FOLEY, Dr Sean, Associate Professor, Macquarie University

Committee met at 09:01

CHAIR ( Senator Chisholm ): I declare open this hearing of the Senate Economics References Committee for the inquiry into Treasury Laws Amendment (2021 Measures No.1) Bill 2021. The Senate referred this inquiry to the committee on 16 March 2021 for report by 30 June 2021. The committee has received 14 submissions to this inquiry together with 26 submissions to the previous Senate Economics Legislation Committee inquiry, all of which are available on the committee's website. As this is a public hearing, a Hansard transcript of the proceedings is being made. However, the committee may determine or agree to a request to have evidence held in camera.

Information on procedure rules governing public hearings and claims of public interest immunity have been provided to witnesses and is available from the secretariat. Any witness called to answer a question for the first time should state their full name and the capacity in which they appear. Witnesses should speak clearly and into the microphones to assist Hansard to record proceedings. To assist the recording of this hearing, please ensure your microphone is set to mute when you are not speaking. I remind media representatives listening to follow the media guidelines and any instructions of the committee secretariat. I ask everyone to ensure they have turned off their mobile phones. I would also like to advise witnesses that answers to questions on notice should be sent to the secretariat by 5.30 pm on Wednesday, 16 June 2021.

I now welcome Dr Sean Foley. Thank you for appearing before the committee today. I invite you to make a brief opening statement, should you wish to do so.

Dr Foley : Dear members of the committee, we're grateful for the opportunity to make a submission to the Senate Economics References Committee on the provisions of the treasury laws amendment bill. Our submission focuses on the proposed amendments to continuous disclosure laws in schedule 2. Australia's continuous disclosure obligations are world-leading and facilitate unrivalled confidence in our market. The ASX has a market capitalisation of over $2 trillion with more than 2,000 listed companies, many of which predominantly undertake their activities outside of Australia. The reason the ASX has historically been able to punch above its weight in the global market for listings has been a focus on fair and efficient markets, free of insider trading and market manipulation, which provide a fair go for all investors, big and small. One of the pillars of this world-leading reputation has been our continuous disclosure regime, which ensures all investors are fully informed, minimises opportunities for insider trading and ensures equity market prices are efficient. While regulatory policy and procedure reviews should be conducted, they should ensure that they maintain or enhance the fairness and efficiency of our capital markets.

My comments reflect my understanding of the importance of shareholder class actions to the Australian regulatory environment and are drawn from my experiences as a lead applicant in a shareholder class action against Gunns, as well as through my expertise and research as an associate professor in applied finance at Macquarie University, together with my colleague Dr Angelo Aspris.

Shareholder class actions are a necessary component of a strong regulatory system. Any actions taken to remove the credibility of the threat posed by shareholder class actions or the ability of shareholders to pursue justice in the face of misleading or deceptive conduct will have deleterious consequences for Australians. Shareholder class actions pursued in this country have not been opportunistic pursuits as a result of share price falls, but rather based on material misstatements and omissions causing real harm to shareholders.

Morabito shows that across the spectrum only 5.1 per cent of shareholder class action claims have been summarily dismissed. This casts doubt over claims of opportunism. Varzaly states that there is 0.22 per cent probability that a publicly listed company will have a class action filed against it and a 0.04 per cent probability that a publicly listed company will have one of its directors named a defendant in a field case. Such evidence suggests that the risk to directors and officers is negligible, putting into question the rationale for making the proposed exemptions permanent.

Managers and directors already enjoy considerable protections around forward-looking guidance. There is little evidence from the academic literature to suggest that forward guidance will increase if class action lawsuits become more difficult to file. We know that the goal should not be necessarily to attain a higher frequency of forward looking guidance, but rather to ensure a high quality of such guidance. There is no academic evidence to support the idea that the current proposed changes would increase either the frequency or quality of provided guidance.

These changes, if enacted, will further increase the difficulty of undertaking shareholder class actions. This reduction in litigation risk will be harmful for market participants. There is a well-developed academic literature drawing on experience in the US, UK, and Canada which has shown a link between reduced litigation risk and increased earnings management, poorer firm performance, decreased investment efficiency, increased cost of debt and increased cost of equity. I suspect that these are not the outcomes that the Treasurer is hoping for. There is also academic evidence showing a link between reduced litigation risk and increased managerial entrenchment, as well as an increased profitability and probability of illegal insider trading.

