The recent New South Wales Supreme Court decision in Re HIH Insurance Ltd (In Liquidation)1 has potentially significant implications for securities class actions where there are allegations that a listed company has failed to disclose material information to the market and/or engaged in misleading and deceptive conduct causing the company's shares to trade at an inflated price.
This decision appears to pave the way for plaintiff shareholders to succeed in these types of securities claims without having to prove direct reliance on the contravening conduct, provided they can establish that they paid a higher price for the securities than they would otherwise have paid had the contravening conduct not occurred.
In this eBulletin, we review the decision and its possible implications for insurers.
- The plaintiffs' arguments
- The question of reliance
- Quantification of loss
- What this means for insurers
- Further information
HIH Insurance Limited was a publicly listed insurance company. On 27 August 2001, HIH was wound up by order of the court and liquidators appointed to it and its subsidiaries.
The plaintiffs are shareholders of HIH who acquired shares:
- in the period 26 August 1999 to 2 March 2000, following the release by HIH on or about 25 August 1999 of its final results for the 1998/1999 financial year (FY1999 Results);
- in the period between 3 March 2000 and 17 October 2000, following the release by HIH on or about 2 March 2000 of its interim results for the six months ended 31 December 1999 (FY2000 Interim Results); and
- in the period 18 October 2000 to 15 March 2001 (being the date on which the provisional liquidators were appointed), following the release by HIH on or about 17 October 2000 of its final results for 1999/2000 financial year (FY2000 Results).
The proceeding arose after the defendants, the liquidators of HIH and its subsidiaries, rejected proofs of debt lodged by the plaintiffs in the liquidation based on alleged losses suffered as a result of having acquired shares for an inflated price.
The plaintiff's arguments
The plaintiffs contended that:
- HIH overstated its operating profit (and as a consequence its net assets) in each of its FY1999 Results, FY2000 Interim Results and FY200 Results because it failed to correctly account for two re-insurance contracts in those results (contravening conduct);
- the contravening conduct distorted the market on which HIH shares were traded by attributing an inflated value to the shares;
- the plaintiffs acquired their shares in that inflated market, which was regulated by the ASX and the Corporations Law; and
- the plaintiffs therefore suffered loss and damage by reason of having paid more for the shares they acquired than they would otherwise have paid for them on the open market had the misrepresentations not been made.
Notably, the plaintiffs did not seek to contend that they directly relied upon, or even read, the relevant financial results before making their decision to acquire the HIH shares. They also did not seek to argue that they would not have purchased the shares at all but for the contravening conduct.
At trial, the defendants admitted that the FY1999 Results, the FY2000 Interim Results and the FY2000 Results wrongly accounted for the re-insurance contracts and that, by releasing them, HIH engaged in conduct that was misleading and deceptive or likely to mislead or deceive in contravention of section 52 of the Trade Practices Act 1974 (Cth) and sections 995 and/or 999 of the Corporations Law.2
Accordingly, the main issues remaining for determination were:
- whether the plaintiffs could establish that their loss was caused by HIH's misleading and deceptive conduct in the absence of any evidence of direct reliance by the plaintiffs on the contravening conduct; and
- if so, the basis for calculating the plaintiffs' damages.
The question of reliance
The defendants, in reliance on the oft-cited decisions of the Court of Appeal in Digi-Tech (Australia) Ltd v Brand3 and Ingot Capital Investments Pty Ltd v Macquarie Equity Capital Markets Ltd4 and of the Full Court of the Federal Court in Ford Motor Company of Australia Ltd v Arrowcrest Group Pty Ltd,5 argued that it was not sufficient for the plaintiffs to prove that they paid more for their shares than they otherwise would have but for the misrepresentations. Rather, each of the plaintiffs would need to establish direct inducement by the contravening conduct to enter into the transactions, in the sense of having directly relied on the overstated financial results to acquire the shares in HIH, without which there was no causative link between the contravening conduct and the plaintiffs' losses.
The defendants' argument is based on a distinction between, on the one hand, cases where the plaintiff is a 'passive victim' of the contravening conduct and a third party has been induced by the conduct to act to the plaintiff's detriment and, on the other hand, cases in which the plaintiff actively entered into the transaction by which they claim to have suffered loss (ie, the Digi-Tech category of cases). In the former, so-called 'indirect causation' may be available whereas, in the latter, the plaintiff's own conduct is a necessary link in the chain of causation and direct reliance must be established. The defendants contended that the present case fell within the latter category.
Justice Brereton concluded that none of the authorities cited by the defendants precluded the application of 'indirect causation' as distinct from 'reliance based' causation to the present case. Rather, he interpreted the authorities as standing for the proposition that where misleading conduct provides the opportunity for an investor to enter into a transaction, that investor will not be entitled to recover if they knew the truth of the underlying misrepresentation or were indifferent to its truth and proceeded anyway.
In distinguishing this case from the Digi-Tech category of cases, His Honour observed that this was not a case in which no-one was misled. While the contravening conduct may not have directly misled the plaintiffs, it had misled the market in which the shares traded (constituted by investors and informed by analysts and advisors) and in which the plaintiffs acquired their shares.
His Honour noted that investors who acquired their shares on the open market do so at the market price, which they may reasonably assume reflects an informed appreciation of a company’s position and prospects, based on proper disclosure. In that way, they are induced to enter the transaction (in this case, to their detriment) on the terms on which they do by the state of the market.
In the circumstances, it was held that causation could be established by the facts that:
- HIH engaged in the contravening conduct (ie, the release of overstated financial results to the market);
- the market was deceived by the contravening conduct into a misapprehension that HIH was trading more profitably than it really was and had greater net assets than it really had;
- as a result of the contravening conduct, 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 the absence of evidence that any of the plaintiffs knew the true position of the company or were indifferent to it, but proceeded to buy the shares anyway, His Honour concluded that 'indirect causation' was available and direct reliance on the contravening conduct need not be established.
Quntification of loss
To establish 'indirect causation' in this case required the Court to analyse whether the contravening conduct had the effect of inflating the market price of HIH shares. In order to reach a conclusion about this, it considered a number of alternative measures of loss in an effort to quantify the inflation (if any):
- the difference between the price paid and the price that would have been paid had the contravening conduct not occurred but all other factors remained constant;
- the difference between the price the plaintiffs paid for their shares and their 'true value'; or
- the difference between the price paid and their value in the plaintiffs' hands at the date of trial (the 'left in hand' approach).
Having regard to a variety of hypotheses contented for by the parties' experts and noting this was not a 'no transaction' case, the Court concluded that the first measure listed above was the correct approach. Noting the difficulties inherent in such a hypothetical exercise, Justice Brereton determined that the impact of the contravening conduct was represented by the difference between the price at which HIH shares actually traded on the market and the hypothetical price achieved by applying the price to book value at which they traded to a book adjusted for the re-insurance contracts. This had the benefit of isolating the contravening conduct from other market influences.
What this means for insurers
The uncertainty surrounding the question of whether individual group members would be required to establish individual reliance on misleading statements or non-disclosure by a company has been a significant factor as to why no shareholder class action to date has reached final judgment.
With the Court having removed a major hurdle to a plaintiff's ability to establish causation in securities class actions, the decision is likely to embolden plaintiffs (and their litigation funders) so that achieving reasonable settlement outcomes may now be more difficult for insurers. However, in our view, given the potential for this decision to so considerably alter the playing field, it is likely to be appealed.