The growing impact of rising shareholder class actions

Boards are caught in the middle of rising shareholder class actions and increasing D&O insurance costs. Here’s what directors need to know.

Shareholder class actions are entering a dangerous, unpredictable phase for boards as millions of dollars pour into litigation funding and new types of claims emerge. Some leading directors and legal experts believe litigation funding, absent of regulatory reform, is morphing into an asset class for sophisticated investors — too far from its intended purpose to help small plaintiffs secure access to justice.

The size of settlements has increased in the past three years and several new ones could result from the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. AMP could have to defend five competing class actions after allegations of wrongdoing (four of the actions have been transferred to the Supreme Court and are likely to be consolidated).

Another fear is shareholder class actions based on environmental, social and governance (ESG) claims, such as the effect of climate change on capital allocation decisions, or data breaches or non-compliance with privacy laws or regulations.

“Boards should be concerned about class actions and litigation funding,” says David Crawford AO FAICD, chair of South32 and Lendlease and long a critic of litigation funding. “Australia has become a global capital in litigation funding, mostly for the benefit of law firms and litigation funders rather than the people who suffered the loss in the first place. Too many class actions have little or no real benefit to the community.”

Crawford says the threat of class actions is distracting boards. “It’s got to a point where a company that downgrades its profit outlook, makes a bad acquisition or doesn’t sufficiently factor in the effect of climate change into a decision has to worry about being sued. It adds more compliance cost and time for boards.”

Graham Bradley AM FAICD says class actions will make boards more risk averse. “Inevitably, the threat of class actions will force boards to err on the side of caution and source more external advice before issuing forward-looking statements. Investors always press boards to disclose more, not less, information to the market, but this creates risk, especially the risk of class actions.”

Bradley, non-executive chair of HSBC Bank Australia, EnergyAustralia and GrainCorp, says class action trends in the US are worrisome. “Fortune 500 companies are increasingly facing class actions around mergers and acquisitions (M&A). Viewed with hindsight, either the acquirers have paid too much for an acquisition or sellers have sold themselves too cheaply. Either way, the directors are routinely exposed to class actions. Law firms and litigation funders believe somebody has to pay for that loss and compensate shareholders. It’s a dangerous trend for boards.”

Class actions on the rise

Class actions in the US soared in 2017, topping one a day, according to a NERA Economic Consulting study in January. There were 432 shareholder lawsuits that accused companies of false or misleading statements or concealing bad news, up 44 per cent on a year earlier. Merger objections made up more than half of class action filings in the US in the first half of 2018.

In contrast, class actions in Australia have grown steadily rather than exponentially since the introduction in 1991 of a new Part IVA of the Federal Court of Australia Act 1976 (Cth), which initiated a federal class action regime and paved the way for this country to pioneer litigation funding. However, in September, in what is set to be the largest class action in the nation’s history, law firm Slater & Gordon launched legal action on behalf of around one in three Australian workers believed to have their super invested as cash with the banks.

On average, 15.4 class actions have been filed annually in the Federal Court of Australia since 1992, according to research by Professor Vince Morabito at Monash University. Twenty-five class actions were filed in the Federal Court in 2016–17, or less than one per cent of actions. Almost half of all resolved proceedings were settled, often within 12 months. Less than 10 per cent of proceedings (including those beyond shareholder actions) made it to trial. However, there have been no final judgements on the merits of any cases.

At face value, this data does not support claims that a floodgate of class actions against ASX-listed companies has emerged or that growth in litigation funding is encouraging fee-hungry law firms to pursue lower-merit cases and early settlement from defendants. There is clear evidence from the King & Wood Mallesons report released in April, Class Actions in Australia 2016–2017, of an increase in settlements paid.

The Australian Law Reform Commission (ALRC) wrote in its Inquiry into Class Action Proceedings and Third-Party Litigation Funders: “These fears (about Part IVA) have, in large measure, not materialised. As was intended, the regime has enabled claims to be brought by people with small claims whose number may be such as to make the total amount at issue significant and to deal efficiently with similar individual claims.”

