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Shareholder Class Actions The Liberty White Paper Series Executive Summary Australia is now the second most likely jurisdiction, outside North America, in which a company will face In the aftermath of the HIH Royal Commission, it has been recommended2 that personal duties and liabilities under the Corporations Act be extended beyond directors and officers to corporate officers, employees and other individuals below board level. Defence costs in class action suits (for which directors and officers may be liable regardless of the outcome) can run into millions of dollars.
Securities Class Actions The recent collapse of a number of major Australian compensation claims for losses corporations both within Australia (HIH associated with shareholdings have been Insurance and One.Tel) and overseas made by shareholders against GIO-AMP (Enron, WorldCom and Adelphia) has (settled in August 2003), Telstra and created an environment requiring much Concept Sports among others.
greater vigilance in regard to corporate governance and the actions of directors Bankrolled by litigation funder IMF (Australia) Ltd, the within corporations. case against publicly listed company Sons of Gwalia Ltd and its directors alleges that share value was lost as a result of misleading statements and failure to keep the Today, the greatest litigation threat to corporations market fully informed in respect of gold reserves. is posed by "class actions" and other multi-claimant proceedings – actions brought by or on behalf of Aristocrat, the world's second largest gaming machine hundreds or even thousands of parties in similar manufacturer, currently faces a shareholder class situations seeking significant relief against companies action, claiming damages of $A190 million, for allegedly and their directors and officers. Some class actions misleading shareholders by not keeping them fully even seek orders from the courts to impose major informed before announcing earnings downgrades that changes to the ground rules upon which those wiped $A2 billion from the company's value in 2003. companies operate.
The Statement of Claim cites adverse operational events (eg. significant margin pressures in its US operations, The Hollywood film Erin Brockovich depicted a massive inadequate risk assessment systems and incautious tort claim against a California power company for growth strategies in South America) that should have polluting the city's water supply, and the media is full been disclosed to shareholders when they occurred.
of product liability and other tort cases against major corporations in respect of products such as asbestos, Similarly, a class action by shareholders was brought tobacco, breast implants, heart pacemakers and weight against retailer Harris Scarfe who claimed that, in loss drugs. In Australia, compensation claims relying on the representations made by the directors, have been made against: they acquired shares in the company at a value greater than their true market value or lost the opportunity – Longford Gas for interruptions to gas/power supplies to sell shares in the company prior to the shares – Sydney Water for contaminated water supplies becoming valueless.
– Wallis Lake Oysters for various food contamination – Mobil Avgas for contaminated fuel supplies However there is also an increasing trend for shareholders to bring class actions against companies and their directors for compensation claims associated with their investment in the company's shares. These actions are commonly termed "securities class actions". Being Ordered to Pay Compensation What exactly are class actions? is only Part of the Problem. In the United States, where class actions A crucial, but often poorly understood have been entrenched in their legal system aspect of class action risk is the legal for many years, the term "class actions" costs involved. The GIO claim was describes a litigious process where a worth a staggering $97 mil ion but the large number of claimants, who may have defence costs alone came to $15 mil ion. claims involving common questions of The shareholder class action against fact and law against a particular defendant Aristocrat has been running for several or group of defendants, combine their years and has yet to be resolved and the actions in one proceeding. defence costs are already running into many mil ions of dol ars. Companies need In Australia, "class actions" often take the form of "same to ensure their directors and officers are interest" proceedings which are commenced under the Supreme Court Rules of the various State or Territory or covered for defence costs or they may "representative proceedings" which are brought under end up paying, even where no liability is Part IVA of the Federal Court Act 1976 (Cth) or Part 4A of the Supreme Court Act 1986 (Vic). What is driving the trend for shareholder class actions? "Same Interest" procedures provide a legal regime Today a vast number of Australians invest in shares, whereby numerous persons who have the same interest either directly or indirectly through managed investment in a proceeding, can have the action commenced or funds and superannuation. Institutional investors also continued by one or more of the group who represents have substantial shareholdings in other companies as the whole or part of the group. part of their portfolios.
Traditionally, these "same interest" procedures have Two recent High Court decisions have made bringing been narrowly interpreted, requiring the claims of all class actions on behalf of shareholders and investors group members to arise out of the same transaction more attractive by confirming that: or series of transactions. In recent years, however, a more liberal interpretation of the requirements has (i) shareholders rank equally as unsecured creditors in been adopted by the courts4. the case of an insolvent company (Sons of Gwalia), and Class actions in the Federal Court are known as "representative proceedings". The provisions of (ii) the concept of litigation funding (ie litigation funded the Victorian legislation for class actions procedures by those who "invest" in legal actions initiated by are virtual y identical to those of the Federal Court those who otherwise cannot afford to bring such although class actions in Victoria are known as actions) is not against public policy3. In Part 4 of this series, we will explore in greater detail The term "class action" in the Australian context is the factors driving the recent increase therefore used in a more popular context rather in shareholder class actions in Australia.
than a strictly legal one. Used in this popular context, class actions encompass a range of litigious processes at Federal, State and Territory levels and include various forms of representative or group proceedings and, sometimes proceedings involving multiple plaintiffs or defendants. These various forms of litigious processes provide a means by which the claims of many individuals against the same defendant (or defendants) can be brought by a single representative. For the sake of simplicity, we shall refer to all such litigious processes in this series of White Papers as "class actions".
Footnotes(1) There are a number of recent articles (2) Fol owing the HIH Royal Commission recommendation that personal duties (4) In Carnie v Esanda Finance written by leading law firms of this Report on The Failure of HIH Insurance, and liabilities be extended under the Corporation (1994-5) 182 CLR 398, for country informing us that class actions the Corporations and Markets Advisory Corporations Act beyond directors and instance, the High Court held that "same have become a significant part of the Committee (CAMAC) published a officers to those in senior management interest" means "a community of interest Australian legal landscape. See, for paper ( 2005) which reviewed the or who otherwise take part in, or are in the determination of some substantial instance, the article written by S Stuart personal duties and liabilities under the concerned in, the management issue of law or fact". This more liberal Clark and Christina Harris of Clayton Utz, Corporations Act of corporate officers, of companies.
approach has al owed "same interest" "Class Actions in Australia employees and other individuals proceedings to become almost as broad – A Comparative Review" below board level. The outcome of the (3) Campbel s Cash & Carry Pty Limited as proceedings which are brought in the report was, amongst other things, a Federal Court.
Executive Summary Shareholders in Australia now have available to them the entire suite of corporate malfeasance claims and remedies under numerous pieces of legislation. The Prudential Principle is no longer a barrier to shareholders who wish to bring a class action seeking damages for loss of share value.
The class action against the now-defunct Harris Scarfe Holdings – which went into voluntary administration in 2001 – successfully met the federal requirements: namely, the claims of 7 or more persons were shown to arise from related circumstances and to have given rise to common questions about the directors' duty of care, the entitlement of individuals to recover losses, and the liability of individual directors. Directors and officers and the company secretaries who manage the board's legal responsibilities need to understand the importance of this changed legal landscape, particularly as it relates to the liability of The Prudential Principle Efficiency in the legal process Until the insertion, in 1991, of Part IV-A Class actions brought under the federal into the Federal Court of Australia Act regime must satisfy the requirements 1976 (Cth), an established principle of of Part IVA of Federal Court of Australia law called "The Prudential Principle" had, Act 1976 (Cth). This part of the Act was to a large extent, shielded corporations designed to provide a legal remedy in from shareholder actions. The principle situations where many people are affected provided that a shareholder could not by certain actions or omissions of another recover damages from a company merely and the total amount in issue is significant because the company in which they have but each person's individual loss is small invested had suffered loss.1 and thus not economically viable to recover in individual actions. This loss suffered by the shareholder, the courts said, was no more than a reflection of the loss suffered by Securities class actions fit squarely into this scenario. In the company as a whole.2 In relation to wrongs done to effect, a class action benefits from economies of scale the company, it was the company that was the proper – the larger the number of group members, the lower the plaintiff to commence proceedings, not its shareholders. individual costs associated with bringing such an action.
