By Charles Demoulin – Partner at Deminor Recovery Services
Institutional investors are encouraged to exercise the rights attached to the securities in which they invest assets for their beneficiaries (retirees, clients, etc) and to actively engage with investee companies.
There is also a renewed interest for ‘fiduciary duties’ of institutional investors and the extension of those duties to environmental, social and governance (ESG) issues related to their investments. Institutional investors must often manage assets in the long-term interest of their beneficiaries while taking into consideration the long-term consequences, both financial and non-financial, of their investment activities.
By acting as ‘good stewards’ through the exercise of due care in the selection of investments and the monitoring of investee companies, institutional investors can contribute to the creation of value in the long term for their beneficiaries. It can also help investors prevent, to some extent, undue destruction of value. Unfortunately, institutional investors are sometimes confronted with misconduct, wrongdoing or even fraud that can lead to significant losses on their investments, which also harm the interests of beneficiaries. Institutional investors must then consider available options to recover the value that has been destroyed – or at least part of it.
While looking at the recent developments and how industry practices have evolved, it seems increasingly more difficult to disregard the option of litigation when harm has been done to assets entrusted to a professional investor. We will therefore focus on some aspects related to legal actions that can help institutional investors protect the assets under their management.
1. Evolution towards a more active and direct participation in litigation to protect the assets For many decades, investors have been able to rely on the mechanism of class actions in the United States in which one or several (institutional) investor(s) act(s) as ‘lead plaintiff(s)’ in the interest of an entire class of aggrieved investors. Where those class actions lead to recoveries, most often through a class settlement, investors included in the class can claim their own share of those recoveries even if they have not been themselves directly and actively involved in the litigation.
There have been discussions and opinions in the United States about whether and to what extent institutional investors have a fiduciary duty to take the necessary steps to collect available damages to which they are entitled as a result of a class action. A related issue is whether those investors have a duty to take a more active role in this type of litigation (e.g. by acting as lead plaintiff) or to leave the class (opt out) in order to pursue individual claims for their own benefit.
In Europe, the question of the involvement of institutional investors in securities class actions has also been raised. In a 2007 paper, the UK National Association of Pension Funds (NAPF) asked the question “Do trustees have a fiduciary duty to join a securities class action?” and answered that “It seems self-evident 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.” This is not limited to trustees in the strict legal sense but also applies to other ‘fund fiduciaries’ (as confirmed by NAPF in a document from 2015).
At first sight, starting a court action could be considered as taking investor stewardship obligations to another – more contentious – level. We see however no reason to exclude litigation and the enforcement of rights from the scope of engagement activities that can be expected from institutional investors. In its Global Stewardship Principles that were ratified in 2016, the International Corporate Governance Network (ICGN) provides under Guidance 4.3 ‘Engagement escalation’: “Investors should clarify how engagement might be escalated when company dialogue is failing including… seeking governance improvements and/or damages through legal remedies or arbitration.”
The relevance of this issue for institutional investors has not diminished, quite the contrary. Over the last years, they have been presented with a higher number of opportunities to recover losses through litigation, which are no longer limited to securities class actions. This is due to some extent to a landmark opinion of the US Supreme Court of 24 June 2010 (Morrison vs National Australia Bank) which significantly restricted the scope of US securities regulations (and related class actions) with respect to ‘foreign cases’. As a result, institutional investors had to consider alternatives to litigation in countries where US-style class actions are not necessarily available and investors have to be directly and personally involved in a court action. This is very often the case in Europe.
This evolution had an impact on how institutional investors could effectively discharge their duty ‘to protect the assets’. If litigation requires a direct and active involvement from the investor, the decision whether or not to be involved in a court action can have far-reaching consequences.
2. The importance of taking informed decisions and monitoring the investment chain Where an institutional investor has a (fiduciary) duty to consider participating in litigation, the first step consists in being properly informed, essentially about (1) the existence of a potential claim, (2) the size of the recoverable losses, and (3) how and under what conditions those losses can be recovered. Investors usually want to be involved in meritorious claims (even if they can participate based on a ‘no cure, no pay’ model) and to understand the consequences of being involved in a court action (what can be expected from the investor during the proceedings? etc). Institutional investors should gather as much information as possible at an early stage, bearing in mind that claims for damages can sometimes be subject to relatively short limitation periods.
Even though there are differences between jurisdictions and the same questions are not relevant in all of them, certain issues can be common to various legal systems. It can be useful to draw a list (or to seek assistance to draw such a list) of all key issues related to potential litigation for which investors should seek input before deciding whether or not to participate.
Once the investor has received the information, the next step consists in analysing it in order to come to an informed decision. Even where investors owe a fiduciary duty towards beneficiaries, this does not prevent them from seeking proper advice before taking their decision. Investors may also adopt standardised procedures to facilitate their work and decision-making process, including by adopting internal policies with respect to litigation.
