Fiduciary Duty and Securities Class Action Lawsuits

August 15, 2007 -

Fiduciary Duty and Securities Class Action Lawsuits

The scope of an investment adviser's fiduciary duty continues to expand. There are indications that an investment adviser with discretion over a client's account may be responsible for protecting the client's right to participate in class action lawsuits involving securities owned by him or her.

A new burden for advisers to take discretion

If you think proxy voting on behalf of clients is a burden, dealing with the paperwork associated with securities class action lawsuits may add to your heavy workload. Typically, the owners of those securities are sent legal forms requesting that they participate in the litigation or opt out of the proceedings. To receive their share of any settlement or verdict, proof of claim forms must be filled out and submitted.

According to Matthew C. Dallett, an attorney with Palmer-Dodge, the SEC has indicated that it expects advisers with discretion to protect their clients' interests in the proceeds of these securities class action verdicts and settlements. In recent months, the SEC contacted advisers to learn about their policies and procedures regarding class action litigation affecting securities held in their clients' accounts.

According to Dallett, the SEC hasbegun asking some advisers for the following information about:

· Their process for identifying which clients are eligible to participate in class action lawsuits;

· Their thought process for deciding whether to participate in class action lawsuits; and

· Their records relating to clients' participation or non-participation in class action lawsuits, including the total recoveries.

Mutual funds lawsuits

In taking this action, the SEC seems to be following the lead of mutual fund shareholders who sued fund managers, investment advisers, and other related parties, for failing to file claims in class action lawsuits. According to an article by Jonathan Glater in The New York Times on January 19, 2005, dozens of class action lawsuits were filed in early 2005, alleging that the parties failed to file proof of claim forms on behalf of shareholders. The lawsuits contended that this caused shareholders to lose out on billions of dollars.

The investment companies that manage mutual funds were accused of ignoring their obligation to file claims in securities class action lawsuits. When securities class action lawsuits are settled or damages are awarded, shareholders are eligible to participate in the recovery. It was alleged that if these investment companies submitted claim forms in those cases, the recovery would have increased the total assets held by the funds and their Net Asset Value would have gone up.

The lawsuits made many allegations, including breach of fiduciary duty and negligence. Furthermore, the plaintiffs alleged that the defendants did not maximize each individual's investment in the mutual funds.

Although the number of shares held by a mutual fund is likely to be far greater than those held by the average client, investment advisers may be subject to the same standard. Even if a client's share of any potential settlement or verdict will be small, an adviser may still owe a fiduciary duty to ensure that the client is eligible to participate in the recovery.

There will, however, be limits on an adviser's fiduciary duty. It is doubtful that an adviser would be required to initiate a lawsuit on behalf of clients. The adviser should not, nonetheless, cause clients to lose out on their rightful claims to some of the proceeds of an existing securities class action lawsuit.

Course of action

If the SEC and other regulators raise their expectations regarding an adviser's fiduciary duty to protect clients' interests in securities class action lawsuits, advisory firms have a number of options. The first option is to follow the path many advisers use in conjunction with proxy voting. In their Forms ADV, they disclaim responsibility for proxy voting and will only offer guidance to clients if asked to do so. Similarly, an adviser, even one with discretion, may disclaim responsibility for exercising clients' rights to participate in the proceeds of class action lawsuits affecting securities they own.

Even if an adviser discloses in the Form ADV that it will not be responsible for protecting clients' interests in litigation involving securities they own, the firm should still implement appropriate policies and procedures. These policies and procedures should address the following issues:

· How the adviser will notify clients regarding securities class action lawsuits; 

· How the adviser will evaluate the merits of securities class action lawsuits and whether the potential benefit exceeds the amount of time and paperwork involved; 

· How proof of claim forms will be transmitted to clients if the adviser disclaims responsibility for submitting them; and 

· What records the adviser will create and retain to document this process.

Many advisers lack the staff and resources to take on this additional work. Aside from the paperwork involved in filling out these forms, evaluating securities class action claims and lawsuits may be a complicated endeavor.

Even if an adviser with discretion owes a fiduciary duty to protect clients' interests in securities class action lawsuits, it won't necessarily be obligated to pursue the claim. The adviser may make the decision that the expense of pursuing the claim outweighs the potential recovery, which is often a negligible amount. Once again, advisers should document their thought processes and retain these records in case regulators or clients question their actions. In most cases, however, the safest bet is to make sure clients' get their fair shares of the verdict or settlement pot, no matter how small it is.

In some instances, custodians are responsible for pursuing shareholders' recovery in class action claims. Even in those instances, however, the adviser in charge of a discretionary account may be required to ensure that the appropriate steps have been taken on the client's behalf.

At a minimum, advisers with discretionary authority should be checking their Forms ADV to see if they have disclaimed responsibility for handling client claims in class action lawsuits. They should also contact NCS for a sample policy and procedure that addresses this potential problem.