Let the money do the monitoring: how institutional investors can reduce agency costs in securities class actions.

• Author: Weiss, Elliott J.

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1. Introduction

   Controversy abounds about securities class actions,(1) centering on the fact that attorneys operating on a contingent fee basis initiate most such suits in the names of "figurehead" plaintiffs with little at stake. Some critics charge that class actions are mostly "strike suits" that avaricious plaintiffs' lawyers file with a view to coercing settlements from innocent defendants unwilling to incur the high costs of litigation. Other critics focus on the agency costs inherent in class actions initiated and maintained by attorneys who operate without meaningful client supervision. They claim that when class actions are settled, as most are, plaintiffs' attorneys often shortchange the plaintiff class.

   Plaintiffs' attorneys respond to these criticisms by arguing that they perform a public service and protect innocent investors. Class actions, they claim, constitute a necessary supplement to the efforts of the Securities and Exchange Commission (SEC) to deter securities fraud and provide the only effective mechanism for compensating investors injured by securities fraud.(2) Plaintiffs' attorneys also assert that Rule 23 of the Federal Rules of Civil Procedure requires that courts approve class action settlements and awards of attorneys' fees(3) and assures that class members' interests are "scrupulously protected."(4)

   Committees in both houses of the 103d Congress held hearings on whether new legislation was needed to control class action "abuses"(5) but reached no conclusions and recommended no legislation. The 104th Congress has already begun to revisit these questions.(6) Arthur Levitt, Chairman of the SEC, has argued consistently that "[p]rivate actions are crucial to the integrity of our disclosure system because they provide a direct incentive for issuers and other market participants to meet their obligations under the securities laws."(7) He has opposed legislation that would decimate the effectiveness of class actions, while supporting other changes in the rules governing such actions, "because private litigation imposes substantial unnecessary costs when it is abused by private plaintiffs or their attorneys."(8)

   The agency-cost literature, with its emphasis on the absence of effective protection for class members' interests, first sparked our interest in class actions. We knew that institutional investors own a majority of the stock of publicly held corporations(9) and account for a significantly larger portion of securities trading.(10) It therefore seemed likely that institutional investors had similarly large stakes in most class actions. If so, it also seemed likely that institutions, acting individually or collectively, might be well situated to monitor the conduct of plaintiffs' attorneys as proxies for all members of plaintiff classes.

   We found that institutional investors' stakes in class actions were even larger than we thought. The fifty largest claimants in a large sample of class actions accounted for more than 57% of the dollar value of all claims filed.(11) More significant, the ten largest claimants in twenty class actions for which we were able to obtain detailed claims data accounted, on average, for 40.5% of the dollar value of the claims filed.(12) The largest claimant, on average, accounted for 13.1% and the second largest for 6.7%.(13) Data we gathered from a small group of institutions tended to corroborate these findings. The two largest recoveries received by the State of Wisconsin Investment Board in one recent year represented roughly 13.7% and 20.2% of all amounts recovered by class members in those actions. The California Public Employees Retirement System had recoveries, over a twenty-one month period, that equaled roughly 14.2%, 10.0%, and 6.2% of the amounts recovered by class members in three class actions.(14) Three other large institutions had comparably large recoveries. Moreover, there are substantial differences, often amounting to millions of dollars, between the allowable losses claimed by institutions in class actions and the amounts they actually recovered.(15) This further suggests that institutions could realize substantial benefits by serving as litigation monitors.

   Of course, institutions would likely find such service worthwhile only if, as many commentators claim, excessive agency costs pervade class action litigation. To examine this claim, one must first understand the dynamics of class action litigation and how they relate to the criticisms frequently directed at such litigation. Part II describes the characteristics of class actions that have become the focus of most critics' concerns. Plaintiffs' attorneys, not investors, initiate most class actions. We explain the dynamic that leads plaintiffs' attorneys to file class actions quickly, often within days of the events giving rise to such litigation, and note that virtually all class actions that survive motions to dismiss and motions for summary judgment are settled.

