First-to-File

First-to-File is a legal principle that, in certain contexts, gives procedural advantages to the person or entity who is the first to file a lawsuit. In the investment world, this concept most often crops up in relation to shareholder litigation, particularly class-action lawsuits. When a company's stock price plummets due to alleged wrongdoing like accounting fraud or misleading statements, multiple investors might want to sue. The “first-to-file” rule suggests that the first shareholder to get their complaint to the courthouse has a presumptive right to be appointed as the lead plaintiff and have their chosen lawyers lead the case. However, this isn't the whole story. For securities lawsuits in the United States, this initial presumption is often overturned by a more powerful principle established by the Private Securities Litigation Reform Act of 1995 (PSLRA), which favors the plaintiff with the largest financial interest in the case. So, while speed matters, the size of your stake often matters more.

Imagine a public company announces a massive accounting error, and its stock price tanks. A stampede of lawsuits is almost inevitable. The “first-to-file” concept creates a veritable race to the courthouse among law firms specializing in shareholder litigation. Why the rush? The law firm that represents the first-filed case might get a leg up in being appointed as lead counsel, a lucrative position that controls the litigation and earns a significant portion of any final settlement or judgment. This has led to a criticized practice where some law firms have “professional plaintiffs” on standby, ready to file a lawsuit at a moment's notice, sometimes without a deep investigation into the merits of the case. They are betting that being first gives them an advantage in the complex process of consolidating multiple similar lawsuits and selecting the leadership team.

For a value investor, whose focus is on a company's long-term intrinsic worth, the “first-to-file” frenzy can seem like a distraction from what truly matters. The goal of shareholder litigation should be to recover losses and hold management accountable, not to win a procedural race.

The good news for diligent investors is that the law has checks and balances. The PSLRA was specifically designed to curb the influence of lawyer-driven litigation. It established a procedure where a judge must appoint the “most adequate plaintiff” to lead the class action. The law presumes that this person or group is the one with the largest financial stake in the outcome. What does this mean?

• Size Trumps Speed: An institutional investor like a pension fund that lost $50 million has a much stronger claim to be lead plaintiff than an individual who filed first but only lost $5,000.
• Quality of the Claim: A hastily filed complaint might be weak on facts. A well-researched claim, even if filed later, can be more compelling. A value investor's strength is in analysis, and this applies to legal claims as much as to balance sheets.

In most major securities fraud cases, the lead plaintiffs are not the individuals who won the race to the courthouse. They are large institutional investors who have the resources and financial incentive to manage complex litigation effectively. Their large losses give them the standing under the PSLRA to take control. For the average investor, this is generally a positive development, as these institutions, such as mutual funds, are often more aligned with maximizing the recovery for all shareholders rather than just securing a quick settlement for the lawyers.

So, if you own shares in a company embroiled in scandal, should you rush to call a lawyer and be the “first-to-file”? Probably not. Here’s a more sensible approach:

1. Stay Informed: If a lawsuit is filed, you will likely receive a notice as a potential member of the “class.” Read it carefully.
2. Assess the Situation: Understand what the lawsuit is about. Does the claim of fraud or mismanagement have merit? How does it affect the company's long-term value?
3. Let the Big Fish Lead: In most cases, it's best to let the process play out. A large institutional investor will likely step up to lead the case, and as a member of the class, you will benefit from any recovery they secure. Your role is typically passive.

The “first-to-file” rule is an interesting legal quirk, but for the value investor, it's a sideshow. The main event is, and always should be, the fundamental strength of the business and the integrity of its management. A lawsuit is often a sign that one or both have failed, and your focus should be on the long-term implications for your investment, not on a short-term race to the courthouse.