Corporate fraud - from Enron and WorldCom to recent instances of options backdating - has become an unfortunate part of the investment equation for public pension funds. Many institutional investors' portfolios have suffered large losses as a direct result of false financial reporting and the failure of corporate officers to live up to their fiduciary responsibilities.
The primary tool for investors to redress corporate fraud is securities class action litigation. Through litigation, billions of dollars have been recovered for investors. Certain large public plans take a prominent role in such litigation, and many smaller plans have been active as well. Because significant sums have been recovered each year, it is increasingly important that public funds monitor their portfolios to ensure that they recover the funds to which they are entitled and do not "leave money on the table."The GFOA recently adopted a Recommended Practice (RP),"Developing a Policy to Participate in securities Litigation Class Actions," designed to highlight the fiduciary obligation of public pension plan governing bodies to recover funds lost through investments in public securities as a result of corporate mismanagement and/or fraud.
This article addresses securities litigation - what it is, how the process works, the benefits of securities class action litigation, and why some criticize such litigation. More importantly, this article considers securities litigation from the perspective of mediumand small-size public pension plans, including what such public plans definitely should do and what they might consider doing to implement the GFOA's RP Specifically, this article addresses what is involved in monitoring a public plan's portfolio, including:
* What should be considered in developing a securities litigation policy;
* How to ensure a plan's participation in settlements;
* What it entails to get involved in class action cases; and
* The advantages and disadvantages of participating in a case as lead plaintiff.
WHAT IS SECURITIES LITIGATION?
A securities class action complaint is a collective legal action to recover the losses of all individuals and institutions that lost money because of a company's fraud or mismanagement. In most situations, except for a few large institutional investors that may have losses in the millions, it is not practical or economically feasible for public pension plans or individuals to sue a company individually.
In most situations, a case is filed after corporate irregularity that negatively affected investors is uncovered. In such a case, some investors would have purchased the stock at "an artificially inflated price" because its market price was based on false financial data disseminated by the company at that time. In any securities class action lawsuit, the time period during which the stock price was artificially inflated is called the "class period." The class period is established by the plaintiff subject to approval by the courts. Investors who purchased stock during the class period may initiate or participate in a class action lawsuit as long as they did not sell their stock during the period for a profit.
How the securities Litigation Process Works
In 1995, Congress adopted the Private securities Litigation Reform Act (PSLRA) to address certain perceived abuses of securities class action litigation. PSLRA requires federal courts to appoint one or more lead plaintiffs. Congress believed that the individuals or institutions with the largest losses would take a more active role in securities litigation and therefore be preferable lead plaintiffs to individual investors with comparatively modest losses.
Under the PSLRA, notice of a case filing must be published within 20 days of the filing date to notify potentially affected investors.This publication starts a 60-day window for potential lead plaintiffs. Specifically, within 60 days of publication, one or more persons may move for appointment as lead plaintiff. The court then selects the lead plaintiff(s), presumptively the plaintiff or group of plaintiffs with the largest financial loss. Thus, in effect, Congress established a preference for institutions to act as lead plaintiff.
Lead counsel, selected by the lead plaintiff, is then approved by the court. In the largest cases, typically an institution, such as a public pension fund, will step forward and agree to serve as lead plaintiff. The activities of plans in acting as lead plaintiff have been extremely important in fighting corporate fraud and mismanagement by recovering tens of billions of dollars for investors. In many cases, smaller plans have been selected to be lead plaintiff when those with possibly larger losses did not decide to step forward to serve as lead plaintiff.
Because every entity that traded stock during the class period and suffered a loss is considered a class member for purposes of the litigation, plans do not need to take affirmative action to become a class member. However, if and when there is a settlement, plans must notify the settlement administrator of their desire to participate in the court-approved settlement by filing proof of claim by a prescribed deadline, or otherwise forfeiting money rightfully due to the plan's investors.
