Securities Litigation

Why securities litigation can be used as a risk management tool

Originally published in the May 2008 issue

Institutional investors should consider securities litigation as an important risk management tool. Increasingly, British investors are joining American securities class-action litigation. The American court system provides considerably more options for defrauded investors to sue the companies they invested in, as the system is open to any investor who invested in a company that lists on a US stock exchange.

“That damned decimal dot.” This remark, attributed to a British Chancellor of the Exchequer, certainly holds true for the lives of many a fund manager. A decimalplace or two, a fraction of a fraction of a point in performance, can determine a reputation and the ability to procure or retain funds. One would think, therefore, that money managers would avail of every mechanism to mitigate risk and increase gain. Yet, a device lies in plain view and, quite amazingly, is both ignored and occasionally scorned. This is how the mechanism operates.

Somebody buys an option for you. If it goes in the money, you keep nearly all of the profits; if it expires worthless, you don’t have to pay a dime. In other words, you receive a free option, with the upside mostly yours and the downside entirely another’s. You’d think only a lunatic would spurn that deal. Well, odds are you are that lunatic.

That option is securities litigation, whether individually or leading a class. Not the vexatious kind, but securities litigation in response to deft pieces of trickery and where counsel agrees to serve contingently. To be sure, explanations are offered for why funds can’t be bothered to recover what’s been taken from them and their investors by deceit. “Who wants to be regarded as litigious, or expose one’s private investment stratagems; litigation demands time, and what’s the point anyhow – the returns are meagre, and will be gained regardless by passive class membership?” None of this holds analytic water.

Let’s start with the two princes – principle and principal. Principle declares that it is poor form to stand aside whilst your money and that of those who entrusted theirs to you is filched or at least devalued. Principal could give a damn about form; it’s a quant, and minds very much that it is somehow less than it was before it had been cheated. Securities litigation serves the interest of both princes. But does it matter? Does litigation matter to bottom lines – “we mean”, ask the princes, “Is there enough in it for us?” Yes.

While true that some litigation settles for small sums, it is also undeniable that many provide significant sums. In a case against Cendant, for example, Kirby McInerney recovered about $350 million, comprised largely of institutions holding a preferred instrument. That result represented about 100 cents recovery of every dollar lost, with many class members receiving cheques well into the seven and even eight figures – cheques that went to the bottom line in a single reporting period. Think about it: for example, a billion dollar fund appreciates $100 million a year, $25 million a quarter, $8 million a month. Additional millions to the bottom of any of those periods moves the decimal dot.

“The ability to advise current and prospective investors that you have a firm…diligent in pursuit of recovery where wrongdoing has occurred, is an invaluable asset”

Nor is that kind of recovery likely, much less certain, to occur if funds do nothing or if they wait on the SEC. That overworked agency has generated recoveries perhaps only a twentieth that private actions have. And legion are instances where fund losses are absorbed in a larger class, given an ill-deserved, minuscule share of any settlement, or vanish in a bankruptcy proceeding. Sometimes, possible sources of recompense are left off-shore. Frequently enough too, fund claims unwittingly are not even part of an existing case, thereby forfeiting any possibility of recovery. By approaching our firm in matters involving Adelphia, Amazon, Bennett Funding, Cendant, Lipper and Manhattan Fund, to name a few, diligent funds have secured outcomes not otherwise likely, sometimes certainly not. “Still, it’s not worth our time.” Really? Millions of bottom line dollars for about a day of toil is more than you earn otherwise?

A fund willing to chase down those who take its client’s money creates a powerful marketing tool. The ability to advise current and prospective investors that you have a firm on call, at no expense to them, that will be vigilant of wrongdoing and diligent in pursuit of recovery where wrongdoing has occurred, is an invaluable asset. And where a fund’s performance has been injured on account of fraud, isn’t it preferable to claim fraud than imply shoddy investment advice?

No one who seeks recovery on account of plain wrongdoing can or has been fairly regarded as litigious. Has that term been applied to, for example, any Enron suitor? We are unaware of any instance where any client has been denied access to company sources because it has sued another to recover what had been wrongly taken from it. Besides, this supposes publicity. Generally, there is none – except as wanted for marketing.

Nor is there any basis to fear that a fund will be forced to lay bare what drives its investment decision. To begin with, funds draw funds by publicising unique or at least distinctive ways of deciding when and what to buy, so the concern is apocryphal. Regardless, confidentiality orders assure that stratagems are filed under seal, never to be seen by anyone outside the lawsuit.

This touches on an additional benefit of leading a class: to assure that the largest part of any settlement fund is allocated, where otherwise appropriate, to the period in which the fund has made its purchases. Settlements are a zero sum game, usually. Defendants are willing to pay a certain amount of money often without regard to whether the class period is a day or years. Nor do defendants care how settlement proceeds are allocated along the class period line. But given that the defendants wrongdoing and the quality of the cause vary dramatically across the class period line, a needlessly broad class period prejudices people who bought time and lost most evidently on account of the actual fraud. Absent control of how the funds are allocated, these investors would have their settlement share given to those who don’t merit. Lead plaintiff can control how settlement funds are distributed and thereby avoid the problem.

Summing up, securities litigation, class or individual, is an under-appreciated and potentially valuable mechanism to mitigate risk and loss. It also broadcasts to the investment population that funds care when money has been lost and will seek recovery without additional financial risk to its investors.

Roger Kirby is a Managing Partner at Kirby McInerney, LLP, a securities plaintiffs law firm based in New York.