The issue of forward-looking guidance is complex. Although forward-looking guidance to the market where the statements contain value-relevant information for investors is useful, seeking greater protections for firms and their officers from litigation as a means of achieving this is not. Absent the threat of shareholder class action, shareholders face substantial principal agent problems, which are likely to result in poorer operating performance and managerial entrenchment.

It has been established in the literature that corporate governance influences companies decisions to voluntarily disclose, with better corporate governance improving reporting practices. If it is our goal to improve the quality of disclosures, ensuring that investors are well-informed and protected, then we should consider more wide-ranging measures and incentives to allow this to happen. Corporate culture starts at the top and there is a strong need to incentivise companies to foster a culture of compliance, not misconduct. Before making these temporary measures permanent, a thorough analysis of the effect of the temporary COVID-19 changes should be performed to assess whether key objectives were achieved during this period of uncertainty. To my knowledge, such an analysis has not yet been undertaken.

The financial impact of compliance costs presented in the explanatory memorandum is not credible. It is true that directors and officers' insurance costs have increased over time. However, to claim causation between shareholder class actions, increased settlement sizes and higher premiums ignores numerous other risk factors that are just as likely to increase fees as shareholder class actions. Reliance on anecdotes and vested interests to unravel this puzzle will likely produce suboptimal outcomes. Public enforcement cannot be relied upon to ensure good corporate governance. Public agencies face constant resource constraints and their employees inevitably suffer from numerous incentive problems. Private litigation, beyond simply working to deter negligent and fraudulent conduct, helps to mitigate the moral hazard problem in public enforcement because it effectively serves to monitor the enforcer.

In order to protect investors and promote fairer, more efficient capital markets, we need regulations that are enacted with consideration based on evidence. The changes proposed in schedule 2 of the Treasury laws amendment bill, specifically those outlined, were introduced with haste in order to deal with the severe uncertainty COVID-19 brought to our listed entities. They were not designed to be, nor should they be, permanent. It is our opinion that these proposed changes will not have the desired impact on directors and officers fees, nor will they serve investors. Instead, they are likely to generate negative welfare outcomes for all Australian investors. Further, these changes threaten the stability of our regulatory and enforcement system. They threaten the continued prosperity of our capital markets and they undermine the reputation Australia has spent decades cultivating as both the global and regional pillar of excellence with exceptionally fair and efficient capital markets. This reputation has allowed our country of just over 25 million people to develop a thriving capital market with over 2,000 listed securities, representing the 15th largest exchange by market cap in the world. The proposed changes threaten to damage our capital markets, destroying a significant amount of economic activity and wealth creation in the process. It seems the only winners from such a change are likely to be dodgy directors and bad businesses.

CHAIR: Thanks, Dr Foley. I'll hand to Senator McAllister to start.

Senator McALLISTER: Thanks very much for appearing and for your submission, Dr Foley. I think it would help if you provided in some simple language an explanation of the changes to continuous disclosure that are proposed here. You're deep in the information as part of your research, but for some of the other people who are taking an interest in this hearing a simple explanation might be helpful.

Dr Foley : Sure. The key issue here is the requirement of recklessness on behalf of the directors of the firm in their failure to disclose information to the market. The continuous disclosure regime is designed to ensure that investors are fully informed about the likely prospects of the firm when they make the decision to buy or sell securities. This differs quite significantly from other regulatory regimes in the world. In the US, for example, they have periodic disclosure that requires companies to make quarterly statements about this information. Even if a material change occurs to the company, as long as the directors don't announce it to some segments—just to these analysts or something like that—then they don't need to tell anyone. This means that there's a lot more opportunity for things like insider trading and market manipulation and it means that when investors make decisions they are not necessarily fully informed about the state of the market as it is.

