United States: New Lawsuits Against Mutual Funds Highlight Fiduciary Duties of Institutional Investors

Article by Thomas S. Richey, John R. Bielema and Daniel G. Ashburn

Plaintiffs' lawyers recently filed numerous lawsuits alleging that some of the nation's largest mutual funds breached fiduciary duties to their shareholders by failing to file claim forms to collect securities class action settlement payouts to which the funds were entitled. Whether or not meritorious, these lawsuits highlight the duties of trust officers, investment advisors, pension fund managers and other institutional fiduciaries and investors with regard to class action claims, and the need to have procedures in place to determine when and how to collect their share of settlements whenever appropriate.

The new lawsuits themselves purport to represent classes of individual mutual fund investors, and are comprised of more than 40 separate actions in 11 states, including New York, Illinois, Texas and Colorado. The lawsuits target companies that sponsor and manage mutual funds and their parent companies, reportedly including American Funds, Dreyfus, Janus, MassMutual, Merrill Lynch, Neuberger Berman, Putman, Vanguard, Van Kampen, Wells Fargo and others. The defendants include not only the companies themselves, but also the companies' directors and fund advisors.

The securities class action settlements at issue in these suits against mutual funds typically involve portfolio companies in which the funds have invested. The mutual funds, as shareholders, may be members of the plaintiff class and thus eligible to share in the settlement proceeds.

Many securities class action settlements unfortunately yield only nominal recoveries for the shareholders and raise questions regarding whether the shareholders' interests have been properly represented. However, all class action settlements require court approval, and once approved and final the rights of the parties - including class members - are fixed. There have been significant recoveries in some securities class action settlements. Given the size of institutional holdings, even a relatively modest per share settlement can yield a payment that greatly exceeds the cost of preparing and filing a proof of claim. Class members, to share in the settlement proceeds, have little more to do in this process than to wait for a settlement and file proofs of claims.

The lawsuit against Neuberger Berman is illustrative: It alleges that during the preceding three years, "hundreds" of securities class action cases were settled and that the mutual funds managed by Neuberger Berman "were eligible to participate in the recovery in a significant number of the cases by virtue of their ownership of the securities during the requisite time period of each case." The plaintiffs contend that, had the defendants submitted claim forms in these cases, "the settlement funds [they would have collected] would have increased the total assets held by the Funds, and such increase would have been allocated immediately to the then-current investors upon the recalculation of the [Funds'] Net Asset Value (NAV)." Yet the plaintiffs claim that the defendants "failed to submit Proof of Claim forms in these cases and thereby forfeited Plaintiffs' rightful share of the recover[y] obtained in the securities class actions."

The plaintiffs maintain that the defendants' failure to collect the class action settlement payouts amounted to not only negligence, but also breach of fiduciary duties owed to individual investors both under common law and under the Investment Company Act of 1940.¹ In addition to compensatory damages, the plaintiffs seek punitive damages, return of all commissions and fees paid by plaintiffs to the funds and return of all fees and consideration paid by the funds to the fund advisors.

Several of the companies that have responded to the lawsuits maintain that they have filed proofs of claims in those class action settlements where they were entitled to recovery.² However, a study published in the Washington University Law Quarterly asserts that only about a third of institutional investors who are entitled to file such claims actually do so.³

Claims and rights to distribution of settlement monies are fund or trust assets. Many institutional fiduciaries and investors may not have adequately considered the potential recoveries available through class action settlements and whether they have a duty to their shareholders or beneficiaries to secure their share of the recoveries. However, as the recent lawsuits involving mutual funds make clear, it is important for all trust officers, investment advisors, pension fund managers and other institutional investors to evaluate the steps they can take to ensure that potential recoveries are not forfeited through inaction.

Institutional investors should establish procedures to monitor the filing and progression of class actions involving securities they hold or have held in order to make informed decisions as to how to obtain the optimum recovery. Under the Private Securities Litigation Reform Act of 1995 ("PSLRA"), plaintiffs are required to publish a notice announcing the filing of securities class actions against public companies.⁴ They generally use press releases for this purpose. Procedures to monitor securities class actions can be undertaken in-house, or may be outsourced to companies that specialize in monitoring and claims-filing services or to outside counsel.

Class action announcements and notices must provide a "definition" of the class. In securities class actions, classes are typically defined in terms of persons who purchased (or sold) the security during a period of time before facts were disclosed or events occurred that led to a drop in the market value of the security. Institutional investors and fiduciaries need only check their trading records against the class definition to determine class membership.

Many institutional investors are beneficial owners of securities that are held in the name of brokers or a depository trust. In these cases, settlement administrators may not be able to identify the beneficial owners and will rely on the broker or trust to forward the notice of settlement. Institutional investors should determine whether they are receiving notices for securities they own.

Where an institutional investor is not the registered holder of its securities, the institutional investor should determine whether its brokerage and custodial agreements include provisions for settlement notifications. Some custodial agreements will provide for the custodian to file and collect settlement claims.

Class action notices generally are sent for two reasons - first, to notify class members that the class has been "certified," i.e. the case will proceed as a class action; second, class members must also be notified of a settlement, informing them of the terms of the settlement, where and when a fairness hearing will be held on the settlement and giving them an opportunity to be heard on the matter. Frequently, in the case of an early settlement, these two topics will be covered in a single class notice. Typically, a class action settlement notice will provide instructions about the filing of proofs of claims once the settlement is approved and becomes final. The approval process can sometimes take months, even years. It is critically important that you calendar the deadlines in the notice and follow the instructions in the proof of claim form because failure to do so will result in a loss of your right to participate in the settlement.

Securities class action lawsuits typically allow class members to "opt-out" of the class at various stages of the litigation and to pursue their claims separately against the defendants. Class members are given an opportunity to opt out when the class is certified, i.e. the judge determines that the case is one that can proceed as a class action. The timing and consequences of opting out of a class will vary from case to case, and deadlines for opting out are generally strictly enforced. Once a class member opts out, it will not be eligible to participate in the settlement. A potential claimant who opts out early in the proceedings will retain more rights than one who decides to opt out after a settlement is announced. Institutional investors should carefully consider at each juncture whether their interests are adequately served by remaining a part of the class, or whether they may achieve more favorable results by opting out of the class and pursuing claims separately or not pursuing any claims at all.

Establishing proof of your claim involves demonstrating that you were a member of the class, providing information of your purchases of the security, and if you sold the security, similar information on the sale. Information in the class notice should provide an estimate of the per share distribution. The final amount of the distribution could depend on how many class members file proofs of claims.

Class settlements are only one aspect of securities class actions. Because institutional investors are often major stakeholders in securities litigation, they may find their interests best served by taking an active role in the litigation, including acting as a class representative and controlling the litigation.⁵ Under the PSLRA, the designation of "most adequate plaintiff" is weighted in favor of the claimant that "has the largest financial interest in the relief sought by the class," and confers upon the designee the power (subject to court approval) to select and retain counsel for the class.⁶ There are many cases in which institutional investors, particularly state pension funds, represent the shareholder class. Even where a class member does not seek to control the litigation, he or she can still participate in the settlement process. Class members can object to the settlement if it is inadequate. They can also object to class counsel's fee petition, which is usually awarded out of the settlement funds, if it appears that the lawyers have not adequately represented investors.

As these recently filed lawsuits illustrate, it is important for institutional investors to have a system in place to address monitoring of securities class actions involving portfolio companies, handling of class action settlements and in general to assess their proper role in securities class actions. The plaintiffs' bar has certainly taken notice.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.