Benefits for Investors
The lead plaintiff acts as a fiduciary and represents the interests of all class members during the litigation. The lead plaintiff does not receive any extra recovery by being lead plaintif. However, the benefits of taking the lead - determining the course of the litigation and the outcome - are significant. The terms of any settlement, including those addressing economic recovery and corporate governance, are strongly influenced by the lead plaintiff. Experience has shown that settlements are significantly larger when institutional investors take the lead. If a lead plaintiff is a public pension plan, then it also is much more likely that important corporate governance changes can be achieved. Improved corporate governance can have a long-term and sometimes a relatively immediate benefit for the company's shareholders, including the plaintiff fund if it continues to hold the stock in question. Improved governance also has a general benefit to the investment marketplace by establishing standards. Finally, the legal fees generally are lower if a public pension plan is the lead plaintiff.
Criticism of Class Action Lawsuits
As one would expect, most criticism of class action lawsuits comes not from public funds, which have recovered billions as a result of class action lawsuits, but from corporations and business interest groups representing defendants. These groups argue that an attorney will find a client and file a class action lawsuit against a corporation any time a stock drops, even if the losses were caused by legitimate market and economic conditions and not by the company These groups also argue that the majority of the recovery goes to the attorneys filing the lawsuit and not affected investors.
These perceptions are not accurate. Plans file meritorious claims that have resulted in substantial recoveries for all investors, and all legal fees are closely scrutinized by the lead plaintiff and must be approved by the court. Fees are typically determined on a case-by-case basis. Public pension funds as lead plaintiffs have been instrumental in enhancing such scrutiny of fees and costs in securities litigation.
THE OBJECTIVES OF PUBLIC PENSION PLANS
As noted in the GFOA's RP, public plans have "a fiduciary obligation to recover funds" lost in their investments due to corporate fraud. There are two aspects to such asset recovery. The first aspect, which is important to all plans, is to monitor the plan's activities to identify losses that may be recoverable by participating in class action litigation. As noted in the GFOA recommended practice, the purpose of monitoring is primarily to ensure that plans obtain their pro rata share of the recovery in all settled cases. The second aspect involves participation in securities litigation as lead plaintiff.
Monitoring provides plans with a process to identify losses where claim forms should be submitted. By reviewing loss histories, the plan is able to identify losses that are subject to recovery through class action litigation. Timely review of information is critical. Every time a case settles, a deadline is established by the court for all affected investors to submit claim forms. If a claim form is not submitted on the plan's behalf before the claim deadline, then a plan will not receive its share of the recovery and will have "left money on the table." The amount that the plan would have received will be distributed to those entities that filed their claim forms, thereby increasing the recovery by those plans filing claims in a timely manner.
Timing is crucial with respect to considering active involvement in securities litigation. Once a case is published, investors, including public pension plans, have only 60 days to decide whether to serve as a lead plaintiff. In this short period of time, the plan must weigh a number of factors, including the merits of the potential case, its loss estimates, and corporate governance considerations.
Unless a plan has its portfolio monitored on an ongoing basis, it will be extremely difficult to know - or recover - its losses in either settled or new cases. That is why the GFOA RP suggests developing and adopting a policy to set forth procedures for monitoring and participating in class action securities litigation.
Most public funds want to know (and in this electronic age, as fiduciaries, should know) how they are affected by corporate fraud. Monitoring provides that information promptly and automatically Electronic transfer of data makes monitoring a pubic fund's portfolio relatively easy provided that such data is available electronically.
As noted in the RR public plans have four options to monitor their investment portfolio. The public plan can (1) utilize internal staff, (2) negotiate with its custodian bank to perform this service; (3) hire a third-party claims advisory service; or (4) engage external securities litigation counsel.
Most plans use their custodian to submit claim forms, and the RP identifies specific procedures that should be included in agreements with custodians. Many public plans also engage law firms to monitor their portfolios as well, for several reasons. First, it provides the plan with an ability to doublecheck their estimated losses in cases that have settled. second, a law firm, unlike a custodian, can provide an analysis of potential new cases and guidance as to available options. Third, there may be situations where the law firm identifies instances where no case has been filed. It is the second and third components that "drive" the securities litigation process and begin the recovery process when investors have been harmed by fraud or corporate mismanagement.
