Yes, Institutional Investors Can Make a Difference in Securities Fraud Litigation

Institutional investors do in fact make a difference as lead plaintiffs in reaching larger settlements and improving corporate governance.

Given the costs of serving as a lead plaintiff and the free rider problem, institutional investors may not want to lead class-action lawsuits even if they hold the largest financial stake in the defendant firm. Consequently, it is important to provide empirical evidence on the effectiveness of institutional monitoring through class-action litigation.

A forthcoming paper to be published in the Journal of Financial Economics, entitled Institutional Monitoring through Shareholder Litigation, concludes that relative to securities fraud class actions with an individual lead plaintiff, lawsuits with an institutional lead plaintiff are less likely to be dismissed, have significantly larger settlements and are associated with more board independence after the lawsuit.  

The paper, which can be found here, is written by professors from four different universities: C.S. Agnes Cheng of Louisiana State University, Henry Huang of Prairie View A&M University, Yinghua Li of Purdue University, and Gerald J. Lobo of the University of Houston. As stated by the authors in a Harvard law blog, found here, the driving motivation behind the paper was the lack of evidence on the effectiveness of institutional investors exercising monitoring power through litigation.

Such evidence is much needed because the Private Securities Litigation Reform Act of 1995 (PSLRA) established a preference of granting lead plaintiff status to plaintiffs with the largest financial stake in the class action, thus providing institutions an opportunity to critically affect the litigation by serving as the lead plaintiffs.

In addition to documenting the implications of the lead plaintiff provision in the PSLRA Act, our findings also underscore the important monitoring role of institutions, as both an immediate discipline of management as well as long-term corporate governance.

The authors hypothesized that generally institutional investors are "free-riders" and take the benefits of class actions led by other individual plaintiffs, unless the potential benefits to them outweigh their agency costs. The study, as described by the authors, used a sample of 1,811 securities class actions filed between 1996 and 2005, and confirmed that hypothesis. The study found that:

1. When the likelihood of winning is high, the potential damage is large, and the defendant firm is important to the institutional owners, institutional owners are more likely to step forward to serve as the lead plaintiff.
2. Institutional investors are more likely to serve as the lead plaintiff when the lawsuit:
• involves an accounting-related allegation,
• has an accounting firm as the co-defendant,
• has a longer class period, has a larger negative market reaction to the revelation event, and
• has a larger potential investor loss.
3. The probability of having an institutional lead plaintiff is also higher when the defendant firm has a larger market capitalization, has a higher level of institutional holdings, and is operating in a high-tech industry.

The authors then sought to control for these determinants to find out whether, even then, there was a difference in litigation outcomes when institutions became involved. Using multivariate regression analysis to control for these determinants of when institutions are likely to get involved, the authors concluded:

1. That relative to lawsuits with an individual lead plaintiff, lawsuits with an institutional lead plaintiff are less likely to be dismissed and have significantly larger settlements;
2. All types of institutions show significantly better litigation outcomes with public pension funds generating the largest settlement amount;
3. Within three years of filing the lawsuit, defendant firms with institutional lead plaintiffs experience greater improvement in board independence than defendant firms with individual lead plaintiffs.

These findings should be reason enough for institutional investors to step forward and serve as lead plaintiffs. So get involved!