A number of recent reports analysing United States (US) class action activity in 2011 have identified three trends of potential significance to Australia.
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Increased claims against Chinese companies
First, reports by Stanford Law School Securities Class Action Clearinghouse, in conjunction with Cornerstone Research, NERA Economic Consulting and PwC, have identified an increased number of class actions being commenced against Chinese entities. As noted in our report Class Actions in Australia: The year in review 2011, as more Chinese entities list in the US, or undergo a reverse merger1, Courts have seen a related increase in the number of cases commenced against Chinese entities.2
The US Securities Exchange Commission (SEC) has been keeping a close eye on reverse merger transactions, and in July 2011 released an Investor Bulletin warning investors about the risks of investing in reverse merger companies. The Bulletin indicates that the SEC has:
- seen a number of examples in which private companies who are party to a reverse merger have appointed small US auditing firms, which can lack the resources to meet the company’s auditing obligation. Combined with the company’s operations being conducted offshore, this further increases the risk that the auditing firm may not identify instances of non-compliance with relevant accounting standards, giving rise to causes of action; and
- suspended trading in six reverse merger entities from March 2011 to May 2011 due to issues with the adequacy or accuracy of their public filings.
In December 2011, this was followed up with the introduction of more stringent listing requirements for companies that become public through a reverse merger, which apply to Nasdaq, NYSE and NYSE Amex. Under the new rules a reverse merger company is prohibited from applying to list until:
- they have traded in the US over-the-counter market or on another regulated US or foreign exchange for a year following the reverse merger, and filed all required reports with the Commission, including audited financial statements; and
- the company maintains the requisite minimum share price for a sustained period (including for at least 30 of the 60 trading days), immediately prior to its listing application and the exchange’s decision to list.
However, despite reverse mergers providing ripe conditions for potential class actions, as always there are some risks associated with commencing a class action against a foreign domiciled company as, even if successful, the plaintiff may not be able to enforce the judgment if the majority of the defendant’s assets are located offshore.
Increased class action activity in relation to mergers and acquisitions
Second, both the Stanford and NERA reports, as well as research by Cornerstone,3 all indicate that the number of merger-related class actions remains high.
For example, media reports indicate that within five hours of the announcement by BJ’s Wholesale of a $2.8 billion leveraged buyout deal, five different plaintiff law firms had commenced an investigation into whether the board had breached its fiduciary duties by not investigating the possibility of obtaining a better deal from a different party.
The Cornerstone Report found that multiple actions were commenced in almost all transactions relating to US public companies worth more than $100 million.
Such class actions are ordinarily based on claims that:
- the transaction price did not result from a sufficiently competitive auction;
- conflicts of interests arose;
- restrictive break fees or no-solicitation provisions may have discouraged additional bids; and
- the target made inadequate or misleading disclosure about the proposed transaction.
Of the 565 merger-related actions commenced between 2010 and 2011 that were tracked by Cornerstone Research, 69% settled. However, none of the settlements for which terms were reported resulted in a higher bid for the target, and only 5% resulted in a payment being made to shareholders. The most common remedy was a requirement that the company provide shareholders with additional disclosure (82%), modifications to “deal protection” provisions such as break fees (17%) and changes to the merger documentation (13%).
The commencement of class action litigation prior to completion presents a major impediment to the transaction succeeding. Trends indicate that the affected companies are far more likely to expedite a settlement of the proceedings, which is further increasing the incentives for law firms to challenge transaction terms. However, there are disadvantages in choosing to settle, which could hinder a plaintiff’s desired ‘quick’ settlement, namely:
- allegations of a breach of fiduciary duty are highly damaging to directors. Without proceeding to judgment, the directors are unable to preserve their personal reputation; and
- there may be added incentive for shareholders to commence an action in relation to future merger activity if the firm gains a reputation that it is likely to expedite settlement.
Increased number of accounting-related class actions
The third significant trend is the increasing number of accounting-related claims – including class actions surrounding reverse mergers, focussing on allegations of accounting fraud or other issues surrounding financial reporting – although there has reportedly been a reduced number of claims naming an accounting firm as a defendant.
Both NERA and PwC report that significant numbers of accounting-related cases involve foreign entities and, in particular, Chinese firms.
However, this trend may also be attributable to the US Supreme Court’s June 2011 decision in Janus Capital Group, Inc v First Derivative Traders. In that case, the Supreme Court held that it would not “expand liability beyond the person or entity that ultimately has authority over a false statement”. The issuer of a prospectus is the person who actually “makes” any false statement in the prospectus. This decision is likely to limit class action plaintiffs’ ability to sue accounting or auditing firms in connection with misstatements made about public companies.
Trends to watch
One significant trend in the US that has not visibly affected Australian class actions to date is the prevalence of claims against directors and officers. PwC reports that in the US, the majority of claims continue to name senior executives as defendants (CEOs in 86% of claims, CFOs in 69%). While in Australia there have been class actions in which directors and/or senior executives have been joined (for example, GIO and Centro), to date it has been rare.
In the year ahead, US pundits will be watching closely to see whether the SEC’s new whistle-blower regime has an effect on the number of cases filed. Under the Dodd-Frank reforms, the SEC is able to pay monetary rewards to an individual who provides original information leading to a successful SEC enforcement action with penalties greater than US$1 million. While there is a high correlation in Australia between action taken by the Australian Securities & Investments Commission and follow-on class actions, there is no such additional incentive for whistle-blowers.
However, other US trends are already being reflected in Australian cases, including the role of institutional investors as key group members and the increased willingness of plaintiffs to name professional advisors as respondents.
Australia has not had the volume of class action judgments seen in the US, with only one securities class action going to hearing and judgment, being the Timbercorp proceedings. While NERA reports that Australia is on par with Canada, the rate of filing of securities class actions remains well below that witnessed in the US. However, with the Australian economy growing strongly and attracting more capital from China, it is likely that similar trends could be witnessed here.