It is significant to note that monitoring and evaluation services provided by law firms are free to develop good will with the plan. Because the services are free of charge, some public funds have more than one firm monitor their portfolio in order to obtain a different perspective. Most plans will choose to limit the number of firms providing monitoring services. In considering arrangements with law firms, a plan should ensure, among other things, that the service is confidential and they are under no obligation to file a lead plaintiff motion in any case the law firm might recommend.
While firms provide their monitoring services gratis, plans should be aware that firms require access to securities data. As a result, they will need to interact with the plan's custodian bank. Once electronic transfer is established, the burden on the custodian should not be significant. Nevertheless, each additional firm used by the plan adds to the administrative load of the custodian.
ENSURING A PLAN'S PARTICIPATION IN SETTLEMENTS
Smaller pension plans are not as likely to be involved as a lead plaintiff in a securities litigation case, but it is still imperative they participate in the recovery of settlement claims. Separate from the monitoring procedures that identify potential claims, procedures should be put in place for submitting claim forms for cases that have settled. This can involve a review process to be sure that submitted claims are tracked, that the plan receives all monies to which it is entitled, and that the settlement funds are properly deposited.
Another advantage of establishing a policy for this aspect of plan administration is to establish the roles of involved parties. There may be tasks that are appropriate for staff, the custodian, legal counsel, and others. It is important to define those roles to ensure effective action in a timely manner.
CONSIDERING INVOLVEMENT IN LITIGATION
Plans should expect counsel to do extensive research before recommending that a client consider filing a lead plaintiff motion. It is also important to recognize that just because a plan has a significant loss in a case, counsel may not recommend a lead plaintiff motion be filed. Counsel, if they are selective, may not believe the case is particularly strong or they may be aware of other plans with significantly larger losses that are likely to move to be the lead plaintiff.
Those plans that are not among the largest funds should presume it is unlikely that they will be the lead plaintiff in one of the large high-profile cases. However, over time they may be the lead plaintiff or have a role in other cases. Prosecuting these cases is just as important to investors as the larger cases that are in the public eye. In certain instances, counsel may recommend that a plan file with another plan a joint lead plaintiff application. Before any joint application is filed, discussions should be held to ensure all parties have similar objectives.
The Plan's Role in a Case
If a plan is selected as lead plaintiff, the plan will meet with counsel and decide the plan's level of involvement. The extent of involvement is largely dependent upon the objectives of the plan based on its resources and interest in participating. Plans should always be involved in all-important decisions and stay informed of the progress of the litigation, any upcoming court and filing dates, and settlement negotiations.
Advantages and Disadvantages of Being a Plaintiff
Some plans are reluctant to take an active role in securities litigation. These plans often focus on the fact that they do not receive additional funds by being the lead plaintiff. In other instances, they are unwilling to commit time and effort to take an active role in a case. As pointed out in the GPOA's RP,a monitoring and litigation policy will help establish a proper framework that benefits the plan participants as well as the larger pension plan arena and some plans may decide for a variety of factors, typically their size, that they are not interested in being lead plaintiff.
Many plans, however find significant advantages when they do get involved in the process. They recognize that recoveries are larger when plans are involved and further they find the process is not overty burdensome Besides significant recoveries, as long-term investors, public pension plans will benefit from the improvements in corporate governance accomplished through litigation. Finally,in these challenging times for public pension plans.involvement in securities litigation demonstrates to plan beneficiaries that they will take all possible steps to protect the plan's assets.
GFOA members should consider acting upon the GFOA's RP and develop a policy to participate in securities class actions. All funds should consider the most cost-effective and beneficial option to monitor their losses. This monitoring will help ensure that they receive their pro-rata share of settlements and keep informed about their losses in newly filed cases. Some funds may want to consider engaging outside securities counsel so that they have the option to participate in class action litigation.
