With power comes responsibility

The front page of the Australian Financial Review on July 28, 2006, proclaimed that: “Institutional investors are joining a wave of class actions against listed companies, spearheading a push by aggrieved shareholders to pursue legal avenues to recover their losses.”

The role of institutional investors in shareholder class actions is not new, as it has been established in the United States since at least 1995. However, the US experience is now of interest in Australia due to institutional investors being courted to participate in shareholder class actions.

This raises questions about why are institutional investors so attractive to class action promoters, what does the class action offer the institutional investor, and what role will institutional investors play going forward?

The US experience of institutional investors and securities class actions

In 1995, the US Congress enacted the Private Securities Litigation Reform Act (PSLRA), which resulted in mandatory procedures for the appointment of a lead plaintiff in securities class actions.

VIEW ALL

View all

In general, PSLRA created a presumption that the “most adequate plaintiff” was the claimant with “the largest financial interest” in the suit.

The lead plaintiff provisions were adopted with the expectation that a class member with a large financial stake and who had been a sophisticated user of legal services would actively monitor the conduct of a securities class action, so as to reduce the litigation agency costs that may arise when class counsel’s interests diverged from those of the shareholder class.

The lead plaintiff also has the responsibility of selecting or dismissing counsel, which can be used to force meaningful negotiations regarding fees. The plaintiff lawyer in a class action is paid through either a contingency fee or on a common fund approach being a share of the total recovery.

The institutional investor was encouraged to take the lead in securities class actions so as to prevent lawyer-driven suits. In particular, the US was concerned about ‘strike suits’ — where lawyers with pre-existing arrangements with small shareholders would commence suit in the hope that a corporate defendant would settle the case because it was cheaper to pay the settlement than incur the costs of defending the matter.

In the US, each party bears their own costs in litigation, so even a victory for the defendant would be expensive.

The involvement of an institutional investor was expected to result in more favourable settlement terms for class members, lower legal fees, fewer strike suits or other unmeritorious litigation, more adjudications of class actions, improvements in corporate governance and greater deterrence of securities fraud.

The institutional investor was expected to be more discerning in terms of the suits they joined, thereby ensuring that only legitimate claims were pursued and that they would take an active role in the conduct of the suit.

The government sought to align institutional investors’ financial interests with the public interest in a legal system that redresses real wrongs for the benefit of those harmed.

One view on the impact of the PSLRA is captured by an empirical study by NERA Economic Consulting, Recent Trends in Shareholder Class Action Litigation: Beyond the Mega-Settlements, is Stabilization Ahead? (April 2006) which found:

“One of Congress’ major goals for the PSLRA was to involve institutional investors as lead plaintiffs. In this the PSLRA has been effective, though the effect has taken time. In 2000, 14 per cent of settled cases had an institutional lead plaintiff.

“In 2005, the figure was 38 per cent. Controlling for other case characteristics, cases with an institutional investor lead plaintiff settle for a statistically significant one-third more.

“It is possible that institutional investors are more likely to choose to be involved in cases with greater merit, although we are controlling for other easily observable features of the suit. Alternatively, institutional investors as lead plaintiffs may retain more effective counsel, supervise counsel more effectively, and provide an independent contribution to strategy.”

The settlements that have been achieved with institutional investors as the lead plaintiffs include US$6 billion from Worldcom, US$3.5 billion from Cendant Corp, US$2.6 billion from AOL Time Warner and the Enron litigation where recovery of more that US$7 billion has been achieved to date. However, in Enron one has to query whether the institutional investor reduced legal fees when, according to The New York Sun, class counsel earned US$690 million in fees and the case may yet go to trial.

However, for each of the headline grabbing settlements there are still many cases without institutional investors at the helm — 62 per cent according to NERA.

The reasons for non-participation are numerous. Institutional investors don’t participate in litigation because it is not their area of expertise — their skills are in fund management or investment decisions. Litigation takes up management time, so there is an opportunity cost — could the resources be better spent on the main business?

Institutional investors can avoid many of the costs set out above and still recover by simply being part of the class and free-riding on others’ efforts.

Some institutional investors don’t participate in class actions at all because the companies they invest in are also their clients. For example, banks and insurance companies hold investment portfolios but also want corporations to use their services.

The institutional investor who retains the investment in a going concern entity on which they have lost money has a dual role as investor and shareholder. Resources used to defend a class action or to fund a settlement or adverse verdict reduce the resources within the entity that could be directed towards dividends or investments that increase the share price. The institutional investor effectively funds their own payout from the litigation. Of course, funds are also diverted to paying the lawyer’s fees.

The frequency of securities class actions in the US has seen some institutional investors adopt litigation guidelines that consider the above factors, so as to guide decision-making. It remains an unanswered question as to whether institutional investors have served the public interest that Congress had in mind. It is clearer that institutional investors will decide how and when to participate in securities class actions based upon the financial incentives they face.