Of course there were exceptions to this principle, fraud being one of them.
The second purpose of the Act was to provide efficiency in legal process. Rather than having a large number of The Prudential Principle is no longer a barrier to similar actions brought by a large group of claimants, shareholders in Australia who wish to bring a class the class action mechanism provides for a single action action seeking damages for loss of share value. In to be brought on behalf of all the claimants.
fact, the Federal Court has recently said that in some circumstances the proper plaintiffs are in fact the (i) The class must consist of at least 7 persons who shareholders and not the corporation.3 have claims against the same defendant. Consequently, shareholders now have available to them In order to determine whether the first requirement the entire suite of corporate malfeasance claims as well is met, we need to look at how the claim group is as remedies under the Trade Practices Act 1974 (Cth), described in the Statement of Claim. A useful test in the Australian Securities and Investment Commission determining whether the description of the group will Act 2001 (Cth) and the Corporations Act 2001 (including satisfy the first requirement is: is the description such as amended by the Financial Services Reform Act 2001).
that a person, with the assistance of a legal adviser if necessary, can ascertain whether he or she is a member We have, so far, focused on corporations as defendants in a securities class action. We should, however, note that corporations can also be plaintiffs in such an In the case of a securities class action, it is not difficult action. Such institutional investors may have substantial for a person to determine whether he or she had shareholdings in other companies as part of their purchased shares in a particular company during the portfolio of investments and their rights to be members relevant period specified in the Statement of Claim of a securities class action must not be overlooked. and thus fall within a particular class. It is not even Whether or not they choose to opt out of such an action necessary to identify all of the group members, either is a separate issue, and will be discussed in Part 3 of by name or by number.
this series.
The word "claim", for the purpose of this first requirement, has a wide meaning and is not limited to a cause of action. It encompasses everything that might lawfully be brought before the court for a remedy.5 (ii) The claims of all persons are in respect of, or arise – the alleged unreasonableness of the opinion on its out of, the same, similar or related circumstances.
financial statements made by the directors. The lowest threshold that must be met to satisfy this (iii) The claims of all persons must give rise to a second requirement is that the claims must arise out of substantial common issue of law or fact.
"related circumstances". The third requirement is satisfied if there is a significant The word "related" suggests a connection wider than question common to all members of the class.8 similarity or being identical. In each case, we need to determine whether the similarities or relationships The word "substantial" used in this context does not between circumstances giving rise to each claim are mean that which is "large" or "of special significance" sufficient to merit their grouping as a class action.6 or would "have a major impact on the.litigation" but, rather, is directed to issues which are "real or of Let's have a look at a couple of examples: In a class action against Phillip Morris the court found, In the Harris Scarfe litigation, there was a common at first instance7, that despite the differences between question of law and fact as to: the individuals' claims - their length of time as smokers, the number of cigarettes smoked, their different medical – whether the directors of the company owed a duty histories, etc - there was a sufficient relatedness. That of care to its shareholders to ensure the accuracy of was because, if the allegations of a breach of Section statements made in statements and reports required 52 of the Trade Practices Act 1974 or breach of duty by the Corporations Act; succeeded, then the claims of all the group members – whether the duty of a director to exercise care and would be advanced. Alternatively, if these claims failed, diligence imposed by the Corporations Act entitled then the claim of each member of the group would also shareholders to recover individual losses for its fail. These circumstances were therefore found to be sufficiently related. – whether the communications made by the directors (communications to the Australian Stock Exchange, In the current Harris Scarfe Holdings litigation, the the securities market and to shareholders, press company argued that the group members were not releases, the company's half-yearly report, etc) were sufficiently related. They pointed to the fact that communications for which the individual directors the group could potentially be made up of 11,300 persons who bought and sold shares at different times (over a five-year period) and the probable differential Requirements for a shareholder class action reliance each member of the group may have placed on the various representations in the many published The essential requirements which must be established documents. They pointed out that the six directors who before a person can bring an action under the federal were sued each held that position in the company for a different length of time and one of them was, for a part of that time, an executive director. (i) there must be 7 or more persons who have claims against the same defendant; Despite this argument, the court found that there was a sufficient degree of relatedness between the (ii) the claims of all those persons are in respect circumstances of the various claims, namely: of, or arise out of, the same, similar or related circumstances; and – the means by which the company and the directors informed their shareholders and the market as to (iii) the claims of all those persons give rise to a the company's financial performance and financial substantial common issue of law or fact.
– the ongoing misstatements of its financial position, its net assets and inventories; and Footnotes(1) Prudential Assurance v Newman in relation to conduct which misleads or (5) Finance Sector Union of Australia v 182 different brands of cigarettes, Industries Ltd (No 2) [1982] 1 Ch 204.
deceives or tortious rights in relation to Commonwealth Bank of Australia (1999) 77 separate items of public statements negligent misstatements, then the proper 94 FCR 179 at 186. and lobbying, different forms of (2) This principle is based on the ancient plaintiffs are in fact the shareholders and advertising, and different forms of principle of company law cal ed Foss v not the corporation: Johnstone v HIH (6) Zhang v Minister for Immigration, Local statements ranging from bil boards at Harbottle (1843) 2 Hare 461; 67 ER 189 [2004] FCA 190; see also Sons of Gwalia Government and Ethnic Affairs (1993) 45 sporting events to submissions to a which provided that, in relation to wrongs Limited (Administrator Appointed) v Senate Committee, al contributed to done to the company, it is the company Margaretic [2005] FCA 1305.) show that the circumstances were not that is the proper plaintiff to commence (7) Nixon v Philip Morris (Australia) proceedings, not its shareholders.
(4) Petrusevski v Bul dogs Rugby League Ltd (1999) 95 FCR 453. On appeal, Club Limited [2003] FCA 61.
however, the Ful Court of the Federal (8) Carnie v Esanda Finance Corporation (3) The Federal Court has recently said Court disagreed. The court said that, Limited (1995) 182 CLR 398.
that, where shareholders are seeking factors such as there being three sets remedies not dependent on their status of defendants (each a large tobacco (9) Wong v Silkfield Pty Ltd (1999) as a shareholder, such as statutory rights company), over a 39-year period, 199 CLR 255.
Executive Summary Not all class actions are resolved in court. The court can order a discontinuance based on a number of different circumstances which are dependent on the facts of each case. A person's consent is not usually required in order for them to be a member of a class action. Class members may, however, choose to ‘opt out' if they don't believe that there will be adequate financial return for the risks they are taking. When do discontinuances occur? The court would, however, attempt to give effect to the The court can order a discontinuance intention of the Act. It would therefore try, as far as it of a class action based on an application can, to allow a class action to continue to the stage where the substantial common issues are resolved. by a defendant corporation or its directors Once that stage has been completed, the court may or officers - or on its own motion.1 Under consider any order or direction under the Act.
the Act, the court has a wide discretion to ensure that class actions are not frivolous, – Fulfilling the legislative intent, of course, works both ways. The way the Federal Court disallowed the oppressive or an abuse of process.
continuance of Aristocrat's claim (in October 2005) is a useful example. The court may order a discontinuance if it believes that: When framing the definition of "class", lawyers (i) the proceedings will not provide an efficient and for the shareholders had defined the class as effective means of dealing with the claims of the shareholders who purchased shares in the company group members, or during a relevant period and who also appointed that particular law firm as their lawyers. The effect of (ii) it would be "otherwise inappropriate" for the claims this definition of "class" was to create, effectively, an to be pursued in a class action. opt–in process for members when the Act provides for an opt-out one. The court said that this definition This may occur, for instance, when the cost of the created a "fatal flaw" in the proceedings. It had proceedings, or the cost of distributing any verdict, the potential to subvert the Federal Court Act and would be excessive in relation to the costs incurred if amounted to an abuse of process. The action was each class member conducted a separate proceeding.2 therefore not allowed to continue on that basis. The definition of "class" in Aristocrat was later amended (in February 2006) and the offending – In both Bright v Femcare and Guglielmin v criterion was removed. The action was then allowed Trescowthick (the current Harris Scarfe litigation) the defendant corporations and their directors and officers made an application to discontinue the class action even before defences to the proceedings had been filed.
