A Mission Statement for Mutual Funds in Shareholder Litigation

This Article analyzes the conduct of mutual funds in shareholder litigation. We begin byreviewing the basic forms of shareholder litigation and the benefits such claims might offermutual fund investors. We then investigate, through an in-depth docket review, whetherand how the ten largest mutual funds participate in shareholder litigation. We find thatalthough shareholder suits offer potential benefits, the largest mutual funds have essentiallyforfeited their use of litigation. This finding is particularly striking given that index fundsand other long-term oriented mutual funds generally cannot sell their shares when theyare dissatisfied with company performance, leaving them with only two levers in corporategovernance—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 theirinvestors. Collective action problems and conflicts of interest raise significant obstaclesto mutual fund participation in shareholder litigation. Yet, we argue, there are situations inwhich shareholder litigation could create value for mutual fund investors. We therefore turnto 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 inshareholder litigation.Our mission statement is grounded on the perspective of the broadly diversified “marketinvestor.” The repeat-play incentives and broad diversification of many mutual funds, indexfunds in particular, suggests that they could create value by focusing principally on deterrenceobjectives. Mutual funds should bring shareholder suits against portfolio companies whendoing so would meaningfully enhance deterrence. They should also scrutinize the litigationbrought by other shareholders, objecting to outcomes that fail to promote meaningfuldeterrence. At the same time, mutual funds should focus on compensatory goals in litigationagainst nonportfolio defendants because extraportfolio claims do not raise circularityconcerns. In addition, mutual funds should consider whether litigation can be used toimplement corporate governance reforms. Finally, in all cases, mutual funds should closelymonitor litigation agency costs. We close by suggesting ways in which the incentives ofmutual funds might be restructured to bring about these changes