What role is there for Australian institutional investors in shareholder class actions?

Shareholder class actions are still in their infancy in Australia, compared to the United States.

Nonetheless, the incentives that Australian institutional investors face will influence the role they play in shareholder class actions.

The Australian litigation costs regime provides an inducement for a well-resourced institutional investor to avoid the role of lead plaintiff (or representative party in Australian terminology) in a class action.

Generally, a losing party is liable for the other side’s costs. However, in the class action context that is limited to the lead plaintiff only and does not apply to other group members.

Consequently, institutional investors can place themselves in a win-win situation by not being the lead plaintiff because they will recover if the lead plaintiff succeeds but will not be liable for any costs if the lead plaintiff is unsuccessful.

In Cook v Pasminco [No 2] (2000) 107 FCR 44, the Federal Court in dealing with the choice of an undischarged bankrupt as the representative party, observed that if “one prospective representative party is a person whose means appear to be sufficient to meet, wholly or partially, an adverse costs order, while another is almost insolvent. Solicitors are not subject to any legal or ethical obligation to choose the former”.

The advent of litigation funding changes the above calculus as the funder may indemnify a lead plaintiff for any costs orders against the lead plaintiff and pay the legal costs of the suit in exchange for them bringing the class action and paying a percentage of their recovery to the funder.

The financial risk of an adverse cost order is ameliorated for the institutional investor but they must be prepared to pay the funder 30 to 40 per cent of any recovery.

Australian institutional investors, like their US brethren, face opportunity costs and the direct costs of a slice of any recovery. The institutional investor may avoid having to share its recovery under the opt-out class action procedure that exists at the Federal level and in Victoria, because the institutional investor is automatically part of the class action unless they take steps to actively exclude themselves.

As a result, if a funder brings an action for some shareholders, all of the shareholders benefit. The institutional investor can free-ride and so may be better off simply monitoring class actions against their investments and only coming forward once there are funds to be distributed.

Of course, if all class members try to free-ride, there would be no class action.

Indeed, institutional investors’ mass of shares may be critical to making a class action economical to run. Institutional investors are attractive clients for litigation funders because one funding agreement captures a large number of shares and their associated potential recovery. A litigation funder must expend much more effort to obtain funding agreements covering a sufficient number of shares when they are held by individual investors. Consequently, an institutional investor may make or break a shareholder class action.

The advantages are not all one-sided.

The litigation funder can substantially reduce the risk of pursuing litigation, can monitor the lawyers (but someone still has to monitor the funder), and marshall expertise on the prospects of success. As institutional investors obtain more experience with shareholder class actions, their position of strength may allow them to negotiate more favourable funding arrangements. The institutional investors may be able to choose between funders. Perhaps some institutional investors will become litigation funders.

If the institution has a strong case with large claims at stake, it may be worthwhile to expend the resources of taking on a more active role to maximise returns by retaining their own lawyers and either pursuing the class action directly or only suing on their own behalf. The latter course may be necessary if their interests diverge from other group members.

However, the additional weight of numbers and the media attractiveness of the out-of-pocket small investor may allow the institutional investor to bring greater pressure to bear for a substantial settlement. The visibility of a class action is far greater than commercial litigation between two corporate entities.

Power and responsibility

As in the US, it’s financial incentives that will determine the role that institutional investors play in shareholder class actions.

Accordingly, institutional investors must give careful consideration to whether a law suit has merit, whether a class action is the appropriate litigation vehicle, if a law suit may cause unintended harm to beneficiaries such as when the class action bankrupts the defendant causing shares to be worth even less, whether being the lead plaintiff is sensible, whether litigation funding is desirable or an unnecessary expense.

The institutional investor, even if indemnified against costs by a funder, must factor in the Australian costs regime because it provides different incentives for defendants than the US system.

A successful defendant can recover a proportion of their costs, so there is a greater incentive to fight litigation with the result that the litigation may be more drawn out, discovery will take place, expert witnesses to prove, and quantify losses will be necessary and cases may go to trial. The institutional investor may therefore face larger opportunity costs and greater intrusion into their business.

Although Australian institutional investors have not been co-opted into the role of lead plaintiff by government to pursue matters of the common good, the institutional investor may still take on a pseudo-regulator role.

Their decisions may determine if a class action goes forward, whether conduct is placed under the bright light of litigation and associated media coverage, whether pressure is exerted on governments and regulators to take action.

With power comes responsibility. The pseudo-regulator role should not be overstated, as a Federal Court class action only needs seven people to be able to be commenced.

Nonetheless, institutional investors are influential entities and their participation will give a class action credibility. Whether that remains the case depends on how judicious institutional investors are about the selection of class actions they participate in.

Michael Legg is a senior associate in the Litigation and Dispute Resolution Group at Clayton Utz specialising in securities class actions. He was previously a class actions lawyer in New York. Zein El Hassan is a partner in the Financial Services Group at Clayton Utz.