Shareholder class actions can serve to help remedy this issue. It's almost like speeding. Speeding is a strict liability offence. You don't need to prove that the person who was speeding had the intention to speed; you simply need to prove that they did it. I think that's a really good analogy for the continuous disclosure regime as it currently is. It's not quite strict liability. It's still quite difficult to prove, but you don't need to prove that the directors had the intention of misleading the market; it's simply enough to show that they had the information and they didn't disclose it. That's the sort of analogy with speeding. If we introduced regulations that say, 'We need to prove not only that they did it but that they had the intention to do it,' it would put a significantly higher bar on shareholder class actions and potentially also increase the regulatory burden on the regulator, ASIC.

Senator McALLISTER: I'm thinking about the actors in this system. Can you make some comment about the likely changes to corporate behaviour should a requirement for recklessness or intention be introduced?

Dr Foley : Sure. What has been really successful in Australia's continuous disclosure regime is the ability to censure directors who choose not to act in the best interests of shareholders or market efficiency. What we've seen in our research, particularly of Australian shareholder class actions, is that firms tend to improve their disclosure culture in the wake of shareholder class actions. They tend to rejig their managerial staff and make changes to their accounting policies. This is in general quite beneficial. Firms that do act badly and are the subject of shareholder class actions tend to improve their practices. Also the threat of shareholder class actions tends to generate better disclosure practices from current listed entities. If you reduce the credibility of those threats—if it's going to become significantly more difficult to run shareholder class actions and potentially more difficult to run public prosecutions from ASIC—I think that would likely lead to poor governance outcomes, a decrease in the amount of disclosure that firms give to the market and a decrease in the informational efficiency in the market. I think this will tend to increase managerial entrenchment and just lead to poor outcomes for Australian-listed firms.

Senator McALLISTER: Some of the other submitters have drawn a distinction between the impact on retail investors and institutional investors. How would you characterise the difference in the impact on institutional investors compared with retail investors of these changes?

Dr Foley : I think that both will suffer. If we look at the participation in shareholder class actions over the last decade, we've seen increasing participation by superannuation funds and other institutional investors in shareholder class actions, indicating that they have additionally been wronged or harmed by poor disclosure. However, there is a sense that institutional investors may have more time and resources available to them to make their own educated opinions about the state of a company, as it were. I think that, in that sense, the information asymmetry in the market is heightened for retail investors, which means that any reduction in the information provision by listed entities is likely to have a disproportionate impact on retail investors. However, I believe that the proposed changes would damage both institutional investors and retailers.

Senator McALLISTER: So to sum up, just thinking about all these actors, who stands to benefit from schedule 2?

Dr Foley : That's the really interesting question. My impression is that if a company is acting in the best interests of its shareholders, schedule 2 will have no impact on them. Schedule 2 will have a deleterious impact to retail and institutional investors. As I said at the end of my submission, I think the only actors who are likely to benefit from this are dodgy directors or bad businesses—businesses who wanted to hide or misstate information to the market. In the shareholder class action I was involved in, for example, director John Gay was prosecuted for insider trading. That was one of his motivations for not giving information to the market. The company raised quite a large amount of money immediately prior to their share price halving when they released the information. They knew exactly what was going on and they chose to enrich their directors and try to prop up their balance sheet before they released that information to the market. I think it's these sorts of companies who are really likely to benefit. I think for good companies, or companies who are acting in the spirit and intention of the law, schedule 2 will make no difference to them. I think it's the companies who are acting on the fringes who are really likely to benefit from this.

Senator McALLISTER: You mentioned the class action that you were involved in—this makes you a most interesting witness. You were the lead plaintiff. Can you explain exactly what it was that you were alleging about the behaviour of the company in which you had an investment.

Dr Foley : I had invested in Gunns Ltd and they knew that there was a significant problem with their revenue. Effectively, they were not selling as many woodchips to Japan and China or wherever their primary markets were. Rather than disclose this to the market, they sought to withhold that information as long as they could until periodic reporting—that is, annual reports—forced them to give that information to the market. It became clear that their revenue had dropped by 96 per cent, which made the company effectively worthless. As a result, three or four years they later went bankrupt. Does that answer your question?

Senator McALLISTER: You participated in a class action. I don't think anybody would consider that the circumstances you describe see you as an opportunistic person, although this idea has been raised a lot in the context of this legislation. If the measures that are proposed in schedule 2 had been in place at the time you were contemplating being part of a class action, would it have proceeded and achieved the same result?

