Recent developments in the Indian corporate sphere – Satyam being the prime example – have raised several calls for instilling the culture of shareholder activism in India. One key form of such activism that keeps companies under check is the availability of class action lawsuits for securities law violations by companies, their promoters or managers. The threat of a lawsuit, the loss of time and opportunity of management in having to defend the lawsuit and the associated reputational concerns, would deter players from acting in a manner which results in non-compliance with legal provisions. It is useful to consider some of the incentives that are under play in relation to class action lawsuits before dealing with the concept in India.
The Economics of Class Actions
Class actions are most prominent in the U.S. and it would help to briefly consider the position there as that would help identify the incentives that have caused class actions to take on a prominent form of shareholder activism. Curiously, the incentives are not related as much to corporate or securities laws as they are to the procedural laws and rules that govern legal practice.
First, the permissibility of contingency fees in the U.S. has caused the existence of a flourishing plaintiff bar. Plaintiff attorneys are able to charge contingency fees whereby plaintiffs are required to pay a percentage of their compensation (awarded in judgment or received through settlement) to the plaintiff attorneys. The fee is usually around 33% of the awarded amount, which is quite attractive. In case the plaintiff does not succeed, then the attorney does not receive any fees whatsoever. This, in effect, shifts the economic risk of success (or lack of it) in a class action lawsuit from the plaintiff to the plaintiff’s attorney, as the plaintiff does not have to shell out a penny or paisa to litigate on the cause of action. This incentivizes plaintiff attorney’s to identify instances where there has been a violation of corporate securities laws and to take up actions on behalf of potential plaintiffs. Even if plaintiffs are small shareholders and are generally dispersed, the plaintiff attorneys carry out the job of bringing them together in a class action. For instance, in the Satyam case, it has been reported that more than a dozen lawsuits have been filed in the U.S. by various plaintiff law firms on behalf of ADR holders after the accounting fraud came to light.
Second, in the U.S., the rule is that each party pays its own costs of litigation. Hence, even if plaintiffs were to lose, they are not required to bear any costs incurred by the defendants.
Therefore, plaintiffs and their attorneys have significant incentives to bring lawsuits against errant companies in the U.S. This is apart from several strong substantive legal provisions available under U.S. securities laws, such as Section 11 of the Securities Act of 1933 and Rule 10b-5 under the Securities Exchange Act of 1934. The use of the class action mechanism in the U.S. became so dominant that Congress had to enact the Private Securities Litigation Reform Act of 1995 to curtail frivolous actions that are also known as “strike suits”
Indian Law and Practice
At the outset, it is necessary to deal with a misconception that class actions are not possible in India. That is not at all true. The civil procedure law allows combination of suits that relate to the same cause of action, and hence it may be possible for plaintiffs to bring suits similar to class actions in the U.S. However, the difference lies in the economics: the incentives that trigger class actions do not exist. Indian rules on legal practice do not permit lawyers to charge contingence fees. Therefore, there is a complete absence of a plaintiff bar. Plaintiff themselves (especially small shareholders) do not find it worthwhile to initiate class actions as there is neither a certainty of recovery nor of obtaining a net benefit from the suit (after taking into account the costs incurred). Further, India tends to follow the British rule whereby courts can award costs in favour of the successful party, which have to be paid by the losing party. Hence, if plaintiffs are to lose in a class action lawsuit, not only do they end up without any compensation, but they may even have to bear the costs of the defendant company. This would minimize the amount of risk that plaintiffs may be willing to take. For these reasons, it is not possible to have a market-based class action mechanism in a manner that exists in U.S. and perhaps certain other countries as well.
Given the current disposition under Indian law that carries disincentives against class actions, SEBI has recently taken steps to create a class action mechanism. In the recently issued SEBI (Investor Protection and Education Fund) Guidelines, 2009, SEBI has the retained the power, in rule 5(2)(d) to aid investors’ associations recognised by SEBI to undertake legal proceedings in the interest of investors in securities that are listed or proposed to be listed. The expression “aid” in this context is quite wide, and this could include the provision of funding to investors’ association to initiate class actions. A report in today’s Business Standard indicates that SEBI proposes to fund class actions on behalf of investors utilizing this legal provision. The report also contains some details regarding SEBI’s thought process on the types of actions that will be funded as well as other modalities.
As funding has been identified as the key incentive to the creation of a class action mechanism, SEBI’s proposal may help create that incentive in India. However, there could be several issues that could arise in the implementation of such a proposal. Which type of class actions would be funded? Who would determine that, and on what basis? Will the amounts available in the investor protection fund be sufficient to cater to a vast number of class actions? Will regulators have a role in determining who the plaintiff lawyers will be, and how their fee would be fixed? These and other questions need careful consideration before any system is established.
Apart from procedural aspects, there may have to be changes to securities laws if class actions are to be successful. The current rules on several fronts, particularly in areas such as price manipulation and insider trading require plaintiffs to discharge a fairly high burden of proof. Encouraging class actions alone may not be enough, and it may be necessary to address some of the substantive and evidentiary issues as well.
Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.