Crossing the Rubicon: court accepts market-based causation in a shareholder action
Re HIH Insurance Ltd (in liq)  NSWSC 482
The Supreme Court of New South Wales has accepted that shareholders can rely on ‘market-based causation’ to found claims for loss flowing from a company releasing misleading financial information to the market. However, the decision raises a few more questions as it provides a much-anticipated answer.
A major issue in shareholder actions against listed companies for failing to disclose material information is how the shareholders can prove their loss. Does every shareholder need to establish direct reliance on information in the market (ie, by proving that they have read and relied on a company’s financial statements)? Or can the shareholders assert that, at the time they bought their shares, the market was generally misled because misleading information was available?
The latter argument is known as ‘market-based causation’. It closely resembles the ‘fraud on the market’ doctrine in US securities law, which presumes that an investor who buys shares in a well-regulated market relies on publicly available information. ‘Market-based causation’ has not been considered by the High Court and has only been the subject of limited comment by intermediate appellate courts in Australia. Its place in Australian law has, therefore, been an open question.
The decision of the Supreme Court of New South Wales in Re HIH Insurance Ltd (in liq)  NSWSC 482 is notable as the first decision of a superior court in Australia to hold that market-based causation is available. The plaintiffs in Re HIHbought shares in HIH Insurance at a time when the company had released financial results that were misleading, due to the incorrect accounting of two reinsurance contracts. The plaintiffs claimed that the misleading financial results had inflated the price of HIH shares and that, but for the misleading information, they would have bought their shares at a lower price (note that the plaintiffs did not claim that they would not have bought their shares at all).
Importantly, the plaintiffs did not claim to have relied on or even to have read HIH’s financial results. Rather, they sought to rely on market-based causation – that is, they claimed that HIH’s inaccurate financial results misled the market generally, which caused HIH’s shares to trade at a higher price than if the misleading information had not been released. By buying their shares at an inflated price, the plaintiffs claimed, they had suffered loss.
The defendants (HIH’s liquidators) accepted that the financial results were misleading and that, by releasing them, the company had contravened (former) s 52 of the Trade Practices Act and ss 995 and 999 of the Corporations Law. However, they argued that market-based causation was not available and that the plaintiffs needed to prove that they had actually relied on the misleading information.
Brereton J disagreed. His Honour decided that, as intermediate courts had held that ‘indirect’ causation was available in cases of misleading or deceptive conduct, the plaintiffs in this case could rely on market-based causation. Brereton J described the chain of causation as follows: (1) HIH released misleading financial results to the market; (2) the market was deceived into thinking that HIH was more profitable than it really was; (3) HIH shares traded on the market at an inflated price; and (4) the plaintiffs suffered loss by paying that inflated price for their shares. A crucial integer in Brereton J’s reasoning was that ‘the market’ was capable of being misled, which in turn caused investors in the market to be misled. As discussed below, this reasoning is problematic.
Having accepted that market-based causation was available, Brereton J found that it was proved in this case. His Honour sought to calculate the ‘true value’ of HIH shares during the relevant period by applying the price-to-book ratio at which the shares traded to a book adjusted to account for the irregularities in the financial statements. The point was to work out what price the shares would have traded at if the misleading results had not been released. By comparing the resulting ‘true value’ of HIH shares to the price the plaintiffs bought them at, Brereton J found that the shares traded at prices between 6.25% and 13% higher than they should have. His Honour therefore concluded that market-based causation was established and the plaintiffs were entitled to damages for the difference in the price they paid and the price they should have paid for their shares.
It is submitted that the reasoning in Re HIH is problematic in two key respects, which may limit its application in future shareholder actions.
The first issue concerns the characterisation of ‘the market’. The decision is replete with references which paint the market as an anthropomorphised concept: ‘the market did not believe and did not trust HIH’s financial statements’, ‘the market was deceived into a misapprehension’, ‘no reason to suppose that the market was aware’. The problem with ‘anthropomorphising the market’, as Re HIH appears to do, is that the market is comprised of numerous actors – as Brereton J said, ‘constituted by investors, informed by analysts and advisors’. Despite the convenient shorthand that is the reference to ‘misleading the market’, it is not possible to reduce a market comprised of many actors to a single entity that is capable of being misled. What needs to be shown, by evidence, is that some of those actors were in fact misled and were induced to act on those misrepresentations to the detriment of investors. It is not enough to assert simply that because misleading information was available and the shares in a company traded at a higher price than may be rational if the company’s true position was known, ‘the market’ was misled. Whilst it is an open question whether the trading price of shares, resulting from the interactions of buyers and sellers, operates as a proxy for ‘the market’, such a proxy effect seems to have been assumed in Re HIH.
The second issue concerns the quantification of the plaintiffs’ loss. As noted above, the plaintiffs did not argue that they would not have bought their shares if they had known HIH’s true financial position. Rather, they argued that they would have paid less for those shares. This position was accepted in Re HIH, with the result that the plaintiffs’ losses were calculated based on the difference between the price they paid for their shares and the ‘true value’ of the shares. It is questionable, however, whether the plaintiffs’ counterfactual should have been accepted at face value. Suppose the plaintiffs had known the true financial position of HIH in 1999 and 2000 – would they really still have bought the shares? If they did, would they have ultimately sold them and realised a loss (given the downward trend of HIH shares from mid-1999 to the appointment of provisional liquidators in March 2001)? If they had chosen not to buy the shares, would they have invested their money somewhere else – and would they have made a profit or a loss?
It is conceded, as Brereton J noted, that mere difficulty in assessing damages does not relieve the court of doing its best to estimate them, and that some degree of speculation is unavoidable where hypothetical scenarios are involved. It is, however, doubtful whether it should be accepted at face value that the plaintiffs, being apprised of accurate information about the financial position of HIH at the relevant time, would still have bought their shares. That is a fact which should have been proved by evidence.
Given the importance of the issues raised in Re HIHand the difficulties in its reasoning, the case would seem ripe for appeal. However, if the case is not appealed and is allowed to stand, it remains to be seen how courts will treat it in future shareholder actions. The debate about market-based causation is likely to continue at least until it comes to be considered by the High Court.