Dr David Millhouse, Senior Honorary Adjunct Research Fellow, Faculty of Law at Bond University, discusses shareholder class action financing by looking into the Australian Law Reform Commission 2018, the PJC ‘Paterson’ Inquiry 2020, and more. He will delve further into this at the Shareholder Class Actions: Reforms & Risks on Thursday 10 June.
The financing of shareholder class actions has created substantial media interest. Media reporting can have a negative feedback loop acquiring influential global momentum of its own whereas legal scholarship, even when reported, does not. Legal scholarship is not replete with empirical analysis so in the present debate, such analysis should be heeded. Reforms to date illustrate how the confluence of class action law and managed investment scheme (MIS) law is problematic and unresolved. Some proposed reforms are politically contested. Litigation funding is used to increase access to justice for those otherwise unable to prosecute a claim to uncover and remedy incompetence, reckless or egregious behaviour. It can also be misused, perhaps as a strategic tool. Australian present and proposed practice deviates from preferred practices in other jurisdictions emulating divergences seen in comparative fiduciary and best interest law which generate additional director risk where there are cross-border investments.
This seminar provides an insight into present Australian class action law, a summary of proposed new law, and insights into how comparative law may make for a statutory regime which better meets the needs of stakeholders, including litigation funding scheme participants, funders, and the boards of targeted organisations.
Different stakeholders have markedly different and conflicting opinions. This partly arises from financial interests of litigation funders who are beneficiaries of the loss of the common law protections of maintenance and champerty. It also arises from director and trustee concerns about the alleged increase in the volume of litigation, its cost in money, board time and director’s insurance premiums. Similarly, it drives up the cost of financial advice partly from global reinsurer risk re-rating generally but also from the extant [former FASEA] unlimited relevant provider liabilities arising in s 921U of the Corporations Act which broadens the interpretation of who provides financial advice. The Design and Distribution provisions of the Corporations Act (s 994) which will be in force from 5th October 2021 apply to all financial products in Australia sold to retail investors or financial consumers. Litigation financing schemes as MIS are not exempt unless ASIC specifically provides an exemption.
Some argue that lack of public enforcement has led to the growth of private enforcement and the financing that supports it. Supposed lack of public enforcement has been in part attributed to lower statutory standards of disclosure which may become permanent. However, these standards are accompanied by strict director liability (with some safe harbour protections).
Law reform has already occurred with the inclusion in July 2020 of litigation financing within the MIS provisions of the Corporations Act, previously exempted in 2013. More reform is likely, arising from the research conducted by the Australian Law Reform Commission (ALRC) (2018) ‘Integrity Fairness and Efficiency—An Inquiry into Class Action Proceedings and Third-Party Litigation Funders’ and the Paterson Parliamentary Joint Committee Inquiry (2020) ‘Litigation Funding and the regulation of the class action industry’. These follow earlier research by the Productivity Commission in 2014.
Litigation finance of itself is not new. In its securitised third-party form it dates to the 1990’s in Australia and the UK, but later in the USA, noting that the law varies in different US states. This relatively modern development has resulted in a US litigation funding market is estimated to be between USD 50-100 billion in funds under management.
There is a distinction between a class action (being a regulated legal process supervised by the Federal or Supreme Courts) and litigation funding (being, since 2020, defined as a MIS). Litigation funding is not restricted to special purpose MIS. It is also provided (within or outside of a MIS) by law firms operating on a contingency (Victoria only) or no-win, no fee basis. New law may require them to hold an AFSL. Such distinctions in legal practice between Australian jurisdictions prompted the Paterson Inquiry propose the Federal Court be the sole Australian jurisdiction.
Empirical analysis — separating fact from fiction
The financial press has been replete with calls for interventions into the class action industry. As an example, in a succinct op-ed, Albrechtsen identifies four reform needs including remediation of the ‘director’s and officer’s insurance crisis’. Similar issues exist with the cost of professional indemnity insurance for financial advisers with blame being attached to class action litigation.
Marsh says ‘it is not just publicly listed companies that are experiencing premium and retention increases and reduced capacity, [claiming] [t]he effects of litigation funded class actions have rippled through all D&O policies, as well as management liability policies commonly purchased by [SMEs]. Poor insurability is likely to ‘suffocate entrepreneurial [endeavour] and investment and growth-focussed decisions in Australia, as boards become more risk averse’. Australian directors are potentially exposed to liabilities arising from ‘more than 600 pieces of legislation’. Important risks for SME’s, including securities claims and special excess limits for non-executive directors ‘have been restricted or removed’.
