In brief: The Federal Court has dismissed shareholders' claims against Babcock & Brown alleging failure to disclose market sensitive information. The court made important findings on the scope of listed entities' continuous disclosure obligations in the context of accounting irregularities, and potential insolvency. The court has also given theoretical support to market-based causation, although this was not necessary to decide the case. Partner Duncan Travis (view CV) and Lawyer Michela Agnoletti report on the decision, and its implications.
HOW DOES IT AFFECT YOU?
- The Federal Court's decision does not resolve the uncertainty regarding whether market-based causation will be accepted into Australian law. The issue did not fall to be determined, and, although the court gave support to the concept of market-based causation, that view was obiter dictum only.
- A company will only be 'aware' of insolvency for the purposes of its continuous disclosure obligations if the fact of insolvency was, or should have become, known to directors or management, or an opinion existed that the company was insolvent and this opinion should have become known to directors or management.
Justice Perram of the Federal Court recently delivered judgment in the shareholder proceeding against Babcock & Brown Limited (BBL) and its liquidator1. The proceeding was not a class action, but a claim by 77 separate plaintiffs. His Honour's judgment, however, has broad application to civil claims (including shareholder class actions) involving alleged contraventions of the law in relation to market disclosures.
The proceeding was commenced in 2012. The allegations varied as the proceeding progressed towards trial,2 but the critical allegations were to the effect that each of the plaintiffs, who had acquired shares in BBL between 21 February 2008 and 13 March 2009, suffered loss because BBL failed to disclose to the market that:
- its final dividends for 2005, 2006 and 2007 had been paid unlawfully out of capital, rather than profits;
- its financial reports for those years did not give a true and fair view of its financial position because they did not disclose that the final dividends had been paid out of capital, not profits;
- it was insolvent as at 29 November 2008; and
- the final dividend it paid in 2007 had been paid out of funds borrowed on the back of an asset revaluation.
The plaintiffs advanced a market-based causation case. They claimed losses amounting to the difference between the price they paid for BBL shares in an artificially inflated market, and the true value of those shares.
Justice Perram dismissed all of the plaintiffs' claims, with costs. His Honour found that BBL had not breached its continuous disclosure obligations by failing to disclose the matters set out above.
Scope of the continuous disclosure obligations
Justice Perram considered the scope of the obligation to disclose information to the market under section 674(2) of the Corporations Act 2001 (Cth). His Honour focused in particular on the test for materiality in s677, which provides that information is material if it 'would, or would be likely to, influence persons who commonly invest in securities in deciding whether to acquire or dispose of the … securities.' Justice Perram made the following important findings, which guided his consideration of the allegations of breach:
- 'Persons who commonly invest in securities': Justice Perram noted that whether this phrase refers to a hypothetical investor buying securities in the company in question, or securities in general, had not been definitely decided in Australia. His Honour considered the trial decision in Jubilee Mines,3 in which it was held that investors in 'small speculative miners' were the benchmark for that case. His Honour considered that definition to be too narrow. His Honour held that, properly read, the provision referred to investors in listed securities generally. As to the meaning of 'commonly', his Honour held that it did not refer to professional investors, but that 'it does denote a degree of sophistication which might be expected from those who have more than a passing or occasional interest in the activities of securities exchanges'.4 What information should have been disclosed? Justice Perram, agreeing with the Court of Appeal's judgment in Jubilee Mines,5 highlighted the importance of identifying the information that should have been disclosed, before assessing whether that information would have had the 'influence' on persons mandated by s677. His Honour noted that the information that should have been disclosed may not be the same as the information that the plaintiff alleges should have been disclosed.
Payment of dividends out of capital
His Honour accepted that, technically, the relevant dividends had not been paid out of BBL's profits for the relevant year, and were paid in breach of the law in force at the time. Critically, however, his Honour found that the payment had 'no economic significance to the shareholders'. This was because:
- as a matter of financial reality, BBL was part of a consolidated group and there were sufficient profits within the group to meet the dividend; and
- BBL had received a dividend from its subsidiary after the end of each relevant financial year that enabled it to pay its dividend.
