August is a Hot Month for Australian Investors
22 August 2020 will subject litigation funders and their funding agreements to regulations
On 22 August 2020, the Australian securities class action landscape will again be rocked when Treasurer Josh Frydenberg delivers on his May 22 promise to subject litigation funders and their funding agreements to regulation. After uncertainty following the High Court’s rejection last year of common fund orders and optimism this year after Victoria permitted class action lawyers to charge contingency fees, the federal government’s July 23 Regulations, which take effect this month, portend significant setbacks for investors.
This post summarizes the changes and highlights four things to watch for the near term. Without offsetting pressure, investors will continue to see government-led cut-backs on their rights and further erosion of the integrity of the Australian stock market in the coming years.
The July 23 Regulations
Presently, the Corporations Act 2001 (the Act) exempts litigation funders from Australian Financial Services License (AFSL) requirements.[1] It also exempts funding agreements from the Managed Investment Scheme (MIS) requirements including anti-hawking limits on unsolicited funding offers, and Part 7.9 provisions on product disclosures and around issuing, offering, recommending, and selling financial products.[2]
On July 23, the Governor-General released the Corporations Amendment (Litigation Funding) Regulations 2020 which eliminate these exemptions.[3] When the Regulations become effective on August 22, funders doing business in Australia will need to obtain AFSL licenses before offering or entering into funding agreements with investors in securities class actions. Unless exempt, their agreements will need to be operated by responsible entities – i.e. public companies holding AFSL licenses – and their terms will be regulated as investment products. They need to provide harmed investors with Product Disclosure Statements and to satisfy other requirements for offerings.
The Regulations expressly target shareholder class actions. As the June 15 Regulation Impact Statement (RIS) notes, in the Background section of the first page setting up the reasons for change:
[Litigation funding] use in class action claims, particularly those in which shareholders are bringing claims against companies and their directors for alleged failure to comply with continuous disclosure obligations, has grown strongly in recent years.
In addition to removing the statutory exemptions noted above, the Regulations expressly override earlier court rulings recognizing litigation funding agreements as ‘credit facilities’ exempt from regulation under the Act.
At the same time, the Regulations preserve exemptions for insolvency litigation funding schemes (concerning proof and ranking of claims in the winding-up context) and litigation funding arrangements involving one rather than multiple plaintiffs.
Four Near-Term Things to Watch
The impacts from the Regulation will be widespread but their scope is not clear given the number of unknowns. However, we expect to see at least four things to play out near term.
1. Rush to file cases before the August 22: The Regulations are prospective in application, meaning they only affect class action litigation funding schemes entered into on or after August 22. The lawyers and funders (collectively, Organizers) are now scrambling to get as many cases as possible filed before then. Clients can expect heavy pressure this month from Organizers to register for their matters.
2. ASIC implementation: The ASIC did not support removal of the exemptions. The Treasurer noted (RIS, at 9) the agency’s view that “the AFSL regime may not be the most appropriate mechanism” for regulation. The ASIC originally exempted funders from the Act and its exemptions were the basis for the prior Government’s inclusion of them in the Act in 2013. With short notice and little preparation time, the Treasurer has reversed things and thrust on the ASIC a new and complex area for regulation. It is unclear how the agency will handle the transition and implementation questions including those around licensing requirements, disclosure obligations, etc. and whether its pronouncements will add to or subtract from the burdens on funders.
3. Interplay with legal services and contingency fees: Earlier this year, Victoria enacted legislation allowing class action lawyers to charge contingency fees. On its face, with the exemptions removed, lawyers offering contingency fees in securities class actions will be covered by the Act. Like litigation funding agreements, these fee agreements involve advancing costs of litigation and indemnifying class representative from adverse cost orders in return for a percentage of success. We expect courts and the ASIC to address this issue sooner rather than later as securities cases get filed in Victoria.
More problematic, removing the exemption may preclude plaintiff lawyers from working with funders in book builds – even if their funding agreements comply with MIS requirements – because of professional or legal restrictions on their ability to solicit, sell, recommend or advise on interests in financial products, which now includes class action funding schemes.[4] This will also need to be clarified soon.
By contrast, securities class actions funded by conditional fee agreements with lawyers continue to be expressly exempt from the Act.[5] At least one AU law firm has used them after the High Court’s decision last year ending common fund orders. We expect more and perhaps greater use of condition fees in the near term.
Finally, the Regulations only apply to funding schemes for class actions, not individual or group actions. We may an increase in the number of direct suits by larger investors. At least one law firm has pressed this approach in Australia. Collective litigation is the most common approach for securities litigation in other countries outside the US, particularly when class actions are not available or practical. We may see more of direct suits in Australia going forward.
4. Organizers using exempt funding schemes: The requirement that funders hold AFSL licenses is separate from the requirement that funding agreements satisfy MIS requirements. If the arrangement fits the criteria in Section 601ED of the Act they must satisfy the requirements of Chapter 5C of the Act. While the ASIC formulates guidance, we expect Organizers to try to fit their funding schemes into MIS exemptions, bypassing requirements. For example, single plaintiff arrangements continue to be exempt and outside both the AFSL licensing and MIS disclosure requirements. Multi-plaintiff funding schemes are exempt from MIS requirements if they involve fewer than 20 plaintiffs. In short, we expect Organizers to focus more on closed classes with a limited number of investors with large losses and to find other legal ways to avoid regulation of their arrangements.
[1] Paragraph 7.6.01(1)(x) of the Act.
[2] Paragraph 5C.11.01(1)(b) of the Act.
[3] While enacted by the Governor-General, as the Cover Page and accompanying Explanatory Statement show, the Regulations were driven by the Treasurer in coordination with the Attorney-General. Both are vocal critics of litigation funders and shareholder class actions.
[4] As the ES says, “The Full Federal Court in the Brookfield case considered that either the litigation funder or the law firm (or both) was operating the relevant MIS. Lawyers have legal professional obligations under some State and Territory laws that prevent them from operating a MIS. Affected entities may need to consider their own obligations and seek advice as appropriate.”
[5] See ES, at 4 (citing ASIC Corporations (Conditional Costs Schemes) Instrument 2020/38). Under a conditional fee arrangement, class counsel receives payment of their fees contingent on success. Under a contingency fee arrangement, their compensation is also contingent but the amount is defined as a percentage of the success.
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