Monika Bhardwaj, B.Com (Hons.), Company Secretary
Class Action lawsuits have recently made to the front page news, more particularly in western countries. The reason being the sudden fall (bankruptcy) of financial industry giants like Freddie Mac, Wachovia, AIG to name a few and the consequent losses suffered by large number of investors amounting to millions of dollars.
What is this ‘Class Action’ all about?
‘Class Action’, which is also known as ‘Representative Action’, is actually a form of lawsuit where a large group of people collectively bring a claim to the court through a representative.
This form of lawsuit finds its origin in United States and is predominantly tried in their federal / state courts. In United States, such claims are governed by Federal Rules of Civil Procedure, more particularly Rule 23. Later on Class Action Fairness Act of 2005 was introduced which expanded federal jurisdiction over many large class-action lawsuits (where amount in controversy exceeds $5 Million) and mass actions taken in the United States. It is pertinent to note here that Class Action Fairness Act contains carve-outs for, inter-alia, shareholder class action lawsuits which are covered by Private Securities Litigation Reform Act of 1995 which imposes new Rules on securities class action lawsuit to curtail frivolous claims that are also known as “strike suits”.
It is observed that mainly the class action lawsuits are filed either by a large number of consumers who suffer losses due to some illegal claims made by companies about their products (which we may term as “Consumer Class Action”) or by employees of a Company adopting discriminating hiring or illegal salary practices (which may be termed as “Employee Class Action”) or by large number of investors who suffer losses due to erroneous decisions or actions taken by the management of a Company wherein they had invested their hard earned money (which may be termed as “Shareholder Class Action”).
This article primarily focuses on “Shareholder Class Action” lawsuits. We have made an attempt to understand the concept & its existence in western countries and have tried to relate to the Indian context.
What exactly are ‘Shareholder Class Action’ suits?
Generally it is observed that when a Company’s management plays fraud or take erroneous policies with mala-fide intentions and consequently, the share prices falls or the Company becomes bankrupt; the most hit class of people are its shareholders who losses mainly on account of finance and to recover such losses they collectively file Class Action. Most class actions seek to recover shareholder losses relating to falling share prices or, in the worse case scenario, insolvency. History has witnessed that shareholder class action litigation results more from a company’s stock price movements than from the actual commission of fraud by the corporation.
It is interesting to note here that it’s not necessary that such Class Actions are filed only against the Companies; sometime they are also initiated against the errant management including the Directors and other officers. But the class of shareholders must comprise of those shareholders that have suffered common injury or injuries. When one joins a class action suit, he / she have to forgo his / her right to file an individual suit against the Company.
One may find that Shareholder Class Action may either become jury trials or may be settled prior to trials through mediation and settlement. In mediation, the damages and compensation are agreed to by the defendant company. In Jury Trials, the compensation is awarded through a judgment wherein if the compensation is a huge amount the defendant company may opt for appeal. The appeal process may take years and then the concerned plaintiff/s have to wait for long to get compensation and in such cases if the Company declares bankruptcy, the plaintiffs may never get a compensation then.
“The shareholders of a Company, which is in administration, can make claims against the administrator for continuous breach of disclosure guidelines and misleading and deceptive statements and conduct of the Company and such shareholders can be ranked equally with the unsecured creditors rather than making them stand in the queue after the creditors. Accordingly, the shareholders who buy shares in a Company, which becomes bankrupt shortly, relying on the misleading statements or incomplete disclosure by the Company will have an action as a creditor against the liquidator or administrator for any loss suffered as a result of that reliance.” – Federal Court in Sons of Gwalia Limited (Administrators Appointed) v Margaretic.
In Satyam Computer Services case, twelve class action suits have been filed so far and more are expected against the Company and the Managing Director including the other members of errant management of the Company by US Law firms on behalf of purchasers of Satyam’s American Depository Receipts. In the same fiasco, the global audit firm PwC, along with its international and India unit, was also charged with class action for having “recklessly disregarded” a multi-year massive fraud by the management of Satyam. The suit was filed on behalf of the purchasers of the American Depository Receipts of Satyam between January 6, 2004 and January 6, 2009.
