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Private Investment Forum - Q2 2010


The Securities Class Action Settlement Landscape: An Overview for Hedge Funds



Securities class action lawsuits and settlements often make headlines. Everyone is familiar with the infamous cases of Enron and Worldcom and the rampant corporate malfeasances that took place. Billions of dollars of market capitalization – shareholders' equity - were wiped out. Greed, egos, and outright fraud played a role in the collapse of these institutions of corporate America. Increasing regulation, including Sarbanes Oxley and other compliance initiatives, aims to hold companies to a higher and more transparent, standard. Nevertheless, corporate misdeeds continue to occur. And how do investors recover damages?

The simple fact is that although investors will never be entirely compensated for their monetary losses in publicly traded securities resulting from illegal actions, the legal system does have mechanisms for recovering some of those lost funds – the securities class action lawsuit is one. In simplest terms, a class action is a civil lawsuit brought about by people harmed in a similar manner. In the case of a securities class action, the "class" is comprised of those who purchased or held a security of a publicly traded company during a particular period ("the class period") and suffered losses as a result of fraud or other securities law violations. Typically, if a case is prosecuted successfully, the company settles the case (less than 5% of cases actually go to jury trial), and a settlement fund is established to compensate damaged shareholders.

Like other forms of litigation, a securities class action lawsuit takes time to be resolved – in fact, a number of years. From initial filing of the complaint with the court to the payout of settlement fund dollars to damaged shareholders takes as many as five to seven years. Despite the recovery time factor and the intensive data mining efforts required, investment managers need to consider their fiduciary responsibility to their investors to recover securities class action settlement monies on their investors’ behalf.

The process by which damaged investors retrieve settlement funds is complex. As anyone with security investment experience knows, investors receive claims forms in the mail, which means often they are thrown out, ignored, or misplaced. Along with the claim form to be submitted on behalf of each shareholder is the settlement’s "Plan of Allocation." This is the key document in determining the payout of a securities class action settlement. The Plan of Allocation sets forth the parameters which define shareholders who were damaged in the case and consequently, are entitled to settlement funds. The damages incurred by the shareholder, as defined by the Plan of Allocation, are referred to as the shareholder’s recognized loss. A key distinction of the recognized loss is that it differs from market loss. The recognized loss calculation involves integrating all of the Plan of Allocation’s rules of settlement.

The Claims Administrator is a neutral, third party designated by the court to administer the distribution of the settlement funds. Claims administrators are tasked with locating shareholders, notifying them of securities class action settlements, collecting and verifying completed claims forms and ultimately, distributing settlement funds to entitled investors. The claims administrators utilize the recognized loss calculation, combined with the number of shareholders that file claims, to determine a settlement fund’s proration. Proration is the ratio of settlement funds paid out to the investor dollars lost.

Very briefly and vastly simplified - it works like this: Corporate fraud occurs. Shareholders are damaged. A settlement fund is established to compensate damaged shareholders for losses incurred. Shareholders file claims with claims administrators for their share of settlement dollars. Settlement monies are disbursed to shareholders that submit a claim. The problem is that many institutional investors, hedge funds in particular, do not file claims on behalf of their investors and do not collect any money. Ultimately, this lack of action could be viewed as a breach of fiduciary duty. As professional money managers, hedge funds are managing the assets of investors, and as fiduciaries, they need to claim their investors' money.

Why is this 'found' money neglected? It's really the result of many factors. In some cases, the misconception exists that the funds recovered from class action settlements are not worth the effort to file the claims. In other cases, hedge funds don't have the internal resources to keep track of the hundred of cases filed each year, mine trade data for relevant supporting trade information, calculate recognizzed loss and ensure disbursed funds match the settlement fund’s proration. Some firms are also under the impression that their service providers – prime brokers or custodians - are taking care of this function for them. Oftentimes, discrepancies occur between the administrator and the filer whereby additional information is needed to address filing deficiencies. These requests kick back to the manager and typically fall through the cracks. With the advent of high frequency trading, alternative liquidity pools and ever shrinking execution sizes, the sheer volume of trade data today is daunting.

"The simple fact is that although investors will never be entirely compensated for their monetary losses in publicly traded securities resulting from illegal actions, the legal system does have mechanisms for recovering some of those lost funds – the securities class action lawsuit is one."

There are several factors involved in establishing a recovery policy and a comprehensive process for handling securities class action settlements. First, the universe of securities class action lawsuits must be effectively tracked. With cases numbering in the hundreds, and security identifiers in the thousands, the task could be burdensome, especially with leaner hedge fund staffing from the most recent financial turmoil. Case/court databases are an option but come with drawbacks, including introducing a fixed annual cost to the equation. Once the universe of cases is determined, this must be cross-referenced with all of the firm’s trading accounts, applying the particular rules of each settlement across each client account. For firms with vast numbers of client accounts, this can be an acutely onerous task, particularly given the fact that separate claim forms must be filed on behalf of each account holder. Firms need to develop a systematic approach to accurately calculating the amount each client is entitled to once the fund’s proration is established. Complexities and nuances inherent in the claims filing process, including the treatment of options, matching of trades (first in, first out versus last in, first out, etc.) further complicate matters. Each case is different and therefore calculates damages differently. For firms with effective best practices in place, the “found” money recovered from class action lawsuits can be significant, enhancing investor returns. Funds can opt to incur additional fixed cost internally to track and process these claims or consider outsourcing the recovery process to performance or incentive based securities class action claims providers dedicated to the recovery process and equipped with the latest intelligent, automated processes.

In today’s world, markets fluctuate daily and can turn on a dime; waiting years for settlement dollars may not be on the top of an investment manager’s priority list. With stricter hedge fund regulation imminent and increased investor transparency initiatives on the horizon, implementing best practices to address securities class action award recovery makes good business sense. With one to two case settlements being disbursed to investors each week, the longer firms wait to file claims, the more it costs them – and more importantly in terms of fiduciary responsibility – their investors, in lost settlement dollars. In an economic environment where everyone wants to minimize costs, reduce operational inefficiencies, and comply with fiduciary responsibility, it makes sense to count the "found" money of securities class action settlement dollars whenever possible.




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