There’s been several high profile class actions launched by unhappy shareholders against the companies they invest in (otherwise known as securities class actions) lately in Australia. The common theme is a claim 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 is then 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 chief executive overconfidence played in these actions, after controlling for other corporate factors.

We found that overconfident chief executives 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.

Bellamy’s chief executive was recently stood down after the company’s share price fell more than 50%. Similar action has also been launched against Murray Goulburn, Slater & Gordon, and Newcrest.

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. Someone 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.

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 amount 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 $2 billion in damages with a 90% success rate. Litigation Capital Management, Bentham IMF, and JustKapital Litigation Partners have been successful enough to list on the Australian Securities Exchange and perform strongly in 2016.

Regulators in Australia have been relatively encouraging to litigants. For example, the Australian Securities and Investments Commission (ASIC) and the US Securities and Exchange Commission (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 chief executives.

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 $200 million settlement. The regulator, ASIC, is investigating whether Slater & Gordon deliberately falsified books.

Our research shows overconfident chief executives 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 chief executives doing 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 chief executives. They can help to align overconfident chief executives’ interests with those of their companies, and greater board independence can both restrain their actions and force them consider outside perspectives that can attenuate their overconfident beliefs.

Board independence can also help. However, 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 damaging and costly securities class actions in the future.

Mark Humphery-Jenner is an associate professor of finance at UNSW; Suman Banerjee is an associate professor of finance, and Vikram Nanda is a professor of finance, at the University of Texas at Dallas. 

This article was originally published on The Conversation. Please visit the source link below to read the entire article.