Fund Directorsí Responsibility for Securities Litigation - February 2013 Print E-mail
Written by C. Meyrick Payne (MPI) and W. Edward Massey (NexGenCos LLC)   

When the Portfolio has Suffered a Loss Due to Fraud

     Fund directors often think of the plaintiff’s bar as the enemy and class action lawsuits as the bane of their existence. However, when a securities fraud causes a demonstrable loss in a fund’s portfolio, the resulting class action and the decision whether or not to take direct action sometimes represents a sizeable fund asset in the form of an eventual settlement. This bulletin discusses five questions that fund directors should ask themselves about this potential asset and how best to pursue restitution.

     Joining in a class action is automatic: if the fund purchased shares during the class period it is in the class.   The work involved is slight and the fund manager has a fiduciary responsibility to claim whatever recovery accrues.  The benefit, however, is often relatively insignificant. With a class action lawsuit, the fund essentially neither chooses the law firm with which to work, nor negotiates the fee.  The court decides. On the other hand, a fund complex may very well own enough shares to become a candidate for lead plaintiff and the law firm it chooses to be a candidate for lead law firm. Few funds choose this role because they dislike the resultant publicity. When a fund chooses to “opt-out” of the class and pursue its own direct action,  the fund chooses its own law firm, negotiates its own fee, and can maximize its potential recovery from the loss. On the other hand, the irritant effect on the defendant is substantial, and that is a consideration for a fund complex, especially where the defendant is a money-center bank which, in some way, may control a portion of the fund’s distribution channel.

     The fund’s decision to opt-out of the class action and pursue a separate settlement will depend upon the cost-benefit analysis discussed below, but first comes the selection of a law firm to represent you and others who chose to opt out. Your first concern may be to ensure that you are not letting a “fox into the hen house”.  Fears about welcoming a plaintiff’s bar law firm into your organization can be addressed by contract and ethics, particularly to ensure that proprietary trading secrets will never be divulged.

     On the subject of fees, the potential client has great latitude.  Usually the firm will propose a pure contingency, ranging from 8% to 35% of recovery, depending both on amount of potential recovery and the stage at which the settlement may be reached. Alternatively you may enter into a retainer arrangement where the law firm acts as a consultant on several potential litigations. Such an arrangement can either be with or without expenses. In some ways MPI has come to see such a review of potential actions as similar to the services often used by fund complexes to evaluate proxy votes that accrue as a result of owning securities in the portfolios. 

     Deciding to opt-out of a class action involves a well-reasoned cost benefit analysis. After ensuring that the statute of limitations has not run out, first develop an estimate of damages by analyzing the size of the holding, estimate the losses (either by using internal resources, or asking the plaintiff’s firm with whom you are working, or retaining a specialized consultant). Second, estimate the recoverable damages after taking counsel’s recovery split into account. (Reviewing this estimate and its methodology should be considered an important element of the selection process for the law firm under consideration). Third, conduct a critical assessment of the merits of the case, particularly the indicia of fraud, the simultaneous activity of regulatory or enforcement authorities, and the likelihood of proving the case. Fourth, estimate the delta between staying with the class action and opting out. Settlement is the most likely outcome for both the class action and the opt-out scenario.  Settlement most often occurs because the defendant recognizes that a trial will likely result in a worse situation from their point of view or that the costs and effort involved are too much of a distraction from their regular business. The existence of a separate opt-out case compounds the defendant’s dilemma.

     Opting-out represents additional work for the manager. Most of this falls on the general counsel’s office. However some of it will inevitably impact portfolio management, fund accounting and even custodial services. Since this effort will have little to do with managing portfolio assets today, another factor in making the decision is a clear plan for minimizing the distraction to executives central to the current operation of the business. In spite of the additional work, potential direct securities’ actions are a potentially significant asset of the fund.

     Like so many managerial choices, the best are made when everyone can agree ahead of time what constitutes success. In particular, what contingencies are acceptable if a case goes on for longer than expected or a less than hoped for outcome becomes available. Significant improvements, however, over the class settlement have historically been achieved. The ACE Report1 cites three examples: in the WorldCom case opt-out plaintiffs received 83% more than if they had remained in the class; in the AOL-Time Warner case they recovered 71%–83% of their losses (which translated into a recovery of 16-24 times the class) and in the Qwest case the opt-out participants recovered more than the entire class (for some participants that was 32 times as much as what they would have received in the class settlement.)

     A possible outcome is a counter-claim that could reverse the entire logic stream and end up damaging the very shareholders for whom the action has been taken. In addition, damaging facts, documents or emails may come to light, especially if the firm’s document retention policies have not been followed. Potential witnesses may prove unreliable or not credible in depositions or trials. The company against which the action is taken is certainly not going to be pleased and may take some deliberate or incidental retaliatory action. Clearly these adverse reactions are much less likely in a class action than in an opt-out situation.


     Recovering potential damages in securities litigation is a complex legal and business decision in which the fund directors have an interest because these recoverable damages represent an asset of the funds they govern. 


 [1] ACE Report (D&O Newsletter), No. 69, November 2008.


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