More companies were sued in 1998 for securities fraud than ever before, according to the Stanford Securities Class Action Clearinghouse. The 235 companies sued in 1998 broke a previous high set in 1994, the year before the Federal Private Securities Litigation Reform Act passed. For securities litigation attorneys, business is booming, but this is not good news for institutional investors. Whether you view securities fraud cases as critical law enforcement actions that supplement meager resources of the Securities and Exchange Commission, or as frivolous strike suits, institutional investors have a lot at stake. They also have a lot to gain from rationalizing the securities class action system.
Some statistics are disturbing:
* As much as $3 billion could be paid to settle securities fraud cases that are currently pending, according to the Stanford Clearinghouse.
* Shareholders typically recover only about 14% of their damages in these lawsuits, while their attorneys take an average 32% of recoveries in fees, according to the National Economic Research Associates.
As the primary owners of corporate America and the largest claimants in individual securities fraud lawsuits, institutions have an overriding interest in the integrity of the marketplace and the deterrence of corporate fraud. As class members, they have a direct interest in enhancing recoveries where they have legitimate claims and in improving efficiency of the litigation process.
In securities litigation, shareholders not only end up paying fees of class counsel out of any recovery, but as corporate owners they also indirectly bear almost all of the costs of defending the company and funding any settlement through company payments of insurance premiums and settlement contributions. Conversely, the individuals who commit corporate fraud rarely bear the consequences. The NERA study found that, when directors and officers are named as defendants, they end up paying an average of 0.3% of settlements. Recovery from culpable individuals is rarely pursued by class counsel. Also, the company and its owners end up bearing lost opportunity costs from management time spent on securities fraud litigation.
Given these financial dynamics, it's easy to see why securities litigation is booming. Congress attempted to address the situation when it passed the Private Securities Litigation Reform Act in 1995, in part by allowing large claimants to take an active client role in securities class actions as lead plaintiff. The Department of Labor recently stated in a filing it made in a class action involving Telxon Corp., that ERISA fiduciaries now have an affirmative duty to determine whether becoming lead plaintiff is in the best interests of plan participants. As the first cases with institutional investor lead plaintiffs come to resolution, a new model for active management of securities class actions is emerging.
These cases focus on two areas that have received little attention from other class action players: (1) aligning the economic interests of class members and class counsel and (2) reviving the deterrence function of fraud lawsuits. Simply put, the new model requires that compensation of class counsel be set in a way to encourage efficiency and reward success in achieving the class members' goals. It emphasizes pursuit of personal payments from individual defendants where their conduct was egregious, and inclusion of corporate governance changes in settlements where faulty governance may have been a factor in events leading to the lawsuit.
The CellStar Corp. case was one of the first class actions with an institutional investor lead plaintiff settled under the reform act. After being named lead plaintiff, the State of Wisconsin Investment Board, with CellStar losses in excess of $10 million, engaged in a competitive selection to retain lawyers to represent the class. The proposals were reviewed by a panel including attorneys and investment management representatives, evaluating fee schedules, experience and proposed litigation plans.
The winning law firm, Grant & Eisenhofer, based its contingency fee on a sliding scale, starting at 12.5% and increasing up to 25% of amounts in excess of $15 million. SWIB also agreed to support a fee bonus of up to 1.5% if the case were resolved within set target dates, to emphasize the time value of money to class members. This fee structure was intended to align the interests of lead counsel with the class.
CellStar settled last January for $14.5 million. This was in excess of 50% of estimated damages, more than three times higher than the average 14% recovery in securities class action cases. The new fee schedule reduced class legal fees to 18%, a savings of $2 million from typical fee award levels. In addition, the settlement included corporate governance changes that SWIB believed would address underlying issues that may have contributed to the lawsuit. Among the changes were reconstitution of the board so that a majority would be outside directors and prohibition of the repricing of underwater stock options without shareholder consent.
The California Micro Devices Corp. case, involving the Colorado and California state teachers retirement funds, shows an emphasis on personal accountability. The funds' efforts recovered $4 million in assets from former corporate officers. Among other recoveries, they obtained $4 million from the company's auditors. The CellStar and California Micro Devices cases show how large investors can add value with active management of class action claims, by focusing on personal responsibility and addressing underlying problems. Use of competition in selecting lead counsel and restructuring class counsel's fee schedule to align the lawyers' economic interests with the interests of class members saved millions of dollars in fees, and produced substantially higher recoveries than usual. If similar structures were used regularly, lead plaintiffs could also discourage lawyers from filing frivolous cases by providing a very low percentage or no fee award for nuisance value settlements (e.g., under $1 or $2 million). By refocusing on deterence and realigning fees of lead counsel, this new litigation model could lead, over time, to a declining trend in the incidence of securities fraud and the number of lawsuits, as well as a reduction in the assets lost to costs of class action litigation. That would be of great benefit to all shareholders..
Keith L. Johnson is assistant legal counsel for the State of Wisconsin Investment Board. Richard H. Koppes is an attorney with the law firm of Jones, Day, Reavis & Pogue and a consulting professor of law at Stanford University. He is the former deputy executive officer and general counsel to the California Public Employees' Retirement System. The comments in this commentary are solely those of the authors and do not represent the position of their institutions or clients.