Insights from the US: will knowledge, recklessness or negligence in Australian securities class actions actually change anything?

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Last week the Federal Government introduced permanent reforms to the continuous disclosure regime and misleading and deceptive conduct provisions in the Corporations Act 2001 (the Corps Act) and ASIC Act 2001 (the ASIC Act) which provide that companies and their officers will not be exposed to civil liability unless they had a requisite mental element, being knowledge, recklessness or negligence.  This change is in line with the recommendations of the Parliamentary Joint Committee for Corporations and Financial Services[1] and also extends the temporary measures originally introduced at the height of the COVID-19 pandemic.

This change brings Australia’s continuous disclosure regime closer to that of its counterparts in the United States and the United Kingdom, and there is much we can learn from our international colleagues.

Background

On 10 August 2021, the Treasury Laws Amendment (2021 Measures No. 1) Bill 2021 (Cth) passed both Houses of Parliament.  The bill amended the Corps Act and the ASIC Act to permanently implement a fault element into the continuous disclosure civil penalty provisions and to also provide that companies and their offices are not exposed to civil liability for misleading or deceptive conduct in connection with the contravention of the continuous disclosure obligations, unless the required mental element has been proven.

Specifically, a new Section 674A provides that an entity will only be liable for a contravention of its disclosure obligation where it:

knows, or is reckless or negligent with respect to whether, the information would, if it were generally available, have a material effect on the price or value of ED securities of the entity.”

A similar provision has been included for unlisted entities or listed entities with rules not requiring disclosure.[2]

The amendments also introduce accessorial liability where a person was involved in the contravention, although they will have a defence if they took all reasonable steps to comply with an entity’s obligations and then reasonably believed the entity to be compliant.[3]

As a consequence of the new civil penalty provisions, new sections have also been added into the Corps Act [4] and the ASIC Act[5] which provide that misleading and deceptive conduct claims will only be  available where the requisite mental element is established (knowledge, recklessness or negligence).  These are necessary changes which go further than the temporary changes originally introduced in 2020 which only applied to the continuous disclosure breaches and did not extend to the misleading and deceptive conduct provisions.  These amendments create consistency across the relevant breach provisions as shareholder class actions in Australia are routinely brought alleging breaches of the continuous disclosure regime and the misleading and deceptive conduct provisions in the Corps Act[6] and the ASIC Act.[7]

Commentary

Shareholder class actions are a common feature of Australia’s class action landscape and there has been little sign of that trend abating with the continued influence of third party litigation funding and the emergence of new players in the plaintiff class action lawyer space.  The confidence with which these types of claims have been pursued has been fuelled by Australia’s previous “strict liability” regime which has not required proof of intentional wrongdoing, recklessness or negligence.

The introduction of the fault element is intended by the Federal Government to address an imbalance between the benefits to the market of continuous disclosure obligations and the costs imposed on entities and officers, particularly the rapidly increasing insurance premiums in relation to listed entities.

These changes may bring some comfort to companies in reducing the number of speculative shareholder class actions being issued, but they don’t mean that companies (and their directors and employees) should be any less vigilant in ensuring that companies meet their ongoing continuous disclosure requirements.  These amendments also add another string to the bow of Boards who, following the landmark Federal Court decision in Worley,[8] now have greater insight into how, through a documented paper trail, a listed entity can seek to demonstrate the reasonable basis for earnings guidance.  Thus, whilst Australia has seen a growth of shareholder class actions over the last few years, the Worley decision along with these amendments give Boards some ground in defending such litigation.  However, litigation funders and other stakeholders will still be on the lookout for shareholder class actions, many of which already contained allegations of knowledge and negligence prior to these amendments in any event.  How then will the passage of this legislation impact on the securities class action landscape in Australia?

The US approach and what we can learn

In the United States, class action securities litigation is routinely filed after a significant corporate event, such as a restatement, earnings miss, extraordinary corporate transaction, and the like.  The law applicable to most of these challenges is the Private Securities Litigation Reform Act of 1995 (PSLRA), which applies to corporate statements to the market outside the context of a registration statement or prospectus.  The PSLRA was passed as a way to deter the flood of frivolous filings against corporations, officers and directors, which inflict substantial costs and potential reputational and headline risk.  One way in which it attempted to do so was to strengthen the pleading requirements to require plaintiffs to specifically plead facts establishing scienter in order to survive a motion to dismiss challenge.  Where those standards are not met, the case can be dismissed at the motion to dismiss stage before any costly and burdensome discovery occurs. 

