Institutions Take Lead On Securities Suits

More institutional investors are using securities class-action lawsuits to seek compensation and changes in corporate governance–a trend risk managers need to keep in mind when renewing policies.

Buoyed by changes in federal law in 1995, investors are leading more cases than ever before. This is driving up settlement values and the amount of motions, discovery and other tools used to pursue a case. The result is dramatic–institution-led cases now settle for multiples over those led by individual plaintiffs.

The Private Securities Litigation Reform Act of 1995 (PSLRA) provided that the plaintiff with the largest financial interest in the outcome of a securities class action is presumed to be the most adequate lead plaintiff in the case.

The theory was that the party with the most at stake is fairly poised as the driver and strategist in the case. Most often the party with the largest financial interest is the institutional investor, representing a host of investors with an aggregate investment that far overshadows those of individual shareholders.

Institutional investors were viewed as better equipped than individual shareholders to pursue actions on behalf of a class, for a variety of reasons, such as:

o The institution would be less interested in filing frivolous actions, mindful of the time and expense to the institution.

o It would be well-equipped to actively pursue meritorious cases given the institution's financial resources and access to professionals such as attorneys and financial experts.

o The institution also would be more likely to resist faster, less-robust settlements, and instead would stand firm and pursue recovery of the highest returns, in view of its fiduciary responsibilities to its investors.

As a result, after passage of the PSLRA, expectations were that the individual shareholder would be lead plaintiff in fewer suits, and that the institutional investor would be lead plaintiff in many more. It worked. After a slow start following PSLRA enactment, more cases are prosecuted by institutional investors than ever.

In the first year following passage, institutional investors served as lead plaintiffs in only eight out of 105 filed cases, according to a study by the Securities and Exchange Commission.

In the three years following passage, union and pension funds served as lead plaintiff in a mere 4.8 percent of the cases, according to a recent study by PricewaterhouseCoopers, “2005 Securities Litigation Study.”

By 2005, institutional investors were lead plaintiffs in 38 percent of cases filed that year, according to an NERA Economic Consulting study. It appears those who predicted more and more cases would be led by institutional investors on account of the dynamics created by PSLRA were correct.

The cases managed by institutional investors also seem to result in a higher level of work by counsel and better financial results, as measured by the volume of litigation activity within a case, according to a recent study by Michael Perino–”Institutional Activism through Litigation: An Empirical Analysis of Public Pension Fund Participation in Securities Class Actions.”

This study examined the total number of docket entries, such as filed motions, in a sampling of cases. It found that cases with pension funds as lead plaintiffs show more litigation activity than those without the pension funds as lead plaintiff.

The study also showed that the ratio of settlement value to the number of docket entries suggests the increased amount of attorney work resulted in higher recoveries.

Hence, the study suggests that institutional investors are able to fund and manage counsel to a relatively higher level of productivity that yields proportionately better financial returns.

Moreover, the institutional investor lead plaintiff is getting larger recoveries than individual shareholders in that role. The mean settlement of a case involving a pension fund is $376 million, in contrast to $21 million for a case not led by a pension fund, according to the study.

A case settles for one-third more when led by an institutional investor, according to the NERA Economic Consulting study.

These dramatic differences are driven at least in part by the fact that the institutional investors have pursued some of the largest mega-cases–they were lead plaintiffs in the WorldCom cases (which settled for $6 billion); Enron (which settled for $7 billion); Cendant (which settled for $3.5 billion); and AOL Time Warner (which settled for $2.6 billion).

In the decade since passage of PSLRA, it appears the institutional investor has taken on the responsibility of lead plaintiff in a growing number of cases. In more than one-third of securities class-action cases filed, boards and companies now have to reckon with the formidable foe of the institutional investor, rather than the more removed and less resourceful individual investor.

Executives and companies sued can expect higher settlements and more active prosecutions than ever before, resulting in an even greater drain on time and resources.