Lately in Australia, there have been several high-profile class actions—otherwise known as securities class actions—launched by unhappy shareholders against the companies they invest in. The common theme is a claim that these companies have not been straight with investors, issuing falsely optimistic information or concealing negative information.
If it’s proved to be true, this sort of conduct does indeed damage market confidence and harms shareholders. The issue, then, is how shareholders and boards might mitigate the risk of these class actions occurring. This comes down to what types of executive (and board) characteristics are associated with the risk of litigation and what actions accentuate this risk.
To further understand what is driving these class actions, we looked at a set of nearly 1,400 securities class actions targeted against US-listed companies. We wanted to see how much of a role CEO overconfidence played in these actions, after controlling for other corporate factors.
We found that overconfident CEOs seem more prone to overstate their firms’ prospects or conceal negative information in the erroneously overconfident belief that future performance can make up for past failures.
One of the most recent examples of a company accused of misleading shareholders in Australia is a class action against infant formula maker Bellamy’s Organics.
Securities class actions are also more common in the United States. For example, 270 were initiated in 2016. In Australia, class actions are arguably one of the fastest growing areas of litigation, albeit from a rather low base.
When do securities class actions usually occur?
The general rules governing these sorts of class actions are similar in the US and in Australia. Investors can sue if they have suffered a loss as a result of the defendant making a false statement that alters share prices, when the defendant knew it was false or was reckless.
|Bellamy’s||Alleged breaches of continuous disclosure obligations between 14 April 2016 and 9 December 2016, culminating in its price falling nearly 50% and its market capitalisation falling more than AUS$500m.||Maurice Blackburn|
|Murray Goulburn||Murray Goulburn allegedly misled investors about its likely revenue in its Product Disclosure Statement (PDS), issued on 2 July 2015. It forecast net profit after tax (NPAT) of AUS$85.8m. Murray Goulburn downgraded this to AUS$63m on 29 February 2016. The company noted Chinese regulators had tightened regulations and denied an impact on profitability. On 27 April 2016, the company downgraded NPAT forecasts to AUS$39–42m. The share price fell more than 40%.||Slater & Gordon|
|Slater & Gordon||The class action alleges Slater & Gordon’s management misled investors about its profitability and about the risks involved in its acquisition of Quindell in April 2015. In December 2015 the company withdrew its 2016 profit guidance, which it had reaffirmed in November 2015. It reported a net loss of AUS$1.02bn in 2016, attributable in part to a AUS$879.5m impairment charge. It restated its 2015 profit from AUS$82m to AUS$62m.||Maurice Blackburn|
|Newcrest||It’s alleged Newcrest misled investors about production and profit. It downgraded production forecasts, wrote off all goodwill, and impaired the value of its mining operations. The case settled out of court for AUS$36m.||Slater & Gordon|
Securities class actions typically follow large falls in share prices. They usually involve alleged breaches of listed companies’ obligations to inform the market of information that might have a material impact on its share price. Often this involves concealing negative information, such as declines in sales or profitability. Such obligations exist in Australia, Canada, and the US, for example.
These class actions can also coincide with regulatory investigations.
What’s behind the surge in class actions?
An increase in the amount of litigation funding options for these class actions, coupled with encouragement from regulators, has spurred the number of class actions.
Litigation funding helps to facilitate securities class actions. Individual shareholders in a class action will recover only small damages, which will be insufficient to pay for their litigation costs, and class members do not want to be personally liable for costs. So litigation funding agencies step in by offering to pay the legal costs in return for a share of the winnings if the class action is successful.
The number of cases funded has increased recently. Bentham IMF, a listed funder, has seen strong growth in the number of cases funded. JustKapital has also seen strong growth since its listing by reverse merger in 2015. It announced that it acquired a portfolio of five cases in July 2016.
Litigation funding has also become more profitable for the companies involved. IMF Bentham, one of the largest litigation funders, claims to have recovered more than AUS$2bn in damages with a 90% success rate. Litigation Capital Management, Bentham IMF, and JustKapital Litigation Partners have been successful enough to list on the ASX and perform strongly in 2016.
Regulators in Australia have been relatively encouraging to litigants. For example, ASIC and the SEC can pursue companies for civil penalties for failing to disclose. This also enables class actions, because it helps litigants to prove their case, or tip off litigants about conduct that could give rise to a case.
For example, in 2016 ASIC announced that it would investigate whether Slater & Gordon deliberately manipulated financial reports. Such a finding would help litigants establish that Slater & Gordon misled the market.
What companies should do to avoid a class action
The evidence suggests that lax governance and poor oversight can drive securities class actions. This is especially the case in the presence of overconfident CEOs.
A key example is the case against property developer Centro, where directors allegedly failed to properly familiarise themselves with the company’s books, and financial statements were issued without the directors’ scrutiny. This resulted in a class action with a AUS$200m settlement. The regulator, ASIC, is investigating whether Slater & Gordon deliberately falsified books.
Our research shows that overconfident CEOs tend to overestimate their own abilities and the performance of their companies. Because of this, they overinvest, overestimating the returns and underestimating the risks of projects. This manifests, for example, in overconfident CEOs carrying out worse takeovers.
The issue is, then, what shareholders and company boards can do to reduce the risk of such distortions. Increased regulatory scrutiny can help, but regulators lack resources to proactively prevent disclosure lapses and typically respond after wrongdoing becomes apparent.
One clear remedy for companies is to improve corporate governance. Improved governance and appropriate compensation schemes for executives, can help to manage overconfident CEOs. They can help to align overconfident CEOs’ interests with those of their companies, and greater board independence can both restrain their actions and force them to consider outside perspectives that can attenuate their overconfident beliefs.
While board independence can help, independent directors must themselves be encouraged and incentivised to monitor firms— in the Centro case, independent directors had not done so. One such avenue would be through compensation schemes tied to the company’s performance over an extended period of time.
With improved governance, and structuring incentives to align directors’ and executives’ interests with those of shareholders, companies may avoid costly and damaging securities class actions in the future.
Mark Humphery-Jenner is associate professor of finance at the University of New South Wales; Vikram Nanda is professor of finance at the University of Texas at Dallas; and Suman Banerjee is associate professor of finance at the University of Wyoming.