Prof. Morabito of Monash University has conducted empirical analysis published in a series of important scholarly papers on class action litigation which does not support the claims made by Marsh or similar claims in the financial press. Questions therefore arise as to the underlying reasons for the rise in premium costs and the reductions in cover. Morabito’s data has some support from the litigation funding industry.
Morabito, based on his data contends ― ‘no balanced or objective assessment of the volume of class action litigation in Australia could possibly lead to the conclusion that there has been an explosion in the number of class actions filed in Australia.’ Or indeed, shareholder class actions. His research also shows that ‘after 2018 there has been a decrease in the number of (a) Australian class actions; (b) federal class actions; (c) Australian funded class actions; and (d) federal funded class actions.’ It is shareholder class actions that seem to be the subject of financial press and insurer attention, including claims that shareholder class action litigation was not originally proposed to be an outcome of Pt IVA of the Federal Court Act. In the four class action jurisdictions analysed, there have been 634 class actions over Morabito’s study period of 27 years and 4 months. These concerned 420 disputes. Of these, 122 were shareholder cases involving 63 companies or groups, only 9 of which were in financial services and products. He also reports a declining trend in shareholder class actions declining from 44.7% of all actions in 2016–17 to 32.2% in 2019-20. Of the 122, 67% were brought against the companies only, not the directors. In only 4.9% of the cases, the actions were brought against the directors alone. The proportion of cases joining directors in the action have declined from 18.8% of the total sample to 10% of cases filed in the 2018–19 financial year.
Morabito’s data leads to the conclusion that there needs to be a more thorough government review of the D&O insurance sector, perhaps by the ACCC or Productivity Commission into the underlying issues contributing to both insurance availability and cost. A review may determine whether this historical data is an accurate predictor of future trends. Morabito’s data covers shareholder actions. Some of these are vertically integrated financial services entities. Future review should ensure all MIS class actions are within the dataset.
Legal analysis demonstrates the very broad application in private law of class actions in seeking redress to imbalances of power. These are not only shareholder or investor originated actions. Since inception to 2016, of the 329 Pt IVA proceedings in the Federal Court, only 89 were on behalf of investors. From a director perspective, every organisation needs a potential class action risk analysis.
Historically, since the introduction of the class action provisions in March 1992, third party litigation funders did not require an AFSL but were and are subject to general law interventions and court oversight.
‘In July 2013, litigation funders were specifically exempted… from the requirement to hold an [AFSL]…’ Their exemptions extended to Pt 5C of the Corporations Act and the National Consumer Credit Code. These exemptions have been supported by scholarly opinion where there is a net benefit argument, by the ALRC (initially) and by ASIC.
This previous and now reformed exemption from the financial advice and MIS provisions of the Corporations Act for litigation financing and contingency fee charging were an example of Hayne’s ‘special rules, exceptions and carve-outs’, there being considerable but unsuccessful support for ‘a bespoke licensing regime that sat outside the [AFSL] regime but imposing comparable obligations’. Some participants supported AFSL and MIS reform to include class action financiers. Others, perhaps conflicted, do not.
Morabito concludes —’There is no objective basis for implementing any measures that will directly or indirectly restrict the ability of class actions to allow claimants to seek access to our courts with respect to their legal grievances. Attention should be placed instead on giving courts presiding over this type of litigation adequate powers to ensure that class members are treated fairly and receive adequate compensation in successful class actions’. Which, of course, is the purpose of a MIS and the voluminous jurisprudence relating to them. It does not restrict the access of claimants to the courts in redress of grievances. Indeed, it may reduce costs over those of a bespoke statutory regime, being a new body of law. It may also allow more transparency to counterparty directors.
The Australian Law Reform Commission 2018 — an interim review
Its terms of reference included consideration of adequacy of regulation of conflicts of interest between scheme participants and funder, lawyer and participants, and between funder and lawyer. It also included whether or not to impose prudential standards on litigation funders. At the time, litigation funding schemes were not MIS, but as this author’s empirical analysis has identified, MIS capital adequacy given the size and extent of some MIS requires reform.
The ALRC provided 24 Recommendations. Important amongst these were Court express statutory power to make common fund orders and amendments to the Corporations Act and ASIC Act to confer exclusive jurisdiction on civil matters commenced as representative proceedings on the Federal Court. A common fund order is a court order requiring all participants to contribute proportionate costs of the litigation from their settlement proceeds.
Rec 16 proposed including ‘law firm financing’ and ‘portfolio funding’ within the definition of ‘litigation funding scheme’. As is often the case in Australia, definitional boundaries can be contentious. ‘All that the word “scheme” requires is that there be some programme, or plan of action’. It is not a defined term, but there are constituent statutory elements. Judicial analysis concluded a litigation funding scheme was indeed a MIS, satisfying these five essential elements in s 9 of the Corporations Act.