   Part III addresses agency-cost issues. Commentators point out that plaintiffs' attorneys invariably face a choice between maximizing their own income and maximizing the benefits realized by the plaintiff class and suggest that plaintiffs' attorneys often place their own interests first.(16) Moreover, both courts and commentators are skeptical whether courts use their power to approve proposed settlements and award attorneys' fees effectively to constrain attorneys' self-serving behavior.(17)

   We describe two cases that exemplify the problems involved in judicial review of settlement terms and awards of attorneys' fees. Then we highlight three recent cases in which plaintiffs' attorneys agreed to a settlement term that is highly prejudicial to class members whose claims probably represent, in dollar values, more than seventy percent of the claims of the plaintiff classes. Finally, we discuss two criticisms of class actions that relate to these agency-cost issues: Janet Cooper Alexander's claim that virtually all class actions are settled on a formulaic basis that takes no account of the merits of the parties' positions;(18) and assertions, made mostly by representatives of companies in industries that have been frequent targets of class actions, that most class actions are non-meritorious "strike suits." We show that the evidence on which Professor Alexander relies does not support her conclusion. We conclude that the strike suit claim probably has some merit and involves agency-cost issues.

   Part IV addresses the commonly held assumption that no class member has a large enough stake in the typical class action to justify service as a litigation monitor. Our data, referred to above,(19) demonstrate the size of the stakes that institutional investors have had in numerous class actions, and also show that individual investors with small losses recover a very minor portion of the amounts paid out in class action settlements.

   Part V points out that an institutional investor would find it worthwhile to serve as a litigation monitor if it were "lead plaintiff," that is, the class member whose lawyer is designated lead counsel for the class. We describe how judicial practices and interpretation of rules governing selection of lead counsel, provision of notice to class members, and discovery directed at plaintiffs currently make it difficult and unattractive for an institutional investor to act as a lead plaintiff, and how other procedural rules discourage institutions from intervening in class actions and filing objections to proposed settlements.

   Part VI proposes new practices, consistent with current procedural rules, that courts could adopt to encourage institutional investors to become lead plaintiffs. These practices would allow market forces, not courts, to play a dominant role in determining who served as plaintiffs' lead counsel in class actions, how lead counsel would be compensated, and the settlement terms that counsel for the plaintiff class would be inclined to propose.

   Part VII discusses whether institutional investors are likely to participate actively in class actions if courts begin to interpret procedural rules as we suggest. We submit that creation of a litigation environment more conducive to active institutional participation, appreciation of the benefits that might be realized by acting as lead plaintiff, and concerns about liability for breach of fiduciary duty are likely to lead at least some institutions to begin to play a more active role.

   Part VIII concludes by noting that constructive institutional participation also has the potential to alleviate many current concerns about the legitimacy of class action litigation, and thus might increase significantly the extent to which such litigation advances the disclosure policies of the federal securities laws.

2. The Dynamics of Securities Class Action Litigation

   Securities class actions serve a socially beneficial function: promoting investor confidence in the integrity of the securities markets. The SEC has "consistently stressed the importance of private actions under the antifraud provisions of the federal securities laws,"(20) because such actions "ensure that investors have a meaningful right to seek recovery against those who defraud them"(21) and provide "deterrence against securities law violations" that supplements "the Commission's own enforcement activities."(22) In Basic Inc. v. Levinson, the Supreme Court endorsed class actions as necessary to implement "the congressional policy embodied in the [Securities and Exchange Act of] 1934."(23) More specifically, the Court created a presumption that "an investor's reliance on any public material misrepresentations ... may be presumed for purposes of a[n SEC] Rule 10b-5 action"(24) because otherwise the predominance of individual issues would preclude maintenance of class actions to enforce Rule 10b-5.(25)

   Courts sometimes refer to plaintiffs as private attorneys general...