In each case, the court refused to exercise its discretion on the basis that the application for its exercise was premature. – Bright v Femcare – The court made it clear that it would not always consider applications made at early stages of a class action to be premature. It may not be efficient or effective for the class action to continue if there was: an incompatibility, conflict between the representative party's case and the cases of the represented parties, or if the only substantial common issues were ones of law on which a decision in the case of one group member would bind the others.
2. Risk of losing – a class member who does not With a few exceptions, a person's choose to opt out would automatically receive not consent is not required in order for them only the benefit in the final outcome but also the burden. It is all very well if the action is successful to be a member of a class action. Under and the members can share in the monetary the federal regime of a class action, compensation awarded but what if they lose the if a person happens to fall within the case? Losing the case would mean that the class description of a class, that person is members would be bound by the outcome and, depending on the arrangements as regards funding deemed to be included in the class action for the case, they may have a financial burden at the – unless he or she chooses to opt out of it. end of the day.
Until that positive step of "opting out" is Double edged sword taken, that person will continue to be part of the action and will be bound by the The opt-out procedure, whilst initially an advantage for plaintiffs in that it creates a large class at the beginning eventual outcome of the case.
of the action, also has a number of difficulties: The opt-out process – Notices to class members in respect of their right to opt-out are usually given either by way of direct The typical ‘opting out' process involves the following: mailing, advertisements in national newspapers or broadcast on radio or television. This can be a costly – Once the action commences, the court will fix a exercise and, so far, these costs have usually been date up to which class members may opt out of the borne by the plaintiffs (or their litigation funders), at least at first instance. – They do this by providing a written notice to the – Another difficulty which confronts plaintiffs' lawyers – The court gives directions as to the manner in which is the task of convincing class members to provide class members are to be notified and the procedure financial support for a class action, especially in the which must be followed if they wish to opt out of the early stages. Since class members who are within action (to ensure members are aware of the action). the class will obtain the benefit (or the burden) of any – If any class members do choose to opt out of judgment in relation to common issues, many class the action, then they are free to pursue individual members take the view that they do not need to be actively involved in supporting the class action.
Why opt-out of a class action? – The most problematic issue with the opt-out procedure is that until the class is finally determined There are several reasons why a member may choose to and the value of their claims assessed, it is difficult opt out of a class action: for the defendant corporation and their directors to assess their potential liability and engage in any 1. Control – a plaintiff shareholder (for instance, a large institutional investor) may wish to institute its own legal proceedings against the relevant corporation and their directors and officers so that it could control the way in which the litigation is run. The downside, of course, is the costs involved in running separate litigation.
GIO Australia Holdings Limited Corporations which prepare contingency plans for The class action that followed, initiated by a former defending class actions should keep in mind the extent shareholder Shane King, potentially included 67,000 of the legal manoeuvrings which finally brought an end shareholders. Following the normal procedure, members to one of Australia's largest class actions - involving GIO of the class were notified that a class action was on foot Australia Holdings Limited (now known as AG Australia and that they could opt out if they so chose. 17,000 Holdings Limited). members chose to opt out and 22,000 entered into formal retainer agreements with King's lawyers. The class action arose out of AMP's takeover of GIO The rest of the members did not respond.
in 1998/1999. In that case, GIO was defending a class action brought by disgruntled former shareholders GIO then sought and obtained a court order entitling it who chose to reject a takeover offer from AMP. GIO to send another questionnaire to those members who recommended that its shareholders reject AMP's offer had not responded and, by this process, another 4,000 of $5.35 per share on the basis that the offer was members opted out. The other 24,000 members had not inadequate, unfair and unreasonable. Despite that responded to the questionnaire.
recommendation, AMP acquired more than 50% of GIO's shares in the takeover bid. The court was then persuaded by both parties to rule that members of the class may continue to hold that Subsequently, the minority shareholders who had status only if they chose to opt-in to join the action. rejected the takeover offer on the recommendation of This was a way to "close the class" so as to enable GIO either sold their shares on the market for less than the defendants to have an indication of the size of their the AMP offer or had their shares acquired compulsorily potential liability if the matter proceeded to trial and it as part of a scheme of arrangement in which they would also be relevant in determining the size of any received only $2.75 per share.
settlement offer.
In the end, GIO was able to reduce the potential number of 67,000 members in the class action to an actual number of 23,000. Once the shareholders knew the amount that was being offered by way of settlement ($112 mil ion) and how many people would share in it, the settlement was approved by the court in August 2003.
Extracted from "GIO class action gives corporates a lesson in tactics" by Luke Buchanan of Clayton Utz 13 October 2003.
This GIO case provides an important tactical lesson for It is interesting to note that, after the court's decision both corporations and directors on the one hand and in the Aristocrat claim, the litigation funder for the plaintiffs on the other. shareholders in that case, IMF (Australia) Limited, questioned whether or not it was economically viable for The advantages to corporations them to continue funding the claim given that they were not able to control the class size to a manageable level. – Reduces the number of plaintiffs involved.
The funding agreement provided that, in the event of a – Allows the corporation to assess the size of its successful outcome, IMF would retain 20-40% of the judgment, depending on the number of the shareholders – Makes it easier for corporation to determine a who were in the action.
settlement figure.
At the end of the day, class actions for litigation funders The advantages for plaintiffs are no more than business deals - they need to be confident that there is going to be adequate financial – By knowing the precise number of class members return at the final outcome. On reflection, IMF must who have opted in allows them to assess the have decided that there was sufficient financial incentive reasonableness of any settlement offers that may be for them to continue funding the Aristocrat claim as made by the defendant. the offending criterion in the definition of "class" was subsequently removed and the class action has been In view of the GIO settlement, lawyers acting for the allowed to proceed.
shareholders in the Aristocrat litigation must have wanted to shorten the whole process for "closing the The recent commencement of the Telstra class action class" by providing a narrow definition of "class" also suggests that the inability of plaintiff law firms and in the Statement of Claim. That attempt to control the funders of class actions to restrict class members to class size to a manageable level at the outset the persons instructing a particular law firm of solicitors was, however, unsuccessful. (thus effectively creating an opt-in process) has not reduced the commercial attractiveness of class actions.
The court in Aristocrat said the requirement for class members to instruct the law firm, Maurice Blackman Cashman, which was already representing the applicant shareholders, breached the "opt-out" provisions of the Act. It would mean that shareholders would have to pursue their claims against Aristocrat individually unless they were represented by that firm. It would also have required shareholders to formally "opt-in" to the process which is not a requirement of the Act. Footnotes(1) Under Part IVA of the Federal Court of (2) The court's discretion is discretionary Australia Act 1976 (Cth). Furthermore, the even where the conditions for the court has discretion to make any order it exercise of the discretion are met: thinks appropriate or necessary to ensure Australian Competition and Consumer that justice is done in the proceedings.
Commission v Giraffe World Australia Pty Ltd (1998) 84 FCR 512. It is therefore difficult to determine the precise circumstances in which a court would exercise their discretion. Much depends on the facts of each case.