Having reached this conclusion, Justice Perram considered the information that should have been disclosed to the market. That information was not limited, as the plaintiffs alleged, to the fact that the final dividends had been paid out of capital. It also needed to include the following facts:
the consolidated group had sufficient retained earnings to pay the dividend; the issue only arose because the dividend paid to BBL by its subsidiary was to be received as income in the year after the relevant year of income, so it could not be counted in that year; and this was purely an accounting issue and had no impact on the value of BBL's shares.
Justice Perram concluded that, if this information had been disclosed, it clearly would not influence persons who commonly invested in securities in deciding to acquire or dispose of BBL shares. He also concluded that the financial reports disclosed to the market contained information that would permit it to be deduced that the dividends were paid from capital, so the information was 'generally available' anyway. For these reasons, the claim failed.
No true and fair view in the financial statements
Justice Perram carefully considered ss296 and 297 of the Corporations Act, requiring financial statements to comply with the accounting standards, and give a true and fair view, respectively. Because there had been unlawful alterations to BBL's capital structure by reason of the dividend payments, Justice Perram concluded that there had been a breach both of the accounting standards, and of the obligation to give a 'true and fair' view.
This was not, however, enough for the plaintiffs' claim to succeed. Justice Perram again focused on the information that should have been disclosed. It would, he found, be misleading to disclose that the accounts did not give a true and fair view without also disclosing that this was purely an accounting issue and had no impact on the value of BBL's shares. Had all of that information been disclosed, it would not have influenced persons who commonly invested in securities. The claim failed.
The parties agreed that BBL was insolvent on 29 November 2008. Justice Perram formulated the critical question as being whether BBL was 'aware' of this at the relevant time. Listing Rule 19.12 provides that awareness arises if 'a director or executive officer … has, or ought reasonably to have, come into possession of the information in the course of the performance of their duties'.
Justice Perram considered the meaning of 'aware' in this context, and concluded that the plaintiffs needed to show one of the following:
- that BBL's insolvency was actually known to the directors or management; or
- it should have become known to the directors or management; or
- an opinion that BBL was insolvent existed and should have become known to the directors or management.
The factual circumstances, as at 29 November 2008, were such that none of these could be shown. In fact, Justice Perram regarded it as 'dubious' that BBL was insolvent on that date at all. Given that BBL's facilities did not begin to fall due until 2015, the short-term funding that was procured to meet the Babcock & Brown group's immediate cash needs, and the work being done at the time to restructure the Babcock & Brown group's debt, there was nothing available to the directors by way of material, advice, or opinion, by which they were, or should have become, aware of BBL's insolvency. The claim therefore failed.
Payment of 2007 dividend out of asset revaluation
Justice Perram found that there was no evidence to prove that the dividend was funded by loans arising from an asset revaluation by BBL's subsidiary. That claim also failed.
No court in an Australian shareholder class action has reached final judgment on whether, to establish causation:
- each group member needs to prove that they actually relied on the contravening conduct (known as direct causation); or
- it will be sufficient to show that the contravening conduct artificially affected the market price in a way which led to the group members' loss, without them having to establish actual reliance (known as market-based causation).
In the United States the 'fraud on the market' theory, founded in the efficient markets hypothesis, has, since 1988 6, been applied to claims brought under Rule 10b-5 of the Securities Exchange Act. The market-based causation theory was developed separately to suit Australian legal principles of market-disclosure and causation. In 2014, the US Supreme Court heard a challenge to the validity of the 'fraud on the market' theory based on new evidence said to show that markets are fundamentally not efficient.7 The Supreme Court rejected that challenge on the basis that the theory does not depend on an 'unjustifiably robust' view of market efficiency, but rather on the 'fairly modest' premise that 'market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices'. Had the Supreme Court rejected the 'fraud on the market' theory, the case for recognising market-based causation in Australia would have been substantially weakened.
