Toward a Mission Statement for Mutual Funds in Shareholder Litigation
Mutual funds own approximately 30 percent of the U.S. equity market, and the Big Three fund families – Blackrock, Vanguard, and State Street – are the largest blockholders in the vast majority of large, publicly traded companies. This has made mutual funds a force to be reckoned with in American corporate governance. Mutual funds tout their active engagement in corporate governance and claim to be “good at it.” But are they?
Traditionally, there are three levers of power in corporate governance: voting, selling, and suing. Selling is not an option for many mutual funds – especially index funds, ETFs, and other passive funds that are effectively long-only – leaving them with only two remaining levers: voting and suing. Yet mutual funds use only one: They vote, but do not sue.
We study the conduct of mutual funds in shareholder litigation in a forthcoming article in the University of Chicago Law Review, “Toward a Mission Statement for Mutual Funds in Shareholder Litigation,” available for download here.
In our study, we collected data on mutual fund participation over a 10-year- period in each of the major forms of shareholder litigation: derivative suits, state law direct and class claims, appraisal actions, and private securities litigation. We found that the 10 largest mutual funds, including each of the most vocal funds on corporate governance, very rarely participate in shareholder litigation.
Collectively, these funds were involved in the filing of just 10 traditional shareholder suits over our sample period.
However, these suits often involved the same underlying facts. The 10 suits we found involved only five different instances of managerial misconduct.
All but one of the cases alleged violations of the federal securities laws; we found one appraisal action (T. Rowe Price’s ill-fated attempt to seek appraisal at Dell). We found zero instances of state law class or derivative litigation pursued by the 10 largest mutual funds over our 10 year period.
Moreover, the securities claims were typically not brought as class actions, but rather as individual complaints.
None of our mutual funds served as lead plaintiff over our sample period.
These results are striking in themselves, but for additional perspective, we gathered evidence on the litigation activity of prominent pension funds, hedge funds, and individual shareholder plaintiffs. Our evidence indicates that these plaintiffs litigate more frequently. When we ran the same search on the 10 largest public pension funds, we found 31 shareholder suits against 22 different defendants. Moreover, some public pension funds are considerably more active. For example, the Louisiana Municipal Police Employee Retirement Fund (“LAMPERS”) was involved in 93 shareholder claims over the 10-year period we studied. Large hedge funds and individual frequent-filer plaintiffs also engage in shareholder suits more often than our set of mutual funds. Moreover, there are interesting qualitative differences between the types of litigation pursued by these different plaintiffs. The large pension funds tend to bring traditional securities class actions under Rule 10b-5. LAMPERS and the frequent filer plaintiffs are more likely to bring merger litigation under state law or related disclosure claims under Rule 14a-9. Meanwhile, hedge funds are most likely to bring fiduciary duty suits under state corporate law in connection with their activist interventions.
Although we do not claim to know the optimal amount of litigation, the quantitative and qualitative differences between the litigation pursued by mutual funds and by other institutional investors raises serious questions whether mutual funds are acting as faithful governance intermediaries for their investors. If mutual funds could create value for investors by engaging in shareholder litigation yet are failing to do so, then they would seem to be failing in their fiduciary obligations to investors. Indeed, in spite of building in-house stewardship groups, mutual funds seem to consider litigation hardly at all.
We consider and reject a series of explanations for mutual funds’ failure to participate in shareholder litigation. The failure cannot be explained by substantive legal barriers or structural obstacles, both of which are limited and manageable. Nor can it be fully explained by the circularity problem that arises when shareholders are both plaintiff and defendant. Although mutual funds own the market and are therefore likely to be on both sides in many suits, they may still benefit from systemic deterrence and governance benefits won through shareholder suits. Moreover, not all shareholder recoveries are funded by the corporations owned by shareholder plaintiffs.
Agency costs and conflicts of interest present a more plausible set of explanations. Mutual funds likely do not want to sue the corporations that they rely on for 401(k) and other advisory business. Furthermore, because the benefits of shareholder litigation must often be shared with a class that includes their competitors, mutual funds may see little advantage to themselves in pursuing litigation. Although there may be considerable truth to these explanations for why mutual funds do not pursue litigation, they do not explain why mutual funds should not sue. Moreover, if true, they suggest that mutual funds may indeed be failing their investors by not litigating.
We therefore seek to articulate a mission statement for mutual funds in shareholder litigation. As market investors – holders of broadly diversified portfolios – mutual funds are in an ideal position to use litigation to produce benefits for shareholders and to prevent lawyers from diverting and destroying those benefits. Focusing on the long-term perspective of the market investor, we argue that mutual funds ought to pursue extra-portfolio litigation for compensation and intra-portfolio claims for deterrence. They also ought to consider whether litigation can be used to secure meaningful corporate governance reforms. At the same time, recognizing that litigation often creates more costs than benefits, mutual funds can add value by exerting an oversight role over shareholder litigation across the portfolio and intervening to minimize litigation agency costs.