Executive Summary There are a number of factors fuelling the increase in securities class actions in Australia. Legal commentators have cited the 2003 National Tort Law reforms and the GIO Settlement as possible drivers. The removal of the Prudential Principle, growing shareholder activism, a greater amount of litigation funding and more rapid information dissemination has also been identified. Securities class actions have become part of our legal landscape just as they are in the American legal system. Whilst class actions themselves do not increase the potential liability of those involved they do increase the need for Directors and Officers to be very vigilant in how they manage the affairs of the company.
Class actions are not a recent occurrence. There is also a growing trend for the public to view The federal regime which allows them has securities and other financial instruments (such as been in operation since 1992. However, the mezzanine lending agreements made famous by Westpoint) as products. Shareholders in a it is only recently that there have been company nowadays tend to consider themselves as an increasing number of securities class consumers rather than participants in a venture. They actions being brought in Australia. What is should therefore be entitled to the protection which behind this growing trend? the law provides to purchasers of other products. The continuous disclosure requirement under the Corporations Act reflects this sentiment.4 Factors Driving Securities Class Actions in Australia 5. Litigation Funding There are a number of possible "drivers" of the growing trend.
Another driver of the trend for class actions in Australia is the availability of litigation funding. 1. National Tort Law Reforms Some legal commentators have suggested that it Sons of Gwalia class action is financed by litigation funder is partly driven by the success of the major tort law IMF (Australia) Ltd, a publicly listed litigation financier. reforms of 2002 and 2003.1 The reduction in the number of personal injury claims Aristocrat is another example of class actions funded by IMF. and medical negligence claims following these reforms may have given some plaintiffs' lawyers an impetus to – The position has always been that plaintiffs meet the look for alternative ways to initiate actions.2 costs of any litigation they wish to bring and face 2. The GIO Settlement the possibility of having to pay the legal costs of the defendant if they are not successful. Accordingly, The GIO settlement was one of the largest securities unless the plaintiffs could afford to bring the action class actions settlements in Australia. It involved a and were relatively confident of their claim, they settlement sum of $112 million and a payment of would not proceed.
$15 million in legal costs to the plaintiffs' lawyers and could have also given an added impetus to – Unlike the United States, contingency fees (where a securities class actions.
lawyer arranges with a client to receive a percentage of any damages awarded) are prohibited in Australia. 3. Removal of the Prudential Principle Such a prohibition does not apply to non-lawyers. Litigation funders can therefore offer to fund litigation Also, our courts have categorically removed any in return for a share of the proceeds if the litigation doubt that shareholders can bring class actions against is successful. Funding agreements with these companies typically provide that the plaintiffs will pay nothing if they are not successful in their claims.
The current Sons of Gwalia litigation is a good example of shareholders bringing action on the basis – IMF started providing funding to litigation in 1997 of misleading and deceptive statements. In the recent but the funding was then limited to insolvency judgment by the High Court in Sons of Gwalia Ltd v practitioners. In 2001, IMF listed on the Australian Margaretic, the court made it clear that shareholders Stock Exchange and began funding commercial rank equally with unsecured creditors in the distribution litigation and class actions. There are currently of the company's assets in liquidation. The court further four other litigation funders in the litigation funding said that such shareholders are entitled to sue in their capacity as members of the public rather than members of the company.
– There has always been a debate as to whether litigation funding is against public policy and the 4. Shareholders Activism courts have scrutinised such funding agreements very carefully. Those who argue against such A vast number of Australians own shares in companies agreements are concerned that they would amount – either directly or through managed funds or to "maintenance and champerty" which, historically, superannuation. There are also many shareholders who were torts and crimes at common law. are large institutional investors who will watch very carefully the performance of their investment portfolio. There is now definitely an increase in shareholders activism.
Maintenance - occurs where a party's costs are paid by 6. Information Dissemination a stranger who has no interest in the litigation.
Class actions nowadays are attracting vast media Champerty - is a form of maintenance where the funder, coverage and community awareness of this litigation in return for funding the litigation, is entitled to receive a tool is increasing. share of the proceeds if the litigation is successful. The rationale was to prohibit the encouragement of litigation, The more public awareness there is about the especially for ulterior purposes or at the risk of the conduct (or omissions) of companies through the financial rewards colouring the fair conduct of media and the internet, the more potential material the proceeding.
there is to fuel class action claims.
– Today, both maintenance and champerty have Where to from here? been decriminalised in Western Australia and, in Today we can be in contact with persons New South Wales, Victoria and South Australia, maintenance and champerty are now neither crimes at the other side of the world almost nor civil wrongs.
instantaneously via the use of email communication and other forms of – The pendulum in the debate seems to have swung in favour of litigation funding agreements on the basis that their availability increases access to So what are the implications of increasing interaction justice for members of society who would not between, say, plaintiff lawyers from the United States otherwise have it. and their counterparts in Australia? What is the Australian legal landscape going to be like in – There is a perceived public benefit in allowing third parties to fund litigation for people with genuine claims who would not otherwise have the financial Securities class actions have become part of our resources to bring the claim.5 legal landscape just as they are in the American legal system. If we have learnt anything from the American – This view has paved the way for a much more experience, it is that class action litigation poses significant role for litigation funders. Since the Fostif significant risks to those involved in terms of legal case endorsed strongly the role of litigation funders, exposure and reputation costs, not to mention the time it is likely they will seek to exercise a greater say in and expense involved in defending such actions. Whilst the litigation they fund. class actions themselves do not increase the potential liability of those involved – they do increase the burden – The Fostif case may also have the effect of giving on those involved to be very vigilant in how they manage litigation funders an added impetus to bring class the affairs of the company. actions on behalf of shareholders and investors in companies (solvent or otherwise). Having said that, however, we must bear in mind that whether or not litigation funders will agree to provide funding for a class action is, at the end of the day, very much a commercial decision. Commercial viability would be the key factor in deciding whether or not they will invest in funding a particular class action.
Footnotes(1) See, for instance, S Stuart Clark (2) This is not to say that class actions (3) We have seen in Part 3 that the (4) The prohibition on corporations' and Christina Harris, "Class Actions in increase the legal burden of corporations Federal Court in Johnstone v HIH [2004] misleading & deceptive conduct under and their directors and officers. It simply FCA 190 said that, where shareholders the Trade Practices Act 1974 (Cth) - A Comparative Review", Clayton Utz.
means that there is a greater likelihood of are seeking remedies not dependent and also the ASIC Act 2001 (Cth) are a law suit against them if they have failed on their status as a shareholder, good examples of such protection for in their compliance with the law resulting such as statutory rights in relation to in losses to shareholders and investors.
conduct which misleads or deceives or tortious rights in relation to negligent (5) This view has been affirmed recently misstatements, then the proper plaintiffs by the High Court in Campbel s Cash & are the shareholders and not the Carry Pty Limited v Fostif where the court took the view that the concept of litigation funding is not against public policy. Executive Summary There are a number of differences between the Australian and American litigation systems. These differences include the treatment of contingency fees, jury trial procedures, awarding of punitive damages and the way in which legal costs are allocated. In order to prevent Australia from heading down the US path of numerous large class actions it is crucial that corporations and their boards of directors have a risk management plan. However, despite all the risk controls it ultimately comes down to balance between risk management and business judgment. Are we Destined for a US-style Litigation Landscape? There has been a dramatic surge in securities class It is generally thought that jury sympathy occurs when actions in the United States in recent years. The figures injured plaintiffs face major corporations with actual or perceived "deep pockets". It is therefore a perceived advantage to have jury trials.
– 175 actions were filed during 2005– Total settlements increased from US$145 million in 1997 to US$5.5 billion in 2005 – 772 shareholder investor securities class actions The United States have a system of jury trials. have been filed in the United States Federal Court jurisdiction since 22 December 1995. Many commentators regard US class action litigation as In Australia, class actions are heard by a judge being widely abused by plaintiffs and their lawyers1.
(or judges as the case may be) and not involving any jury.
