RECENT YEARS HAVE SEEN A RISE IN SHAREHOLDER CLASS ACTIONS BROUGHT BY INSTITUTIONAL INVESTORS IN THE US, AND EUROPEAN PENSION FUNDS ARE NOW BECOMING INVOLVED. WE EXPLAIN HOW CLASS ACTIONS WORK AND CONSIDER THE PROS AND CONS OF PARTICIPATING FOR UK PENSION FUNDS. WE ALSO HIGHLIGHT RECENT TRENDS IN THE US AND EUROPE.

IN 1995 the US legislature passed the Private Securities Litigation Reform Act (PSLRA), which, among other matters, sets out the circumstances in which institutional investors can bring actions against companies in respect of losses caused by unexpected falls in share price resulting from corporate fraud. The number of cases brought under the PSLRA steadily rose in the years that followed, with many being brought by US pension funds, and has now settled at between 150 and 200 actions a year.

European and UK pension funds have only become aware of the potential of entering into US class actions relatively recently. The scandals at WorldCom and Enron served to open the eyes of European funds to the possibility of obtaining large sums in compensation for losses incurred as a result of corporate misfeasance. At the same time, US investors have started to bring class actions against non-US companies, such as GlaxoSmithKline, that trade in US markets.

Some American law firms that specialise in class actions are starting to pursue business quite aggressively in the UK, trying to persuade pension fund trustees that they have a fiduciary duty to join class actions. Consequently, trustees and pension scheme managers need to understand what class actions are, whether there are benefits in pursuing them and, also, the alternative courses of action that are evolving.

Group actions US and UK style

A class action is one in which one or more main claimants makes a claim on behalf of a group of individuals or organisations (“the class”) who have suffered a loss as a result of the conduct, which usually has to be negligent or fraudulent, of the defending person or organisations. Once the class is defined, any person who falls within that definition is entitled to a share of any damages awarded, even if they do not actively participate in the action. They may, however, opt out of the action.

While class actions are allowed in a number of legal jurisdictions, the majority of shareholder class actions occur in the US. This could be because it has the most developed system of litigation in this field. Class actions as such do not exist within the English legal system. If a number of people wish to bring a group action in the English courts, there are two main ways of trying to do so:

• a group litigation order; or
• a representative action.

Under a group litigation order, the court sets up a register of individuals bringing litigation on the same issue, for example pensions for part-time workers. Individuals have to bring their own proceedings and then wait for the main proceedings to be heard. Once the main action has been decided, individuals may pursue their own claims relying on that judgment.

Under representative actions, one or two claimants are chosen to represent the claims of a number of people. Once the action is decided any orders made bind every other beneficiary with exactly the same claim. Representative actions are quite commonly brought when a pension scheme winds up in deficit and the trustees are trying to deal with the claims of competing priority groups.

A key difference between US-style class actions and the English alternatives relates to cost. US class actions are brought on a no win, no fee basis, and if plaintiffs win the costs are met out of any compensation order made by the court. In the UK the loser pays the costs of all parties. This acts as a significant disincentive to bringing a shareholder action in this country.

SUMMARY OF KEY POINTS

Under US law institutional investors are able to bring shareholder class actions against com panies and their advisers whose negligence or fraud has caused a steep fall in their share prices.

Class actions are not possible in the UK so UK pension funds are increasingly joining US actions where a sufficient link to the US can be shown.

A UK pension fund that joins a class action may do so in an active or a passive role. If it takes an active role it needs to decide whether to be a lead plaintiff and control the action. Taking a lead involves a considerable commitment in management time.

UK pension funds need to have bought their shares on a US stock market, or to demonstrate there is a connection with the US.

Several European countries and the European Commission are looking at ways of introducing a mechanism for collective redress.

A number of large European and UK pension funds are using Dutch law in a ground-breaking process to agree a class settlement with Shell.

Reasons for bringing an action

Shareholder class actions are used by investors to try and recover losses that have occurred as a result of fraud, misrepresentation or other corporate misconduct by a company, its directors, officers or its advisers. They may also be used to change corporate governance practices. UK pension funds are less likely to use such actions for this latter purpose as they tend to use direct negotiation to bring about change.

