This article was written by Moira Saville, Roger Forbes, Patricia Matthews and Laura Stockdale.
An investor buys shares in a listed company on market. They do so without reading the company’s recently released accounts or undertaking any other investigation into the affairs of the company – they just like the name of the company. It later transpires that the company’s operating profit was overstated in its most recent accounts. When the truth is revealed, the market reacts adversely and the shares drop in price.
Does the investor have a claim?
In HIH Insurance Limited (In Liquidation) and others  NSWSC 482, a Judge of the Supreme Court of New South Wales held that the investors can in such circumstances make a claim under the provisions of relevant statutes concerning misleading and/or deceptive conduct. The Court held that in such cases the principle of “indirect causation” is applicable and that investors do not need to prove that they directly relied on the misleading conduct of the company.
This is the first securities claim to use the indirect causation principle to award damages to investors. Unless overturned on appeal, it confirms the approach on causation taken by plaintiffs and litigation funders in securities class actions.
When bringing a misleading or deceptive conduct claim, an applicant must prove that their loss was caused by the misleading conduct. Usually causation is established by the applicant proving that they relied on the misleading conduct to their detriment – they were misled by something that the defendant stated or they made an assumption about certain facts because the defendant failed to disclose relevant matters in a public announcement, possibly in breach of the defendant’s continuous disclosure obligations as a listed entity. However, in certain circumstances, causation can be established by indirect means and without the plaintiff either knowing of, or being misled by, the defendant’s conduct.
In this case, HIH Insurance had overstated its operating profits in its FY1999 results, FY2000 interim results and FY2000 results, as a result of wrongly accounting for certain reinsurance contracts. This was conceded by the defendants to be misleading or deceptive, thereby making this case unusual as typically defendants contest such allegations. As a result of these contraventions, it was alleged that the shares in HIH Insurance had traded at an inflated price. Several investors who had purchased shares in HIH between 26 October 1998 and 15 March 2001 brought a claim for misleading or deceptive conduct and sought to recover their loss, but did not seek to prove that they had read or relied on the relevant reports.
In approaching the question whether the plaintiffs could claim damages on the basis of indirect causation, that is, without proving direct reliance on the contravening conduct, Justice Brereton identified two key inquiries: was indirect causation available in cases such as this; and whether on the evidence causation had actually been established, in that the contravening conduct had distorted the market price so as to cause the shares to trade at an inflated price.
In relation to the first inquiry, the Judge explored the relevant cases and concluded that indirect causation is an available means to connect a defendant’s misconduct and the loss for which the plaintiff seeks a statutory remedy.
The Judge held that by overstating its operating profits, HIH had “deceived the market” and had “induced [the investors] to enter the transaction”. In such situations, the judge held that an investor will be able to recover loss when: (1) a company misstates its financial results; (2) the market (being the whole body of investors) is deceived that the company is trading more profitably than it is; (3) the shares of the company trade at an inflated price and (4) a particular investor paid the inflated price for the shares and thereby suffers loss.
Thus the causation element is based on presumed reliance by the vast body of third party investors who have traded or held the relevant shares and thus contributed to its trading price in an efficient market in which all relevant information, including the profit reports, is taken to be factored into that price. The fact that the actual plaintiffs may have placed no such reliance on the reports was not fatal to their claim.
In relation to the second inquiry, the Judge concluded that the appropriate measure of damages is the difference between the price paid by the investors and the price that they would have paid had the contravening conduct not occurred (but all other factors remained constant). This exercise also involves a determination of whether the contravening conduct in fact had any impact on the market price.
Other decisions on indirect causation in the market
The principle of indirect causation may have had its genesis in so-called ‘advertiser cases’. For example, when Company A falsely advertises a new product, causing consumers to stop buying a similar product produced by Company B, Company B can obtain compensation from Company A for its misleading conduct, even though it was the consumers, and not Company B, who in fact relied upon Company A’s misleading conduct.
Whether to recognise indirect causation in investor claims has long been a live issue in securities actions, including class actions.
In Grant-Taylor v Babcock & Brown Limited (In Liquidation)  FCA 149, Justice Perram of the Federal Court commented that an investor could recover damages against a company who had failed to comply with its continuous disclosure obligations without proving a direct causal link between the non-disclosure and their loss, although the comments in this decision were strictly obiter. The Full Federal Court of Australia recently considered this decision on appeal, but declined to consider “the important issue of causation” as it was unnecessary to resolve the issue on appeal. Prior to that decision, the Full Federal Court had considered indirect causation in a strike-out context in Caason Investments Pty Ltd v Cao  FCAFC 94, where it held that indirect causation can be pleaded in shareholder actions.
Why this matters
Many securities class actions, and the litigation funding industry which supports them, rely on indirect causation theory as a key part of their business model. Many such claims would simply not be marketable or financially viable if it was necessary to prove individual reliance by each member of a large plaintiff class. Any requirement on shareholders to give evidence of reliance themselves may dissuade prospective plaintiffs from joining the class: they may be required to give extensive discovery and give evidence about their investment process. Most such actions settle before trial and, until now, there has been no final and binding Australian judicial pronouncement as to the application of indirect causation theory in such cases. This has been a strong contributor to the fact that most shareholder actions have settled before judgment, with both class action promoters and defendants apparently being unwilling to risk a decision on indirect causation adverse to their interests.
HIH Insurance Limited is the first decision to determine authoritatively that the indirect causation theory is applicable in investor claims against listed companies and will encourage further such claims. However, this authority remains to be tested at appellate level. Even if upheld, Plaintiffs will still need to show that the relevant conduct was misleading and that it caused the price for securities to be inflated to the detriment of a plaintiff.