The involvement of European institutional investors in US-based shareholder litigation is still in its infancy. Only a few have taken the lead or co-lead plaintiff role or collected their share of the myriad of settlements coming down the pipeline each year. The majority are losing out on millions of euros simply because they fail to file a proof of claim form in cases that have reached settlement. One of a few bright spots is the recent corporate governance settlement reached in a direct action against News Corp with a group of Australian, Dutch, UK and US institutional investors (see box).
In addition, European institutional investors have recently sought lead plaintiff positions in high-profile
securities class actions against companies such as Delphi Corp, United Health Group, Pfizer, Parmalat and Merck & Co. Further, in many instances these European institutions teamed up with US-based institutional investors. We hope that this is a harbinger of things to come.
European investors put forward a variety of reasons to explain their historic lack of participation: a fear of the US system of litigation, a lack of familiarity with the leading US firms in this field, a lack of trust as to the motives of some of these firms and misunderstandings about the contingency fee system, pursuant to which class action law firms get paid in the US. Also, there is scepticism about the size and scope of the losses and potential recoveries, both monetary and through corporate governance reforms. That scepticism extends to questioning the wisdom of suing a company in which you still own shares. Lastly, many institutional investors cling to the traditional cultural response that ‘we just don't do that sort of thing in Europe'.
Our answer to the European question of ‘why sue a company (especially in the US) that we own?' is a simple one. For those European investors that see themselves as active engagers, it is a tactical instrument to help achieve their goal of changing corporate behaviour and increasing value. In that sense, dialogue is also a tactical tool. It works in most countries and with a minority of US companies. But when it comes to the majority of US companies, active engagers may have little choice but to consider litigation in the US.
Shareholders in the US have few rights to effect real change in the companies in which they invest. Their votes on shareholder resolutions are non-binding and, except in rare instances, they can neither nominate directors independently of management, nor vote against the management's slate of proposed directors; they can only withhold their support. Recent attempts by the Securities and Exchange Commission to change the director nomination and election process were roundly defeated by organised business. Moreover, the state of Delaware and its judiciary, where the overwhelming majority of US publicly traded companies are incorporated, has historically been very favourable to companies and their boards. Seen in that light, attempts by European investors to initiate a dialogue would, at many companies, risk being soundly rejected.
est it be forgotten, when a securities class action is pursued, those who bear the brunt of the losses that gave rise to the case are the ultimate beneficiaries. Ergo, the ultimate responsibility of these institutional investors is their fiduciary duty to pensioners, savers and unit holders. From that, the response of European institutional investors that ‘we just don't do that sort of thing in Europe' raises questions as to whether they are being derelict in their duties of loyalty and care, particularly in the area of filing to collect on settlement claims.The concept of active engagement and responsible investment extends as well to the investee company. Corporate fraud and malfeasance are not just about corporate insiders enriching themselves at the expense of shareholders and other stakeholders.
Three avenues exist to effect corporate governance changes. The first arises through a standard securities class action, where the lead plaintiff can demand governance reforms as part of any settlement. The second avenue is through an independent ‘derivative action'. Derivative actions are utilised where breaches of fiduciary duty occur, regardless of whether fraud or malfeasance may have occurred. In this case, the shareholders move on behalf of and for the benefit of the company itself, which has failed to pursue recovery from the harmful activities of its corporate officers or executives due to conflict of interest.
The third avenue, which is a recent trend, is a direct action by one or a small group of investors regarding a particular issue. The News Corp case is the most prominent example of this type of action. The goal is to secure corporate governance reforms (pay-for-performance plans resulting in deep cuts in executive compensation, for example, are now increasing) to change the future behaviour of the board, its committees, executives and management, such that the governance failure that gave rise to the action is less likely to occur in future. One further advantage is that, because the litigation is done through the judicial system, the settlement and its attendant governance reforms are legally binding. The reasoning behind this approach is readily understandable once the following is clear: contrary to the prevailing mythology, there is little ‘shareholder democracy' when it comes to US corporations. Shareholders cannot nominate their own director candidates independently of management, short of engaging in an expensive proxy fight, nor can they vote against those put forward by management. Their only option is to withhold voting support, with the result that the management slate still wins.
