The NSW Supreme Court recently handed down its decision in Re HIH Insurance Limited (In Liq). This long-running saga began with the collapse 15 years ago of Australia’s (then) second largest insurance company, HIH Insurance Limited, and has since seen a royal commission, the imprisonment of various senior management figures, and losses totalling more than $5 billion.
This decision has attracted a lot of attention across the financial and corporate sectors. The decision is the first in Australia to explicitly accept ‘indirect market-based causation’ in cases involving misleading or deceptive conduct. This will potentially pave the way for investors to bring claims against listed companies who misled the market, without needing to establish direct reliance on the misleading information.
The case was brought by several shareholders of HIH who bought shares in the company in the three years leading up to its collapse. In the case the parties agreed that HIH had released misleading financial results for the financial years ending 30 June 1999 and 2000, which overstated the company’s profits by some $92 million and $108 million respectively. These overstatements related to the accounting treatment of complex reinsurance contracts entered into by subsidiaries of HIH.
The plaintiffs argued that they had bought HIH shares following the release of the financial results at a share price which was higher than it would have been had HIH stated its true profit in its financial results. None of the plaintiffs claimed, however, to have actually read the financial statements. Instead, the plaintiffs’ argued that they had indirectly relied on the market, which had in turn relied on the misleading or deceptive conduct of the company, thereby causing the plaintiffs to purchase shares at an inflated price.
While it was not in dispute that the plaintiffs had suffered loss, the liquidators of HIH argued that the plaintiffs failed to show that the misconduct of HIH actually caused their loss. Specifically, they argued that indirect causation is only available where the plaintiff’s involvement is passive and a third party has been induced by the defendant’s misleading or deceptive conduct to act to the plaintiff’s prejudice. In this case, as the plaintiffs had acted positively to purchase the shares, the position taken by the liquidators was that the plaintiffs were required to establish actual reliance on the defendant’s misconduct, by showing that they had read and relied on the misstated financial results in deciding to purchase their shares.
The court rejected this argument, instead finding that the plaintiffs need only show that someone in the chain of causation relied on the misconduct of the defendant. In this case, while the plaintiffs themselves had not relied on the misstated financial results, other investors, as well as brokers and financial advisors, had, factoring in the misstated financial results into the share price of HIH. The plaintiffs then traded on the back of the inflated price set by the market.
The second key issue before the court was the quantum of damages. The court favoured a relatively simple formula: apply the price to book ratio at the relevant time the shares were bought to the adjusted book value of the company based on the actual profits. This resulted in adjusted share prices which were between 87% and 94% of the traded share price at the relevant times, and hence the plaintiffs were able to recover this difference.
The court’s willingness to utilise the price to book ratio was premised on the fact that the company was, during the relevant period, trading at a price which gave it a market capitalisation of less than its book value. The court commented that in such cases a book value multiple provides a significantly more reliable basis than an earnings multiple, as shareholders would typically be more focused on the net-asset backing as the company approaches insolvency. In addition, the court accepted that valuation methodologies for insurance companies were generally more focused on book multiples over earnings multiples.
Ultimately, it is likely that this decision will be appealed, providing an appellate court the opportunity to settle the position on indirect market-based causation in Australian law, as well as potentially offer further insight into the appropriate methodology for calculating loss. In the meantime, this case serves up a strong cautionary tale to companies about ensuring that they do not mislead the market.