Such schemes now being MIS would require those law firms to hold an AFSL unless specifically exempted. It was followed in Rec 20 proposing a specialist practice accreditation requiring law firms and their solicitors to undertake CPD in the identification and management of actual and perceived conflicts of interest and duties in class action proceedings. Rec 22 developed this theme requiring the avoidance of conflicts of interest, and to disclose the detail should they then occur. Rec 21 proposed a prohibition on law firms and solicitors having a financial or other interest in a third-party litigation funder which supports the same proceedings. Relevant to the media attention given to litigation financing schemes, Rec 24 proposed a review of continuous disclosure obligations and to misleading and deceptive conduct obligations arising in both the Corporations and ASIC Acts.
PJC ‘Paterson’ Inquiry 2020 — foundation for future reform
The commercial benefits to litigation funders reported in the media found echoes in this Inquiry — ‘Courts and civil remedies were not established as novel investment vehicles to deliver handsome profits to innovative financiers or creative lawyers… Australia’s highly unique and favourably regulated litigation funding market has become a global hotspot for international investors… to generate investment returns unheard of in any other jurisdiction…’ Noble sentiments indeed, and not without foundation. However, some of the reported sentiments ignored Morabito’s analysis.
There were 31 Recommendations. The Federal Court be empowered to hold selection hearings to determine which of competing or multiple class actions should proceed, based on the ‘best interest’ and preference of class members. However this falls short of a certification process found in other jurisdictions where the Court must approve the commencement of a proceeding or not. Common funds orders have a chequered judicial history and Rec 7 proposes to end same. Other recommendations extend the power of the Court to close or re-open a class, funder indemnity of representative plaintiffs against adverse costs orders and withhold approval otherwise, and a statutory security for costs from the funder. Court intervention is proposed to be extended to approval of the Federal Court for a litigation funding agreement to be enforceable and varied, rejected or amended by the Court with approval requiring the exclusive jurisdiction of that Court. Rec 30 proposes that exclusive jurisdiction be given to the Federal Court; if not, then State Supreme Courts to achieve consistency with it.
Where law firms provide contingency funding, the AFSL regime be extended, if feasible, to them. Other recommendations propose regulation over fees, costs, minimum returns to class participants, and the publication of Australian company tax paid by the litigation funder over the prior three- year period.
A law firm is not permitted to promote or operate a MIS. The Legal Profession Unform General Rules 2015 (updated) provide a grace period until 22 August 2021 where the firm has an interest in the MIS or the RE of the MIS if it is a litigation funding scheme. This particularly applies where group costs orders are in place. A group costs order (Victoria only, since July 2020) is a contingent liability for legal costs including disbursements. A group costs order may be a MIS. If they are not, then third party litigation funders finance a MIS, but the law firm funding does not.
Australian corporate law is replete with references to ‘best interest’. The Paterson Inquiry uses this aphorism frequently, and to ‘interest’ in respect of the obligations of the Federal Court to scheme participants. Lawyers are both fiduciaries and have best interest obligations to their client, being the legal representative of the scheme plaintiff participants.
Conflicts of interest recommendations note the best interest to members test in MIS law and emulate the ALRC recommendation in prohibiting law firms having a pecuniary interest in the funder of the proceedings where they act for the plaintiffs. Rec 28 supports the application of the MIS regime but proposes tailoring that regime for the specific needs of litigation financing. However, the architecture of the law remains as prioritisation over prohibition except in specific circumstances. This weakness in MIS law thus continues into the litigation financing industry. Where the law firm is a class participant, it compromises its best interest duty and its fiduciary duty to the client. Some United States opinion suggests lawyer contingency fees ‘fly in the face of a lawyer’s fiduciary duty to their client’ and that ‘litigation which is lawyer funded, lawyer managed, and lawyer settled is unacceptable’.
A litigation funder is not necessarily a fiduciary, but a promoter of a MIS is. Directors of the RE of a MIS have a fiduciary duty to the RE (as a company) and the RE has a best interest duty to the MIS member, in this case the class action participants. These participants may also include the funder, its related and associated parties (including indirectly its RE), and the law firm acting. It is difficult to see how conflicts of duty and interest can be resolved or managed in such a Gordian Knot. The advent of the MIS regime in litigation financing may result in vertically integrated related party RE’s which compromise Hayne’s reform thesis. An RE, as trustee, can only fulfill its statutory and general law obligations if it is unfettered. That means a statutory architecture of prohibition, not prioritisation, and elimination of Dual Interest.
