Damian Grave , Leah Watterson and Helen Mould caution that the judicial development of shareholder class action law in Australia could have unintended consequences if issues relating to causation, loss and damage are not understood.
Challenges for the new shareholder class action
Although the number of Australian shareholder class actions has proliferated in recent years, none has proceeded to judgement yet. Two undetermined questions loom large, how are shareholders to:
- Prove that the corporation’s contravening conduct caused loss and damage?
- Establish the type of loss and damage suffered and then calculate it?
As yet, there remains no judicial guidance as to how these questions will be resolved in market based shareholder actions.
Recent shareholder class actions have involved allegations, under the Corporations Act 2001 (Cth) and other legislation, that misleading corporate disclosures and failures to disclose have negatively affected the price of a company’s securities, causing loss and damage to shareholders. The alleged contravening conduct may arise from statements made in Australian Securities Exchange (ASX) announcements, analyst briefings, annual reports or in speeches made by the company’s directors as examples. To succeed in these claims, shareholders must show a causal connection (referred to as causation) between the alleged misconduct and the loss and damage alleged to have been suffered.
In an article published in the November 2009 issue of the Company and Securities Law Journal, the authors examined the main competing theories of causation, the types of loss and damage which are claimed and the role of expert evidence in determining these issues. Full text of the article can be found at (2009) 27 C&SLJ 483. A summary of key points follows.
A difficulty arising in the context of shareholder class actions is determining how causation should be established, in particular, where the loss is referable to a fall in the price of a security, which is publicly traded on a stock exchange. Various theories of causation have been discussed. The three main theories are:
- The “fraud on the market” theory; and
- a form of indirect causation referred to below as ‘mere inflation’.
The conventional mechanism for proving causation in Australian misleading or deceptive conduct claims has been reliance. In shareholder class actions, reliance-based causation might require shareholders to prove that they read and relied upon the misleading disclosure or omission when deciding to purchase the company’s securities.
If actual reliance can be established and the evidence demonstrates that the contravening conduct affected the price of the securities, there is little dispute that shareholders would be able to establish causation.
Policy considerations support the view that reliance is the appropriate test. If shareholders could receive compensation even though they have not conducted any research into the listed companies into which they invest, there would be little incentive for shareholders to read ASX announcements.
Reliance can be applied as the appropriate mechanism for proving causation where contraventions involve failures to disclose information. This is because the failure to disclose will be assessed in light of information that was disclosed to the market or assumptions or expectations that were reasonably held by investors.
Fraud on the market
The fraud on the market theory involves making a rebuttable presumption that a shareholder has relied on the integrity of the market price when making an investment decision in an open market transaction.
The theory rose to prominence following the 1988 decision of the US Supreme Court in Basic Inc v Levinson where the court stated that:
“[I]n an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business… Misleading statements therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements.”
The theory assumes that the market is performing a substantial part of the valuation process normally undertaken by an investor in a face-to-face transaction.
Contrary to some perceptions, plaintiffs in recent Australian shareholder class actions have not attempted to adopt the US fraud on the market theory; rather they have proposed an indirect theory of causation based on elements of the fraud on the market approach. This indirect theory is discussed below under the heading “mere inflation”.
In the US, the fraud on the market theory does not exist in a vacuum. It has developed judicially and been shaped and confined by legislative reforms. The detail of these aspects is discussed in the article referred to above.
Consideration of these limitations is essential to explaining why Australian courts should tread cautiously before applying elements of a US theory outside their native legal framework.
According to the “mere inflation” theory of causation, plaintiffs essentially claim that the corporate defendant engaged in misleading or deceptive conduct or contraventions of the continuous disclosure provisions of the Corporations Act by making misleading representations or by failing to disclose information to the market and such conduct caused the market price of the defendant’s shares to be inflated. It is then alleged that by purchasing shares at an inflated price, the plaintiffs have suffered loss.
The mere fact that the share price was inflated at the time of purchase is said to be sufficient to establish a causal relationship between the disclosure (or non-disclosure) and the loss.
A similar, if not identical, approach was specifically rejected by the US Supreme Court in Dura Pharmaceuticals v Broudo.
In Australia, more concern has been expressed about the prospect of adopting the US fraud on the market theory than has been voiced in relation to the mere inflation theory.
However, the mere inflation theory may be more problematic. If applied without limitation, it could provide compensation to shareholders who knew that the information the subject of the complaint was untrue but traded anyway.
The mere inflation theory is premised on an oversimplified understanding of the causal relationship between the contravention and the alleged loss, and it lacks the significant prerequisites which restrict the operation of the fraud on the market theory in the US.
Types of loss
In the event that shareholder plaintiffs can establish a causal link between the contravention and the loss suffered, courts will need to identify and quantify the actual loss suffered.
The loss measures alleged in recent shareholder class actions have included:
- The difference between the price at which the shareholder acquired their interest and the true value of that interest;
- The difference between the price at which the shareholder bought their interest and the market price that would have prevailed but for the contraventions;
- The difference between the price paid for the shares and whatever is ‘left in hand’ upon a sale of the shares; and
- The loss of opportunity to achieve a reasonable rate of return on the money used to purchase the interest in the securities.
Plaintiffs in some recent shareholder class actions have contended that the third measure above is to be preferred. In many scenarios, and particularly where the share price has declined significantly and not recovered, this measure will lead to a higher quantum figure.
However, a fundamental difficulty with the ‘left in hand’ methodology is that it attributes the full amount of any share price decline to the alleged contravening conduct and fails to take into account unrelated market movements or other information that may be responsible for the fall in price.
Where a plaintiff alleges that a contravention caused the plaintiff to purchase securities at a price higher than their true value or at a price higher than the shares would have traded had the true information been known, the analysis will generally begin with an enquiry into the extent (if any) to which the price was inflated.
In addition to proving that the share price was inflated, a plaintiff will need to show that the company’s contravention (and not some other event or factor) caused the inflation.
Expert evidence regarding these matters may assist the court. Such evidence could be adduced from experienced investors, fund managers or market analysts with relevant expertise. The opinion of such persons may be informative but may be vulnerable to criticism that it is subjective or contains aspects that are not testable.
A methodology commonly used in the US to analyse questions relating to causation, loss and damage is the event study.
Using statistical methods, the event study aims to measure the impact of particular information on a security’s price. Event study evidence may be led to infer that particular information was material and to quantify the impact of that information on the share price.
Event study evidence has been sought to be relied upon in a number of Australian shareholder class actions. As yet, there is no judicial guidance in Australia as to the assistance it will provide in these types of actions.
Unless the complexity of the issues relating to causation, loss and damage are understood and inform the debate surrounding shareholder class actions in Australia, the law risks moving forward in a way that may have adverse and unintended effects in the years to come.
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