Some recently seen Class Action suits are on Freddie Mac, Wachovia, Fannie Mac.
In United States, the law which deals with Class Action suits is “Class Action Fairness Act of 2005”.
Types of Class Action Suits:
Apart from share-holder Class action suits, there are some other types as well. Class Action lawsuits may be filed for matters relating to Dangerous consumer products, Unauthorized telephone charges, Unpaid overtime, Unauthorized Web loyalty charges, Unauthorized disclosure of credit card information, Illegal debt collection practices, Predatory lending practices, Excessive loan servicing charges, Unfair credit reporting, Pharmaceutical liability, Product liability.
Scenario in India:
We have observed that in India, class action lawsuits may be compared to Public Interest Litigation (PILs) allowed under Civil Procedure Law, wherein an individual or a group of individuals are allowed to file a complaint. Such litigation’s are mainly used in consumer complaints and rising environmental & cultural concerns; generally limited to protection of fundamental rights and are meant for protection of public interest. Such litigation’s can be initiated either by the Court itself or by a public spirited individual/s that represent the victim/s. In such cases, generally victims are unable to approach courts due to financial disability or otherwise. One may find that in India, though the principles of class action suits by shareholders against managements have been upheld by various Courts in the past, these are yet to be reflected in law.
Class Action Vs. PIL
Interestingly, it can be observed that though both Class Action lawsuits and Public Interest Litigation’s allow a large number of plaintiffs to bring collective suits that relate to same cause of action by way of representation as opposed to conventional lawsuit wherein the plaintiff represent himself only; still these both differ from each other. Like in Class Action lawsuits the plaintiff’s attorney charges contingency fees; which means no fees in case of failure and in case of success it is directly related to the amount of compensation / award (whether awarded in a judgment or received through settlement) and hence the risk of success or anxiety to succeed gets shifted from plaintiff to his Attorney, which is not so in Public Interest Litigation’s since as per Indian law, lawyers are not permitted to charge contingency fees. Another difference is in Class Action lawsuits, US Law requires each party to bear its own cost of litigation irrespective of the result of the lawsuit and hence even if plaintiff losses, he is not required to pay the defendant his cost of litigation. However, as per Indian law the courts may ask payment of such cost by the losing party. Actually, these differences alone acts as a deterrent to use class action mechanism in India, the way it is used in US and other European Countries. Further, PILs can only be filed against public bodies / regulatory bodies / state in High Court or Supreme Court under Article 226 or 32 of the Constitution respectively however; the Class Action lawsuits can be filed even against the private bodies. For establishment of Class Action litigation there must be a legal injury to the plaintiff however in PIL such injury / damage is not necessary.
Shareholder Class Action and Indian Corporate
In India, the need to codify class action litigation in Indian law had been recommended by J J Irani Committee which submitted its report to Ministry of Company Affairs on May 31, 2005. One may find that after the Satyam Fiasco, the greater need to encourage class action litigation’s has been felt in India. The provisions contained for representative suits in Section 397 and 398 in the existing Companies Act, 1956 for oppression and mismanagement may be termed alike US Class Action.
However, there is no specific provision for class action litigations under existing Indian Companies Act.
Interestingly the proposed Companies Bill 2009 however contains few provisions for class action lawsuits. Clause 32 of the Bill states that “A suit may be filed or any other action may be taken under Section 30 or Section 31 by any person, group of persons or any association of persons affected by any misleading statement or the inclusion or omission of any matter in the prospectus.” Similarly Clause 215 and Clause 216 propose to provide for a class action mechanism. Once enacted, these provisions will enable the shareholders of a Company to hold the errant companies and their management responsible for the wrong-doing.
