Transactional class and derivative actions have long been controversial in both the popular and the academic literatures. Some commentators have argued that every deal faces litigation, that the overwhelming majority of such cases are frivolous, that the only people who benefit from them are the lawyers, and that the costs of these suits outweigh their benefits to shareholders. Others have taken the opposite view, that the litigation costs are overblown and that shareholders benefit from such suits. Yet, the debate over this litigation has so far neglected to consider a change in legal technology, adopted in Delaware a decade ago, favoring selection of institutional investors as lead plaintiffs. My article, “Private Policing of Mergers and Acquisitions: An Empirical Assessment of Institutional Lead Plaintiffs in Transactional Class and Derivative Actions,” fills the gap, offering new insights into the utility of mergers and acquisitions litigation. The most significant findings in the paper are that public pension funds and labor union funds have become the dominant institutional players in these cases, and that public pension fund lead plaintiffs correlate with the outcomes of most interest to shareholders: an increase from the offer to the final price, and lower attorneys’ fees.
Delaware’s goal in favoring the selection of institutional lead plaintiffs in mergers and acquisitions litigation was similar to the goal of the lead plaintiff provision of the Private Securities Litigation Reform Act of 1995. The theory behind this reform was that institutional investors—in contrast to traditional lead plaintiffs, who were often individuals selected by class counsel—would be motivated and sophisticated monitors of the lead attorneys. The institutional investors’ comparatively large economic stakes in these deals would incentivize them to monitor class counsel, and their comparative sophistication would enable them to act on that motivation skillfully. I set out to assess this Delaware reform by asking several empirical questions: have institutions accepted Delaware’s invitation to serve as lead plaintiffs in deal cases? What case attributes attract institutional investor lead plaintiffs? Are different institutional types more inclined to litigate particular kinds of deals? And finally, do institutional lead plaintiffs improve case outcomes for shareholders?
Based on a hand-collected dataset of Delaware class and derivative actions filed from November 1, 2003-Dec. 31, 2009, I found that institutional investors play as large a role in these cases as they do in federal securities fraud class actions, leading 41% of them. Controlling for the size of the deal and other factors, institutions are more likely to assume a lead role in cases with lower premiums, at least until the collapse of Lehman Brothers in September 2008, at which point most institutional types increase their litigation activity and sue in higher premium deals too. Other case and deal characteristics significantly predict institutional lead plaintiffs, such as the number of complaints filed in the case (an illustration of lead plaintiff competitiveness), the length of the complaint (a measure of attorney effort), whether the transaction is cash-for-stock, the market capitalization of the target, and the presence of a “go shop” provision (which negatively correlates with institutional lead plaintiffs). I also find that public pension funds, in particular, target controlling shareholder transactions.
As noted above, I present evidence that public pension funds, alone among institutional types, statistically significantly correlate with the outcomes of greatest interest to shareholders—both an increase in the offer price and lower attorneys’ fees. The favorable outcomes associated with public pension funds may be because they are better shareholder representatives. They are fiduciaries with access to counsel, including, in some cases, the state attorney general’s office or the city counsel’s office. They are comparatively sophisticated, repeat consumers of legal services with established relationships with law firms and, in many instances, portfolio monitoring arrangements with these firms. Such portfolio monitoring may allow the funds to play the law firms against each other in negotiating the best contracts for legal representation, and securing the highest quality work product. Public pension funds may make better litigation decisions than other lead plaintiff types. They may prevent lead counsel from expending too little effort, settling the case too quickly, or underinvesting in the litigation. The law firms may also work harder to please public pension fund clients, given their potential to serve as repeat customers and as a credible source for referrals. The funds may also have the political clout or the media savvy to attract attention to the case, or to exercise other levers of power that may compel the defendants to increase the offer price.
Another potential interpretation of this result is that public pension funds cherry pick the best cases, that is, they obtain lead plaintiff appointments in those cases with the greatest likelihood that the final price will exceed the offer price. This could be because they select the cases with case attributes that correlate with good outcomes. It could also be that they select cases in which arbitrageurs will drive the price up above the initial offer price. I cannot rule out these possibilities, but my paper offers some evidence that cuts against them. The variables that predict a public pension fund lead plaintiff differ from those that predict an increase in price, suggesting that these funds are not simply cherry picking the best cases. Moreover, the correlation between public pension funds and an increase in price persists even controlling for factors that one would associate with cherry picking, such as the premium, multiple bidders, controlling shareholders, pre-bid price changes, and whether the deal is hostile or friendly. Overall, the results are consistent with the view that public pension funds outperform traditional lead plaintiffs as monitors of class counsel and that they reduce agency costs for shareholders in mergers and acquisitions litigation
The paper is available for download here, and will be published in the Delaware Journal of Corporate Law.