Lessons learnt from shareholder class actions

Jason Betts identifies four major lessons for directors from the growth of shareholder class action litigation and discusses how to address the risks.

The growth in class action litigation in Australia, particularly third-party funded class actions brought on behalf of shareholders against listed Australian entities, has significantly changed the risk-and-liability profile for directors in this country. As the recently settled Centro shareholder class actions have demonstrated, these cases almost always focus on the way in which listed entities make their public disclosures, and this has direct implications for the processes boards follow in reaching continuous disclosure decisions and approving Australian Securities Exchange (ASX) announcements.

To manage the risks, listed entities and their directors should seek specialist class action advice at critical junctures in the corporate lifecycle, and well in advance of any class action threat, so that the risks can be minimised and managed. They should also:

1. Consider direct and indirect class action exposure

The incidence of directors being named as defendants or joined to shareholder class action proceedings is in fact reasonably low. It is generally not in the interests of those that promote class actions to sue individual directors in circumstances where it is forensically easier to advance a continuous disclosure claim against a listed entity. Naming directors complicates the proceeding because the test for establishing the complicity of individuals in corporate governance breaches is harder to meet than the requirements for a basic claim against a corporate entity itself under section 674(2) of the Corporations Act 2001. But the general absence of direct personal exposure does little to limit the heavy involvement of directors in shareholder class actions.

Continuous disclosure claims always implicate the highest levels of an entity’s management and the board. Defending the class action will require a number of the entity’s directors to provide significant evidence in the proceedings, with affidavits in excess of 100 pages involving hundreds of the entity’s documents being commonplace. Preparing the director’s evidence may take months in a complex claim, and should the matter proceed to trial, cross-examination over numerous days is common. The mere prospect of this process will often cause a director to appoint independent counsel (the costs of which will not always be met under available insurance) and as it evolves, it will present a major distraction to a director’s continuing professional life.

Finally, in circumstances where an entity’s auditors or other independent advisers are joined or cross-claimed into shareholder class action proceedings, the risk of directors or senior management being cross-claimed against by those third parties is very real. These class action risks must be carefully assessed by anyone considering directorship, and the costs and inconvenience of involvement should be factored into a decision to join a board. Some of the cost risks can be addressed by appropriate insurance and company indemnification clauses, but each potential director’s risk tolerance will be different and should be considered in the context of the volatility of the entity’s underlying business. Speaking to a class action specialist before accepting directorship would enable a more informed decision.

2. Have specialist advice for key disclosure issues

While hindsight is generally regarded as a useless attribute, in shareholder class actions the reality is that directors’ conduct is judged in the context of perfect hindsight. Once an announcement is made that surprises the market, it is relatively easy for class action promoters to plead claims against the disclosing entity to the effect that material information should have been disclosed at an earlier time. Once pleaded, it is the burden of the targeted entity and its directors to explain why no earlier disclosure was required. The fact that the information surprised the market will often effectively establish the "materiality" of the information for disclosure purposes, leaving the entity to explain why it did not "know" and/or could not disclose that information at an earlier time.

As recent shareholder class actions emerging out of the global financial crisis (GFC) have established, in the context of current financial markets it can be difficult for directors to demonstrate that the extent of the downturn in credit markets and the emergence of subprime was impossible to predict. While almost everyone accepts that the GFC was unprecedented, there will always be documents within an entity’s records that can be misinterpreted as suggesting an entity was aware of negative information well in advance of any disclosure. This is usually nothing more than the ordinary contingency planning and scenario analysis that all listed entities undertake. Accordingly, extraordinary care must be taken in respect of ASX disclosures likely to have a significant effect on the market. Boards should seek input from class action specialists to ensure such announcements are drafted in a way that dampens the potential for scrutiny from those that prosecute shareholder claims. Taking extra care to contextualise the disclosure, connect it to previous announcements, build in contingencies based on market volatility and demonstrate transparency about the effect of events that may occur can all add up to the difference between a solid disclosure and an announcement that attracts the interest of a third-party class action funder.

