ARTICLES A Mission Statement for Mutual Funds in Shareholder Litigation Sean J. Griffith† & Dorothy S. Lund†† 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 share- holder litigation. We find that although shareholder suits offer potential benefits, the largest mutual funds have essentially forfeited their use of litigation. This find- ing is particularly striking given that index funds and other long-term oriented mu- tual funds generally cannot sell their shares when they are dissatisfied with com- pany 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 mu- tual funds, index funds in particular, suggests that they could create value by † T.J. Maloney Chair and Professor of Law, Fordham Law School. †† Assistant Professor of Law, University of Southern California, Gould School of Law. Thanks to Alon Brav, William Birdthistle, Erik Gerding, Dan Klerman, Robert Rasmussen, Michael Simkovic, Leo Strine Jr, and David Webber for thoughtful comments and input. This draft has benefited from comments received at the Boston University Law Review Symposium, the Corporate and Securities Litigation Workshop, the National Busi- ness Law Scholars Conference, the Southern California Business Law Workshop, and from workshops at Harvard Law School, the University of Minnesota Law School, the Univer- sity of Southern California Gould School of Law, and Vanderbilt Law School. We are also grateful for conversations with plaintiffs’ attorneys and mutual fund representatives who wish to remain anonymous. Finally, thanks to Taylor Apodaca, Benjamin Bloodstein, Matthew Schob, Kevin Sette, and Dmytro Usyk for superlative research assistance. The viewpoints and any errors expressed herein are the authors’ alone. 1149 1150 The University of Chicago Law Review [87:1149 focusing principally on deterrence objectives. Mutual funds should bring share- holder suits against portfolio companies when doing so would meaningfully en- hance deterrence. They should also scrutinize the litigation brought by other share- holders, 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 con- cerns. 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. INTRODUCTION .................................................................................................... 1151 I. SHAREHOLDER LITIGATION .......................................................................... 1158 A. Shareholder Litigation in Theory ...................................................... 1158 B. Shareholder Litigation in Practice .................................................... 1162 1. Derivative suits. .......................................................................... 1163 2. State law direct and class claims. .............................................. 1167 3. Appraisal claims. ......................................................................... 1170 4. Private securities litigation. ....................................................... 1173 II. MUTUAL FUND PLAINTIFFS ......................................................................... 1177 A. Mutual Fund Participation in Shareholder Litigation .................... 1178 1. Countrywide. ............................................................................... 1183 2. Petrobras. .................................................................................... 1184 3. American Realty/VEREIT. ......................................................... 1186 4. Tyco. ............................................................................................. 1187 5. Valeant. ........................................................................................ 1188 B. Mutual Fund Participation in Appraisal Actions ............................ 1190 C. Compared to the Litigation Efforts of Other Shareholder Plaintiffs ............................................................................................. 1194 1. Public pension funds. ................................................................... 1194 2. Hedge fund plaintiffs. .................................................................. 1198 3. Individual plaintiffs. .................................................................... 1201 III. WHY DON’T MUTUAL FUNDS PARTICIPATE IN SHAREHOLDER LITIGATION? . 1202 A. Legal Barriers .................................................................................... 1204 B. Structural Obstacles .......................................................................... 1207 C. Circularity .......................................................................................... 1209 D. Agency Problems ............................................................................... 1211 1. Corporate client conflict. .............................................................. 1211 2. Collective action problems. .......................................................... 1214 3. Diminished incentives due to fee structure. ............................... 1216 E. A Revealed Preference on Stewardship ........................................... 1217 2020] A Mission Statement for Mutual Funds 1151 IV. A MISSION STATEMENT FOR MUTUAL FUNDS IN SHAREHOLDER LITIGATION .................................................................................................. 1219 A. Litigate Outside of the Portfolio for Compensation ......................... 1220 1. Exit cases. ..................................................................................... 1220 2. Extraportfolio defendants. ........................................................... 1222 B. Ensure that Litigation Inside the Portfolio Provides Effective Deterrence .......................................................................................... 1224 C. Litigate to Implement Meaningful Governance Reforms ................ 1228 D. Intervene to Contain Litigation Agency Costs ................................. 1231 E. Implementing the Mission Statement .............................................. 1234 CONCLUSION ....................................................................................................... 1239 INTRODUCTION Corporate law creates three basic levers for investors to use in influencing the governance of the companies they own. They can vote.1 They can sell. And they can sue.2 Each of these remedies serves to align the interests of managers and investors. Because managers would prefer not to be replaced by a new slate of direc- tors, not to suffer a share price decline from widespread investor selling, not to have the company sold to a hostile bidder, and not to be sued, they are more likely to work to maximize investor wel- fare. That, at least, is the theory. Reality, however, is considerably more complex. In US public markets, the vast majority of company shares are held by institu- tional intermediaries on behalf of investors. Mutual funds are among the most common institutional owners, holding about one- third of the total US stock market.3 In particular, the “Big Three” fund families—BlackRock, State Street, and Vanguard—own sig- nificant blocks in virtually all publicly traded companies.4 This 1 Engagement is arguably a fourth pillar of governance, but we view this as a com- ponent of voting because the effectiveness of the engagement is largely driven by the threat of voting against management. 2 William T. Allen and Reinier Kraakman, Commentaries and Cases on the Law of Business Organization 201–02 (Aspen 5th ed 2016). 3 2018 Investment Company Fact Book *40 fig 2.6 (Investment Company Institute, 2018), archived at https://perma.cc/UV9S-6C6B (providing data showing US mutual funds and other investment companies held 31 percent of all US corporate equities in 2017). 4 See Jan Fichtner, Eelke M. Heemskerk, and Javier Garcia-Bernardo, Hidden Power of the Big Three? Passive Index Funds, Re-concentration of Corporate Ownership, and New Financial Risk, 19 Bus & Polit 298, 313–14 (2017) (finding that the Big Three own the largest stakes in at least 40 percent of all US-listed companies and in approximately 88 percent