in-last-out (LIFO) or first-in-first-out (FIFO) method relied on by most courts.
It’s impossible to determine, at the outset, how much the involvement of any one fund as lead plaintiff will increase the recovery. Finally, while many judges reimburse lead plaintiffs for time spent on their litigation duties, such awards are not guaranteed. Unfortunately, it’s also impossible to predict the final recovery amount, or even the recoverable damages, at this stage of the litigation; those issues are subject to judicial rulings, expert testimony, and the evidence produced in discovery. But the initial case analysis may provide an inkling of potential settlement size based on the overall damages, the legal strength of each corrective disclosure, and the timing of the investor’s class period purchases and sales. It also may identify a legal claim that wasn’t included in the initial complaint, such as a purchase in a particular stock offering, or an additional alleged corrective disclosure. If appointed Lead Plaintiff, the fund could assert these additional claims in an amended complaint, thus increasing the value of the case.
Securities litigation policies also identify non-financial factors to consider when deciding whether to act as lead plaintiff. Those factors include:
- The value of ensuring that the litigation is well managed and efficiently handled, especially if the fund has large potential damages.
- The ability to negotiate the settlement amount.
- The opportunity to incorporate governance improvements at the settlement stage.
- The desire to police egregiously unlawful behavior, deter future fraud, and protect market transparency.
- The ability to negotiate attorneys’ fees.
- The chance to serve as a positive example of shareholder involvement for institutional investors, which the PSLRA has charged with leading such actions.
- The interest in sharing the responsibility of serving as lead plaintiff among like-minded institutional investors to ensure that the U.S. class action system continues to function efficiently as an enforcement mechanism.
In addition, it is important to remember that certain lawsuits, such as shareholder derivative class actions, do not directly return money to investors. These lawsuits primarily address breaches of fiduciary duty by corporate leaders who have exposed systemic, harmful governance and cultural practices that harm long-term shareholder value. As fiduciaries, pension fund trustees should consider some or all these policy issues when deciding whether active participation in litigation is warranted.