According to a survey of Fortune 1000 companies by BTI Consulting Group: Australian plaintiffs do not have the opportunity to enlist the sympathy of any jury in pursuing their – Total spending on outside legal counsel reached claim for compensation.
US$56.4 billion in the United States.
– A typical company in the BTI survey spent US$19.5 million on outside legal counsels' fees, nearly double the US$10.5 million average only five years ago.
Punitive damages are awarded to punish the defendant Will Australia Head Down the Same Path? for the wrongful act committed.
Given the increasing trend for securities class actions in Australia, should we also expect an exponential increase in the number of securities class actions? The American legal system allows for punitive damages to be awarded against the defendant. We take a look at some of the differences between the American and the Australian legal systems to Very large sums of damages have been ordered in see whether we are likely to end up with a Directors the form of punitive damages. and Officers litigation environment like that in the U.S.
Punitive damages are not usually awarded. Contingency fees are where plaintiff lawyers agree with their clients that in the event of a successful outcome, Damages are generally awarded in Australia on the lawyer receives a percentage of the judgment or the basis of the compensation principle. The aim settlement sum awarded to the plaintiffs (plus the is to put the plaintiff into as good a position as he expenses incurred by the lawyers). If the claim fails, or she would have been if the wrong had not been the plaintiffs' lawyers do not receive any legal fees.
Contingency fees for lawyers are permitted.
The percentage of the judgment or settlement sum is often in the range of 10 to 25%, and even up to 40%.
Such a contingency agreement between a lawyer and client is illegal. The lawyer can only take his or her "normal" fee plus an agreed uplift which is usually expressed as a percentage of the so called normal fees. This limitation clearly has restricted Australian lawyers from earning the kind of enormous fees that their American counterparts could earn. Punitive Damages Example – Phillip Morris USA v Williams "Fraud on the market" theory has helped to open In the very recent case of Phillip Morris USA v Williams, the doors to many securities class actions in the the jury awarded the estate of the deceased plaintiff, US in recent years. Williams, US$821,000 in compensation damages and US$79.5 million in punitive damages! However the trial judge thought the amount of punitive damages was excessive and reduced it to US$32 million. On appeal "Fraud on the market theory" has not yet been to the Oregon Supreme Court, the US$79.5 million was accepted by an Australian court 3.
restored. The tobacco company appealed against this decision. Ultimately, the United States Supreme Court had to consider the functionality of punitive damages Loser Pays Legal Costs and, in particular, whether the award can be made to punish a corporation for injury to persons who were not part of the litigation. The losing party does not generally have to pay In February, 2007, the United States Supreme Court the successful party's costs. thought the US$79.5 million was not an appropriate amount and the matter has been referred back to the There may therefore be instances where actions are commenced before there has been a proper Oregon Supreme Court for it to consider an appropriate assessment of the merits of the claim. Given the amount using a new constitutional formula set by contingency arrangements, plaintiffs have nothing to lose (except for expenses incurred). There is always the chance that the case would be settled – even if the claim has little or no Fraud on the Market Theory In the United States, there is now a legally accepted presumption that the price of shares in an open and developed market is a reflection of all material The party who loses the case normally has the information that is publicly available in the marketplace burden of paying not only its own costs of bringing about those shares, including false and misleading the action but also those of the defendant in information issued by a company. defending the action. The theory further presumes that shareholders rely There is therefore a clear disincentive on the on the accuracy and truthfulness of the available plaintiffs' part to bring an action unless they information in making their investment decisions. believe they have a real chance of success. Legal costs alone involved in major class actions Before this theory was accepted, each individual could easily amount to many millions of dollars. shareholder in a securities class action against a company had to prove reliance on a particular piece of false information. This complicated the threshold question of whether the class action gave rise to a substantial common question worthy of prosecution. While we are definitely seeing a significant increase in the number of securities class actions brought in How could you show "commonality" when each Australia. Australian corporations are unlikely to face shareholder might rely on different pieces of false and an American litigation environment for class actions in misleading information? the very near future. The "fraud on the market theory" overcomes the issue That is not to say that corporate Australia have of "commonality" of claims that all plaintiffs in the same nothing to fear. Directors and officers may be sued by action have to establish in order to bring a securities shareholders and investors if they have committed a class action in the United States. It is now not necessary wrong such as failure to perform continuous disclosure. to show individual reliance on any one or more pieces This chance of law suits and the possibility of actions of information.
taken by ASIC has always been there but these rules have been given more "teeth" by the threat of class actions by shareholders and investors.
There are currently a number of significant shareholder class actions on foot in Australia: Sons of Gwalia, Aristocrat and Telstra. The question we need to ask is: what should corporations and their directors and officers do from a risk management perspective? – It is interesting to note that in 2006, there was a sharp drop in the number of securities class actions – Corporations operating in Australia face a filed in the US – a 38% drop to 110 actions filed. A plethora of Commonwealth, State and Territory key reason is the greater care taken by companies requirements, not to mention their potential liability in reporting their financial results. Australian at common law. In addition to imposing liability on companies and their directors and officers can take corporations for their breach, these laws may also comfort in the fact that the risks of potential law impose penalties on individuals involved in these suits can be reduced and managed. The practice of corporations either for their own misconduct (such having proper processes and procedures in place as aiding and abetting a corporate breach) or simply to ensure due compliance with legal requirements is in consequence of the position they hold or the just good corporate governance.
functions they perform in the company.5 – Moreover, companies today are seeing their annual – It is therefore crucial that corporations and board performance reviews as an opportunity to their board of directors and officers have a risk undertake a group-wide compliance review and to management plan to reduce and manage their risks ensure optimal effectiveness and efficiency of board of liability. How do they ensure the information upon members and operating arms. which they act is necessary, reliable and accurate? How do they ensure proper compliance with these From a risk management perspective, consider the legislative requirements? In the case of information that is being disseminated to the public, how do they ensure that such information is accurate and timely? 1. What process and procedure has your company got Since most of the current shareholder class actions in place to ensure the accuracy of information that is are based on the grounds of misleading and being provided to the board and to the public? deceptive conduct or failure to fulfil continuous 2. How does your company ensure timely compliance disclosure obligations, it is clearly necessary for with legal requirements such as continuous corporations to examine their internal procedures to disclosure obligations? see if they can minimise the risks of class actions in 3. Are such procedures objectively reviewed from time 4. Has your company prepared a risk management – The recent securities class action against the contingency plan in the event of a securities class retailer Harris Scarfe is an example of a case action against your company? based largely on alleged inaccuracies in the 5. What appropriate insurance do your directors company's communications to the Australian Stock and officers have in place to protect their risks of Exchange, the media, the securities market and to personal liability? shareholders. Could these alleged inaccuracies have been avoided? Clearly, at the end of the day, it is a question of balance between good risk management and – Not only do directors need to ensure that proper business judgment.
processes and procedures are in place to provide them with the confidence that they need in the management of the company, they also need to have those processes and procedures objectively reviewed from time to time. Footnotes(1) See, for instance, "Class Action himself which may wel exceed the that the common issues between class certification in Australia. Once an action Litigation" by John Emmerig, Blake compensation payable to the plaintiff", members predominate over individual has been properly commenced, it will issues as is the requirement in the United continue until the defendant successful y (c) they are expressly authorised by States. It is sufficient if there is at least applies for a discontinuance of the action, (2) According to established principles one "substantial" (meaning "real or of or until judgment or settlement.
in Australia - Rookes v Barnard [1964] substance" rather than "large") common AC 1129 - there are only three situations In short, it seems that punitive damages issue of law or fact.
(5) See, for instance, the Discussion under which punitive damages may be wil rarely be awarded in Australia.
Paper prepared by Corporations and (4) Having said that, we should note that Markets Advisory Committee - CAMAC (a) there is "oppressive or unconstitutional (3) However, there is some question there is a system of certification that is - on "Personal Liability on Corporate action by the servants of the about plaintiffs' need for this theory in required in the United States – that is, Fault" (May 2005).
