Investors who say, ‘See you in court’

Claims are routinely filed by firms seeking class certification in relation to a range of alleged corporate misconducts. In Europe, the position has been markedly different until recently.

Investor action has been sporadic at best. It has often been spearheaded by retail investors who have formed action groups in desperation and attempted to use the legal system to their advantage, often on a misconceived premise. The institutional client base has stayed on the sidelines. As a consequence, with the deck very much stacked against them in terms of firepower, resources and merits, retail actions have floundered and sent out a very mixed message as to the utility of such claims.

It is erroneously thought that the English group action system is cumbersome and ill-suited to shareholder claims. Although retail actions have gone wrong for various reasons, in truth the nub of the problem has been that the law firms running the actions on behalf of retail investors have not been as well versed in the culture of the claims as their American (and Australian) contemporaries.

They have also not been as incentivised without contingency fees. Flowing from that, it is also right that the English courts have not gained a solid understanding of the legal theory underpinning investor actions and the nature of the economic claims that need to be advanced.

Concepts such as fraud on the market or the nature of stock inflation are, as yet, alien to the English courts. The key sections in the Financial Services and Markets Act – which encompass principles that are litigated almost weekly in the US – have not yet been the subject of a canon of English law.

Indeed, one or two of the key sections have not been litigated in their present form at all. It is extraordinary in many ways that some of the seminal case law in prospectus liability is more than a century old, and nothing of substance has really been developed since those times.

One of the key drivers for change in Europe has been the shift in the legal landscape and the rise of corporate governance houses and boutique litigation-only law firms that are willing to take on the establishment. These firms have certainly been aided by the developing litigation funding industry and the availability of new fee structures.

Such changes have coincided with more focused attention to the oversight agenda and a realisation that shareholder activism has many facets to it – that can include, in appropriate circumstances, litigation.

There has been a growing awareness that those in the fund management industry (who, after all, should be seen as the trustees of retail holders) have a fiduciary obligation to consider claims and to do more than sit on their hands and watch the retail investors try to do all the running.

The litigation in England surrounding the failure of RBS is particularly telling – the retail investor base took the lead, but it is actually the institutional shareholder participation that is likely to gain the company’s attention and change the mood music.

The institutional investor community is likely to have greater legal remedies at their disposal because, in many instances, key shareholders are able to have almost a direct line to the company – and it follows that representations will be made to them that have not been made to the retail investors. Issues of reliance between the two groups are also likely to be different. Losses are also vastly higher.

It is therefore likely that shareholder claims will get off the ground and get to the attention of a company’s chief executive, rather than its general counsel, only if institutions step up to the plate. It is only when corporate claims are ventilated in the boardroom that progress will be made.

The power of the activist investor is clearer than ever before. The activity of the short-seller Gotham City almost brought two public companies to their knees, and the threat of focused litigation has to be seen as a specific weapon in the armoury.

Past attitudes of fund managers –either to take the losses on the chin or to wait for the stocks to recover – are now no longer acceptable when significant losses, if grouped together, can actually lead to engagement from a corporate and a swift settlement.

There is no better way for a new broom to sweep up than by seeking to isolate past misconduct and agreeing a resolution with investors.

Such behaviour can change the approach to corporate governance and lead to a revival of company fortunes. In this way, litigation can lead to a clean-up of market misconduct.

Jeremy Marshall is chief investment officer at Bentham Europe

The RBS case: key points

The RBoS Shareholders Action Group is pursuing legal action on behalf of thousands of investors who lost money subscribing for shares during the 2008 RBS rights issue.

As it states on its website: “We believe the directors of the bank acted improperly by misrepresenting the underlying strength of the bank at the time and by omitting critical information from the prospectus. This led to thousands of shareholders taking part at an over-inflated price.”

It also claims that:

• The true purpose of the rights issue was not disclosed. Whereas it was inferred as an attempt to improve ratios, the bank was actually strongly advised by the Financial Services Authority [FSA, now the FCA] to shore up a balance sheet that had been critically damaged by its acquisition of the Dutch bank ABN AMRO.

• The ABN AMRO acquisition was portrayed as going well in the RBS prospectus, whereas in reality it was not.

• RBS was required to disclose its capital ratios and did not.

• RBS failed to make adequate goodwill impairment writedowns in relation to ABN AMRO in circumstances where the goodwill had not been tested for impairment, in spite of severe market instability.

• RBS’s risk management and control systems were found to be fundamentally flawed

• The group failed to disclose its reliance on $11.9bn (£7.9bn) in loans provided by the US Federal Reserve.

Source: RBoS Shareholders Action Group

Timeline of events

• February 28 2008: Fred Goodwin was quoted as saying, “I think the main news is that with our view of all the businesses, the positive view that we have of the ABN businesses has been confirmed,” and “There are no plans for any inorganic capital-raising or anything of the sort.”

• February 29 2008: RBS drew down $706m from US Federal Reserve emergency funds.

• April 3 2008: RBS informed the FSA that it was likely to have fallen below individual capital guidance levels at the end of March.

• April 9 2008: Hector Sants, the chief executive of the FSA at the time, indicated the authority would need written confirmation from RBS that it would be pursuing a rights issue.

• April 22 2008: RBS announces a £12bn rights issue. RBS failed to disclose to shareholders and the market that it had found it necessary to draw on $11.9bn in loans from the Federal Reserve.

Source: RBoS Shareholders Action Group

RBS’s rebuttal

In a statement, RBS said: “While RBS and its former directors made some business decisions that have been criticised, this does not mean that they misled investors or acted illegally.

“We believe we have strong defences to the claims that are being brought against the group and that is why we intend to defend these vigorously and to protect the interests of our shareholders, including UK taxpayers.”