A Mission Statement for Mutual Funds in Shareholder Litigation

Abstract

This Article analyzes the conduct of mutual funds in shareholder litigation. We begin by
reviewing the basic forms of shareholder litigation and the benefits such claims might offer
mutual fund investors. We then investigate, through an in-depth docket review, whether
and how the ten largest mutual funds participate in shareholder litigation. We find that
although shareholder suits offer potential benefits, the largest mutual funds have essentially
forfeited their use of litigation. This finding is particularly striking given that index funds
and other long-term oriented mutual funds generally cannot sell their shares when they
are dissatisfied with company performance, leaving them with only two levers in corporate
governance—voting and suing. Mutual funds vote, but they do not sue.

We analyze potential explanations for the failure of mutual funds to litigate on behalf of their
investors. Collective action problems and conflicts of interest raise significant obstacles
to mutual fund participation in shareholder litigation. Yet, we argue, there are situations in
which shareholder litigation could create value for mutual fund investors. We therefore turn
to the normative question: How should mutual funds litigate on behalf of their investors?
Answering this question allows us to articulate a mission statement for mutual funds in
shareholder litigation.

Our mission statement is grounded on the perspective of the broadly diversified “market
investor.” The repeat-play incentives and broad diversification of many mutual funds, index
funds in particular, suggests that they could create value by focusing principally on deterrence
objectives. Mutual funds should bring shareholder suits against portfolio companies when
doing so would meaningfully enhance deterrence. They should also scrutinize the litigation
brought by other shareholders, objecting to outcomes that fail to promote meaningful
deterrence. At the same time, mutual funds should focus on compensatory goals in litigation
against nonportfolio defendants because extraportfolio claims do not raise circularity
concerns. In addition, mutual funds should consider whether litigation can be used to
implement corporate governance reforms. Finally, in all cases, mutual funds should closely
monitor litigation agency costs. We close by suggesting ways in which the incentives of
mutual funds might be restructured to bring about these changes.

Keywords: mutual funds, index funds, institutional investors, corporate governance, stewardship, litigation, shareholder, engagement, monitoring, agency problems, activism, hedge fund, pension fund, market investor

JEL Classification: G23, G34, K22