Australia. Under the federal regime, as the plaintiffs have the onus to show that (b) the "defendant's conduct has been we discussed in Part 2 of this White the action is appropriately brought as a calculated by him to make a profit for Paper Series, there is no requirement class action. There is no such system of Executive Summary As the Government moves to crack down on white collar crime, findings from a growing number of Royal Commissions and inquiries have led to civil and criminal proceedings against corporate directors and officers. Many directors and officers are not aware that the best form of protection from a risk perspective is actually a right to indemnity they could seek from the company (rather than insurance protection). These indemnities transfer personal liability to the company.
However, no matter how broadly an indemnity is drafted, it cannot indemnify directors and officers against every possible liability or the associated legal costs – indeed a corporate indemnity is only worth something if the company is solvent. It is therefore important for directors and officers to also secure a second line of defence through the purchase of appropriate insurance protection.
Securities Exposures – An Emerging Pattern Case Study – Multiplex – With the collapse of HIH in 2001, and corporate We are now witnessing legal disputation between failures since, it has become a political necessity for ASIC, Multiplex and the Multiplex shareholders who are the Federal Government to be seen doing more to claiming in excess of $100 million against Multiplex in prevent poor corporate conduct and punish white relation to the ill-fated Wembley Stadium project in the – Consequently, we are seeing an increasing number The ASIC inquiry was mainly concerned with Multiplex's of royal commissions and inquiries into companies' failure to disclose price-sensitive information about affairs. The findings have been used as a foundation the loss sustained in building the Wembley Stadium. for civil and/or criminal proceedings brought by ASIC The inquiry resulted in a deal between Multiplex and and other regulatory authorities against the directors ASIC whereby Multiplex would pay $32 million in and officers of those companies. compensation for investors who lost money as a result of this failure to keep the market informed.
– Directors and officers (for the purposes of this paper we will refer to them collectively as "officers") Following the ASIC inquiry, lawyers for the shareholders required to attend official inquiries need legal began a shareholder class action against Multiplex representation to protect their interests even and compelled ASIC by subpoena to hand over its though they are not necessarily being accused of investigation documents. ASIC did not initially object to wrongdoing at that stage. If regulatory proceedings providing this access (not surprisingly, Multiplex did) but ensue, they will incur costs in defending those is now resisting on the grounds that it would reveal the sources of information for its investigation. It transpired that two unnamed executives, believed to be directors – The regulatory proceedings may also result in: of Multiplex at the time of the ASIC investigation, have personally retained barristers to resist the access to a) An order against them to pay compensation to their interview transcripts. At first instance the plaintiff was granted access. That decision is on appeal. The shareholders' lawyers have now been granted access to b) An order against them to pay pecuniary penalties ASIC's transcripts of interview and other select materials to the regulator. ASIC had objected to producing.
c) An order banning them from managing – The current Multiplex case is a good example of the "spiral" that can take place. What starts out as a regulatory investigation could end up in a multi- d) Imprisonment. million dollar shareholder class action against the company and its officers. The evidence elicited – A pattern that has existed in the US for a number from the regulatory investigation can form the of years has started to emerge here in Australia. It foundation of, or at least evidentiary assistance to, begins with a regulatory investigation by a corporate the shareholder securities claim. "watch-dog" into the conduct of a particular company, followed by a regulatory prosecution – The AWB case is another example where a or proceeding if some wrongdoing has been regulatory investigation has resulted in a multi-million discovered, followed by a shareholder securities dollar shareholder class action. The case began with claim against the company and/or its officers. the Cole Commission of Inquiry into the conduct of AWB (in relation to its dealings with Iraq) under the – One of the key aspects of this trend is the access to United Nation's Oil-For-Food Program. There is now evidence produced at the regulatory investigations a multi-million dollar shareholder class action being and proceedings by plaintiff law firms and their brought against the company by AWB shareholders litigation funders in order to bring shareholder class who lost money after the collapse in AWB's share actions against companies and their officers. By fully price following the Cole Commission of Inquiry. cooperating with the regulators, officers potentially put themselves in a vulnerable position when it – In terms of managing and transferring risk, corporate comes to potential class actions by shareholders.
officers need to be aware not just of their exposure to securities claims by a class of shareholders but also of the associated regulatory exposures.
Corporate Indemnity – The First Line of Defence Deeds of Indemnity & Access – When corporate officers think about their exposure – To ensure a greater degree of certainty in regards to personal liability, their foremost thought is usually to corporate indemnity, it has become common about insurance protection. They sometimes forget practice for certain officers to enter into deeds of that their most obvious (and perhaps best) source of indemnity and access with the companies they risk protection is seeking a right to indemnity work for. These deeds are contracts the company from the company. enters into with each individual officer which ideally mirror the indemnity contained in the company's – An indemnity from the company arguably offers greater protection than insurance protection, because: – For instance, they usually: a) The interests of the company and those of a) Provide indemnity for liability, legal costs, a right the individual officer are often (but not always) to be advanced funds for anticipated legal costs closely aligned. If an officer is sued, then his or and a right for the company to take control of her risk of liability is likely to affect the interests the action. Unlike the company's constitution, of the company.
however, such deeds cannot be altered unilaterally without the prior consent b ) Indemnities almost always provide much broader protection than that offered by insurance policies which offer indemnity on the basis of the terms, b) Entitle the officer to access board papers and conditions and exclusions of those policies (and other company records in the event that they subject to the requirements of the Insurance are sued. Having access to these documents will Contracts Act 1984). be essential to defending any claim.
– While officers are generally entitled to indemnity from – A broadly drafted corporate indemnity may not only the company when they are carrying out their duties protect officers against actions brought against in good faith and are acting honestly and reasonably, them by third parties but also protect against it is usual for the constitution of a company to actions commenced by the officers when defending provide a right of indemnity to both current and allegations (for instance, defamatory imputations) former officers.
made against them.2 Corporate Constitution – Conventional D&O Insurance policies will not provide cover for actions commenced by an officer against – The Corporations Act 2001 (the Act) provides that a third party. These policies are generally designed a company may provide an indemnity to its officers to provide cover for claims made by third parties subject to the limitations set out in section 199A (see against the officers in their capacity as officers of the discussion below) and the powers of a company are enshrined in its constitution. – Becoming an officer brings with it an increasing – A company is therefore legally entitled to provide exposure to personal liability so protection against an indemnity to its officers within its constitution. that exposure should be a key consideration The Act has been amended in recent years to allow when deciding whether to become a corporate companies to provide broader indemnities - so it officer. Securing an appropriate indemnity from the is important for officers to review their company's company is something that should be negotiated constitution to ensure it provides an indemnity as and finalised before one accepts the offer. If the broad as that permitted under the Act.
company has not addressed this issue as part of the offer or is not aware or prepared to address the – Whilst this is an important step in the process issue it should ring warning bells in the ears of the of managing personal risk, it is also important to potential corporate officer.
understand that a company's constitution can be amended in certain circumstances. There is therefore a risk that the indemnity could be amended or even removed at a later date. Such a change could happen after an officer has left the company and without their prior knowledge.
Limitations on Corporate Indemnity Indemnities to Middle Management – When becoming an officer, most people ask for a In light of the report by the Corporations and Markets full indemnity from the company – that is, they want Advisory Committee (CAMAC), released in April the company to reimburse them for any liability and 2006 (titled "Corporate Duties Below Board Level") associated costs and expenses incurred if and when which, amongst other things, recommended the they are sued for carrying out their duties on behalf extension of the obligations of directors and officers to "any other person who takes part, or is concerned, in the management of that corporation", corporate – The reality is that, no matter how broadly a deed of indemnities should be reviewed to ensure that they indemnity is drafted, the Act limits the extent cover those who take part in or are concerned in the to which companies may indemnify their officers. management of the company.