In Australia, many cases involving market-based causation have been settled with the court's approval.8 Further, the question of market-based causation has been considered recently in interlocutory applications in the Supreme Court of Victoria and the Federal Court. In both cases, the pleading of market-based causation was attacked as likely to be struck out or to fail at trial. The court rejected the attack in both cases:
- In Camping Warehouse Australia Pty Limited v Downer EDI Limited  VSC 357, Justice Sifris refused to strike out a statement of claim for its failure to plead direct reliance on the misleading and deceptive conduct said to have caused the plaintiff loss. His Honour held that the plaintiff's claim did not meet the test of being 'plainly hopeless', given that the law in this area was 'far from clear'.9
- In Caason Investments Pty Limited v Cao  FCA 1410, the applicants sought to amend their claims to introduce market-based causation claims. The respondents resisted the proposed amendment. Justice Farrell described the dispute as follows:
The market based causation claims are that alleged contraventions by the respondents caused the market to inflate the price of Arasor shares in the Period beyond their true value or the market price which would have prevailed but for the alleged contraventions, thereby causing loss. The respondents say that such a claim is unknown to Australian law and should not be permitted.
Her Honour accepted that the state of the law in market-based causation was not settled. It could not be concluded, therefore, that the market-based causation claims had 'no reasonable prospect of success' at trial. The amendments sought by the applicants were permitted.
This was the state of play on market-based causation in Australia prior to Justice Perram's judgment.
Although it was not necessary to decide it to resolve the case, Justice Perram concluded that he would likely have found in favour of the market-based causation case advanced by the plaintiffs. His Honour's reasons for reaching this view included the following:
- reliance is not a necessary condition for establishing causation;
- s674 of the Corporations Act requires disclosure of market-sensitive information that would be expected to affect price, hence the provision assumes a price impact on the market in general;
- there is authority to support the proposition that, if A misleads B, and as a consequence B misleads C, C is not precluded from recovering from A.10 The situation in this case, where A is alleged to have misled the market (or many Bs), which led to the price changing which caused loss to C, is not relevantly different; and
- it is artificial to speak of reliance in non-disclosure cases.
Justice Perram stated:
...I would accept that a party who acquires shares on a stock exchange can recover compensation for price inflation arising from a failure to disclose material required by s 674 to be disclosed, as long as they are not themselves aware of the non-disclosed material.
His Honour's view was, however, expressed in a case where the issue did not fall to be determined. It is obiter dictum, and therefore does not resolve the longstanding uncertainty about market-based causation. That issue remains undetermined by a court at first instance, and unconsidered by an appellate court.
Given Justice Perram's findings about the lack of economic significance of the payment of dividends out of capital, and the 'true and fair' nature of the accounts, it is not surprising that his Honour concluded that the plaintiffs suffered no loss in relation to the non-disclosures. On the issue of the 2007 dividend being paid out of an asset revaluation, the plaintiffs advanced no evidence on loss. His Honour held:
The consequence of this conclusion is that the plaintiffs have suffered no loss in relation to these non-disclosures. Whilst it is, no doubt, distracting that the plaintiffs lost money because of the collapse of BBL, they did not lose a single cent as a result of the events surrounding the payment of the 2005-2007 dividends. They lost money because of the financial crisis in 2008.
His Honour accepted the undisputed evidence that, if BBL had been required to disclose it was insolvent on 29 November 2008, the plaintiffs would have recovered 74.7 per cent of the purchase price paid.
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Observers of shareholder class actions have long awaited a judgment that decides whether market-based causation will be accepted in Australia. Regrettably, that judgment has not yet arrived. Justice Perram's judgment did not need to address the issue, and his Honour'sobiter dictum observations regarding market-based causation leave the uncertainty in this area unresolved. It is to be hoped that a court will have the opportunity to make a binding decision on this area of the law before too long. It is, however, generally accepted that the position will not be finally resolved until it is considered by the High Court.