The exercise of an investor’s duties towards its beneficiaries to protect their assets and interests must also take into account the roles and tasks of third parties throughout the entire investment chain. Institutional investors should start by making sure that the information about potential litigation efficiently flows back to them, so they can rapidly consider this option and take an informed decision.
In relation to the decision-making process, it is also important to identify the persons or entities vested with the proper powers and authority when it comes to actively participating in litigation. Indeed, the management of investments is often characterised by a certain degree of delegation to third parties (asset managers, custodian banks, etc). It is problematic if an institutional investor is prevented from claiming or recovering damages because no timely action was taken. It can be equally problematic if a claim is brought without the required authority or if several similar claims are brought by, or on behalf of the same investor due to a lack of coordination or oversight.
This pleads for clear, robust and transparent processes, not only at the level of the institutional investor (including its own internal governance) but also in its relationships with all parties involved in the investment chain. While the support of other parties is often required in order to participate in litigation (e.g. a custodian bank providing statements of the investments to support the claim for damages), the institutional investor should also make sure that decisions to actively participate in litigation are taken at the proper level and that those decisions, once taken, are executed accordingly. This includes the issue of delegations (to the extent they are legally and/or contractually possible) and the extent of those delegations. The same goes for the ongoing monitoring and reporting on the further steps of the litigation.
Institutional investors should therefore include appropriate clauses in their agreements with parties involved in the management of the assets. Delegation of tasks and responsibilities (which can make sense from a practical point of view) should not entail any dilution of fiduciary duties and accountability on the part of the institutional investors.
“If litigation requires a direct and active involvement from the investor, the decision whether or not to be involved in a court action can have far-reaching consequences”
In this respect, we can refer to the ‘Model Contract Terms Between Asset Owners and Managers’ proposed by the ICGN to help asset owners formulate their contracts with fund managers. The ICGN document includes proposed model terms for stewardship under which it suggests the following additional clause, depending on the extent of delegation of stewardship activities to the manager (language used here is equity-specific but could be easily amended for relevant rights under other asset classes): “The manager is granted authority to carry out the following rights in respect of assets held in the Portfolio: (voting/bringing forward counterproposals/ proposing shareholder resolutions/calling for special audits/attending general meetings/calling an EGM/recovering the proceeds of class actions or other litigation brought by other parties/bringing class actions, derivative actions or other litigation]. An appropriate proportion of the costs of any such exercise of rights will be attributable to the Portfolio. The Client retains the following rights in respect of assets held in the Portfolio: [bringing class actions, derivative actions or other litigation/recovering the proceeds of class actions or other litigation brought by other parties/calling an EGM/attending general meetings/calling for special audits/proposing shareholder resolutions/ bringing forward counterproposals/voting). The Manager undertakes to raise with the Client situations in which the exercise of some of these rights might be appropriate, and the parties will agree on an appropriate good faith allocation of any associated costs.”
Institutional investors should act as good stewards by making sensible investment decisions, by exercising their rights as shareholders and investors and by engaging with companies in order to create value in the long term for their beneficiaries. This may also help them prevent such value from being destroyed or at least better understand or mitigate the risk of value destruction. However, there will still be circumstances in which, in spite of all their due care and efforts, undue harm will be done to the assets under their management. At that point, bringing a claim can become a valid option to recover (part of) the losses, in the interest of the beneficiaries.
Recent examples of successful recoveries show that litigation, even outside of the context of US securities class action, is an efficient and valid way to recoup losses suffered as a result of misrepresentations, fraud or other forms of misconduct. Over the last few years, institutional investors have demonstrated a high level of awareness and interest for this concrete way of ‘protecting the assets’ being placed under their care. It is, therefore, not surprising that an ever-increasing number of those investors consider participation in litigation, whenever possible and justified, as part of the duties they owe towards their beneficiaries.
About the Author:
Charles is a Partner of Deminor Recovery Services. Deminor assists investors with recovering investment losses on a global scale in cases of corporate misconduct, market abuse, violation of corporate laws and securities laws, bankruptcy or restructuring, investment fraud and similar situations. Those losses are recovered through individual or collective actions. Deminor has been and is currently involved in several high profile cases in Europe and Asia, such as Fortis, Olympus and Volkswagen.
Charles is specialized in corporate law at both national and European level, with a special focus on corporate law, financial law and litigation. He is often invited to speak at conferences and seminars dealing with those topics. He actively participates in discussions and consultations on legislative reforms at the European and national level. Charles already addressed members of both the European and Belgian Parliament. Charles is a member of the Shareholder Responsibilities Committee of the ICGN (International Corporate Governance Network).
1NAPF, Securities Litigation – Questions for Trustees, p.2