Unless a plan has its portfolio monitored on an ongoing basis, it will be extremely difficult to know - or recover its losses in either settled or new cases.
Securities Litigation Definitions
Key Entities Involved Appointed or Elected Legal Counsel: The elected or appointed legal counsel for the plan who may have the authority to empower securities litigation counsel to pursue lead plaintiff status and/or settlement participation.This may or may not require the approval of the pension plan Aboard.
Class Member: Entity or individual who held stock during the class period and had a loss. Class members do not have to take affirmative action until a settlement is reached.
Custodian Bank: Boards of most pension plans have a contractual relationship with a financial institution to serve as master trustee/custodian on behalf of its clients. The custodian bank receives notices of class action and can determine eligibility. With the consent of the board, the bank can then file a "proof of claim" to participate in the settlement.
General Counsel: In-house legal counsel for the plan appointed by the plan's governing body and generally independent of the employer affiliated with the system (such as a city or state).
Lead Plaintiff: The petitioning entity with the largest claimed losses as a result of securities fraud designated by the court to lead a class action lawsuit. The lead plaintiff selects the legal counsel to prosecute the case and is influential in setting the legal fees as well as negotiating a settlement.
GFOA Recommended Practice
Developing a Policy to Participate in securities Litigation Class Actions (2006) (CORBA)
Background. Public Pension Plan governing bodies (the Board) and chief administrative officers (CAO) have a fiduciary obligation to recover funds lost through investments in public securities as the result of corporate mismanagement and/or fraud. The process for recovery of such investment losses by a Public Pension Plan (Plan), or any other holder of record during the class period is through class action or individual securities litigation.
Class action is initiated when a complaint is filed with a federal court The 1995 Private securities Litigation Reform Act (PSLRA) requires federal courts to appoint one or more members of the putative class with the largest financial interest and willingness to serve as the lead plaintiffs). Once the lead plaintiff has been appointed all the pending legal actions are consolidated under the control of the lead plaintiff and the litigation proceeds. Every entity or individual that held stock during the class period and sustained a recognized loss from alleged securities fraud becomes a "class member" for purposes of litigation and any future settlements. In other words, Plans do not need to take any affirmative action to become a class member However; if and when there is a settlement a settlement administrator is appointed and gives notice of the settlement to all class members. At this time, Plans must notify the settlement administrator of their desire to participate in the court-approved settlement by filing a notice (proof of claim) by the prescribed deadline. If Plans fail to file a timely proof of claim with the settlement administrator; they will be forfeiting money rightfully due each class member
Thus, Plans can participate in class action litigation either as lead plaintiff or as a class member through the settlement process. In most cases only larger Plans will be eligible to serve as the lead plaintiff, which requires special considerations not covered in this recommended practice. This recommended practice will focus on developing a policy to address the more common and pressing problems of monitoring a Plan's eligibility to participate as a class member in the class action litigation and recovering losses from settlements.
Recommendation. A considerable number of Plans have not been filing proof of claim forms to participate in settlements in which they have eligible claims and, as a result are forfeiting money.
Therefore, the Government Finance Officers Association (GFOA) recommends that every Public Pension Plan develop and adopt a policy setting forth procedures for monitoring and participating in class action securities litigation. Such a policy should cover the issues described below.
The first component of a securities litigation policy should be an agreed upon set of objectives that the Plan intends to pursue through its participation in class action litigation which may include:
* Fulfilling the Plan's fiduciary duty by effectively managing claims as Plan assets.
* Maximizing recovery of Plan assets on claims while minimizing fees paid to obtain recoveries.
A Plan should develop clean written procedures for monitoring class action litigation and settlements.
Key issues to consider in designing these procedures include:
* A single person or entity (the monitor) should be assigned to monitor securities litigation and agree to established monitoring procedures. Plans may utilize internal staff; negotiate with their Custodian Bank to perform this service; or hire external securities litigation counsel or another third-party claims advisory service.
* Each class action litigation, from the time of the filing of the complaint through to the settlement and recovery, should be monitored and Plan eligibility determined.