In the UK, falling share prices have led to an increase in pension schemes seeking to recoup losses where they can in order to maximise returns. A survey¹ published by the National Association of Pension Funds (NAPF) reports that one specialist classaction adviser states that in 2006 $18.3 billion was paid out by US companies under classaction settlements. However, the NAPF also notes that it has been estimated that around $2.4 billion remains unclaimed by European and UK investors. As a result the NAPF has produced a short guide² for trustees to assist them in deciding whether or not to pursue class actions.

US law firms often argue that UK pension fund trustees have a fiduciary duty to their beneficiaries to become involved in class actions. In its guide on the topic the NAPF is slightly sceptical of this claim. It points out that, even in the US, a recent case where this was alleged against the trustees of a mutual fund did not get to court. The NAPF’s more measured view is that “trustees have a duty to protect the assets in their scheme and that they should therefore at the very least not neglect opportunities to recoup losses, where the cost and effort are commensurate with the expected return.”

Becoming involved

Before deciding whether to become involved in a US class action, a UK pension fund that holds shares in the relevant organisation needs to be sure that it can prove that it was a shareholder at the time the act complained about took place, and that it either bought its shares on a US stock market or, if the shares were purchased in the UK or Europe, that there is a connection with the US in respect of its holding. (If the pension fund invests in pooled funds, the manager of the fund is responsible for bringing any action. However, the trustees may wish to bring pressure to bear on the pooled fund manager to become involved.)

Assuming that a UK pension fund believes that it will be able to meet the conditions for filing a case, it has several possible courses of action open to it:

• take an active role, either by initiating an action, becoming a main plaintiff or taking over as lead plaintiff;
• where the fund has suffered a considerable loss, opt out of the action and launch a separate case;
• take a passive role and make a claim from the settlement fund once the action has been decided; or
• do nothing.

As far as the final option is concerned, some schemes may do nothing because they are unaware that they have a cause for action. Others may decide, having reviewed their options, that the costs of claiming any damages outweigh the benefits. A further reason why trustees may choose to do nothing is because of concern that any compensation payment will result in a fall in share value of the defendant company. However, because the amount of the compensation is fixed, all that happens if the trustees do not claim is that their share of the damages is passed to the other claimants.

A major obstacle to participating in US class actions is the difficulty of discovering that a complaint has been filed. US courts are under no obligation to seek all possible members of a class to advise them of the action. In addition, once a claim has been filed there is usually a 60-day deadline for completing the necessary processes to join the action or to take over as lead plaintiff. Therefore, before the possibility of any action arises, it may be prudent for trustees, particularly of larger funds, to formulate a general policy in respect of class actions. This could set out basic conditions that have to be met before considering whether to take a key role in the action and save time when a cause for action arises.

Taking an active role

If trustees decide in principle that they wish to participate in class actions where their criteria are met, they can then either ask their fund managers or custodians to advise them of any potential or forthcoming actions. Alternatively, there are a number of US law firms and specialist recovery services that monitor court records constantly and then advise trustees of any actions from which their scheme may benefit.

If a scheme’s trustees become aware at an early stage in the proceedings that they may be eligible to recover damages, then they have to decide whether to take an active or passive role. If they only become aware of the action at a later stage, they may still be able to take a passive role.

Even if a scheme does not file the original claim, it may still become the lead plaintiff. The advantages to a UK fund of becoming a lead plaintiff are that the fund:

• is able to define the class of shareholders who will benefit from the case;
• negotiates the lawyers’ fees;
• can control how much money goes into the compensation pool;
• protects against US lead plaintiffs effectively discriminating against non-US claimants; and
• is able to set any corporate governance improvements to be included in the settlement.

However, there are disadvantages to being a lead plaintiff, which may outweigh the benefits. The NAPF notes that taking a leading role in securities litigation involves a considerable commitment in management time and costs as an action can easily take two or more years. Negotiating settlement terms may be very time-consuming. In addition, the NAPF warns that there may be intrusive disclosure requests from the defendant’s lawyers.