– Corporate indemnities do not and, in fact, cannot What does this mean? indemnify officers against every possible liability and its associated legal costs. Section 199A of the – It means that corporate indemnities should no longer Act prohibits indemnities to officers for liability to the be limited to officers who report directly to the board company incurred as an officer of the company. So, if the person bringing the claim against the officer is the company itself for, say, breach of a director's – Companies should consider whether there are any duty, then the deed of indemnity cannot operate to managers, external consultants, consultants or protect the officer.
advisers who take part in or are concerned in the management of the company. – Section 199A of the Act also prohibits a company from indemnifying its officers against: For instance, a national sales manager of a major corporation, whose dishonesty or negligence a) A liability for a pecuniary penalty order or a could cause substantial harm to the company, could compensation order made under the Act.
be liable for a breach of statutory duty even though he or she is technically not an "executive officer" of b) A liability which did not arise out of conduct in good faith – that is, it arose out of conduct in bad faith.
– Instead, it extends to those activities involving a segment of the company's overall business. It covers c) Legal costs incurred where: a wide range of activities relating to management of a corporation, each requiring an involvement of The officer is found to have a liability for which some kind in the decision-making process of that they could not be indemnified.
There is a finding of guilt in respect of criminal proceedings. – From a commercial perspective, companies may Orders sought by ASIC or a liquidator where not wish to provide indemnities to all persons who the grounds for such orders have been are concerned in or take part in the management of The court denies relief, in connection with proceedings for relief under the Act.
For instance, they would probably not wish to indemnify all external consultants and advisers. – The efficacy of deeds of indemnity depends, of They must, however, consider the situation and course, very much on the solvency of the company. make a judgment call as to the extent to which If the company is insolvent or does not have they would provide corporate indemnity to those adequate funds to back the indemnity, then that right who take part in the decision-making process of to indemnity is virtually worthless. – It is therefore important for officers to secure a second line of defence by purchasing appropriate insurance protection to act as a "back-up" against the risks of personal liability.
Footnotes(1) See: Treasury's Discussion Paper (2) See, for instance: Whitlam v National (3) This example was given by Justice entitled "Review of Sanctions in Roads and Motorists' Association [2006] Austin in the case of ASIC v Vines & Ors Corporate Law", issued in March, 2007 NSW SC 766; however that decision [2005] NSWSC 738 where his Honour which is expected to be finalised in was overturned by the Court of Appeal, said that management is not confined to November this year.
whose interpretation was that the central management.
indemnity was not sufficiently broad.
Executive Summary Directors and officers have become far more exposed to personal liability over the past few decades. Directors' & Officers' Liability (D&O) Insurance can protect directors and officers against shareholder class actions by transferring personal liability risk. It is vital, however, that the limitations and exclusions of D&O Insurance are understood. This means that as management teams become more exposed to personal liability, it will become important for directors and officers to undertake a new, more vigilant approach to risk management.
Risk Transfer - Insurance Protection There are several types of insurance policies which In general terms, D&O Insurance covers past, present may provide the kind of protection directors and and future directors and officers of the company for: officers need in terms of transferring their risks of personal liability. 1. Their legal liability to pay compensation to The most well known type of insurance is Directors' & Officers' Liability (D&O) Insurance – D&O Insurance is 2. Legal costs associated with defending a claim most frequently purchased and acts as the cornerstone made against them alleging a "Wrongful Act" for the transfer of management liability risk. committed by them in the performance of their duties as directors or officers of the company.
There are, however, a number of products that can be purchased in addition to D&O Insurance. For example: "Wrongful Act" – D&O policies usually define this very broadly to mean any act, error or omission committed – Personal D&O Insurance – a policy usual y or allegedly committed in the capacity of director or purchased by individual directors to cover their risks officer of the company. Most current shareholders class of liability in respect of multiple board positions. Its actions in Australia typically allege some form of failure benefits are two-fold: to disclose material information (see the Telstra claim that settled in November 2007), misleading conduct or 1. It provides the insured with their own limit misrepresentation to shareholders. All of these are likely to fall within this definition.
2. It can act as a safety net in the event that a – Given the breadth of the "Wrongful Act" definition company is unable or refuses to indemnify the and other key policy definitions such as "Claim" and director, or a corporate D&O policy does not "Loss", it would be fair to say that, at first glance, respond to a particular claim.
the insuring clauses of most D&O policies available in the Australian market are likely to respond to a – Prospectus Liability Insurance – offers protection shareholder class action made against directors and more pertinent to risks associated with particular officers insured under the policy.
securities claims. This type of policy is designed to cover the company and its directors and officers in Limitations & Exclusions the event of securities claims being made against them arising out of a specific capital or debt raising However, like all other types of insurance, D&O policies transaction. Prospectus Liability Insurance is have their limitations and exclusions. Directors and becoming increasingly popular, particularly for larger officers need to be aware of what they are. Indeed, as a matter of prudent risk management, It has the benefit of ring-fencing a higher risk activity from the corporate D&O insurance programme. As a separate policy it also has the 1. Peruse the terms and conditions of their D&O advantage of providing a separate limit of liability cover before they join a company. over a policy period of up to 7 years. Furthermore, the premium can be capitalised as part of the costs 2. Make sure that they read the policy before it is of the transaction.
renewed each year. They then can be fully aware of the extent of their exposures in the event of a claim being made against them and they can then manage that risk accordingly. Finding the gaps in a policy after a claim has been made is clearly not ideal. D&O Policy Exclusions – Fines & Penalties Exclusion D&O policies contain a number of common exclusions Another risk that is typically excluded in D&O which may operate to exclude part or all of a policies is the liability for fines and penalties that shareholder securities claim. Some of the major ones may be imposed on directors and officers. Fines and are as fol ows.
penalties are usually excluded either by way of a specific Fines & Penalties Exclusion or by way of – Major Shareholder Exclusion a "carve-out" within the definition of the word "Loss" in the policy wording. Most D&O policies contain some form of Major Shareholder Exclusion. Generally the intention As discussed in Part 6 of this White Paper Series, behind it is to prevent parties with significant equity regulatory proceedings are often a pre-cursor to a in the company from benefiting by bringing a claim securities claim. If, as a result of those proceedings, against the directors and officers for a wrongful act a director or officer is ordered to pay a civil penalty, which they themselves were party to or had the then this liability will not be covered by the policy opportunity to prevent. (even in the absence of any intentional wrongdoing) by virtue of this exclusion. However, some Major Shareholder Exclusions currently in use in the marketplace have the potential It is, however, increasingly common for D&O policies to operate well beyond this intent. For instance, the to provide an extension in respect of pecuniary exclusion could operate to exclude a claim brought penalties but it is usually sub-limited and the cover by a shareholder who was not a major shareholder is often restricted to penalties imposed in certain of the company at the time the relevant "Wrongful countries or under certain legislation.
Act" was committed. Clearly, a major shareholder is unlikely to be in a position to influence the decision- – USA & Canada Jurisdictional Exclusion making of the company when it was not a major shareholder - yet, depending on the wording of the One exclusion that is often overlooked in respect exclusion, it could still apply.
of securities exposures is the USA & Canada Jurisdictional Exclusion.
Even if the exclusion does not go beyond its original intent, directors and officers need to be aware Even though an Australian company may only be that claims (and not just securities claims) brought listed on the Australian Stock Exchange, it is not against them by major shareholders are unlikely to uncommon for their shares to be traded on the be covered under the company's D&O policy. Careful New York Stock Exchange as American Depository perusal of the policy wording is therefore crucial.
