Security class action lawsuits are on the rise in Australia as a new system of funding this litigation has emerged in recent years in response to increased in regulatory enforcement activity. The scope of the increase can be seen in both the number of class actions filed as well as the size of these cases.

Between 1999 and 2003, only six security class actions were filed, according to a report by NERA Economic Consulting. That number shot up to 22 between 2004 and 2009, with six filed in 2009 alone. Even more security class actions are expected in the coming months, as cases related to the financial crisis of 2008 have not yet entered the pipeline.

These class actions have targeted a number of Australia's largest companies, generating headlines nationwide. In the last decade, for instance, security class actions have been brought against companies such as insurer GIO Australia Holdings Ltd, miners Sons of Gwalia and Oz Minerals, gaming machine maker Aristocrat Leisure Ltd, wheat exporter AWB and retail property company Centro Properties Ltd.

Although the litigation risk is far lower in the Land Down Under than it is in the United States, it is, nonetheless, a growing concern. 

Changes in the litigation environment in Australia began around the turn of the century with an increase in regulatory enforcement of the country's continuous disclosure rule. Further changes occurred in 2006 due to a court ruling that opened the way for litigation funding arrangements, which created financial rewards for pursuing this litigation that previously did not exist.

Up until this time there was little financial incentive. Law firms were prohibited from charging contingency fees, as is customary in the United States and instead received only a flat fee for their efforts. Shareholders, meanwhile, were reluctant to come forward because of the risk of incurring significant litigation expenses.

Under the new litigation funding arrangements, litigation funding firms pay the cost of the litigation (including the fees to the law firm) and indemnify the litigant against the risk of paying the respondent's costs if the case fails. In return, if the case succeeds, the litigation funder is reimbursed for the costs of the litigation and receives a percentage of the proceeds. The percentage is contractually agreed with the litigant and is typically between 30%?40% of the proceeds. By allowing the litigation funders, which had been limited to handling corporate insolvencies prior to this ruling, to receive a percentage of the proceeds, class actions have become too lucrative to ignore.

Of the 22 class actions filed since 2004, 17 of them were financed by a litigation funder, according to NERA. Before 2004, none of them were. This rise has also come at a time when regulators are getting tough on breaches of Australia's continuous disclosure requirements. The Australia Securities and Investment Commission began to increase its enforcement of the continuous disclosure rule after the 2001 collapse of HIH, one of the country's largest insurance companies.

The continuous disclosure rule requires companies to immediately inform the Australia Securities Exchange of developments that a reasonable person would expect to have a material effect on share price. This requirement may seem straightforward enough, but it can sometimes be difficult for companies to determine the appropriate time to disclose sensitive information. Even companies that do their best to comply with this requirement can end up as targets of a regulatory inquiry.

To manage the security class action risk, companies interested in doing business in Australia should take steps to understand the country's continuous disclosure rule and do their best to comply with it. To help them meet their disclosure requirements, Australia requires companies to have an internal corporate governance committee and explain their corporate governance policy in their annual reports. 

The Australia Securities Exchange has also established a set of best practices related to continuous disclosure. Companies are not required to comply with all of the best practices, but they are expected to discuss the steps they are taking.

While companies are at an increased risk of security class actions, directors and officers themselves are generally protected as long as they take all reasonable steps to ensure that the company met its obligations -- and as long as they believed the company was complying with its disclosure obligation.

With the sharp increase in security class actions, insurers have become much more vigilant about the risks they are willing to accept and will want to be comfortable with their insureds? exposure and business practices. Companies with strong corporate governance processes will be in the best position to obtain coverage at favorable terms and conditions.

Likewise, buyers should consider their insurers carefully. Companies should look for an insurer with expertise in security class action claims. These exposures can take years to work their way through the legal system, and it is important for companies to have a carrier that understands the consequences of underwriting this type of business.

As the security class action industry matures, the number of security class action lawsuits will undoubtedly grow, while the severity of the claims will gradually decline. Currently in Australia, with litigation funders on the prowl and regulators watching carefully, risk is heightened, and companies should proceed with caution. No one wants to become tomorrow?s headlines.

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Authored by:

Mark T. Lingafelter is managing director of Chubb Insurance Co. of Australia.

The above article is reprinted from the September 2010 on-line edition of Risk Management Magazine.