Shareholder Litigation Without Class Actions and The “Semi-Circularity Problem”

What would happen to shareholder litigation if the class action disappeared? In my article, Shareholder Litigation Without Class Actions, forthcoming in the Arizona Law Review as part of its symposium on Business Litigation and Regulatory Agency Review in the Era of the Roberts Court, I sketch out some possible futures of post-class action shareholder litigation. For now, such litigation persists despite recent existential challenges, most notably the Supreme Court’s decision earlier this year in Erica P. John Fund v. Halliburton. While these actions may continue in their current form, sustained criticism from sectors of the academy, and from business lobbies, suggest that existential threats to these suits will continue. Such threats have already re-emerged in the form of mandatory arbitration provisions and “loser pays” (more accurately, “plaintiff pays”) fee-shifting provisions in corporate bylaws or certificates of incorporation. While it is possible that such provisions will not spread widely—perhaps because of organized shareholder opposition—the rapid adoption of fee-shifting provisions suggests the possibility that mandatory arbitration or “plaintiff pays” or both could become ubiquitous. If so, either type of provision could eliminate the shareholder class action, or at least drastically reduce its prevalence. As I describe in greater detail in the article, mandatory arbitration provisions requiring bilateral arbitration of claims and barring consolidation of such claims would eliminate the class action in either litigation or arbitration form. (Importantly, even if Delaware were to try to curb arbitration provisions, such action could be preempted by federal law under the Supreme Court’s recent Federal Arbitration Act decisions). Similarly, fee-shifting provisions would greatly increase the risk to plaintiffs generally, and to entrepreneurial plaintiffs’ lawyers in particular, who bear the risks and costs of this litigation, potentially threatening the existence of the plaintiffs’ bar itself and restricting class actions to only a small handful of the most egregious cases. I discuss arbitration and fee shifting provisions in the article, and in the summary below, but I do not confine my analysis to these provisions. Rather, my focus is to assess what would happen to shareholder litigation if the class action disappeared, regardless of the particular mechanism of its demise.

I divide my analysis of the post-class action landscape into four categories: what remains (maybe nothing, maybe arbitrations brought by large institutional investors with positive value claims), what disappears (corporate governance suits, disclosure-only suits, much of M&A litigation in its current form), what happens to the plaintiffs’ bar (possible elimination, or even replacement by traditional firms), and the rise of what I call the “semi-circularity problem.” The “semi-circularity problem” is a twist on the more familiar “circularity problem” of shareholder class actions. Without class actions, individual and small institutional investors with negative value claims (claims whose expected value is negative because litigation costs outweigh the probable award) lose the ability to recover for, say, fraud because their claims become economically unviable without the ability to aggregate them. Larger investors with positive value claims may still recover damages in litigation or arbitration, as discussed below. Therefore, for small investors, it’s not just that they lose the ability to recover. To the extent they remain invested in defendant companies post-fraud, these investors may end up subsidizing the losses of large institutional investors who bring positive value claims in individual actions or arbitration. This “semi-circularity problem” creates a distortion favoring larger over smaller investors. I say more about each of these topics below.

