The following article appeared in the December 2003 edition of ISS's SCAS Alert:

Puncturing the Myths of Opting Out
By Bruce Carton, Executive Director

On Nov. 17, Judge Cote of the U.S. District Court for the Southern District of New York found in In re: WorldCom, Inc. Securities Litigation, No. 02 Civ. 3288 (DLC), that law firm Milberg Weiss had "engaged in an active campaign to encourage pension funds not to participate in the class action and instead to file individual actions with Milberg Weiss as their counsel."

The Court further found that while "there may be sound and good reasons for filing an individual action and choosing to opt out of the class action…certain communications with Milberg Weiss had resulted in confusion and misunderstanding of the options available to putative class members, and did not appear to have presented a forthright description of the advantages and disadvantages of both the individual action and class action options."

To address this confusion, the court ordered that the lead counsel in the class action was permitted to draft a curative notice to be provided to all members of the class and to each plaintiff who had filed an individual action.

The WorldCom case is only the latest development in an "institutional opt-out" trend that has gathered momentum this year. In July 2003, for instance, state pension funds in Ohio and California elected to opt out of the class action pending against AOL and filed individual actions in their own state courts. In addition, in September 2002, Ohio reportedly joined at least four other states--Illinois, Alabama, West Virginia and California--in opting out of the federal class actions against Enron and filing individual actions in state court. Betty Montgomery, then the Ohio Attorney General, stated at the time that pursuing recovery in state court gave Ohio "three important advantages… We improve the likelihood to recover real dollars, we move our case more quickly through the system, and most importantly, we have complete control over our lawsuit."

Does an institutional opt-out in favor of an individual state court action really provide institutions with these and other advantages? While there are theoretical arguments in support of individual actions, the advantages sought by institutions often do not materialize in practice. Indeed, both plaintiffs' counsel and defense counsel at the recent Institutional Investor Forum in New York agreed that individual state court actions make sense only in rare instances.

Larger, Quicker Recoveries?

In theory, an individual action may result in a larger recovery for an institution than the "pennies on the dollar" settlements that are not uncommon in class actions. Discussing his state's decision to opt out of the AOL case, current Ohio Attorney General Jim Petro explained, "The class-action lawsuit, you get peanuts at the end of it . . . The only guys who make money are the lawyers."

In reality, however, any settlement with a plaintiff in an individual action will almost certainly be tethered to, and come after, a settlement with the class plaintiffs. Boris Feldman, a securities litigator with the law firm Wilson Sonsini Goodrich & Rosati, explained at the Institutional Investor Forum that he would not settle an individual action first because the price-per-share offered to the plaintiff in the individual action would immediately become the floor for any settlement in the much larger class action. In addition, Feldman said he would expect plaintiffs' counsel in the class action to demand a "most favored nation"-type provision in any class settlement agreement, requiring the settling defendant to increase the amount of that settlement accordingly if it subsequently settled with an opt-out plaintiff for more money per share. Such a clause would make it very expensive for a defendant to settle on more favorable terms with an individual opt-out plaintiff.

Indeed, the plaintiffs' law firm Bernstein Litowitz Berger & Grossman, co-lead counsel in the WorldCom case discussed above, offers the following eye-opening bit of research: to its knowledge, no individual action has ever settled prior to a pending class action or settled on more favorable terms. To the contrary, the firm states that in its own high-profile cases such as Cendant Corp. and 3Com Corp., huge settlements were obtained and paid out to the class while individual class actions remain mired in litigation.

Moreover, unlike class actions where the enormous potential damages weigh in favor of, and promote settlements before, trial, the relatively insignificant potential damages presented by one individual action will make defendants more willing to risk a trial, with the additional prospect (and delay) of appeals should the plaintiff prevail.

Control Over the Lawsuit?

Theoretically, the opt-out plaintiff can chart its own course through an individual action, independent of the parallel class action. As the WorldCom case shows, however, this independence will be illusory where plaintiff's counsel represents a number of institutional opt-outs also filing state claims. In WorldCom, Milberg Weiss filed at least 47 individual actions on behalf of over 120 pension funds. Defendants were able to remove the individual cases to federal court and, over Milberg Weiss' objection, consolidate all of the cases with the class action for pretrial purposes. In any event, plaintiffs' counsel handling multiple opt-out cases will need to coordinate the efforts ongoing in each of the cases, and will be pulled by trustees for each plaintiff who have their own views and strategies on how to proceed. So much for independence.

No Stay of Discovery?

Unlike federal securities class actions subject to the Private Securities Litigation Reform Act of 1995 (PSLRA), state cases do not have a statutory stay (prohibition) of all discovery while a motion to dismiss is pending. In practice, however, defendants will fight hard and often be successful in obtaining a stay of discovery in the state cases, as well. It is highly inefficient to require the defendants' executives, for example, to give depositions in numerous cases on the same issues, and courts are inclined to coordinate discovery in the class and individual actions.

Even if early discovery is permitted, however, it will be a two-way street, presenting the individual plaintiff with significant discovery obligations and possible embarrassment that a class member will not face. Fund trustees and managers will themselves be subject to discovery by defendants. As Feldman stated at the Institutional Investor Forum, "if you like depositions, you'll love being an opt-out plaintiff." He further warned that the discovery requested in such cases is not limited to the security at issue, but also extends to the fund's performance and decision-making with respect to other investments.

Other Downsides of Individual Actions

Individual actions present other notable disadvantages:

--Significantly higher attorneys' fees: According to law firm Bernstein Litowitz, capable plaintiffs' counsel will need to charge an individual plaintiff a fee that is a substantial part of any recovery. In a class action, by contrast, fees as low as 10 to 15 percent are not uncommon, and any fees paid to class counsel will be scrutinized for fairness by the federal court.
--No 1934 Act claims: Plaintiffs filing an individual action in state court will not be able to assert a fraud claim under Rule 10b-5, the core claim of many securities cases. Plaintiffs will be limited to state claims and 1933 Act (non-fraud) claims only.
--Shorter limitations periods: Negligence-based claims under state law and 1933 Act claims have shorter limitations periods then fraud claims, which may eliminate or reduce the recovery available to individual plaintiffs.
--No reforms: Institutional investors have increasingly sought to effect corporate governance reforms as part of class action settlements. Individual actions are far less likely to achieve such results.
--State court forum: Because they are the forum for the overwhelming majority of securities fraud lawsuits, federal courts are more familiar with the substantive and procedural issues accompanying such suits than state courts.
--Undermining the process: The institutional opt-out trend has the potential, on a "macro level," to undermine the foundation of the securities-class action process established by the PSLRA--that institutions will assume the lead plaintiff role and control securities class actions. If a sufficient number of institutions choose to opt out of class actions, defendants in these cases will have no ability to achieve finality through a settlement, thus destroying the leverage and ability of institutions leading the class actions to effect favorable settlements.

There may well be a combination of circumstances in which, notwithstanding the disadvantages discussed above, an institutional opt-out makes sense. The current evidence suggests that in most situations, however, the time, effort, and expense of an institutional opt-out are not warranted.