Receipts or "ADRs". – Prospectus Liability Exclusion As a result, directors and officers are exposed to regulatory actions which might be taken by the US It is also common for D&O policies to contain a Securities and Exchange Commission. They are also Prospectus Liability Exclusion. These exclusions can exposed to claims by aggrieved ADR investors who operate retrospectively and/or prospectively. are entitled to sue them under US securities laws. US securities laws are renowned for being some As the name suggests, they are intended to exclude of the world's toughest. This exclusion would likely any claims made against the insured persons prevent the policy from responding to these actions.
that arise out of the issuing of a prospectus for the purchase or sale of the company's securities. – Pollution Exclusion Shareholder class actions typically claim compensation for loss caused by fluctuation in the Another exclusion to be aware of is the Pollution value of the securities purchased or sold by those Exclusion. Directors and officers should examine the shareholders. If the shareholders purchased or sold precise wording of this exclusion and consider the their securities pursuant to a prospectus (rather than extent of their exposure. in the course of open market trading), and the policy contains a Prospectus Liability Exclusion, then it is This exclusion may operate to exclude cover for a possible that the policy will not respond to the claim.
securities claim if the underlying cause of the loss in shareholder value is connected with the release of pollutants into the environment. What are the potential exposures of directors and officers if a securities claim is based on an allegation of their failure to act in response to climate change or a failure to grasp the impact of emissions on the business? Are greenhouse gases a "pollutant"? To ‘C' or not to ‘C' – that is the Question? In April this year, the United States Supreme Court, in a – When an insurance policy offers an extension of 5-4 decision, ruled that greenhouse gases are indeed a cover, it is natural to assume that this is a good thing pollutant. The court did not order the US Environmental which will benefit the insured. Ironically, it is not Protection Agency to regulate greenhouse gases, but just the exclusions in a D&O policy that need to be the court did direct the agency to take a new assessed – some extensions of cover need serious look at the gases. consideration, too. D&O Insurance was originally conceived to protect a company's directors and From a prudent corporate governance standpoint, officers against personal liability. So, when a D&O management must put in place a proper process for policy is extended to cover parties other than the disclosing the potential impact of global warming on directors and officers, it should raise questions as the business (for instance, are there tourism assets to whether that extension is appropriate. that could be adversely affected by greenhouse gas emissions?) – For instance, when a D&O policy offers an extension known as Entity or Company Cover for Securities Inquiries Extension Claims (often referred to in the insurance market as "Side C" cover), insured directors and officers need Most current D&O policies provide an Inquiries to know that this cover has the potential to cause Extension which covers the costs incurred by directors some serious problems. and officers when they are required to attend regulatory inquiries. – Side C cover basically provides protection for the company as opposed to claims against its However there are some "pitfalls" directors and officers directors and officers. Whether it is appropriate to need to be aware of: have the company covered under a D&O policy really depends on what those buying the policy believe the – As an official inquiry usually pre-dates any claim primary purpose of the policy to be. If they believe (as defined in the policy), it would be unusual for the primary purpose of the policy is to protect the inquiry to be alleging any wrongdoing by the the directors and officers alone, then extending director or officer. Yet some D&O policies require the policy to cover the company would not be an allegation of a "Wrongful Act" as defined in the appropriate. If they believe that it is appropriate policy in order to trigger the extension. This is a to include protection for the company, then that serious restriction of cover which should be avoided. decision should be made with a clear understanding of the issues that can arise.
Other restrictions of cover that may appear within an Inquiries Extension that should be The more significant of these issues are summarised as – The restriction of cover to legal costs (as opposed to (i) Insufficient Limit of Liability non-legal costs which may also be incurred). D&O Insurance is almost always subject to an aggregate limit of liability. This means that the – The costs of actually attending the inquiry (significant one limit of liability is provided to cover all claims costs can be incurred in preparing for the attendance against all insureds during the policy period. One at the inquiry). characteristic of securities claims or shareholders' class actions is that they usually involve large It is also not uncommon for insurers to seek to sub-limit compensation claims and involve massive legal the cover provided under this extension. costs. A claim by directors and officers under their D&O policies as a result of such actions has the tendency to exceed the limit of liability provided by the policy. If a securities claim is made against the company as well as against the directors and officers, it becomes even more likely that there will not be enough "money in the kitty" to cover all of the claims against all the insured parties. To include the company as an insured in the D&O policy means that the insured directors and officers may be sharing an already inadequate limit of liability. Directors and officers need to be aware of their exposures to personal financial risks in such instances and bear this in mind when deciding whether or not they wish to have Side C cover.
(ii) D&O Policy a Corporate Asset With conditions in the D&O market continuing to soften, Most claims against directors and officers arise insurers are not only reducing premiums but also looking when the company goes into liquidation. If the D&O to gain a competitive advantage by offering an array policy includes Side C cover, this raises the prospect of new coverage extensions. In this context, it has of the liquidator claiming the policy as a corporate become almost standard practice for insurers to offer asset. This is what happened in the Enron case and Side C cover – some insurers even have it as a standard it resulted in the insurer being unable to advance extension or insuring clause automatically provided defence costs to the directors and officers. Whilst, within the policy. as far as we are aware, this situation has not yet arisen in Australia, it is clearly an issue that must Most of these new extensions do offer some benefit to the insured directors and officers but for the reasons stated above, Side C cover needs to be treated with a (iii) Proof of Debt Claims great deal of caution. The effect of the High Court decision in the Sons of Gwalia case is that, in an insolvency situation, If a decision is made to purchase this cover, careful shareholders are now able to sue for misleading and consideration needs to be given to increasing the policy deceptive conduct to recover their loss and rank limit, or agreeing a pre-set allocation of the limit to the alongside unsecured creditors in doing so. Side C cover. Purchasing a separate "tower" for the Side C cover may mitigate some of the problems mentioned This raises the prospect that shareholder Proof of above in the event of a securities claim.
Debt claims and the external administrator's costs in assessing those claims may be covered under Side C of the company's D&O policy. In that event, the policy's limit of liability may be eroded even before – The exposure of corporate directors and officers to claims are made against the directors and officers. personal liability has been steadily increasing for This means directors and officers are left exposed to several decades and the increasing frequency of personal risks of liability.
shareholder class actions and associated regulatory actions in recent years in Australia is just another (iv) Order of Payments manifestation of that trend. When there is an insufficient limit to cover the claims that are made against multiple insureds, issues will – Whilst the law surrounding shareholder class actions arise as to how the limit is to be allocated and who in Australia is at an early stage of development (for is to be paid first. Some D&O policies address this instance, at the time of writing, the "fraud on the issue by having "Order of Payment" clauses which market" theory is being run for the first time in the state that the directors and officers will get "first bite Aristocrat trial), it is likely this trend will continue into From a practical point of view, however, being able – The recent CAMAC proposals (see the April 2006 to take the "first bite of the cherry" may not provide report by the Corporations and Markets Advisory much comfort given the timing of the various claims Committee entitled "Corporate Duties Below Board that come before the insurer. It is not often easy to Level") suggest that this exposure to personal prove the precise order of the claims made under the liability will extend below board level to those policy. The inclusion of Side C cover may not only involved in any aspect of managing a company.
increase the chances of an insufficient limit scenario. It is also likely to make the order of payments by – What does all this mean? It means that the insurers even more difficult.
exposures of company management, at all levels, to personal liability will, in all likelihood, continue to (iv) No Skin in the Game increase. More importantly, it means that past efforts One unforeseen side effect of providing Side C to identify, control and transfer this risk are unlikely cover is that, when faced with a securities claim far to suffice and a new level of risk management exceeding the policy limit, companies have had no vigilance will be required. motivation to defend the claim and have instead prevailed on insurers to settle the claim for the policy limit. For directors and officers who feel they have done nothing wrong and who have their professional reputation on the line, this is clearly not ideal. The potential conflict of interests in such cases provides another reason for companies and their directors and officers to think carefully before including Side C cover in their D&O policies.
For more information on The Liberty White Paper Series please contact Richard Head on 02 8298 5800


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