That begs the question of roles. Which entity is the promoter? Promoters are fiduciaries in general law. Is it the Funder, the Investment Manager of the Funder, the case Project Manager, the RE, or the Plaintiff Representative? In other MIS, it is common for the investment manager to perform the role of promoter seeking funds from investors.
There is no unanimity of opinion. Presently, these roles can be conducted by related or associated parties of the Funder. The law firm cannot be the Promoter, but it can be an associated party of it. These questions arise now and are largely unresolved judicially. Instead, there will be a continuation of ‘box-ticking’ compliance processes to meet prioritisation obligations. Under present law, it is only the Federal Court which clearly has a duty to act in the ‘interest’ of the plaintiff class participant.
These issues should be central to a Court approved, but presently missing Certification process. That process, as Paterson recommends, requires the appointment of a Contradictor. Of the main comparative jurisdictions, Australia lacks a Certification process by the Court before which proceedings cannot commence.
The essence of the relationships should be fiduciary, objectively in the interest of the class participant plaintiff, not a mash of competing and conflicting best interest duties. Then, there is a common standard requiring Federal Court approval in a certification process, tested by a contradictor. The litigation funding agreement is proposed to be unenforceable in the absence of certain preconditions — this voiding of the litigation funding agreement should extend to the resolution of these issues. Empirical analysis by this author quantifies the cost of wrong policy, especially where there are related or associated parties driving conflicts of duty and conflicts of interest.
Resolution of this architecture is central to litigation financing MIS reform.
Insights from comparative jurisdictions
Of political interest is the continuation of reduced (Covid-19 induced) continuous disclosure civil law liabilities of companies. These are different in other jurisdictions (Paterson, Table 17.2). Australia has reduced company liability private action risk compared with Canada, Hong Kong, South Africa, but not the UK or USA and reduced company liability public action risk compared with Canada, Hong Kong, South Africa, UK and USA. In all of these jurisdictions, directors and officers have personal liability for company breaches, but in Australia and Canada, there are safe-harbour defences for breaches of company civil continuous disclosure obligations.
The arguments against disclosure of the litigation funding agreement include whether a plaintiff has funding, the quantum of it, and the power of the Funder to withdraw. These could be resolved by a Court Certification Process based on fiduciary principles espoused in a Standard which provides for contextual specificity.
The US Federal Litigation Funding Transparency Act 2018 is a transparency regime requiring the disclosure of litigation financing agreements. Wisconsin and the Northern District of California require disclosure of the litigation funding agreement to the Court and the adversary. US disclosure proposals are ‘intended to address a dramatic increase in the risk of conflict of interest that existing rules of court are inadequate to prevent’. In Australia, the existence of the litigation funding agreement requires disclosure but its contents do not except in summary in the context of a Product Disclosure Statement for a MIS. Certification could provide full disclosure to the Court in camera, but not the opposing party or the public. It is then for the Court to determine whether broader disclosure is warranted.
Author’s note
The primary references for this article will be provided in the seminar materials. Pinpoint references can be found at www.millhouse.co in ‘Directors and Officers — Strategic Leadership or Bondage?’ (2020) Enterprise Governance eJournal, Centre for Commercial Law, Bond University
David Millhouse has been a serial entrepreneur in international private equity, venture capital and funds management sectors in Chief Executive and board roles since 1983. David holds a Ph.D in Law from Bond University entitled ‘Systemic and Cyclical Failure in the Australian Financial Products and Financial Services Sectors: Have weaknesses in corporate law contributed to these failures? His PhD has been publicly recognised by the Australian Financial Review (AFR Chanticleer 16th January 2019), television (7th March 2019, ch 601). He is the author of three scholarly articles published in the Law and Financial Markets Review (‘Empirical analysis supports the Hayne long run reform thesis’ LFMR 13:2-3, (2019) and ‘From Campbell to Hayne: W[h]ither Australia? Australian financial regulation and supervision at a cross-roads’ LFMR 13:2-3, (2019)) and ‘W[h]ither Australia? Will Parliament Act?’ LMFR 1492) (2020)). His book ‘Corporate Governance in Non-Bank Financial Entities’ is published by LexisNexisButterworths (October 2019). His most recent publications ‘Best Interest Duties of Financial Advisers – More Law, More Confusion’ February 2020 and Directors & Officers ―Strategic Leadership or Bondage? are published in the Corporate Governance e-Journal at the Centre for Commercial Law, Bond University. He is a regular speaker at law and financial conferences.
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