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.