Bob Baxt considers a recent HIH Insurance ruling involving investors’ ability to recover losses sustained in a wide variety of corporate failures.
The decision of Justice Brereton in the Supreme Court of New South Wales in Re HIH Insurance Limited (in liq) & ors  NSWSC 482 is an important decision involving the ability of investors to recover losses sustained in a wide variety of corporate failures in the financial services and related markets (as well as more generally). Justice Brereton ruled that it was permissible for investors who had purchased shares (and I assume other securities) in a company listed on the ASX, which had lost value as a result of misleading or deceptive conduct (or other relevant breaches of the law), could rely on the argument, favoured in the US, that their loss had been caused by what is termed “fraud on the market”.
Over recent years, Australian courts have rejected claims brought by shareholders (in class actions and otherwise) based on reliance on the “fraud on the market” cause of action. Perhaps the most “famous” of these cases (because of the significant losses sustained by investors), was the decision in Grant-Taylor v Babcock & Brown (in liq) (2015) 104 ACSR 195, which was recently upheld by the Full Federal Court in Grant-Taylor v Babcock & Brown (in liq) (2016) FCAFC 60 (judgement of Chief Justice Allsop and Justices Gilmour and Beach). However, in the further Full Federal Court case of Caason Investments Pty Ltd v Cao  FCAFC, Justice Edelman, one of the members of the court, ruled that it would not be impossible for a “fraud on the market” argument to be relied on in the Australian case.
Hard on the heels of the decision in the Full Federal Court in Grant-Taylor v Babcock & Brown, Justice Brereton has now left the door open for a more positive result in a major action brought by several shareholders who have lost significant sums of money following the collapse of the then second-largest Australian insurance company, HIH Insurance Ltd. As readers of this column may know, following the collapse of that company, a royal commission was held. The report of the royal commission made a number of negative recommendations about the behaviour of management in that company and several senior managers were severely penalised.
In the current case, a number of shareholders in HIH had subscribed for shares in HIH a few years prior to its collapse and alleged that the loss in value of their investments was due in large part to misleading or deceptive information being released by the company to the market in the relevant financial years (namely the years ending 30 June 1999 and 30 June 2000). This information had overstated the profits of the company by amounts over $90 million and $108 million respectively. The overstatements had occurred apparently because the principles of the accounting relied on by the relevant accountants and auditors turned out to be inadequate.
Australian courts have rejected claims brought by shareholders based on reliance on the 'fraud on the market'.
The plaintiffs had relied on: the value of the shares on the share market, and this value (a significant inflation in the price of the shares) had been influenced by the information released by the company and the market response to this information. Their counsel argued that the misleading or deceptive conduct of the company had caused the price of the shares, which they purchased, to be significantly inflated.
The liquidators of HIH argued there was no relevant evidence that there had been breaches of the law on the part of HIH, which caused the actual loss sustained by the shareholders. They further argued that the losses were indirectly caused by the way the information was collated by HIH and released to the market, along with other factors on the way the market would operate. In their view, this could not be the basis upon which the plaintiffs could seek recovery. In essence the liquidators in this case contended that there had to be a direct link between the alleged misleading or deceptive conduct, and the actual decisions to invest. It was necessary for there to be a direct link between the reliance on the information and the loss sustained by the shareholders.
Justice Brereton considered a number of earlier cases including Digi-tech (Australia) Limited v Brand  NSWCA 58 and Ingot Investments Pty Ltd v Macquarie Equity Markets Limited  NSWCA 206. He canvassed the most recent decisions, and in particular he relied heavily on the argument put forward by Justice Edelman in Caason. In that case, the judge explained market-based causation in these words:
“A market-based causation case is not a special sub-category of causation. It is, simply put, an example of indirect causation. One circumstance of market-based causation, albeit inadequately pleaded before the primary judge, involves an alleged disclosure of misleading information to the market in a disclosure statement. That misleading information causes the listed price of securities to inflate which, in turn, causes an alleged loss because the investor purchases the securities at a higher price than he or she would otherwise have paid.” (Caason at para 94 quoted by Justice Brereton at paragraph 69 of HIH).
After discussing some of these earlier cases and emphasising the importance of the comments in Caason, Justice Brereton concluded (at para 73) of this case:
“This is not a case in which, on the relevant hypothesis, no-one was misled; while the contravening conduct had not directly misled the plaintiffs, it deceived the market, (constituted by investors, informed by analysts and advisers) in which the shares traded and in which the plaintiffs acquired their shares. Investors who acquire shares in the 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 the informed depreciation 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.” (Quoting the High Court decision in HW Valuers (Central Qld) Pty Ltd v Astonland Pty Ltd (2004) 217 CLR 640 at 657)).
Justice Brereton distinguished some of the earlier “negative” decisions on the facts in each of the cases. He ruled that the chain of causation that led to a successful claim being allowed in this case flowed from the following factors:
- HIH had released financial information, which overstated the value of the shares in the success of the company.
- The market had been deceived by these facts, which suggested that HIH was trading more profitably than it really was and that its asset base had therefore increased.
- The HIH shares traded at an inflated price on the relevant date when investment occurred.
- The investors paid that inflated price to acquire their shares.
- They had suffered losses.
The following concluding statement from Justice Brereton could be the focus of attention in an appeal:
“I do not see how the absence of direct reliance by the plaintiffs on the overstated accounts denies that the publication of those accounts caused them loss, if they purchase shares at a price set by a market which was inflated by the contravening conduct.
The liquidators of HIH argued that there was no relevant evidence that there had been breaches of the law.
“The contravening conduct caused the market on which the shares traded to be distorted, which in turn caused loss to investors who acquired the shares in that market at the distorted price. In the absence of any suggestion that any of the plaintiffs knew the truth about, or were indifferent to, the contravening conduct, but proceeded to buy the shares nevertheless, I conclude that ‘indirect causation’ is available and direct reliance need not be established (see NSWCA at para 77).”
As noted earlier, Justice Edelman had opened the door slightly in Caason in suggesting that the fraudulent market argument could be a reliable basis upon which such actions might be brought. If the NSW Court of Appeal, and subsequent appeal decisions (and I would suspect that this is a matter that will finish up in the High Court of Australia, if not in this particular piece of litigation then in associated litigation of this case), will place these particular issues under a direct spotlight, the eventual result will have a significant impact in class action litigation involving losses on the securities markets. Readers will well recognise that the number of investors who have sustained huge losses in the securities markets as a result of alleged misleading or deceptive conduct will translate into a very significant litigation storm.
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