Letting billions slip through your fingers: empirical evidence and legal implications of the failure of financial institutions to participate in securities class action settlements.

• Author: Cox, James D.

INTRODUCTION I. THE LITIGATION AND SETTLEMENT ENVIRONMENT II. SETTLEMENT STUDY METHODOLOGY AND RESULTS III. POTENTIAL EXPLANATIONS FOR SLUMBERING A. Sleeping with the Enemy B. A Rolling Stone Gathers No Moss C. Voting with Their Feet D. Who's on First IV. INSTITUTIONAL INVESTOR SURVEY RESULTS V. LIABILITY RULES A. Institutional Investors B. Custodians VI. EASY STEPS TO ENSURE THAT INSTITUTIONS RECEIVE THEIR FAIR SHARE A. Establish a Centralized Information Clearinghouse B. Standardize Trading Documentation and Claims Forms C. Improve Institutional Monitoring of Claims Filing D. Strengthen Institutions' 13F Filing Requirements E. Improve Claims Filing Systems VII. THE SOCIAL WELFARE IMPLICATIONS OF OUR DATA AND SURVEY A. The Mismatch of Injury and Recovery B. Filing Claims Does Matter CONCLUSION INTRODUCTION

In 2004, securities fraud class action settlements produced $5.45 billion in cash to be distributed to defrauded investors. (1) Institutional investors own the lion's share of the publicly traded equity securities in this country and therefore were entitled to collect most of that money by simply filing relatively simple claims forms documenting their trading during the class period. Those institutions that chose to do so recouped large sums of money for their beneficiaries. (2)

However, in a pilot study we published two years ago, we reported that nearly two-thirds of the institutional investors with financial losses in fifty-three settled securities class actions failed to submit claims. As a consequence of this failure, substantial sums that they were entitled to receive were given to others. (3) Using some back-of-the-envelope calculations, one commentator analyzing our results suggested that each year slightly more than $1 billion is left on the settlement table by nonfiling financial institutions. (4) Because we had a small sample of settlements in our study, we could only reach tentative conclusions about the extent of the problem. The pilot study nonetheless portended several disturbing policy implications for securities class actions.

This Article presents the results of a much more extensive investigation of the frequency with which financial institutions submit claims in settled securities class actions. We combine both an empirical study of a large set of settlements and the results of a survey of institutional investors about their claims filing practices. Our sample for the first part of the analysis contains 118 settlements that were not included in our earlier study. (5) The number of settlements examined in this study is, therefore, more than twice as many as we earlier examined. We find that less than thirty percent of institutional investors with provable losses perfect their claims in these settlements. (6)

We then explore the possible explanations for this widespread failure. We suggest a wide range of potential problems, from mechanical failures in the notification and recordkeeping processes to more subtle issues such as portfolio managers' beliefs that only investment activities produce significant returns for their clients.

In order to determine which of these problems were the main culprits, we surveyed institutional investors about their claims filing practices, asking them who was responsible for this task, how they performed it, and what, if any, performance monitoring was done. We learned that most institutions relied on their custodian banks to file claims for them in securities fraud class action settlements, that many of these institutions did little monitoring of whether the custodian actually performed these services, and that custodians had financial disincentives to file claims on behalf of their clients. Nevertheless, virtually every respondent reported that their institution filed claims in all settlements in which it was a class member. Our respondents also identified a number of problems with the claims filing process, including difficulties in learning about settlements, monitoring claims, gathering and compiling information necessary to complete claims, and accounting for payments made after they are received.

Accepting for the moment our empirical findings that many institutions have failed to file claims, should their trustees be liable for this failure? What about their custodian banks that agreed to make these claims for the institutions? If so, what is the appropriate standard of liability that we should apply in this situation? We argue that any such failures should be evaluated as potential breaches of the duty of care consistent with the now invigorated monitoring obligations embraced in Delaware's Caremark decision. (7) Applying this standard to our problem, we believe that the trustees of institutional investors must, in good faith, insure that their fund has an adequate system in place to identify and process the fund's claims. As developed later in this Article, we conclude that Caremark requires institutions to create a monitoring mechanism to insure that this system is adequate, and if they learn it is inadequate, they should take measures to fix the problem. The obligations of the institution's custodians or other vendors are also examined.

Turning to the even broader policy implications of our findings, we identify several discrete problems that can be addressed to help remedy the current situation. First, we believe that the federal courts should create a centralized information clearinghouse or website for settlement notices, claims forms, and other information about securities fraud class action settlements. This information resource would greatly facilitate institutions' learning about settlements and obtaining the materials that they need to file claims. Our first recommendation should also help to improve monitoring by the institutions themselves or, alternatively, to encourage institutions to hire third-party claims monitoring services. Second, the federal courts could also mandate the creation and usage of standardized claims forms and trading documentation. Again, this would facilitate the claims filing process. Third, we think that institutional investors that contract with their custodians to handle their claims filing need to improve their monitoring of the process. Fourth, we believe that the Securities and Exchange Commission (SEC) should strengthen its information gathering from institutional investors under Securities Exchange Act Section 13(f) so as to make that information both more transparent (e.g., identify beneficial owners of shares when filing on behalf of another) and easily searchable. Finally, we believe that government regulators should establish clear guidelines concerning claims filing practices and duties for fiduciaries.

We conclude our Article with two observations about the implications of our results for the goals of securities fraud litigation. Our first point builds off our survey respondents' statements that they do not allocate any recoveries they receive to the individual fund beneficiaries but instead to the fund suffering the loss or, in some cases, to the institutional investors' general fund. Our survey, therefore, reflects a serious mismatch between the beneficiaries of the settlement and those who have been harmed by the securities violation that gave rise to the settlement in the first place. Simply stated, many defrauded beneficiaries are not compensated for their losses, while others are unjustly enriched. Given the enormous importance of institutional investors in the market, this mismatch raises serious doubts about whether securities fraud class actions can be justified as compensatory mechanisms. Moreover, the poor claims filing records of institutional investors exacerbate this mismatch, as many investors are systematically deprived of any benefits from these settlements. This fact raises more doubts about the compensatory function of securities fraud cases.

Consequently, we believe the more persuasive rationale for these cases is the deterrence of fraud. But, in order to accomplish that purpose, the current process needs to undergo some changes. We therefore suggest targeting securities fraud litigation at the individual wrongdoers' level and invoking vicarious liability only when the company benefits from the fraud.

Our second concluding point is that it matters whether institutional investors file claims, for two reasons. First, pension fund trustees should be required to take actions to maximize the value of the assets under their management, such as filing cost-justified claims in securities fraud class action settlements, even if these actions do not create "big money." Using any other legal standard for trustees' fiduciary duties diminishes the value of the duty of care. Second, if institutions are active participants in the settlement process, they will press for changes in the current system and help bring about needed reforms.

The organization of this Article is straightforward. Part I provides a description of the legal and institutional environment within which securities class actions thrive. In Part II, we describe our database, the methodology employed, and the results of our study of 118 settlements. The potentially numerous explanations of why so many financial institutions fail to participate in class action settlements are developed in Part III, and in Part IV, we use our survey of financial institutions to isolate the likely reasons that financial institutions are so frequently missing from the line of claimants that forms at the end of securities class actions. In Part V, we examine the legal standards that ought to be applied to determine whether pension fund trustees and custodian banks that fail to file are liable for their failure and, if so, what the damages ought to be. In Part VI, we propose five easy steps to help ensure that institutions receive their fair share of settlement awards. In Part VII, we discuss two concluding policy implications of our...