Circularity arguments against Australian shareholder class actions ignore their significant benefits
By Matthew Kennedy and Ewen McNee
In their ongoing attack on litigation funding and class actions in Australia, some big business advocates have relied on so-called “circularity” arguments in an attempt to discredit shareholder class actions and curtail the ability of investors to access justice and seek compensation for fraudulent and other unlawful corporate activity.
Circularity arguments have been prominent among pro-business submissions to the Australian Parliamentary Joint Committee on Corporations and Financial Services, which is conducting an inquiry into litigation funding and the regulation of the class action industry.
Exploring the arguments
In a shareholder class action, the class members allege that the company failed to disclose price sensitive information, which in turn caused the company’s shares to trade at a higher price than if the market had been fully informed. It follows that shareholders who purchased shares during the period of the non-disclosure paid an inflated price because of the non-disclosure.
Securities class actions are structured so that shareholders who purchase shares during the period of the non-disclosure bring a claim against the company for breach of the relevant legislation. The class members usually seek compensation equal to the amount of the share price inflation. If the class action is successful, the company pays compensation from its balance sheet or, in most cases, from the proceeds of insurance. Critics say that this sees shareholders in effect compensate themselves. If shareholders only ever bought and held shares then this criticism might have some merit, but the fact is - shareholders who participate in a class action are not necessarily the same shareholders who hold the shares when the class action is commenced or paid out.
To the extent that the shareholder groups are different, there is nothing unusual about current shareholders footing the bill for misconduct that occurred when other people held the stock, even if the prior shareholders benefited from the misconduct. Take the example of a chemical company which unlawfully contaminates a waterway rather than paying to treat chemical runoff. The shareholders at the time of the pollution benefit from the savings. When the company is made to rectify the pollution the later in time shareholders wear the costs of the clean-up and fines. When a company has engaged in wrongdoing it should compensate those it has wronged, whether they are the company’ customers, neighbors, or investors.
In addition, it is still in the interests of shareholders who do not suffer loss from a non-disclosure, and who therefore cannot claim, for the laws relating to continuous disclosure to be enforced. The fact that company money (where there is no, or inadequate, insurance) is used to pay compensation is not a reason to water the laws down. Otherwise that argument would apply to every law which imposes a penalty or compensation obligations on a company.
Investor and regulator support
If detractors of securities class actions are correct that circularity makes class actions futile, then you would expect the ‘victims’ of this circulatory, the investors, to be the most vocal critics of these actions. In fact, when institutional investors have weighed into the debate it has been on the side of allowing and facilitating private claims for loss and damage arising from non-disclosure.
In its submission to the parliamentary inquiry, AustralianSuper, one of Australia’s largest superannuation funds, said:
“The class actions system and the consequences for companies and boards in not complying, operates as a reminder to avoid continuous disclosure breaches.”
HESTA, another major superannuation fund and institutional investor, also said in its submission to the inquiry that:
“HESTA participates in class actions to recover losses but also as a means of encouraging better standards of corporate governance and improved accountability by companies, directors and corporate advisors to their shareholders.”
From our conversations with our shareholder class action clients around the world, it is clear that they see these class actions as an important tool to compensate for breaches of the law and to deter wrongdoing generally.
Those shareholders also ultimately benefit from improved corporate behaviour and governance, through improved company performance. Management are agents for the shareholders. Whilst payment to shareholders from a class action might have a financial impact, the consequence of better corporate behaviour is a reduction in agency costs.
Support for shareholder class actions also extends to Australia’s corporate regulator, the Australian Securities and Investments Commission, who has said:
“The continuous disclosure obligations are critical to protecting shareholders, promoting market integrity and maintaining the good reputation of Australia’s financial markets …. The economic significance of fair and efficient capital markets dwarfs any exposure to class action damages.” [1]
And:
“Shareholder class actions can play an important and complementary role in improving shareholder access to justice and fostering accountability.” [2]
If investors and regulators are broadly supportive of shareholder actions despite possible issues with circularity, then what is the source of the criticism? In a 2008 paper “The Circularity of Life in Securities Class Actions,” Frank Torchio - a litigation expert and academic who is regularly retained as an expert in Australian shareholder class actions - identified the culprits (at page 24):
“Indeed it is curious that the most vocal critics of the lack of deterrents in existing securities laws come not from shareholders but rather from [company directors and officers] (who are ostensibly protecting shareholders interests) and political groups (eg, U.S. Chamber of Commerce) representing the “business community.” There is a surprising absence of outrage from the very parties that would directly “pay” for the lack of deterrents in securities laws – investors. Where are the shareholder activists groups that represent investors in many corporate governance matters? The complaints coming from the “business community” is a bit like the fox complaining to the farmer that he should tear down his fence because it is too costly to maintain and does not stop the foxes from getting into the chicken coup anyhow. Methinks thou dost protest too much.”
At Omni Bridgeway, we have long supported improvements to Australia’s class action system, including further regulation of litigation funders operating in this country through a licensing regime. However, any changes should be based upon empirical evidence that they will improve the class action system for all stakeholders, particularly for class members, including shareholders, and enhance their ability to access justice when they have suffered loss.
So far as Omni Bridgeway is aware, circularity arguments have not been subject to any empirical analysis and are only hypotheses. They ignore the role played by insurance in meeting companies’ liability for securities claims, the fact that the claims are generally by investors who have sold some or all of their shares (indeed class members may have sold their entire shareholding), the deterrent effect of shareholder class actions on corporate misconduct, the positive effects on Australia’s financial markets, and that these arguments have no relevance where claims are brought against an insolvent entity.
As HESTA wrote in its submission to the parliamentary inquiry: “The growth of class actions in Australia should be regarded as a maturing of corporate democracy, not as a development that needs suppression.”
- ASIC, “Australian Law Reform Commission Inquiry into class action proceedings and third-party litigation funders: Submission by the Australian Securities and Investment Commission”, September 2018, at [4].
Ibid, at [46].