Resolving Conflicts Between Institutional and Individual Investors in Securities Class Actions

In my paper, The Plight of the Individual Investor in Securities Class Actions, forthcoming in the Northwestern University Law Review, I offer a reassessment of both federal and Delaware law favoring the selection of institutional investors as lead plaintiffs in securities or transactional class actions. While it is clear that institutional investor lead plaintiffs have brought numerous benefits to class members, their influence has also marginalized the interests of individual investors. I identify four persistent sources of conflict between institutional and individual investors. These include derivatives trading, corporate governance reform, conflicts between selling and holding plaintiffs, and, in the transactional context, conflicts created when institutional investors own a stake in both target and bidder companies. I argue that in many instances, these conflicts render institutional lead plaintiffs atypical and inadequate class representatives, in contravention of the requirements of Fed. R. Civ. P. 23 and its state equivalents. To allay these concerns, I suggest that the optimal solution is for courts to appoint representative individuals as co-lead plaintiffs with the presumptive institutional lead plaintiffs.

Sources of Conflict

Derivatives

Derivatives trading is one source of conflict between institutional and individual investors, primarily because institutions are more likely to engage in it than are individuals. Under current practice, such trading is not systematically accounted for in selecting lead plaintiffs for either federal securities fraud class actions or Delaware transactional class actions. In the paper, I address at some length the unique challenges posed by derivatives trading for selection of the proper lead plaintiff. First, such trading is rarely accounted for in a systematic fashion. When it is accounted for, it may be done in ways that undermine the lead plaintiff’s incentives to monitor class counsel. For example, if derivatives are added into the complaint after selection of a lead plaintiff, they may be used to offset some of the losses that could otherwise be claimed by a lead plaintiff who was selected on the basis of common stock losses alone. This may undermine the lead plaintiff’s motivation to monitor class counsel. Moreover, derivatives trading by a lead plaintiff, when included in the case, may subject the lead plaintiff to unique defenses that may cause their disqualification at the class certification stage. For example, some courts have found that derivatives traders may not invoke the fraud on the market theory. At a minimum, the issue of unique defenses will have to be litigated, imposing additional costs on the class. I argue that individual investors disproportionately suffer from these conflicts.

The Sell-Hold Conflict and Corporate Governance Reform

Institutional investors tend not to sell their comparatively large stakes in a defendant issuer even after a fraud is revealed for fear of further harming the share price. Individual investors are unconstrained by such concerns. The well-noted conflicts between selling and holding plaintiffs tend to break down along individual and institutional lines. Selling plaintiffs want to maximize compensation for the class, driving it a dollar short of bankruptcy. Holding plaintiffs may be more interested in corporate governance reform or other outcomes that are more likely to safeguard their ongoing investments in the defendant. Institutional lead plaintiffs are almost by definition holding plaintiffs, and may act in ways that marginalize the interests of the selling plaintiffs.

Conflicts in Transactional Class Actions

Finally, in the transactional context, institutional investors are often appointed lead plaintiffs for a class of target shareholders with little assessment of their stake in the bidder. Target shareholders may be represented by an entity whose interests may not be to maximize the price paid for the target, depending on the institution’s ownership stake in the bidder. I argue that rigid application of a rule barring lead plaintiffs with a stake in both the target and the bidder is undesirable, as it could disqualify many institutional investors. I note the complexity of engaging in this analysis, particularly where multiple bidders are involved, but argue that at a minimum, institutions with a higher stake in the bidder than the target ought to be disqualified from representing a class of target shareholders. Again, individual investors, who own three or four stocks on average, are much less likely to hold stakes in target and bidder companies than institutional investors.

Solution

I argue that one way to ameliorate these conflicts is for courts to select representative individuals as co-lead plaintiffs with institutions. Individual co-lead plaintiffs should ideally be sellers and should not have engaged in derivatives trading; at the transactional level, they should not own shares in the bidder. Individuals will have an interest in maximizing compensation for the class and they will help stabilize the lead plaintiff group in light of the unpredictability caused by ongoing legal uncertainty over derivatives trading. They will also re-inject into the lead plaintiff group an uncompromised voice for sellers seeking maximum compensation, or for maximum share price at the transactional level. My survey of the finance literature reveals a cohort of individuals who would be both motivated and sufficiently sophisticated to assume the lead plaintiff role. Finally, I note that while subclassing of individual and institutional investors may in rare cases be necessary, subclassing would not only deprive individuals of the benefits of institutional lead plaintiffs, but would defy Congress’s intent that institutional investors lead these actions.

The paper is available for download here.