That, along with poison pills and staggered elections, can entrench a board, whose loyalties may primarily be to the CEO and other insider directors. Further compounding the problem is the fact that shareholder resolutions, even when passed by an overwhelming majority, typically have only an ‘advisory' status.
Management may, if it wishes, simply ignore the vote. The only effective redress offered by the regulatory system governing ownership and control is for shareholders to wage what is in effect a full-blown take-over battle, with the associated huge financial and political costs. When confronted by that situation, it should come as no surprise that institutional investors are pursuing corporate governance reforms as part and parcel of securities class actions and derivative actions. They, along with their representative counsel, are winning some major changes. Many changes have focused on the composition of the board, as well as the structure of other groups such as committees.
Corporate governance reforms have included enabling institutional investors to nominate and elect their own board members; splitting of the CEO and chair roles; the creation of specialist board committees composed entirely of independent directors (with strict definitions of independence); and term limits for directors accompanied by non-staggered elections. The limiting or halting of multiple directorships and the removal of shareholder rights plans (poison pill provisions) also feature prominently. Moves to link executive pay to performance have been realised, along with moves restricting stock option awards. Similarly, strict controls against insider trading and related-party transactions are being introduced.
As regards accounting issues, the banning for audit firms of all non-audit work to the company, precluding the provision of personal tax or financial planning advice to any officer or director, and the regular rotation of audit firms have all have been part of corporate governance reform settlements.
S securities class actions have evolved since 1995, when US legislators brought institutional investors, particularly pension funds, into play with the passage of the Private Securities Litigation Reform Act (PSLRA). The origins of the PSLRA lie in the legislative and regulatory reforms passed in the 1930s to respond to waves of corporate scandals. The intention of those reforms was to protect investors, and wider financial market integrity, beginning with the 1934 Securities Act. Critics of the PSLRA have said that some provisions did weaken safeguards against fraud, by tightening the burden of proof requirements for investors, making it extremely difficult for corporate victims to prove wrongdoing.
From this viewpoint, it strengthened immunity for those companies producing false statements - known in the jargon as ‘safe harbours'. On the other hand, a new aspect of the PSLRA encouraged institutional investors to take the lead and serve as the controlling party in shareholder litigation. The new ‘lead plaintiff' provision of the PSLRA intended that the investor or group
of investors with the largest financial interest in the litigation that has come forward to the court would lead the litigation, and not the lawyer who first filed the case. This eliminated what was referred to as the ‘race to the courthouse'. No longer could an investor with very few shares of a company's stock become a lead plaintiff simply because their lawyer was able to file a complaint quickly. Rather, large investors now have time to evaluate their losses and the merits of a particular case.
They bring to the table their attendant power, skills, expertise and resources to control better the process and outcome. They have the ability to best represent the interests of the class, determine corporate governance measures, negotiate a settlement, or go to trial (though that is very rare). In addition, they have been very successful in significantly reducing attorneys' fees, leaving more money to the class.
Since the passage of the PSLRA several trends have emerged. The number of cases filed each year has risen, from 110 in 1996 to 268 in 1998, with an annual average of 212 in the post-PSLRA period. In line with this, 217 cases were filed in 2004. Curiously, 2005 saw a drop to 176 in the number of cases filed, and filings have been down in the first half of 2006, but commentators have cautioned against seeing this as a trend to less corporate malfeasance and fraud.It could merely be the result of the market recovery. While the vast majority concern US-domiciled companies, non-US-based companies are increasingly involved. In 2004, 29 foreign-based companies were the subject of shareholder litigation, and 22 of these involved allegations of egregious accounting irregularities and fraud. That is the highest number of such cases ever recorded, and is now proportionate to the number of foreign companies listed on US securities exchanges.
