Raising the bar

Conducting due diligence on a company before joining its board is critical for any director looking to ensure that they are associated with a business whose stock is set to rise. Alexandra Cain reports.

Multiple class action lawsuits were filed against Facebook’s directors when the value of its stock plummeted following its share market listing in 2012.

While initial public offering (IPO) related lawsuits that target both directors and companies are a long-established part of the US class action landscape, so far there have not been any class actions launched following a listing in Australia.

Nevertheless, there is nothing stopping shareholders in a newly-listed company mounting a class action in this jurisdiction if the share price drops following listing.

Michael Shepherd, partner with law firm Allen & Overy, says as the number of IPOs in the US rise, so too do the number of IPO-related class actions. “Certain statistics suggest that since the financial crisis, the litigation exposure for a company following an IPO has increased.”

For instance, data released by US economic consultancy Cornerstone Research, shows that in the US there were more federal securities class action filings in the first half of 2014 than there were in the first half of 2013.

Shepherd says a common catalyst for a class action lawsuit is a drop in a company’s share price following an IPO that can be linked to an alleged failure to disclose material information prior to the public offering. This means the onus is on directors to ensure that they accept board appointments at quality companies. So what due diligence should directors do to ensure they are associated with a company whose stock is set to rise?

Company Director spoke to chairmen and directors from a number of recently-listed businesses to find out the process they went through to determine whether to accept the board appointment.

Assessing the business model

Murray d’Almeida MAICD is the chairman of payments business BPS technology, which raised $28 million this year through its IPO. He says when determining whether to accept a board appointment, the most important consideration is the company and the faith he has in its business model, as well as in the senior executives’ ability to implement the business plan.

“I consider the integrity of the company and the people involved. I also like to look at the corporate governance structure and the culture of the organisation.”
From a financial perspective, he considers the organisation’s history making a profit, the debt-to-equity ratio and the interest rate cover. “I’m looking for a sound balance sheet with a strong capital structure.”

Also, d’Almeida says he needs to feel confident the product the business is selling stacks up against other similar products in the market, and that its margins are sustainable. “A low-volume, high margin business is far more attractive than a business operating on high volumes and low margins, which can be problematic if economic conditions change.”

Gail Pemberton FAICD is the chair of OneVue, a wholesale provider of superannuation services. It raised $14 million through its IPO in the middle of the year. She has held board positions for more than 15 years, taking up her first board appointment when she was chief technology officer for Macquarie Bank. Seven years ago she became a full-time director and she now sits on six different boards.

“They all have a common flavour in technology, data — especially internet — and financial services,” she says, adding, “I like dynamic, disruptive companies that have a unique value proposition.”

According to Pemberton, her initial investigations into any potential board appointment starts with an assessment of the entity’s financial statements and board reports, as well as a review of the committee charters and company constitution. “But this is basic due diligence, I also do my own research and talk to contacts and people in my network.”

She says the calibre of the other people on the board is important and she always tries to meet with a number of the other directors before taking on a directorship. “Working effectively on a board requires a truly collegiate environment, so it is important there is chemistry. If not, you can end up with dysfunction.”

Pemberton says that some information in the board papers outside of the financials can be extremely telling. “If you pick up something like high turnover in senior management or in the company generally, that is something you need to get to the bottom of. It could be evidence of a deeper cultural problem. You also need to understand the customer base. For example, you should be on guard for the loss of a major contract or a dependency on just one or two clients.”

She says she will decline a position if it is a business to which she cannot relate or add value. “That is really important to me. It also has to be in an industry I am enthusiastic about. For example, if it is in tobacco or gambling, or something else I am uncomfortable with, or if the risks of the business are unacceptable, I will say no.”

Adding value

Paul Anderson is the managing director of Orthocell, a regenerative medicine company that raised $8 million earlier this year. He has a decade’s experience sitting on boards, specialising in the healthcare area.

He agrees with Pemberton that it is important to be able to add value to a business before accepting a board position. “If I feel I can add value then I look at how I could assist with the company’s strategic development. I look for a cohesive board and a business with a structure that is not complex.”

When Anderson conducts his due diligence on a board he reviews the management structure and past and present directors. He also looks at the intellectual property position of the company and if it has a stable technology base.
“I look at the quality of the data generated and the research supporting the organisation’s growth proposition. I am also looking for what needs to be achieved to increase quality control in the business and develop new technologies.”

