May 2014 | SPECIAL REPORT: OPERATING AN EFFECTIVE BOARD
Financier Worldwide Magazine
Until recently, there were two topics that could reliably cause a loss of sleep for Australian non-executive directors: shareholder class actions and a ‘second strike’ shareholder vote against the annual remuneration report. Over the past 12 months, however, a third, more amorphous, threat has been emerging in the Australian corporate arena – the for-profit shareholder activist.
Shareholder class actions, like the professional shareholder activist, are a US-developed concept, first emerging in Australia at the beginning of this century. Since that time more than 30 have commenced, although uncertainty about the legal status of market-based reliance, difficult damages calculations and the financial burden of this complex litigation have so far precluded any from proceeding to final judgment. All have been commercially resolved, many with a considerable payment by the company or its insurers to the plaintiffs. A significant boost was given to the developing practice in 2006 when the Australian High Court approved third party funding of class actions. Litigation funders were given a further boost by another decision in 2007, which approved ‘closed’ classes limited to those who have agreed to a litigation funder’s terms. Together these decisions prompted a surge in actions.
Litigation funding bodies are now able to fund the expensive task of gathering evidence and targeting disgruntled shareholders as potential plaintiffs, often in tandem with plaintiff law firms who derive a large source of revenue from these claims.
Shareholder class actions are typically brought against companies for misleading the market by releasing financial statements that either contain inaccurate information or omit critical information altogether, or for a breach of a company’s continuous disclosure obligations under the ASX Listing Rules. Commonly both will be alleged, as was the case with Sigma Pharmaceuticals Limited, which faced a proceeding in 2010 at the conclusion of a five week trading halt and the release of financial results that revealed a sharp drop in profits (due to a goodwill write down) only months after raising A$300m in new capital. The class action settled in 2012, with Sigma paying over A$50m, but not admitting liability.
Similarly, OZ Minerals Limited has been subjected to two shareholder class actions for alleged breach of its continuous disclosure obligations and misleading conduct, due to allegedly understating its liabilities by A$300m and not informing shareholders of a risk of insolvency. Both actions were settled for approximately A$60m, however a third claim is currently underway on the basis of the same events.
Billabong International Limited is the latest high profile company to face a shareholder class action. A forecast released by the company in August 2011 indicating strong underlying earnings growth over the next 18 months was followed, four months later, by a profit downgrade warning, indicating its earnings for the first half of 2012 were expected to be around 25 percent lower than previously expected. A significant drop in share price resulted.
Like all class actions, shareholder class actions are expensive and time consuming. They are a significant distraction for Australian public company directors.
While shareholder class actions have been a feature of the Australian corporate landscape for over a decade, the ‘two strikes rule’ is a more recent headache for public company directors. It emerged in 2011 (to supplement a provision providing for a non-binding shareholder vote on executive remuneration) as a response to growing community concern that executive remuneration was under-regulated and excessive. The Corporations Act was amended to provide that, if at two consecutive AGMs of a public company more than 25 percent of the members voted against adoption of the annual remuneration report, then at the second AGM a resolution requiring a meeting to vote on a full spill of non-executive board members must be put forward. If the spill resolution is passed, the spill meeting must occur within 90 days.
To date, despite a number of companies incurring ‘second strikes’, there has not been a full board spill of a listed company caused as a result of the rule. The media has recently reported that eight companies have incurred three consecutive strikes without shareholders taking the next step of spilling the board following the second strike.
Despite the lack of results so far, various public company directors and commentators have voiced their concerns that the two strike rule is being used as a platform for shareholders to express their discontent with any aspect of the company’s performance – be it a flagging share price or certain board decisions – rather than the purpose for which the rule was conceived: to make directors accountable for executive remuneration. There is certainly no statutory prohibition to prevent shareholders voting against the remuneration report for reasons unrelated to executive pay.
For this reason, the ‘two strikes rule’ is considered one of the most easily accessible tools available to shareholder activists to allow them to make their voices heard and is a contributing factor to the view that Australia is fertile ground for shareholder activists. In addition to the very low voting threshold, another reason that the two strikes rule is seen to be shareholder friendly is that it provides an annual opportunity for members to vote to express their displeasure with the board of a company, without requiring them to agitate for and organise a separate meeting. The two strikes rule can also facilitate participation from more conservative or private shareholders in calling for change. Proxy advisers are another group that wield significant voting power in relation to these campaigns.
Similar to shareholder class actions, an industry now seems to be developing around professional shareholder activism. Firms with a for-profit activist business model are increasingly active and gaining more media attention. Corporate Australia witnessed a highly public assault led by a for-profit activist on Washington H. Soul Pattinson Limited last year in relation to that company’s cross-shareholding arrangement with Brickworks Limited.
Investment banks are now offering their services to nervous boards who wish to shore up their defences against a potential attack, particularly as activist US hedge fund campaigns waged against companies such as Sony, Apple and Yahoo have shown that size or relative financial health (or, as demonstrated by the Soul Pattinson campaign in Australia, sheer longevity) will not necessarily stave off activists. However, concerns have been raised about the fact that defence mandates could be viewed as boards using company funds to protect themselves against their own shareholders.
Shareholder pressure is not new to corporate Australia. As with most jurisdictions, there are many examples of shareholders who, in the ordinary course of business, would be unlikely to interfere with the management of a company but are compelled to take action in response to a specific set of circumstances. A recent example is the departure of three David Jones Limited directors, including its chairman, following a controversial share purchase by two of the directors which had been approved by the chairman. In these cases, traditionally the campaigning occurred behind the scenes, with media involvement generally limited to reporting on any resulting board shuffles.
This is quite distinct from the new wave of for-profit shareholder activism, where funds are formed with the mandate to purchase holdings in underperforming companies that are then used as a platform to agitate publicly for change – be it in relation to senior management, executive pay or board composition – with the aim of bringing about an eventual rise in the share price. Several self-identifying activist funds have recently been established in Australia. A number of US-based hedge fund activists, who have created a high profile for themselves and the notion of for-profit activism generally with their unconventional techniques (such as personal attacks on directors or harnessing their social media following to announce their latest stance on an issue) are reported to be taking a close look at the Australian market. This higher profile, more media-focused activism has also resulted in traditional fund managers being more publicly outspoken. Issues that in the past were resolved behind closed doors are now far more commonly being debated through the business pages.
Founders and supporters of for-profit activist funds argue that they act in the best interests of all shareholders by tackling ineffective management, demanding improved profitability and holding directors to account for bloated salaries or inefficient operations. Critics (including many public company directors) counter that this kind of activism is disruptive and short sighted, that it is costly and time consuming and distracts management and boards from long term growth strategies. Ultimately, whether this criticism is valid remains to be seen.
Jeremy Blackshaw is head of the Private Equity & Capital Markets Practice Group, and Marina Cornish is an associate, at Minter Ellison, Melbourne. Mr Blackshaw can be contacted on +61 3 8608 2922 or by email: firstname.lastname@example.org. Ms Cornish can be contacted on +61 3 8608 2623 or by email: email@example.com.
© Financier Worldwide
Jeremy Blackshaw and Marina Cornish