In this post, I will teach you first what a securities class action is and then how these affect the returns calculated on your portfolio of investments.

What Is A Securities Class Action?

According to Wikipedia, a securities class action is

…a lawsuit filed by investors who bought or sold a company’s securities within a specific period of time (known as a “class period”) and suffered economic injury as a result of violations of the securities laws.

How Does This Affect Your Investment Portfolio?

This may seem obvious, but when you own stock in a company, your returns are affected by that stock’s price.  If the company is found to have taken an unlawful action, it can negatively affected the stock price.  In that case, you (the stock holder) will experience a loss.
Since the company was found to have done something illegal, they can be taken to court and you can be compensated by the company for your loss due to the unlawful action.  The process of the lawsuit where the company is taken to court to pay for the stock holder’s losses is called a class action.

Visually: first the stock price goes down due to the unlawful action, the company gets taken to court, investors are paid.

For example, when Enron hid billions of dollars in debt on it’s accounting statement and ultimately went bankrupt, investors who held the stock during it’s downfall were later awarded cash proceeds to compensate them for their loss.

 

How Are Class Actions Reflected in the Performance Return of An Investment Portfolio?

Class actions can be handled a few ways, but I will share industry best practice based on the GIPS Standards, and then further explain how you would apply this in practice.
GIPS Guidance on class actions can be found in the Q&A section on their website.
How should litigation income be accounted for? Should it affect performance?

The Standards do not specifically address the effects of the receipt of funds due to a litigation or bankruptcy settlement on performance. It would seem most appropriate that the settlement proceeds would be accounted for when the firm becomes aware of the timing and amount of funds expected by the portfolio. This might be upon receipt of the funds. The funds received would increase the value of the portfolio (would not be treated as a cash flow) and would thus impact the current performance of the portfolio. This assumes that the portfolio was under the firm’s management at the time the litigation event occurred. If the litigation event occurred before the firm began managing the account the litigation income should be reflected as a cash flow as the firm is not entitled to the benefit of the receipt of the income.

  • Categories: General/Miscellaneous
  • Source: GIPS Executive Committee

What is the Timing of Class Actions?

There are 2 dates relevant for class actions and performance:
1) Class Period: This is when the stock had a drop in price and when investors were harmed
2) Receipt of Funds: A lawsuit takes a while to occur and then it takes time for the proceeds to be paid.  Thus, it can be many years after the investor was harmed that they receive their proceeds.  A custodial bank or investment manager may provide the service of going out and ensuring that the investor who held the stock gets the proceeds they deserve.
On performance, the proceeds are typically recognized when paid.  In my opinion this is done for two reasons:
1) The investment manager only received the funds when they were paid, and thus can only invest them at the time.
2) The only other reasonable option would be to “backdate” the funds to the class period  – which is basically pretending that the funds came in at the same time the stock went down so the loss was never realized.  In my opinion, this is not the best option since this will cause cash drag on the portfolio which is not an accurate picture of their performance.

 

Should The Class Action Proceeds Be Booked as a Profit/Gain or a Cash Flow?

When the money (cash) is received, it increases the value of the portfolio.  The next decision is how this money coming in should be treated:
* Option 1: treat it like a cash flow.  By treating it like a cash flow, you are implying that the increase in the portfolio value was not due to the investments and that cash was contributed by an outside source.
* Option 2: treat it like a gain.  If a cash flow is not put on the performance records, the increase in the portfolio value will be treated like gain and the portfolio’s return will increase from the increase in value.
It is best to use an example to describe when each option is appropriate.  We will use Enron as the example.  The Class Period began on 09/09/1997 and ended 12/02/2001.
* Client 1: Hired Investment Manager A in 1990 who bought Enron and later lost $50,000 in his investment when the company went bankrupt.  In 2008, after the litigation was settled, $45,000 of class action proceeds were awarded to the client’s portfolio which is still managed by Manager A.
The manager recognized a $50,000 loss in performance during the class period of 1997-2001. 
Since the loss in returns was due to fraudulent behavior on the company, the manager was not at fault for that loss.  Thus, the $45,000 in proceeds that are later received should be reflected as a gain in the manager’s performance, so that he gets credit for the additional cash which made him “whole.”
* Client 2: Hired Investment Manager A in 1990 who bought Enron and later lost $50,000 in his investment when the company went bankrupt.  In 2005, Client 2 switches to Manager B.  The $45,000 class action proceeds are received in the client’s portfolio at Manager B in 2008.
Assuming you are measuring the returns of the managers:
Manager A recognized a $50,000 loss in performance during the class period of 1997-2001
Manager B, since they only started managing the portfolio in 2005, did not recognize a loss since he never even held Enron in the portfolio from 2005 – present.
The $45,000 of proceeds is received into the portfolio being managed by Manager B.  Since the loss in returns was never reflected in manager B’s portfolio, t would be unfair to credit him for a gain that has nothing to do with the investment decisions he made.  Thus, the proceeds that are received should be reflected as a cash flow and not increase returns, rather than a gain which would increase returns.
Have a different thought?  Comment or question?  Let me know!

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