What, If Anything, Remains Post-Class Action

Currently, the class action effectively ratifies fund fiduciary passivity in the face of fraud, for example, as long as the institution files a claim form to collect its share of a class action settlement that has been judicially certified. Loss of the class action would remove this layer of legal insulation for fund fiduciaries, potentially forcing otherwise reluctant institutions into more active monitoring and litigating of shareholder claims. Under ERISA, state pension codes, trust law, and other legal sources, fiduciaries have a duty to monitor their portfolios for positive value claims, and potentially to bring such claims. In fact, should a plaintiff be able to demonstrate that defendant fiduciaries failed to detect or assess a positive value claim, the burden shifts to the defendant to demonstrate why failure to act did not harm the fund, rather than the plaintiff having to prove why failure to bring suit did harm the fund. And while it is true that fund fiduciaries who consider suit and decline to pursue it will be afforded some degree of deference for such decisions, some claims will be too large to ignore. The degree of judicial deference to these decisions might be lower than in the corporate context, particularly for fiduciary-trustees like the ones who serve on public pension fund boards who are arguably subject to higher fiduciary standards than corporate board members. Most of these difficulties are avoided by the class action. Most institutions hire third-party portfolio monitors to gauge the funds’ exposure to existing class actions—not to independently assess whether the funds have positive value claims, which is a more complicated analysis. And there is little reason to fear judicial second-guessing of a fiduciary’s decision to file a claim form in a settlement that has already been judicially certified for its fairness, even if the fund would have been better off opting out and bringing a separate action. (There are a very small number of cases challenging trustees for accepting a court-approved class action settlement, typically because the fiduciaries extinguished some other unique and valuable claim by settling). Without the class action, these monitoring and litigating costs will likely go up for funds that have positive value claims.

It is true that there could be some system-wide advantages to this development. Institutional investors with large claims bringing cases on their own might carefully select meritorious cases, carefully monitor their lawyers, improve compensation (for themselves, though not for investors who cannot afford to sue on their own, as I discuss in the section on the “semi-circularity problem” below). To the extent these individual arbitrations or litigations retain some deterrence value, other investors might benefit from them. This leaves us with an empirical question: without the class action, how many suits could we expect to be brought? How many funds will have positive value claims, and how large will the claims be?

While comprehensive assessment of this question is beyond the scope of this article, I describe my conversations with the CEOs of two portfolio monitoring companies. Each describe having numerous clients who regularly have losses in the $10-$50 million range, with one describing a client who had a $350 million loss in one case, In re Schering Plough. These informal calculations suggest the potential for some continuing vitality to shareholder litigation even after class actions. Still, mandatory arbitration and “plaintiff pays” provisions may so alter the expected value calculation as to rule out individual actions in all but the most meritorious cases with the largest losses. Many institutions that have interlocking business relationships with large corporate defendants—like mutual funds who manage the 401(k) plans for corporate employees—might be loathe to bring individual actions even in the face of strong claims for fear of jeopardizing other ongoing business relationships.

What Disappears

Because of the considerations just mentioned, it is possible that virtually all of this litigation would disappear without the class action. In this section of the analysis, I discuss what is most likely to vanish. To begin with the obvious: without the aggregating mechanism of the class action, negative value claims become unviable and largely disappear, though perhaps a small subset might survive because of their nuisance value. Less obviously, remedies like corporate governance reform might also disappear, even from suits brought by positive value claimants. Governance reform efforts make some sense in the class action context, in which the claims of the entire class can be so large as to threaten the defendant company in which most institutions remain invested. Therefore, institutional investors, particularly those serving as lead plaintiffs, might rationally trade off a maximum damages payment for governance reforms, to the extent they believe that such reforms will improve the long-term value of their investments. A large loss by a large institutional investor will be substantially less than the potential losses in a class action, and therefore unlikely to result in material harm to the defendant. Therefore, it makes little sense for such an investor to seek corporate governance reform in litigation. Even if, in the aggregate, the claims of multiple institutional investors added up to a sum that could materially harm the defendant, each litigant or arbitration participant would find itself in a prisoner’s dilemma, in which it would be unwilling to offset its own damages claim in the hope that other institutions will do the same. Free rider problems will similarly hamper any individual institution from seeking governance reforms that benefit other investors, particularly competitors. Finally, even if an institution were to seek governance reform in an individual action, it is unlikely that the defendant would consent to such reform, given that other institutions could then seek additional or even conflicting reforms in their own actions. Deal litigation also likely disappears without the class action, perhaps shifting into appraisal litigation, because of similar free rider problems, and also because of a loss of the remedy of a court-ordered injunction if the case is arbitrated. Much of the plaintiff shareholders’ leverage in transactional litigation stems from the threat (occasionally realized) of an injunction of the shareholder vote. 

