Leaving clients’ money on the table
Fund managers risk lawsuits by failing to claim
Fund
managers who have quietly registered their disapproval of shareholder lawsuits by choosing not to participate in recoveries from securities class actions have long been exposed to investor complaints. They in turn have often shifted the blame to custodians for not informing them about, or assisting them with, such suits.
Both should be very careful in future about leaving other people’s money on the table because complaints may soon turn into class- action lawsuits alleging breach of fiduciary duty.
Make no mistake, the stakes are substantial. In 2004, the total value of all securities class- action settlements in the United States was US$5.5-billion, compared with US$1.9-billion in 2001. Just in the first quarter of this year, over US$ 4- billion was recovered.
Twenty-nine foreign issuers were sued in private securities class actions in the United States in 2001 — the highest number ever. But for the first time it’s roughly in proportion to the percentage of foreign registrants listed on U. S. exchanges, about 14%. So there’s no reason to think that is about to change.
Because of the size of their equity holdings, institutional investors tend to be able to recoup significant amounts for their clients by simply filing a claim.
Yet an upcoming Law Review article suggests they are failing to do so. The authors found about 70% of fund managers with significant provable losses fail to even submit claims in settled securities class actions.
The result is a greater recovery for those who take part in the process because the settlement pool is distributed to them. But it may be problematic for the people whose money was actually lost.
A second troubling aspect of the survey is the way in which settlement payments received by institutional investors are allocated.
Ideally, the money should be credited to those investors who held interests in particular funds at the time of the loss suffered in proportion to their share of the losses. But rather than wrestle with the complex record-keeping and administrative calculations that would entail, most fund managers who file claims either deposit the recovered money into the portfolio that suffered the loss or credit the recovered funds generally for the benefit of all current investors.
This raises obvious concerns about whether securities class-action settlements are compensating those who were injured by the alleged fraud, and suggests the need for better infrastructure to facilitate the allocation of such recoveries.
Returning to the fundamental issue, there are probably many explanations for why the majority of fund managers fail to submit their claims in settled securities class actions. Some are administrative — for example, mechanical complexity and failures in the notification and record-keeping processes. But more disturbing are those that relate to a distaste on the part of many to participate in a process that is alien and often repugnant to them.
The purpose of this article is not to debate the merits of a global trend toward the private enforcement of securities laws. Past efforts to reign-in class-action litigation in the U.S. have enjoyed limited success. Even as the U.S. President and Congress are considering legislation to curb such litigation, the regulatory reforms contained in Sarbanes-Oxley have spawned new causes of action. Likewise, the 2004 PricewaterhouseCoopers Securities Litigation Survey ( www. 10b5.com) predicts more European Union activity.
In Canada, amendments to Ontario’s Securities Act that become effective at year end will provide investors with a statutory cause of action for issuer misrepresentations or failures to make timely disclosure.
This initiative, heralded as a major component of Ontario’s legislative response to Sarbanes-Oxley and the need to restore investor confidence, may well unleash a new wave of securities class- action litigation and settlements.
Irrespective of one’s views as to the public and social welfare implications of class- action litigation, trustees of pension and mutual funds are held to a standard of maximizing the value of the assets they manage for others.
Custodians are also subject to contractual and fiduciary duties to their institutional clients requiring them to take all cost-justified measures to ensure that their customers receive notice of class- action settlements and, where it is their function to do so, file the requisite claims.
The failure of many trustees, fund managers and custodians to do so suggests an area of significant exposure.
Ironically, those who fail to file claims because they disagree with the class- action system may well attract similar claims against themselves, thereby reinforcing the very system they oppose. If they truly believe the system needs reform, apathy is not a legitimate response.
Rather, such institutional investors and their custodians should become active participants and, thereby, place more pressure on the system to improve.
Financial Post
Edward J. Waitzer is the chair
of Stikeman Elliott LLP.
ewaitzer@ stikeman. com