The NAPF also comments that there is a risk of reputational loss in becoming a lead plaintiff if the case is considered to be frivolous or vindictive. Hermes Investment Management, a large UK fund, brought an action against the Italian dairy giant Parmalat, which had collapsed amid allegations of fraud in 2003, only to have the company start an action against it claiming that Hermes had “worsened the financial distress” caused by Parmalat’s collapse. However, Parmalat’s action was quickly dropped, which suggests that it was something of a speculative move in the first place.

Passive route

In its 2007 engagement survey, which covered 39 funds, the NAPF asked respondents if they had been involved in class actions. The accompanying chart sets out the responses.

The survey shows that only four of the 27 funds that have been involved in class actions have taken an active role. The remainder, as with the majority of UK funds, have taken a passive role in class actions. This means that they make a claim once settlement has been reached. They are able to do this because, once the court has made a settlement, any person or body that falls within the class is entitled to damages, even if they did not register their claim when the action commenced.

Once a case has been decided, the court issues a “Notice of settlement”, but it is under no obligation to contact all members of the class with details of its decision. In particular, any class members outside the US are unlikely to receive the notice. Because of the tight deadlines for lodging passive claims, European funds often miss out on claiming their share of compensation. Monitoring all settlements is time-consuming so pension funds may ask their custodians to do it on their behalf or, more likely, use a specialist recovery service.

Even making a passive claim can be costly in terms of time as the information is often difficult to obtain from the US. The filing process can be cumbersome and if there are any errors at all on the forms, they will be rejected. It is also quite resource intensive to claim. Claims will only succeed if there is a full audit trail to prove them. Therefore, again trustees tend to outsource the process to specialist firms.

Recent developments

Just as UK and European pension funds are starting to become involved in class actions, some US lawyers are beginning to question whether it is appropriate for European investors to pursue their claims in the US courts. In some instances the courts are reflecting this viewpoint. In recent months a case brought by European investors against four US-based advisers in respect of Parmalat was dismissed on the grounds that as the investors and the defendant were based in Europe and the shares had not been purchased in the US, there was not sufficient connection to the US to justify bringing an action there. These investors have now filed a claim against the same US advisers in the Italian courts.

In certain other actions, US lead plaintiffs have either excluded European investors from the class or restricted their damages in some manner. In a recent significant development, several leading pension funds, including Railpen (the investment arm of the Railway Pension Trustee Company) and the Universities Superannuation Scheme, opted out of a class action in the US against Royal Dutch Shell and took an entirely different route through the Dutch legal system. The chronology of the case is set out in the accompanying box. The main question mark over the case is whether or not the Dutch court will accept that it has jurisdiction over the non-Dutch funds.

The EU is also moving tentatively towards establishing some form of Europewide system of collective redress. The EU Commission has recently published a white paper3, which is mainly in respect of antitrust provisions, but which also briefly considers class actions. The paper stresses that the EU is not proposing US-style actions run by law firms. Instead, it envisages a system that combines two complementary mechanisms:

• opt-in collective actions, in which victims expressly decide to combine their individual claims into one action; and
• representative actions, which are brought on behalf of victims by qualified entities such as consumer groups.

However, as the wheels of the EU legislative machine grind exceedingly slowly, it may be some time before its solution to the problem is available. In the meantime, several EU countries are looking at ways of dealing with shareholder class actions. If the Dutch court approves the Shell settlement terms, even though some of the claimants are not based in the Netherlands, that will be a step forward.

¹ “Pension Funds’ Engagement with Companies 2007”, available on the NAPF website (www.napf.co.uk) via “Corporate Governance”, then “Research” and “Shareholder Engagement Survey”.

² “Securities Litigation – Questions for Trustees”, available on the NAPF website (www.napf.co.uk) via “Corporate Governance”.

³ “White Paper on Damages Actions for Breach of the EC Antitrust Rules”, COM(2008) 165 final, 2.4.08, available on the EU’s website (at europa.eu/documents/ comm/white_papers/index_en.htm#2008), or from the home page (europa.eu) via “en”, “Documents” and “European Commission”, “White papers” and “2008”.

OUR RESEARCH

In addition to the papers referred to in the text, this feature has drawn on a number of sources, including client briefing papers produced by solicitors Wragge & Co and claims specialist Institutional Protection Services, and seminar papers provided by speakers at a TUC trustee meeting on the topic.