Dr Foley : I don't think it would have continued to proceed, no. Due to the eventual bankruptcy of Gunns, in order to seek redress we needed to name the directors who were in charge at the time. It was already very difficult to undertake the case. The legislation that existed meant that you were walking a very fine line between what directors needed to do and what they could reasonably have done. I think that the law firm at the time, Maurice Blackburn, described it as trying to balance on a single plank of wood in the middle of a running river. I think they were very skilful and lucky that we were able to get that through. If we had also had the additional burden of needing to prove that the directors had a mindset to be reckless rather than just that they were reckless or negligent in their failure to disclose, it would have been very difficult. I'm almost certain the case wouldn't have been successful. It's very hard for me to say if it would have been undertaken at all in the first place. But I can definitely say that seeing how difficult it was to reach a settlement, it would have been very difficult if there was this additional burden.

Senator McALLISTER: I've seen that you've made some public comment about it in some of the media coverage about this. You said, 'We may have been successful against a company, but we may not have been successful against the directors and officers insurance. Directors and officers insurance does not cover negligence or fraud.' Can you just point to that nexus? As you've just said, the company was bankrupt by the time you were pursuing your action.

Dr Foley : Correct—many are, actually. In my analysis, more than 50 per cent of companies in Australia who were the subject to shareholder class actions end up going bankrupt within two years, which really speaks to the lack of opportunism of these cases—the thing that has not been disclosed is something that is critical to the firm itself, and this, in fact, even hinders the academic research of it. If I want to check how disclosure practices have changed, and I go and I look at my sample and 50 per cent of my sample will become bankrupt in two years, it's very difficult to really even speak to how practices have changed.

That balancing act on the plank in the river was really driven by the fact that if the directors are negligent in the dereliction of their duties, directors and officers insurance doesn't cover them anymore. This may be one of the key facets of the proposed regulation, which is that if I say that shareholder class actions are only applicable in the case of negligence of officers and directors, and most D&O insurance policies say that in the case of negligence the policy does not cover the directors, and we know that 50 per cent of these firms are going bankrupt very quickly after they have such negative disclosure practices, then you effectively invalidate the potential of wronged individuals, whether they be retail or institutional, to seek meaningful redress. This could itself effectively kill shareholder class actions in Australia, which I think would be a bad outcome for all involved.

Senator McALLISTER: In your submission and in your remarks just now, you've argued that continuous disclosure is protective against insider trading. Can you explain from your research how widespread insider trading and market manipulation is in Australia?

Dr Foley : Yes. The majority of the research I've done on insider trading focuses on the US. The reason for this is that there are around 50 cases prosecuted cases of insider trading in the US per year. There has been around 18 to 20 since regulations were introduced in Australia, or first enforced around 1999. Even if you adjust for the number of listed entities and the size of the capital markets, this leads to one of two conclusions: either Australians are significantly more honest than Americans in their behaviour or our regulator is significantly less effective or less inclined to prosecute such cases. I believe it's the latter. The point of shareholder class actions is to step in as a private enforcement mechanism alongside and in case public enforcement fails.

I did my PhD with the Canadian regulator. I've got PhD students at the Financial Conduct Authority in the UK. One of the interesting features of the Australian regulatory regime is that ASIC is not funded in the same way as other regulators are funded elsewhere. ASIC needs to ask the government to approve its budget and give it money out of consolidated revenue. The revenue that comes from any successful insider trading actions or anything like that goes back into consolidated revenue. This is very different to elsewhere. In the US, the SEC receives the proceeds of their actions. They face a risk reward. If they can get disgorgement of $100 million from an insider trader, that's an extra $100 million for their coffers. They're much more incentivised to undertake those kinds of actions. In Canada, the OSC, the Ontario Securities Commission, is a crown agency, similar to the Australian Taxation Office. They just impose a levy on the listed entities in the country. They say, 'Hey, we need $100 million and we're just going to take the top 100 firms and just levy a million dollars from each of them'. They have the power to determine their own budget and to extract that from the firms that they regulate.

