US shareholders are more successful at holding miscreant directors to account than their Irish or British counterparts. Recently, Citigroup agreed to pay compensation of $730 million to investors who bought Citigroup’s debt and preferred stock.
Investors claimed that Citigroup concealed losses on troubled assets. Despite agreeing to the compensation, Citigroup has denied liability.
It said “this settlement is another significant step towards resolving our exposure to claims arising from the financial crisis and we look forward to putting the matter behind us”.
Citigroup is not alone. In 2010, Bank of America agreed to a $601.5 million settlement related to its Countrywide mortgage unit. Wells Fargo also agreed to a $590 million payment to investors. Like Citigroup, Wells Fargo denies wrongdoing and settled to “avoid distraction”.
There are, of course, many differences between the US and Irish legal practices. US courts often appoint a lead legal firm to represent an entire class of shareholders – a process known as “class action”. Also, if the class action is unsuccessful, shareholders generally do not have to pay the defendants’ legal costs.
US investors also find it easier to get round a restriction imposed on Irish and British shareholders known as the Foss v Harbottle rule. In essence, this states that if a director commits a fraud or is negligent and the shareholder suffers, the fraudster only has a duty of care to the company and not the shareholders.
In practical terms, this means that, in many cases, the directors' permission must be obtained to take legal action against him.
Shareholder options
However, it's not all gloom and doom. In Britain, there are "unfair prejudice" provisions in company law which provides greater protection for shareholders who suffer from director fraud, weakening the scope for using Foss v Harbottle to escape legal sanctions.
Disgruntled investors are taking action. Royal Bank of Scotland for instance is under fire for misleading shareholders in a prospectus that RBS issued in 2008, when it invited shareholders to subscribe for shares at £2 each. Months later, the share price dropped to 11p.
The case against RBS stems from the requirements under the UK’s Financial Services and Markets Act 2000 (FSMA). Companies raising money from shareholders must publish a prospectus containing details about the entity’s assets and liabilities, the financial position and the profit and loss position.
The shareholders argue that RBS failed to reveal certain losses.
A group of shareholders in Lloyds Banking group was recently unsuccessful in their attempts through the US courts to seek damages from some of its former directors. The shareholder class action alleged that the directors gave misleading statements and deliberately omitted material information when Lloyds asked for shareholder approval to acquire the Halifax Bank of Scotland, whose unrecognised losses caused Lloyds to fail.
The court held that the evidence given was insufficient.
Clive Wolman*, a British barrister specialising in banking and finance, believes shareholders can take successful action if they can prove that they could and would have stopped the frauds or curbed the losses for which directors were responsible and which were concealed by auditors. He says “the court should have regard to the inhibitions on shareholders controlling errant or incompetent directors”.
His main concern, however, is the huge cost that shareholders may face if they fail in an action, and suggests that they persuade their lawyers to act on a conditional or contingency fee and obtain insurance against an adverse costs order.
Legal distinction
A paper by Paul Davies QC** makes a distinction between negligence (carelessness) and deceit (where the director makes a statement he knows to be false).
In the case of deceit, shareholders may find it easier to take action, particularly if they relied on a misleading prospectus.
The EU Transparency Directive adopted in Ireland in 2007 has improved shareholder protection. Now, if in an interim or annual report, a company director makes a misleading statement, he may face legal action.
One leading legal expert in Dublin warns, however, that it is unwise for individual shareholders to attempt legal action against directors, given the huge costs involved, and class actions are not allowed here.
That said, there are a number of laws protecting shareholders from director misstatements. Apart from company law, and rules governing prospectuses, there are stock exchange rules, and the EU Transparency directive.
Given the egregious breaches that some Irish shareholders have suffered, there is a glimmer of hope that they can recover some of that money if they can prove deceit or negligence.
The US class action system, though fairer to shareholders, is not without defects.
Often, ambulance chasing lawyers are driven by contingency fees. Lawyers of the winning plaintiffs are entitled to roughly a fifth of any investor settlement. Not surprisingly, therefore, the initiative to legal action tends not to come from an injured investor but rather from an entrepreneurial lawyer.
* iti.ms/10LyojH
**iti.ms/10LyxDH
Cormac Butler is the author of Accounting for Financial Instruments and has led training seminars for bank regulators and investors on financial risk. He has traded equities and options