The entity’s financial position, including cash on hand and its capital raising history are other factors he examines. “I also need to know that forecasts have been reliable.”

Management software developer Vista Group raised $94 million when it listed on both the New Zealand Stock Exchange and the Australian Securities Exchange in early August 2014.

Vista Group board member Susan Peterson had a lengthy career at ANZ before becoming a full-time director, including acting as a director of many of its New Zealand subsidiary company boards. She is now an independent director of Wynyard Group, which develops advanced crime-fighting software, and The New Zealand Merino Company, as well as a tribunal member of the New Zealand Markets Disciplinary Tribunal.

When it comes to board appointments, she is attracted to businesses that have an opportunity to materially grow their revenues, both locally and overseas. As part of her due diligence, she always assesses how easy it would be for a competitor business or technological advancement to disrupt the sector in question.

“I look for diversity of thought and experience on the boards I sit on. I am also interested in whether the business has a proven capability for successfully delivering results. Once you have satisfied yourself the business opportunity is robust and revenue potential is attractive, the next priority for me is the integrity of those managing the business and those who will sit alongside you around the board table,” she says.

Peterson says the potential for personal liability as a director means it is important to have confidence that all of the appropriate reporting is being tabled for the board to consider. “The governance processes are meaningless if the executives responsible for the reporting do not share your values around what you believe to be appropriate standards of performance reporting.”

She is not averse to working with less mature businesses, as long as there is a willingness to implement robust risk procedures if they are not already in place.

From a financial perspective, it is important to Peterson that the business does not carry too much debt. “I do not mind issuing equity, but debt can be a real constraint to being able to deliver on genuine growth potential.” She says the company does not necessarily have to be profitable, but it does need to have a growth opportunity in domestic and international markets. Rational investors will be interested if the business model is sufficiently robust.

She also says that when a board is preparing a prospectus, there is a team of external specialist professional advisers reviewing the business to ensure risks are identified and disclosed and that the projected financial information can be reasonably justified.

“These advisers will provide formal assurances to the directors. The directors then spend considerable time and effort to satisfy themselves that the content of the prospectus can be verified by evidence. In terms of the projected revenue figures, I look carefully at the level of contracted recurring revenue to provide some comfort. I also look at the customer base to ensure there are no customer concentration risks that could cause concern.”

Says Peterson: “You can never perfectly predict the future. But you must always be able to show that you followed a robust process and made reasonable decisions based on the information and specialist professional advice provided.”

Michael Shepherd agrees one challenge for directors considering board appointments is that companies that are looking at going public are often those that are at a growth stage in their life-cycle when they may be more susceptible to swings in their performance and revenues and have more company-specific risk. “That in itself can make the pre-IPO disclosures more challenging. The best protection is to invest in a thorough pre-IPO due diligence process with quality advisers. The aim of this process should be to ensure that full disclosure of all material information is made prior to any IPO. Investing time and resources into that process will minimise the risk of IPO-related lawsuits and increase the chances of successfully defending any such proceedings,” he says.

When you’re in a difficult position

While there may not have been a class action against directors of a recently debuted listed company in Australia, there have been instances where individual investors have attempted to bring legal action against directors, claiming they had based their decision to invest on incorrect representations made in the prospectus.

So it is worthwhile knowing there is an insurance policy that responds to the risks of large capital raising activities in circumstances in which directors face a large legal bill to defend their actions. It is called public offerings securities insurance (POSI).

POSI protects the personal assets of company directors and office bearers against claims arising from their actions and decisions in connection with an IPO.

“The policy has been around globally for more than 30 years and has been in popular demand in the Australian market over the past 10 years,” says Callum McMillan, financial lines underwriting manager, Queensland at financial advisory firm Zurich.
The policy will usually cover damages awarded in civil courts and in administrative or regulatory proceedings, as well as the potentially substantial defence costs incurred in criminal, administrative or regulatory charges or investigations.

“The biggest reason for the current demand for the POSI product is due to the increased liability directors and officers face as a result of the representations they often make when promoting a potential public offering of securities. Providing such extended seven-year coverage can be expensive. But the cost of buying the POSI policy can be assigned as a transaction cost of the listing,” says McMillan.