We don't have the same in Australia and I think that resource constraints on our regulator significantly hampers their ability and willingness to undertake insider trading actions, which is reflected in the lack of actions that we've seen and the lack of prosecutions. There's ample evidence from the criminal security side that absent effective enforcement tends to not disincentivise the behaviour that you're trying to achieve.

Senator McALLISTER: Your argument in the context of what we're looking at here is that the ability of shareholders to continue to take private action is perhaps a more than usually important feature of Australian regulatory arrangements because of the weakness of the public regulator.

Dr Foley : Yes, particularly the resource constraints of the regulator make it really important that private enforcement is possible and that those actions can be undertaken. The notion that they are opportunistic is really bandied about a lot without much data. We have a very particular legal regime in Australia that involves costs for frivolous actions. They don't have such a regime in the US. They have a lot of what's called 'green mail' with their shareholder class actions, whereby I launch a frivolous case in order to get you to pay me less than it would cost you otherwise to defend. If it costs you $2 million to defend the case, even if it's frivolous, and I'll take a million dollars to go away, then I'm incentivised to bring this frivolous case because I know that I don't face any adverse actions about costs.

In Australia, we have these really significant costs regimes. If I undertake a frivolous action, before I can even take that action, the Federal Court requires a bond for me to cover the potential legal costs of whichever listed entity I'm taking on. I may need to put up some cash before I can undertake the action, knowing that cash is entirely at risk. Given that most of our cases are funded by litigation funders, it seems very unlikely that a litigation funder would be inclined to come in and say, 'Sure, I'll waste my money and face the risk of costs on a frivolous action.' I think that's what we've seen in Australia, with very few cases ever dismissed; almost all shareholder class actions are settled. That's simply because the funders only fund the most egregious cases. If we take away even the ability to do that, I think that we're likely to see much more corporate misconduct in Australia.

Senator McALLISTER: Thinking about schedule 2 again, do the continuous disclosure arrangements at the moment help minimise insider trading?

Dr Foley : They definitely do. I liken it to—I don't know, maybe I use too many road references—these things called silent police. They're these little yellow boxes on the road in the middle of a T-intersection. They're designed to ensure that if somebody goes around and cuts the corner, they'll damage their car. One way to solve the problem of people turning correctly would be to have a policeman on every corner. However, policemen are expensive and these devices are cheap. So what I've done is I've simply structured the road in a way that means that it's going to encourage individuals to utilise the road in the way in which it was intended.

An insider needs to have private information that is price sensitive so that if it were released, it would have an impact on the price of the publicly traded security. Continuous disclosure requires that any piece of information that would have a significant impact on price is immediately disclosed to the market itself. If that's done, the market will adjust to the information that's given because everybody has that information. That's the idea of a fair and even playing field.

If you reduce the compliance with this continuous disclosure regime, what you do is drive a wedge between the private value that maybe only directors or insiders know versus what the public knows. The wider that wedge is and the longer that you leave that available, the more tempting it is for directors like John Gay to trade on it for their own profit. So the continuous disclosure regime isn't designed to generate shareholder class actions; it's designed to reduce the information asymmetry between institutional retail investors and the insiders of the firm. But, in so doing, if prices always reflect the true value of the company, then there's no opportunity to insider trade. So you reduce the temptation, you reduce the opportunity and you improve the playing field for retail and institutional investors.

You asked previously about who this falls the worst on. As a retail investor, I wasn't monitoring woodchip exports to Japan; whereas perhaps an institutional investor would have more ability to do so and to know that maybe something wasn't right from their own perspective. So, in that regard, the proposed changes may fall disproportionately on retail investors.

Senator McALLISTER: Thanks, Dr Foley. I think that's the end of our time slot, Chair.

CHAIR: Just to follow up, what was the conclusion of the Gunns class action?

Dr Foley : The reinsurer, which was a Lloyd's of London style of person, literally from the UK, undertook a settlement to prevent it from going to court. As you may know, no shareholder class action in Australia has ever gone to court to be tested. They all settle out of court. So there was a settlement. The amount is not to be disclosed, but the wronged investors received a meaningful recovery, which I think was a really good outcome.

CHAIR: Thanks for that, Dr Foley.

Dr Foley : No worries. Thanks for your time.