The Plaintiffs’ Bar

There is a broad array of potential outcomes for the plaintiffs’ bar should the class action be eliminated, ranging from dissolution to new competition from traditional law firms to thriving practices representing institutional investors in shareholder arbitration. Loss of the class action poses two potential threats to the class-action plaintiffs’ bar: (1) it might render plaintiff-side shareholder litigation economically unviable; and (2), to the extent it remains viable, it could attract new competitors. It is also possible that loss of the class action could leave the field to meritorious, high-dollar arbitration with generous legal fees led by the same firms that currently dominate securities class action practice, while eliminating many of the firms that specialize in nuisance suits. I entertain each of these possibilities.

Without class actions, overall damages claims could fall far enough (because of the loss of negative value claimants) to sharply reduce legal fees. Likewise, there could be a dearth of institutional investors with positive-value claims, particularly if “plaintiff-pays” provisions are not eliminated by the Delaware legislature. Without claims or clients, the plaintiffs’ bar would disappear. Individual institutional investors might resist the amount of time, effort, and expertise that go into monitoring lawyers in litigation. This would be particularly true if the only successful business model would require a shift from a contingency to an hourly fee, with the institution writing monthly checks for substantial legal fees. Further, even if there were a sufficient number of positive-value claimants, loss of the class action would still pose significant challenges to the traditional plaintiffs’ bar. Rather than facing an early, decisive skirmish for control over the class action at the lead-plaintiff/lead-counsel selection stage, multiple firms might find themselves representing institutional clients in multiple arbitration proceedings over the same set of facts. This poses some risk that the available legal fees would be spread too thin among a set of firms, rendering unviable the traditional model—particularly contingency-fee-based compensation. And even if substantial legal fees could be cobbled together across a dozen or more arbitrations, the cost of litigating those could still be higher than litigating one class action. Should such large payoffs cease to exist, or should the cost off litigating numerous arbitrations exceed the costs of one class action for the lawyers, then the contingency fee model might no longer be viable. The risk reward calculation could be altered. Here, a billable-hour model might become more viable, or at least a blended model involving some billable hours and an outcome-dependent bonus. The potential rise of a billable-hour model and a client base that consists exclusively of institutional investors raises the possibility of new entrants into the field, assuming, again, that there are sufficient positive-value claims to support it.

New Competition from Traditional Firms

As discussed above, many large institutional investors that collect their pro-rata share of settled class actions, but never participate as lead plaintiffs—like mutual funds, insurance companies, banks, hedge funds, and others—could be forced into more costly portfolio monitoring than they currently undertake, and even litigation, over positive-value claims. Many of the same outside counsel that serve multinational corporate defendants in shareholder litigation also serve large institutional investor clients that could have positive-value claims. These law firms might then be forced to choose: help their clients monitor and litigate such claims, or send that business out of the firm; perhaps to a competitor or a satellite firm. One can imagine that traditional law firms might opt to keep this business. Representing large institutions in litigation or arbitration against other large institutions is what these firms do already. Such institutional clients may very well employ former associates of the law firms. Social-network effects, a converging compensation model, and eased marketing challenges make it conceivable that traditional plaintiff-side shareholder litigation and arbitration could be absorbed into traditional defense firms as part of their securities and transactional practices.

A New Normal for Leading Plaintiffs Law Firms

Finally, it remains possible that the loss of the class action will eliminate plaintiffs’ firms that bring nuisance suits, while allowing top firms with institutional clients to continue practicing their trade in a new, but still somewhat familiar, litigation environment. Currently, nuisance firms bring cases with individual-investor lead plaintiffs, mostly because they cannot find an institution that is interested enough in litigating the case. These firms survive by bringing cases no one else is interested in bringing, or by finagling their way onto lead counsel teams in substantial cases run by top firms, often by threatening to object to the settlement. The class action enables nuisance firms to continue to bring suit without any screening by a sophisticated, motivated lead plaintiff.

