Court accepts market-based causation

In brief

Perhaps the most important unanswered question in Australian class action law has been how causation may be established in a shareholder class action. After more than a decade of uncertainty, the Supreme Court of NSW has ruled that shareholders can prove causation by establishing that the price of the shares they bought was 'inflated' by a company's misleading statements. Partner Jenny Campbell and Senior Associate Mark Hare report.

Causation in shareholder class actions

The claims made in shareholder class actions are typically founded on allegations that a company's disclosure, or non-disclosure, of material information was misleading or deceptive and a breach of a listed company's continuous disclosure obligations. Proving that the alleged disclosures or non-disclosures caused shareholder loss is an essential element of these claims.

A critical issue in this context is the method by which causation can be established. In particular, whether:

• it is necessary for each claimant to prove actual reliance on the contravening conduct (direct causation); or
• the requirement can be satisfied by general notions of reliance by the market affecting the price at which each claimant purchased and/or sold their shares (market-based causation).

The answer to this question will determine the process by which shareholder claims are dealt with following the determination of the common issues. That is, whether:

• those claims can be determined collectively with causation essentially being presumed if it can be shown that the market relied on the company's contravening conduct; or
• each claimant must come forward individually to establish that the company's contravening conduct caused their loss.

The uncertainty created by the lack of settled law on this question has been an important issue for plaintiffs and defendants alike. The associated risk is the primary reason why no shareholder class action has ever reached the point of final judgment.

The case against HIH Insurance Limited

On 20 April 2016, the Supreme Court of NSW delivered its judgment in a series of shareholder claims against HIH Insurance Limited (HIH) and its liquidator.¹ Although the case was not a class action, it did involve 117 shareholders.

The principal allegation was that the plaintiff shareholders acquired HIH shares in certain periods between 1998 and 2001 during which the price for those shares was inflated by misrepresentations contained in HIH's FY1999 and FY2000 results. The misrepresentations were admitted by HIH.

Importantly, the shareholders did not contend that they directly relied upon (or even read) the reports of the financial results. But rather, relying on a theory of market-based causation, they claimed that:

• they acquired shares in a market which was distorted by HIH's misrepresentation of its financial results;
• that distortion resulted in HIH's shares trading at prices higher than they would have traded if the misrepresentations had not been made; and
• they suffered loss because they paid more for their shares than they would have otherwise had to pay.

The first decision on market-based causation

HIH admitted that its misrepresentations contravened the prohibition on misleading or deceptive conduct in section 52 of the Trade Practices Act 1974 (Cth). In order to recover damages in respect of such a contravention, it was necessary for the shareholders to establish that they had suffered loss or damage 'by' the contravening conduct.² 

In considering whether the plaintiffs' market-based causation case satisfied that requirement, Justice Brereton started from the proposition that the test is one of causation, not one of reliance. After considering the authorities on this issue, his Honour said that a sufficient causal connection can be established in ways that do not involve the plaintiff directly relying on the contravening conduct. That, in itself, was not ground breaking – there is a long line of authority that establishes that loss can be recovered absent direct reliance when the claimant has not taken any step to expose themself to the loss.

It was, however, argued that this was not such a case because the shareholders had taken a step to directly expose themselves to the loss – by purchasing the shares – and, in those circumstances, direct reliance is an 'indispensable element'. The defendants argued that support for this approach could be found in a number of appellant decisions (most notably Digi-Tech (Australia) Ltd v Brand³ and Ingot Capital Investments Pty Ltd v Macquarie Equity Capital Markets Ltd⁴).

Justice Brereton distinguished those cases on the following bases:

• they did not involve 'market-based' causation;
• they involved a scenario in which the alternatives were a transaction or no transaction, not a transaction at a lower or higher price in which the contravening conduct had the necessary consequence that the higher price would be obtained;
• the sole causative role of the contravening conduct in those cases was, in the barest 'but-for' sense, to contribute to the creation of the opportunity for the transaction to take place; and
• the policy in those cases is to deny recovery when the contravening conduct did not influence anyone, and also to those who knew (or were indifferent to) the true position.

His Honour said that the HIH case is not a case in which no-one was misled. While the contravening conduct did not directly mislead the plaintiff shareholders, it deceived the market (constituted by investors, informed by investors and advisers) in which the shares traded and in which the plaintiffs acquired their shares. He went on to say:

Investors who acquire shares on the share market do so at the market price. In that way, they are induced to enter the transaction (in this case, to their prejudice) on the terms on which they do by the state of the market. Investors who acquire shares on the ASX may reasonably assume that the market reflects an informed appreciation of a company’s position and prospects, based on proper disclosure. The notion that a market may be deceived, manipulated and distorted by misrepresentation is well established.

 

His Honour described the 'chain of causation' in the following terms:

• HIH released overstated financial results to the market;
• the market was deceived into a misapprehension that HIH was trading more profitably than it really was and had greater net assets than it really had;
• HIH shares traded on the market at an inflated price; and
• investors paid that inflated price to acquire their shares, and thereby suffered loss.

In those circumstances, his Honour concluded that market-based causation is available and that the absence of direct reliance by the plaintiffs on HIH's misleading accounts did not preclude them from recovering their losses:

• so long as it could be proved that the market price for HIH shares during the relevant period was 'inflated' by the contravening conduct; and
• in circumstances in which there was no suggestion that the plaintiffs knew the truth about (or were indifferent to) the contravening conduct, but proceeded to buy the shares anyway.

Establishing that the market price was inflated

Expert evidence was led by the parties as to the methodology to be applied in determining what (if any) effect HIH's misleading accounts had on the market price of HIH shares.

The plaintiffs' expert developed a regression model based on the price to book value of other major Australian insurance businesses, conditioned on their recurrent return on equity, and applied this to HIH's return on equity and book value to derive a value for HIH's shares. Justice Brereton was concerned that this approach failed the 'reality test' because it showed that, for certain periods, HIH's shares would have traded at a price higher than what they actually did had HIH's accounts been accurately stated.

Ultimately, Justice Brereton preferred a different and simpler approach. This involved comparing:

• the price at which HIH shares actually traded; and
• the hypothetical price achieved by applying HIH's share price to book ratio to HIH's 'adjusted' book value (adjusted to make corrections for the errors in HIH's misleading accounts).

Applying this analysis, his Honour found:

• that the contravening conduct caused HIH's shares to be inflated by between 6.25 per cent and 13 per cent over the relevant period; and
• accordingly, that market-based causation had been established.

What does the decision mean for shareholder class actions?

This is a significant decision on the approach to causation – a question that has dogged shareholder class actions for years. The question will not, however, be finally resolved until it has been considered by the High Court.⁵

A decision that market-based causation is not available would have been a significant setback for the promoters of shareholder class actions, and would have raised questions about the extent to which they would remain a viable proposition for the funders and law firms involved. In many respects, this decision preserves the status quo (at least for the moment).