One could be forgiven for believing that a chapter in the subprime mortgage crisis closed when, on Feb. 25, the court overseeing the class action against Countrywide Financial, arising from allegations that Countrywide concealed mounting risks during the housing boom, approved a $624 million settlement.
The court, however, also approved a multimillion-dollar escrow for payments to investors that had previously “opted out” of, or excluded themselves from, the settlement. In fact, 33 institutional investors, including several large pension funds and asset managers, chose to opt out and litigate individual cases against the defendants. This is only the latest example of a growing trend in securities litigation in which institutional investors are exiting large class actions in an effort to cut themselves a better deal.
Class-action litigation by shareholders to enforce securities laws is a powerful tool to hold corporate wrongdoers accountable. In most cases, courts provide class members an opportunity to “opt out” of the class and bring an individual action if they so desire. This opportunity is often provided when a settlement is presented to the court for approval, allowing class members to weigh the benefits of the settlement against the risks and potential returns of pursuing individual litigation.
Just 10 years ago, most securities litigators believed that the time, effort and expense of institutional opt-out actions made little sense, as the perceived advantages of such actions were thought to be merely speculative. Since then, however, institutional investors have begun to opt out of large settlements in increasing numbers. Sixty-five investors represented by one law firm opted out of the historic $6.1 billion WorldCom class settlement approved in 2005. More than 100 institutions opted out of the $2.65 billion AOL Time Warner securities class settlement approved in 2006. The $3.2 billion Tyco International settlement approved in December 2007 had some 288 opt-outs, including numerous institutions and mutual funds. Although institutions must opt out individually, they have also opted out simultaneously and litigated as a group, engaging the same counsel to pursue their claims.
Institutions increasingly are opting out of class actions because, by bringing an individual action, they can potentially recover much more — sometimes a multiple of — what they stand to obtain in a class settlement. For example, a group of five New York City pension funds that opted out of the WorldCom litigation revealed they recovered three times more than they would have recovered if they stayed in the class. Several institutions, such as the California Public Employees' Retirement System, which opted out of the AOL Time Warner litigation, subsequently announced they ultimately settled for between approximately nine and 50 times more than they stood to recover under the class settlement. Similarly, several institutions such as the Teacher Retirement System of Texas and the California State Teachers' Retirement System that opted out of the Qwest Communications case announced they succeeded in obtaining 30 times what they would have received had they stayed in the class or greater, with opt-out institutions recovering, in the aggregate, more than the $400 million settlement reached by the class. Legal scholar John Coffee estimated investors who have brought opt-out actions recovered on average 20% to 40% of their actual losses, while class members only received on average 2% to 3%. Thus, much larger recoveries are possible outside of class litigation for institutions.
The decision to abandon a class action and pursue individual litigation carries the risk that an institution may lose its individual case even when a class action obtains a recovery through settlement or trial. However, there are many reasons institutional investors that choose to bring an individual action can get better results. For example, opt-out litigants escape the lengthy and complex issues surrounding class certification, which increasingly are resulting in the denial of class certification in federal courts and can sound the death knell of a class case. At the very least, class-related procedural hurdles can cause significant delays in the prosecution of a class case. Since opt-outs can proceed to trial faster, defendants have a strong incentive to settle an opt-out case before the court makes any decisions that could negatively affect the class litigation. Also, by opting out, an institution may be able to bring strong state law claims or claims unavailable to a class, and in certain instances may be able to file in a state court, which may be more receptive to a particular plaintiff's claims or to securities plaintiffs generally.
For example, if the institution relied directly on the company's yearly or quarterly SEC filings, claims can be made under Section 18 of the Securities and Exchange Act of 1934, 15 U.S.C.S. § 78r that, unlike traditional securities fraud claims, do not require proof of knowledge or fraudulent intent. Pension funds that opt out also may sue in their own states and thereby gain a “home court” advantage. It is worth noting that pension funds that have opted out and surpassed what they would have recovered in the class also have enjoyed significant positive publicity.
Given the recent successes institutions have had with individual litigation, the trend of institutions opting out of some class cases is unlikely to subside and investment funds need to have a decision-making procedure in place and approved counsel standing by in order to not leave free money on the table.
Joshua H. Vinik and Andrei Rado are partners and John R.S. McFarlane is an associate at the Milberg LLP law firm, New York.