Recently, on May 19, 2009 the Securities and Exchange Board of India (SEBI) also notified SEBI (Investor Protection and Education Fund) Regulations, 2009 according to which SEBI will establish an Investor Protection and Education Fund which will be used inter-alia, for “aiding investors’ associations recognized by the Board to undertake legal proceedings in the interest of investors in securities that are listed or proposed to be listed” – clause 5 (2) (d) of the Regulations. Such aid will be subject to certain conditions as stipulated under Regulation 6. This amendment is a path-breaking one and is believed to set shareholder activism in India. Through this an attempt is being made to provide incentive to class action litigation’s. Though a regime has started yet much is needed to make such litigation’s successful in India. In order to make the system functional lot of issues need to be settled which pertains to procedural as well as legal aspects. The procedure need to be clearer in terms of approach. Several amendments are still expected in Securities Law of the country so as to avoid abuse of process.
Benefits of Class Action Suits:
Class action lawsuits are beneficial from various angles.
Firstly, they enable aggregation of large number of individualized claims into one, which is cost effective for claimants and also avoids unnecessary repetition of lawsuit pertaining to common questions of law and fact. It provides an edge to small shareholders to come together and claim damages for the wrong-doing; at the same time lessen the burden on courts.
Secondly, it encourages bringing of claims that are very minimal when you see them individually but are considerable when seen collectively. Small recoveries normally discourages individual when compared to the litigation cost involved. This is the most efficient way of penalizing the wrongdoer and deterring him to repeat his wrongdoing in future where his wrongdoing has caused a significant loss / injury to a number of persons.
Thirdly, it also avoids conflict in rulings passed by different court on same question of facts and law. Fourthly, it provides relief to all individuals (plaintiffs) comprised in the class by way of single judgment or single settlement.
“Class-action lawsuits are an important and valuable part of the legal system when they permit the fair and efficient resolution of legitimate claims of numerous parties by allowing the claims to be aggregated into a single action against a defendant that has allegedly caused harm.” – Preamble to the Class Action Fairness Act of 2005 of United States.
Impact of Class Actions on the ‘Performance’ of an investment portfolio:
In United States, mutual funds may file class action lawsuits on behalf of its investors, with an option given to them to opt in or out of the participation in the lawsuit.
If a company goes bankrupt or goes bust due to any reason suddenly, the stock price of that company falls drastically and if a portfolio holds the shares or securities of that company, then the return on investment obviously gets impacted, since the portfolio value drops to an extent of the quantity of the units held in the portfolio, going by the logic that more weightage the security has in the portfolio, the more will be loss of return. Mutual Funds have no control over this situation and have to report the ‘understated’ rate of return which is caused due to the fall in price of the security.
Now here, two scenarios arise. When the stock price falls drastically, as explained above, the portfolio gives a low rate of return in that particular month or period of months. Now since the class action lawsuit takes long time to reach the settlement, it happens that when the shareholders get compensated for their losses, there is an inflow of funds into the portfolio, which may be huge. Now this un-expected flow of funds causes the return of the portfolio to shoot up, since the portfolio value increases as compared to the previous month or period’s portfolio value. This flow of funds causes the portfolio to get overstated.
Therefore, due to class actions we have two scenarios: One, which makes the return to quote ‘understated’ and second, which makes the return to quote ‘overstated’.
The mutual fund industry is in a debate, whether to include and use this inflow of funds arising out of the result of the settlement, for performance of the portfolio or to give the funds, back to the investor?
Criticisms / Pitfalls:
The Class Action Lawsuits are subject to several criticisms as well. One among them is the large fees for attorney who normally charge conditional / contingency fees which is proportionate (normally a higher percentage of compensation / award money) leaving behind very small portion of money with class members and the second being the time taken for a final judgment, which may take years.
The author or www.taxguru.in does not claim authority or expertise over this subject. The article merely aims at highlighting the facts about Class Action Lawsuits, derived from the information available in public domain. Readers are advised not to consider anything mentioned in the article as a legal advice. Care has been taken while writing this article; however errors or omissions cannot be completely ruled out.