Furthermore, the Parmalat fraud - standing at $17.2bn (€13.6bn) - is bigger than that of Enron, and is often referred to as ‘Europe's Enron'. As to the companies involved, they include many European corporations, as well as companies in China, Canada, Mexico and elsewhere. Investor losses also have risen to record levels. In 2004, the median market capitalisation loss for the defendant company reached $340m a case. Through just the first six months of 2005 that figure rose to $416m a case, representing a six-fold increase in the investor losses as compared to 1996.
The other side of the coin is of course settlements. Prior to the passage of the PSLRA, settlements averaged $5m a case with very few ‘mega-settlements'. By 2003, the average had risen to $23.2m, a 20% increase on the preceding year, rising again to reach $27.1m in 2004. That translates into a mean recovery for institutional investors of approximately $280,000 a case, a significant return. As of the end of June 2006, there was in excess of $15bn in settlement funds awaiting distribution to claimants. Investors only share in these recoveries if they file timely claim forms.
nclaimed money does not disappear or lie unclaimed; it is disbursed to those who do claim, thereby raising their financial returns. That, however, will be of scant reward to those continuing to miss out.
European institutional investors may wish to take a keen look at a particular class action suit, launched in January 2005, against 40 US mutual fund managers. Among other claims, they alleged that the funds had foregone up to $2bn by failing to file settlement claims, and further alleges that this was in breach of their fiduciary duties. Support for the case is derived from the Delaware Chancery Court ruling in the Caremark Derivative litigation. Specifically, the chancellor's ruling stated that directors had a duty to make "... a good faith judgement that the corporation's information will come to its attention in a timely manner as a matter of ordinary operations". By extension, by failing to make this good faith judgement, a fund or pension manager could be "... liable for losses caused by non-compliance with applicable legal standards".
While these actions were subsquently dismissed for a variety of reasons, the ramifications of a successful outcome of such a case would be enormous, given that an estimated two-thirds of institutional investors currently forego the right to file claims in securities class action settlements. It is clear that all institutional investors are beholden to, at a minimum, collect on existing settlements as a part of their fiduciary responsibilities. This type of case simply highlights the importance of diligence with a fund's procedures in tracking securities class action cases.
A new trend in shareholder litigation is to require that individual officers and executives, who are seen as particularly culpable defendants, pay part of the agreed-upon settlements from their personal coffers, as opposed to allowing insurance to foot the bill. This trend acts as a more significant deterrent than just having the defendant corporation or insurance policies pay for the settlement.
Of all the issues associated with participating in shareholder litigation, probably the most confusion arises when discussing the real costs for institutional investors, especially as lead or co-lead plaintiff. As to the financial costs, depending upon the counsel you select, typically they are borne up-front by the lead law firm throughout the process. These costs include hiring investigators, forensic, accounting and damage experts, and all other expenses related to litigating the case. The law firms receive their fees if, and only if, they win the lawsuit or achieve a settlement.
There are, however, minor administrative costs for pension funds and other institutional investors. They vary according to the issue, and complexity of the case. For example, having a specialist firm monitor a European institutional investor's US portfolio simply requires a written request to that effect being conveyed to its custodian bank. Thereafter, fees for the advice offered by law firms regarding whether or not to seek to take a leadership role in applicable cases as they arise, along with the settlement claim service on offer, vary according to the particular firm.
Becoming lead or co-lead plaintiff does extend the administrative
costs since documentation must be produced and reviewed and portfolio managers or analysts may have to sit for a deposition. However, some US law firms will provide a full back-up service to ease the burden, including supplying staff with expertise in document recovery and other matters of interest.
By playing an active role in monitoring the litigation, pushing for a higher settlement, obtaining corporate governance improvements and negotiating a competitive fee agreement with lead counsel, institutional investors can produce benefits for themselves in the litigation that will more than offset their costs. In addition, out-of-pocket costs, such as travel expenses and fees of special advisers or independent evaluation counsel, can be reimbursed from the settlement fund upon court approval.
This article is extracted from US shareholder litigation - a primer for European institutional investors, written by Roy Jones, a consultant, Darren J Check Esq, a partner and director of institutional relations at Schiffrin & Barroway, a US-based law firm, and Daniel Summerfield, senior adviser on responsible investment at the Universities Supperannuation Scheme in the UK