IMF Bentham executive director Hugh McLernon says boards are overreacting to shareholder class actions. “Australia’s class-action regime should remain mostly as it is. Growth in litigation funding has meant investors have had better access to justice. If more listed companies met their disclosure obligations, it wouldn’t be a problem.”

McLernon disputes claims that law firms and litigation funders receive too much of settlements at the expense of plaintiffs, or that their payout share should be capped. He estimates that in large class actions, approximately 60 per cent of the settlement goes to plaintiffs, 26 per cent to the litigation funder and 14 per cent to the law firm, which earns its return through hourly fees. IMF Bentham has to date paid out an average 62 per cent to clients in its funded class actions. Industry-wide estimates suggest that, on average, class members receive about 50 cents in the dollar of settlements.

“Critics underestimate the time, expertise and risk involved in funding class actions,” says McLernon. “If a litigation funder’s share of a settlement fell below 20 per cent, it wouldn’t be viable to fund cases, given the risks. We have to take a portfolio approach, fund several cases and spread risks because the costs of a single losing case can be enormous.”

McLernon says law firms should not be allowed to earn contingency fees in class actions. The ALRC Inquiry has proposed that law firms in class actions should be allowed to enter into contingency fee arrangements — paid a proportion of the sum recovered in winning cases (similar to a litigation funder) rather than charging an hourly rate.

“The last thing we should want is law firms taking large funding risks to cover their fees, expert fees, counsel fees, court fees and potentially adverse costs. Assessing and managing funding risk is not their expertise. The ALRC risks falling into the same trap as the UK, which has supported an all-or-nothing approach to law firms in class actions.”

The AICD in its ALRC submission also argued against contingency fees (ALRC Proposal 5.1). AICD wrote: “…existing fee mechanisms provide a sufficient degree of flexibility in relation to legal fees to promote access to justice and is concerned that contingency fees may further exacerbate the problems with the current class-action regime.”

It is thought that making contingency fees available for law firms could lead to more midsize class actions against listed companies (larger, costlier actions would still require litigation funders with deeper pockets and greater risk appetite).

IMF Bentham, Australia’s largest litigation funder, supports ALRC Proposal 3.1 that the Corporations Act should be amended to require third-party litigation funders to obtain and maintain a “litigation funding licence” to operate in Australia.

The ALRC has questioned if capital adequacy standards should be required of litigation funders and if they should have to join the Australian Financial Complaints Authority scheme. Low entry barriers in litigation funding may partly explain why Australia now has so many such funders.

“Our long-standing position is that litigation funders operating in Australia should be licensed,” says McLernon. “Individuals and companies have a right to know that a litigation funder supporting an action that could end up costing tens of millions of dollars and might not be decided for three years, will have sufficient funding in the future.”

AICD also “strongly supports” the introduction of a comprehensive licensing regime for litigation funders in Australia (a position it outlined in the ALRC Inquiry and the 2017 Victorian Law Reform Commission Inquiry) and proposals to enable courts to address competing class actions more efficiently.

Challenging outlook

A robust licensing regime for litigation funding is an important first step, but on its own may not be enough given trends in class actions and their impact on boards. A rapidly expanding capital pool could attract many more litigation funders and law firms, and boost the number of class actions. McLernon estimates the current pool of litigation funding is around $2 billion and will double within five years. The ASX-listed Bentham raised US$133m in 2017 for its US-focused litigation fund.

McLernon believes institutional investors will allocate more capital to special-purpose vehicles that litigation funders establish. “Litigation funding, on average, provides steady long-term returns uncorrelated to the broader sharemarket.”

Corporates outsourcing large legal actions to specialist funders could further boost the litigation industry’s momentum and funding. Corporates are mostly perceived as defendants in class actions, but big banks, for example, are often involved in many more actions as plaintiffs.

McLernon thinks more companies will use large litigation funders to take on cases that could cost millions of dollars to fund and take years to resolve. “Companies could take funding risk off their balance sheet and use the expertise of specialist litigation funders to manage their claim.”

In its ALRC submission, the AICD said competing class actions from the same dispute cause costs and delays for plaintiffs and defendants, undermine economies of scale from class actions, create an unfair impression that a company is under siege and make disputes harder to resolve.