But there is a small set of plaintiffs’ firms that currently represents institutional investors and regularly appears at the top of rankings like the Legal 500 and Securities Class Action Services. These firms earn significantly higher fees in shareholder and transactional litigation, and they obtain better results for shareholders. These same firms provide portfolio-monitoring services to their institutional investor clients, whom they notify of exposure to claims, and on whose behalf they bring such claims. These relationships could persist in the arbitration context. Instead of notifying their institutional clients when they have a large enough loss to obtain a lead plaintiff appointment, they could notify them of positive-value claims, and aid them in deciding whether to proceed with such claims. Assuming that a significant number of such claims can be identified and prosecuted, it is possible that the firms could continue to exist without much change to their business models, including continued pursuit of a contingency fee-based compensation model. Plaintiff pays or loser pays provisions make this less possible because plaintiffs’ lawyers might be less willing or unwilling to bear the risk of having to pay defense-counsel fees, unless perhaps the institutional clients or third party financiers are willing to engage in risk sharing, or coalitions of plaintiffs firms can bear the risks together.

Crucial to the ongoing success of such firms will not only be the question of whether there are a sufficient number of positive value claims, but whether plaintiffs law firms will be able to substantially increase their recoveries as a percentage of damages claimed over what they obtain in class actions today. There are several reasons to believe that they might be able to do so. For one, institutional investors have recovered a higher share of their damages when opting out from class actions, suggesting the possibility that they could similarly recover more in individual arbitrations. Many of the legal barriers erected against plaintiffs in the PSLRA and in a series of cases will not directly apply in arbitration. Corporate defendants may be more willing to settle on more favorable terms with large, well-connected institutional investors that have personal relationships with boards and senior managers, carry weight in the proxy proposal process and with shareholder voting, and could be sources of future capital. The confidential nature of arbitration proceedings might further pry open defendant purses, both because there will be less stigma to a high settlement that, if it were public, might be interpreted as being tantamount to an admission of liability, and because individual defendants can spend other people’s money—i.e., the corporate shareholder’s—to make the suit go away. That’s true now, but at least it’s public—it may not be in arbitration. It may also be that institutions writing substantial monthly checks to their lawyers in these cases may monitor those lawyers more closely and may themselves be more engaged in the litigation, producing better results.

The Semi-Circularity Problem

Elimination of the securities class action replaces the circularity problem with a semi-circularity problem. Instead of an overlapping set of investors standing on both sides of the litigation as harmed plaintiffs and as ongoing owners of the defendant, the plaintiff profile shifts. Only investors with positive value claims can sue and recover their damages. Thus, for the most part, this group will be composed of large institutional investors who can afford to do so. Conversely, many smaller institutional investors—and most, if not all, individual investors—will have negative value claims. Consequently, they will have no remedy for their wrong. Yet they may very well remain invested in the defendant company after the fraud. If there is a fraud or a mispriced deal, positive-value claimants can sue and recover, while negative value claimants cannot. But the asymmetry runs deeper than just who can and cannot sue. As ongoing owners of the defendant, negative-value claimants still contribute their pro-rata share of settlements obtained by positive-value claimants in arbitration. So, negative-value claimants are not only defrauded, but they must pay to compensate positive-value claimants for that fraud.

The subsidy also introduces a distortion in which the exact same trade for the same amount of money sum made would be actionable if made through a large institution, but not through a small institution or an individual. A $5 million dollar loss incurred by 10 different individual investors would not create economically-viable claims, whereas that same loss incurred by one institution would be economically viable. Unless we have some reason to believe that it is always better to invest through large institutions, loss of the class action needlessly introduces a distortion in the marketplace. It gives large institutions an unmerited legal advantage at the expense of smaller investors.

Finally, I describe how the semi-circularity problem poses a challenge to decades of legislation and rulemaking designed to level the legal playing field between investors. Insider trading regulation and Regulation FD are two examples of securities regulations that are designed to place all investors an equal footing, and that clash with the semi-circularity problem of a post class action world, in which only large investors have meaningful access to private enforcement of the securities laws.

The full paper is available for download here.