The PSLRA requires a plaintiff to “specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading” and “all facts that form the plaintiff’s basis for believing that the statement is misleading.”[9]  Specifically with respect to scienter, the PSLRA requires plaintiffs to “state with particularity facts giving rise to a strong inference” of “scienter” – “an intent to deceive, demonstrated by knowledge of the statement’s falsity or reckless disregard of a substantial risk that the statement is false”[10] (emphasis added).  The plaintiff must demonstrate that each person sued either knew that his or her statement was false or he or she recklessly disregarded a substantial risk of that possibility.  The inference of scienter must be “powerful”, “cogent”, “strong in light of other explanations” and “at least as compelling as any opposing inference one could draw from the facts alleged.”[11]  If the PSLRA’s exacting requirements are not met, “the court shall…dismiss the complaint” (emphasis added).[12]

Given these stringent requirements, in practice defendants often challenge putative class actions at an early stage on a motion to dismiss (similar to a strike out application in Australia) and they are often successful in nipping frivolous suits in the bud where the plaintiffs do not plead the who, what, where, when, and how of the alleged fraud and the basis for concluding that the company’s officers and directors actually knew that a statement was untrue, rather than events simply working out differently than planned for whatever reason.  In assessing the motion to dismiss, one looks to see whether there is any cogent motive alleged, contemporaneous documentation that contradicts the challenged public statements, circumstantial evidence of scienter, insider sales, a restatement, or a governmental investigation, for example. 

Strategies from US class action experience

Given that the scienter requirements in Australia are new, and thus do not have extensive precedent interpreting and fleshing them out, it may be useful to refer to how the United States’ similar scienter standards work in practice.  Some practical tips for cutting off liability at early stages in the US include:

  • Scienter cannot be pleaded generally, and plaintiffs cannot get past a motion to dismiss by lumping together the CEO, CFO, all directors, and other officers.Instead, they must show that each individual actually believed that his or her statement was false when made.
  • A plaintiff cannot predicate a securities class action on fraud by hindsight.Just because something did not come to pass – such as meeting a particular earnings target or completing a hoped for acquisition – does not necessarily mean that statements about that intended future event were false when made.Plaintiffs must demonstrate that there are contemporaneous documents or facts that demonstrate falsity at the time of the statement.
  • Statements of one’s opinion are particularly vulnerable to attack on a motion to dismiss due to the difficulty of providing that an opinion was not actually held.
  • Many statements of future intent are protected under the safe harbour provisions as long as they are accompanied by sufficient cautionary language.It is advisable then for directors and officers to review carefully the cautionary language and ensure that it is specific and updated to include new challenges as they develop.
  • A motion to dismiss may demonstrate that there is no actual motivation to commit fraud, particularly where there are no inside stock sales.In those instances where a corporate director or officer has actually increased his or her stockholdings during the relevant period, there is an inference that he or she was not intending to commit fraud, as it would make no sense to increase one’s financial stake in a company if one knew that its actual prospects were vastly worse than the market perceived.In that scenario, one would sell stock in an attempt to profit off the fraud.
  • Where there are stock sales, in the United States, officers often employ a 10b5-1 plan to insulate such sales from attack as stock sales in and of themselves do not establish motive, only ones that are suspicious in amount or timing.Through the use of a plan that governs when sales may be made and in what amount, one can protect himself or herself.
  • Plaintiffs often include in an amended complaint allegations from former employees (confidential witnesses) who claim that certain directors or officers knew something was amiss.At the pleading stage, any such allegations must be exacting and are often the subject of attack.
  • Clean audit opinions from a respected auditing/accounting firm can also bolster arguments that there was no blatant fraud about which directors and officers should have been aware.

[1] Parliamentary Joint Committee on Corporations and Financial Services, Litigation Funding and the Regulation of the Class Action Industry (Report, 21 December 2020) xxxi and 351.
[2] Corporations Act 2001 (Cth) s 675A.
[3] Ibid, ss 674(3)-(4) and 675(3)(4)).
[4] Section 1041H.
[5] Section 12DA.
[6] Corporations Act 2001 (Cth) ss 674 and 1041H.
[7] ASIC Act 2001 s 12DA.
[8] Crowley v Worley Ltd [2020] FCA 1522.  This is a landmark decision as it is the first shareholder class action successfully defended by a respondent in Australia and only the second shareholder class action to go to judgment. 
[9] 15 U.S.C. § 78u-4(b)(1)(B).
[10] 15 U.S.C. § 78u-4(b)(2).
[11] Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 323-24 (2007).
[12] 15 U.S.C. § 78u-4(b)(3)(A).