Tony Featherstone warns directors to exercise more care than ever when joining the board of a company looking to list on a stock exchange.
Picture this: a fast-growing company wants to raise $150 million through an initial public offering (IPO) on the Australian Securities Exchange (ASX). As part of its roadshow, the CEO and chairman promote the offer to fund managers, analysts, retail investors, media and staff. The IPO quickly closes. Most stock goes to a handful of cornerstone investors and an allocation is given to retail shareholders to ensure a sufficient spread of investors to meet ASX listing rules. The CEO and chairman congratulate themselves for raising the maximum subscription. On listing, the share price falls 10 per cent below the $2 issue price. Within four months, the company downgrades its prospectus revenue forecasts after trading conditions sour. Its stock halves to 90¢ and the its reputation is in tatters.
An eagle-eyed law firm, backed by a litigation funder, compares the CEO’s and chairman’s comments during the IPO roadshow to those in the prospectus. Investors who sold their shares are encouraged to form a shareholder class action. It claims the prospectus contained misrepresentations and false and misleading forward forecasts, and that the CEO and chairman held selective briefings with key investors. It also claims the board oversaw control weaknesses in the company’s accounting systems and that continuous disclosure obligations after listing were breached. The prospect of a class action thumps the share price and the ensuing publicity affects the company’s trading activities. The board decides to settle the case.
That is a nightmare scenario for IPOs that badly disappoint investors after listing. But it is becoming a more realistic scenario if Australia follows the US where there has been a rise in shareholder class actions against IPOs.
Dr John Gould, senior vice-president of Cornerstone Research, which publishes the Securities Class Actions Filing Review in the US, wrote earlier this year: “The sharp increase in IPOs in 2013 [in the US] may provide fuel for a new wave of filings in the next few years.”
Cornerstone identified 150 IPOs on major US exchanges in 2013, the highest in six years. It found the median market capitalisation of IPOs subject to shareholder class actions fell from US$1 billion in 2008 to US$637 million in 2013, signalling that smaller floats are starting to be targeted.
It seems a long bow to extrapolate US activity and suggest a similar threat to Australian IPOs. Shareholder class actions in Australia mostly target larger, established companies, not small ones that list through an IPO. None of the 11 shareholder class actions threatened or filed in Australia in the past six months relate to IPOs.
In addition, there are significant differences between the legal framework for class actions in Australia and the US. In Australia, there are no jury verdicts for class actions and the losing party in an action has to bear the costs. Moreover, a dearth of IPOs in Australia between 2008 and 2012 explains a lack of class actions for new share issues. With most IPOs raising small amounts, there was insufficient damage to attract litigation funders.
But there are similarities between the Australian and US IPO markets. Australia also enjoyed a sharp recovery in IPOs last year, with almost $10 billion raised. With several large offers on their way, 2014 and 2015 could eclipse previous capital-raising records.
The median IPO capital raising is rising and prospectus liability insurance for larger floats provides a pot of money for class actions and their funders to target. Australia is also facing more shareholder activism. How long before a fund invested in an IPO joins forces with other shareholders to seek damages from a failed float?
The litigation opportunities are there. Having covered hundreds of IPOs over the years, I am always surprised at the willingness of some promoters to disclose information to sophisticated investors that was not contained in the prospectus, without releasing the IPO information pack as a company announcement.
Recent IPO trends heighten the risk of shareholder class actions. Several vendors last year allocated most stock to cornerstone investors. The concern would be if those investors were provided IPO information that was not available to other investors during the offer. There is no shortage of fund managers who have been furious at private equity firms unloading IPOs that quickly disappoint the market.
The allocation of stock in IPOs raises other questions: did boards achieve the best possible price for pre-IPO investors (through seed funding) by offering most of the stock to a select group of investors? Granted, these are difficult charges to prove, but investors in failed IPOs may find they have course for redress, judging by US trends.
Directors should exercise more care than ever when joining the board of a company in the process of an IPO. Experienced directors do considerable due diligence, satisfy themselves about statements in the prospectus and ensure there is sufficient insurance to protect against claims arising from capital raisings. Let’s hope Australia does not follow US trends. But with plenty of IPOs on the way and more shareholder activism, it stands to reason that some disappointing IPOs – and their boards – will be targeted in coming years.
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