3. Carefully manage regulator risk before and during the class action threat

As the actions against Multiplex and Centro establish, shareholder class actions frequently emerge at the same time as the threat of regulatory investigations or proceedings against directors and officers. Accordingly, shareholder class actions give rise to significant regulatory risk. This risk has two aspects. First, if the class action is begun in advance of any regulatory action, directors should ensure the defence of the class action is consistent with the potential defences available to them if personal claims are subsequently made against them by the Australian Securities and Investments Commission (ASIC). At the very least, this will involve careful consideration of the unique legal defences available to directors and how they differ from those applicable to the listed entity. Second, and potentially more critically, if regulatory investigations start before a class action crystallizing, the approach in managing the relationship with the regulator may ultimately determine the subsequent exposure of directors. For example, the scope of requests for documents by ASIC should be carefully negotiated and narrowed as far as possible to ensure production is confined to key issues only. This will assist in containing the scope of the immediate regulatory investigation and any subsequent ASIC proceedings. However, it may also serve to appropriately limit the documents available to plaintiffs in any subsequent shareholder class action if they issue subpoenas to ASIC to obtain documents it gathered as part of its investigation. Again, the result is that at the first sign of regulatory interest in an entity’s disclosure or corporate governance practices, class action specialists should be retained to assist in developing a strategic response aimed at minimising the scope for subsequent class action proceedings, or avoiding them altogether.

4. Obtain specialist litigation advice

When a class action threat does arise, general commercial litigation advice will not be sufficient to navigate the listed entity and its directors through the traps and pitfalls that this specialist litigation creates. The Australian class action regime is one of the most sophisticated in the world (on a par with the US and Canada) and in the 20 years since the federal class action regime was created, significant case law and practical experience has arisen. Shareholder class actions have a number of aspects that are significantly different from conventional proceedings and require a specialist understanding of:

• The unique procedural requirements for class actions set out in Pt IVA of the Federal Court Act 1976 (and its various state equivalents);
• The strategy and business model of the major third-party funders that promote class actions in Australia;
• The difficulties associated with properly quantifying class action claims (particularly those on behalf of shareholders), including complex theories of "inflation per share" implicated in claims on behalf of shareholders, and strategies to manage "multiple" or "competing" class actions, as emerged in the Centro and Oz Minerals class actions;
• The complexities of settling class action litigation, including the supervisory role of the court in that process;
• The special strategic issues that arise in class actions, including the interplay with the media, regulators, third-party litigation funders and plaintiffs’ law firms; and
• Substantive areas of law commonly implicated by shareholder class action litigation, including corporate governance and disclosure practices and related accounting practices.

Directors require more than general litigation advisers to negotiate and manage these issues – the sheer size of shareholder class action claims and the potential liability issues that arise directly and indirectly for directors means mistakes in setting strategy or conducting the defence of the proceedings can be enormously costly and exponentially more so than in conventional proceedings. In that context, it is perilous to proceed without advisers who are experts in the defence of class action claims.

Even if each of the risks referred to above can be managed and appropriately limited, there can be a sting in the tail for directors. Where an entity is the target of a shareholder class action, it is often because it has experienced a period of extreme share price pressure as a result of successive disclosures of information about underperformance. In such cases, the combined threats of a shareholder class action and a regulatory investigation or proceeding can induce the entity to proceed into liquidation and administration. The cruelty of that position for directors is threefold. Firstly, if the entity has adequate Side C insurance for securities claims, the appointment of a liquidator may not extinguish the threat of a funded class action seeking to recover compensation for shareholders out of available insurance funds (a threat seen in the ABC Learning matter). Second, a liquidation event will certainly not extinguish the threat of directors or officers being prosecuted by ASIC. Indeed, the fact of liquidation may only serve to encourage such investigations and proceedings, particularly for high-profile collapses that may generate political or public pressure to prosecute. And thirdly, the fact of liquidation or administration may trigger a third barb in the risk profile for directors in the form of the start of a liquidators’ or administrators’ investigation in which directors are called to give evidence and be cross-examined on the circumstances of the entity’s demise (the ABC Learning and Babcock & Brown matters are good examples here). That triumvirate of risk, spearheaded by the class action threat, is one of the most potent in the Australian legal environment and effectively triples the risk profile of directors in that context. Appropriate class action advice is needed to manage all three risks synthetically and consistent with the "lessons learned" referred to above. Directors are well advised to focus on these in developing their own views on shareholder class action risk.

Jason Betts
Partner
Freehills