The ALRC says in instances of multiple class actions, the Court should determine which action will proceed, meaning all class actions are initiated as “open” and that litigation funding agreements would only be enforceable with court approval. The AICD supports Proposal 6.1 in the ALRC’s discussion paper to introduce a specific court power to permit only one class action proceeding to progress.

New class actions emerging

AMP’s experience highlights other emerging risks with class actions. Professor Michael Legg of UNSW Law, one of Australia’s foremost legal experts on class actions, is concerned that a dangerous new type of class action claim is gaining traction in Australia. This claim occurs when an allegation of illegality is made and a company’s share price falls.

AMP was alleged to have broken the law for its financial-advice business, principally that it charged fees without providing service in some instances. As Legg notes, it wasn’t AMP customers who suffered loss who brought the class action, but shareholders who owned shares when the conduct was made public and the share price fell.

Says Legg, “The company should have told the market about the allegedly illegal conduct once it was aware of it. However, it is highly problematic if allegations and shareholder reaction to media reporting can ground a claim for compensation. This creates a new risk for companies, which now need to disclose when they might have breached the law.” Legg says as more litigation funders and law firms enter the market, cases with a lower prospect of success will commence and more class actions occur.

He says rising demand for class actions will drive lawyers and litigation funders to search for contraventions of the continuous disclosure regime by listed companies, or misleading conduct. “Every stock drop will be attributed to the non-disclosure or misleading disclosure of material information. The Australian rule on costs, whereby the loser in litigation pays the winner’s costs, is meant to deter such conduct — but that deterrent is ineffective if companies keep settling and plaintiffs can avoid the risk through buying after-the-event insurance. Class actions have become a lucrative investment and high returns will only attract more investors.”

Legg says boards need to be more courageous and stop settling shareholder class actions. “There has been a tendency to settle on a without-admission basis and argue that the settlement was justified to allow the directors to focus on running the company rather than being distracted by litigation. However, when a company pays a significant settlement, another view is that there was a contravention, and the payment is an attempt to buy peace and avoid an examination of the underlying conduct. If shareholder class actions are truly unmeritorious, then directors need to fight them.”

Class actions deter board risk taking

A likelier outcome is boards taking a more cautious approach to disclosure — and greater risk aversion. Arnold Bloch Leibler partner Jeremy Leibler says the threat of class actions is forcing boards to source extra opinions on major transactions, adding to compliance costs and work. “The board is nervous about approving a management proposal for fear of a class action, so gets another layer of external advice. In some cases, this is justified. Too often it’s about boards covering themselves. The result is a board reluctant to make decisions and money wasted on external advice from lawyers and other experts.”

Leibler says the risk of a class action is unsettling directors. “Good boards don’t sit there passively — they make tough, bold decisions. When directors know litigation funders and law firms are looking for any breach in continuous disclosure, they naturally become more risk averse.”

Recent developments in Directors and Officers (D&O) Liability insurance could also exacerbate board risk aversion. Insurers providing D&O cover have reportedly raised premiums because of the rising risk of shareholder class actions. Ruth Parker, client manager with Aon Risk Solutions, says the D&O market continues to harden, particularly for publicly-listed companies, while it’s less volatile for non-listed organisations. “For ASX 200 companies, we have seen a 95 per cent average increase to primary premiums across our client base, between June 2017 and June 2018. There is significant variability in the ASX 200 group and the rate at which insurers are demanding change is increasing.”

Given the increasingly litigious environment, she says Aon recommends directors review their cover needs and have a clear understanding of the organisation’s appetite for risk. Leibler says boards must find the right balance with D&O. “If companies have too much D&O cover, they arguably become bigger targets for class actions because more money can potentially be recovered. Insufficient D&O exposes boards to risk and directors might find they cannot use their law firm of choice to fight an action because the D&O policy has a cap on the hourly legal fee it will pay.”

The insurance fallout is yet another consequence of the rise in shareholder class actions. A regime that began as a means for small plaintiffs to seek justice has become a contest between asset managers and insurers. Boards and long-term shareholders are caught in the crossfire.