Opening bell for class-action suits
The Companies Act does not prescribe a maximum cap on the damages that may be awarded
Asteep sudden fall in share price can now trigger much more than uncomfortable investor calls for the management of a listed company. Recent moves by the government have resulted in game-changing developments for the securities regime in India, making listed companies vulnerable to class-action lawsuits by investors on the back of big losses in share value.
The scope of issues that can attract a class action under Section 245 of the Companies Act, 2013, is fairly wide, and includes any matters pertaining to the conduct of management that is prejudicial to the interests of the company or its shareholders. A sudden stock price drop often links to a specific event, action or inaction by the company, and allows shareholders to quantify the loss suffered for compensation purposes. If the identified event is proven to result from a wrongful act or a breach in fiduciary responsibility or a lapse in the duty of care and loyalty for instance, it could result in significant monetary compensation payable by the listed company and its directors/auditors to investors. From international experience, the typical corporate actions that attract securities class litigation include misrepresentations in financial documents/prospectus (Facebook, Lyft, Alibaba and Wells Fargo), false forward-looking statements (Electronic Arts Inc.), accounting standards violations (Petrobas, Enron and Worldcom), internal control weaknesses (Costco and Lendingclub), misleading/delayed disclosures (Fiat Chrysler and Yahoo), related-party transactions (Altisource Portfolio Solutions), regulatory issues (Danske Bank) and acquisition/merger integration issues (Daimlerchrysler, AOL Time Warner and Bank of America).
An application for a class action must be made by the requisite number of shareholders/depositors before the National Company Law Tribunal (NCLT). In May this year, the government notified the regulations whereby a “class” for listed companies can now be formed by the lesser of: (A) 2 per cent of the issued share capital, (B) 100 shareholders, or (C) 5 per cent of the total number of shareholders. The government is also reportedly considering a proposal to extend financial support to minority shareholders seeking to pursue classaction lawsuits. At the admission stage, the NCLT will review the application to determine whether the action requires a “class action” and whether the applicants are acting in good faith. If the action is admitted, the NCLT will order a public notice to be issued to all shareholders, after which the matter will be heard on merits. A shareholder, who forms part of a “class”, would need to seek the permission of the NCLT to opt out of the proceedings.
We expect that certain procedural and substantive legal defences will be frequent fliers in class actions. The procedural side includes defences that the minimum representation of members is not met, the applicant is not acting in good faith, or that the cause of action is personal and not of a “class”. A frivolous or vexatious suit could attract a penalty on the applicant which could extend to up to ~1 lakh. On the substantive defences, arguments and evidence would need to demonstrate that the corporate action was not unlawful, wrongful or prejudicial, or entitled to the benefit of the defence of the “business judgement rule”. The individual liability of directors may be defended based on the lack of knowledge, recorded dissent, satisfaction of the duty of care, loyalty and diligence, etc. Often, the company’s defence may seek to ringfence the wrongful act to a single “rogue” actor by demonstrating that the internal controls of the company were otherwise robust. A key point to note is that “market practice” or “everyone does it” is unlikely to hold water as a valid defence. For instance, in an action in the United States in the matter of Vaalco Energy Inc., it was observed that “Just as ‘all the other kids are doing it’ wasn’t a good argument for your mother, the idea that 175 other companies might have wacky provisions isn’t a good argument for validating your provision”.
The Companies Act does not prescribe a maximum cap on the damages that may be awarded. Given current Indian jurisprudence, it is unlikely that there will be punitive damages to the extent that have made class actions headline news in the United States, though we would have to wait and watch. While the liability of the company itself may be limited because of the nature of a body corporate, there are no obvious limitations on the liability of the directors, auditors and experts.
The US securities holders of Satyam received a settlement of $125 million pursuant to a class action in the US. In contrast, the Indian shareholders received no compensation and were only left to observe the regulatory actions taken against the company and its auditors. This situation will likely not repeat. Investors now have rights of restitution that will change the principal-agent relationship, as well as the power balance between shareholders and management. Going forward, we also expect that there will be an activist arbitrage that will come in, that will become a much more sophisticated and essential product in India, and that governance matters and liability concerns will take up more mind space for directors, management and auditors.