* Clear procedures should be established with the Custodian Bank as to the action that should be taken when a notice of a settlement is received. Plans should be aware of how long the Custodian Bank maintains records and consider extending this time period in its contract if necessary.
*To assist in determining eligibility for settlement, Plans should maintain documentation on the purchase and sale of the securities that the Plan currently holds and previously held, including the duration and amount owned as well as all transactions executed for each holding.
* Accurate record keeping is critical because settlement notices may not be circulated until many years after the time the Plan incurred the loss and it is not unusual to need access to investment transactions and holdings that and many years old in order to file a complete and valid claim. Processes should be established to ensure the complete and accurate transfer of Plan trade activity data in the event that the Custodian Bank or other third party maintains this data
* Periodic reviews should be conducted to ensure that monitoring procedures are followed.
Participating in Recovery of Settled Claims
Loss recovery procedures must be established for a Plan to participate in the settlement as an eligible class member where a security is the subject of a recovery.The following issues should be considered when designing these procedures:
* Designate one individual or entity to file recovery forms (proof of claim).This is typically the Custodian or Counsel to the Plan but may also include internal staff. If different from the monitoring official, procedures should be in place to facilitate close coordination.
* Complete and file timely proof of claim forms including supporting documentary evidence with the settlement administrator
* Monitor processing of filed claims through receipt of recovery.
* Periodically review the recoveries for larger claims to verify that the Plan's settlement allocation was calculated in accordance with the court-approved plan of allocation and to ensure the Plan received all monies it was entitled.This may be done internally or by a third-party.
* Even when a law firm files proof of claim forms, payments from the settlement administrator should be sent directly to the Custodian Bank to avoid delays in receipt of funds.
* All Plans should have a standing directive with the Custodian that designates where settlement funds should be deposited.
Any entity or individual involved with securities litigation on behalf of the Plan, whether internal or external, should maintain a record of related activities for inclusion in a regular report to the CAO and Board including the status of all eligible claims and recoveries.
Selecting and Working with Legal Advisors
Plans that choose to utilize external legal counsel should first clarify the intended role of outside counsel. Solicitations for outside counsel should be coordinated through the Plan's general counsel (GC), CAO and Board and an RFP process should be utilized.
The GC and CAO should clarify the working relationship with outside legal counsel. This should include: agreeing upon the Plan's goals/objectives and expected outcomes as they relate to securities litigation; clarifying the roles and responsibilities of the outside counsel, GC, CAO and Board with a particular emphasis on decision-making responsibility; and the means and timing of communication and reporting.
Where counsel is elected or appointed independent of the Board, the Plan should consider entering into a Memorandum of Understanding (MOU) with counsel to clarify the fiduciary and other responsibilities of each part/This MOU may be an appendix to the policy.
Serving as Lead Plaintiff
While pursuing lead plaintiff status requires a separate evaluation not covered as part of this recommended practice, it is important that Plans establish a policy related to this decision. Most Plans make the decision to seek lead (or co-lead) plaintiff on a case-by-case basis. Some establish a loss threshold that must be met before the Plan considers seeking lead plaintiff status. Most Plans will never meet the lead plaintiff eligibility requirements under the PSLRA and as such, many Plans include in their policy an expressed prohibition on seeking lead plaintiff status.
* The National Association of Public Pension Attorneys (www.nappa.org).
* The Stanford Law School securities Class Action Clearinghouse (http://www.securities.standford.edu/).
* The National Association of State Retirement Administrators (www.nasra.org).
* The securities Exchange Commission (www.sec.gov).
Approved by the GFOA's Executive Board, October 6,2006.
MARK MCNAIR practices in the area of securities litigation with a special emphasis on institutional investor involvement Prior to entering private practice, he was an attorney at the securities and Exchange Commission and the Municipal securities Rulemaking Board. JIM COOKE is the deputy treasurer-Clerk for the City of Tallahassee. Florida In his capacity as deputy treasurer-Clerk, he is actively in securities litigation with respect to both monitoring and litigation.…