Masters v Lombe: another chapter in the Babcock & Brown saga
Masters v Lombe (liquidator); Re Babcock & Brown Ltd (in liq) [2019] FCA 1720
Background
Three actions were commenced by applicants who had purchased ordinary shares in Babcock & Brown Ltd (“BBL”) in the period between 12 August 2008 and 12 March 2009 (the “Relevant Period”), which readers will recall was in the midst of the global financial crisis.
On 11 August 2008, BBL had announced to the ASX that its 2008 earnings (that is, net profit after tax (“NPAT”) for the year ending 2008 (“FY08”)) were then not expected to exceed 2007 group net profit of $643 million.
On 7 January 2009, BBL made an announcement to the ASX to the effect that it then believed that asset impairment charges would be such that it would be in a substantial negative net asset position at 31 December 2008. After the ASX received the announcement, BBL went into an immediate trading halt, and was suspended from trading shortly thereafter and did not trade again after that, with administrators appointed on 13 March 2009 and creditors ultimately resolving to wind up the company on 24 August 2009.
The three actions were commenced against BBL’s liquidator. Each action had 100 applicants or more, but none was a group proceeding instituted under Part IVA of the Federal Court of Australia Act 1976 (Cth) although, as will be seen, similar issues arose to those commonly encountered in securities class actions.
Many, but not all, of the applicants had lodged a proof of debt with the liquidator seeking to claim loss allegedly suffered as a result of BBL’s alleged failure to meet its continuous disclosure obligations under s 674 of the Corporations Act 2001 (Cth) and under the ASX Listing Rules by failing to disclose to the ASX information relating to material changes in BBL’s financial position in the period after 11 August 2008. The applicants specified five instances of non-disclosure between 13 August and 8 December 2008. The claims in the proofs of debt were quantified as the amount by which the market price of a share in BBL was allegedly inflated above the true value of such a share at several specific points in time in the last few months of 2008 by reason of the alleged failure of BBL to correct earnings forecasts that it had earlier given. The liquidator rejected all of the proofs of debt.
In each of the three proceedings, each applicant who had lodged a proof of debt appealed from the liquidator’s rejection of it. The question that fell for the Court was whether, before BBL went into liquidation, the applicants had valid claims against it for contraventions of s 674. The evidence adduced by the parties comprised documents and expert evidence. No lay witnesses gave evidence.
Applicants’ allegations as to liability
As to the information that the applicants alleged BBL ought to have disclosed, in a memorandum from the then chief financial officer (the “CFO”) of BBL to its board dated 13 August 2008, the CFO provided two group NPAT estimates: (a) a base case NPAT of $750 million, which assumed that the sale of certain assets was completed; and (b) a second NPAT estimate of between $400 million and $600 million after adjustment for a probability weighted outcome and applying a +/- factor of $100 million to the $500 million adjusted NPAT estimate. In the memorandum, the CFO recommended that BBL retain its most recent earnings guidance (no greater than $643 million) because of lack of clarity regarding any more definite guidance. The board agreed that no change was warranted to the current earnings forecast. The applicants contended that BBL ought to have disclosed that its earnings for FY08 were expected to be in the range between $400-$600 million and that its earnings were therefore expected to be materially lower than the earnings guidance previously provided on 11 August 2008.
Further, on 20 August 2008, the CFO sent an email, which noted that BBL had not provided a floor to its earnings guidance, which he described as an “issue at the moment”, and proposed the following guidance:
Babcock and Brown advises that [its] full year result is expected to be approximately $400 million after tax.
This guidance is subject to no further impairment charges in 2H08 or significant restructuring costs however does include the impact of the impairment charges taken in the first half of the year. Notably the guidance does not include the impact of European wind sales assuming they occur in 2008. The current expectation is that the European wind portfolio will be sold in individual tranches rather than in “one line” and as a consequence the timing of the individual transactions, whilst currently expected to be Q3/Q4, may, in current conditions be deferred to 2009.
The guidance is, as always, subject to market conditions.
He then identified some issues with the proposed guidance. At a meeting which took place on 20 August 2008, the board decided that the guidance in the email was not appropriate because it was too heavily qualified, and the board also formed the view that the sale of certain assets was likely to generate revenue for the group during FY08. Relying on the email, the applicants alleged that, by 21 August 2008, BBL should have disclosed that it expected that its earnings for FY08 were expected to be approximately $400 million, which was materially different from the previous earnings guidance.
The applicants further alleged that BBL ought to have made various other disclosures from 8 October 2008, relying on internal company documents.
Market based causation theory and evidence of share price inflation/loss
As to loss, one issue that complicated analysis of any share-price inflation was the market conditions that prevailed at the time. Readers will of course recall, as noted above, that the Relevant Period took place in the midst of the global financial crisis. Lehman Brothers collapsed in mid-September 2008, about a month after the start of the Relevant Period. Against that background, there was a significant decline in BBL’s share price over the Relevant Period, which took place in the absence of any change in BBL’s earnings guidance.
The expert retained by the applicants (Dr Coulter) was a full-time academic, who lectured in accounting. The primary approach that Dr Coulter took to determining the impact of the alleged contravening conduct was based on the price-earnings ratio (derived by dividing the market price per share by the earnings per share). The expert assumed that the contravening conduct led the market to believe that BBL was trading more profitably than it really was, and that this inflated the price of shares in BBL. He sought to quantify this by working out the difference between the price at which BBL shares actually traded on the market and the hypothetical price achieved by applying the PE ratio at which they traded (ultimately derived using Bloomberg’s report of a ‘consensus’ of security analysts’ earnings forecasts for FY08 as a proxy for market expectations as to earnings) to an adjusted earnings number (that which, it was alleged, BBL should have disclosed).
The expert retained by the respondent (Mr Potter) practised as a forensic accountant. His overall opinion was that it was not possible to conclude that the allegedly overstated earnings guidance provided by BBL at various dates resulted in BBL’s shares trading at a higher price than they would have otherwise.
Mr Potter’s view was that in ascertaining the likely effect on BBL’s share price of the guidance that, it was alleged, ought to have been given, the following factors were important: the circumstances of BBL (including restructuring efforts); the circumstances of the market (including the GFC); and analysts’ and the market’s expectations of BBL’s future NPAT.
As to the latter (NPAT), Mr Potter concluded that the decline in BBL’s share price absent any change in BBL’s earnings guidance was reflective of a market expectation of a significant reduction in BBL’s NPAT for FY08 and following. Interestingly, he formed the view that analysts’ forecasts were not reliable, and so he endeavoured to produce a more reliable assessment of the market’s expectation of BBL’s earnings for the second half of 2008. When he performed this analysis, his calculation of expected NPAT, which he derived from BBL’s traded share price and the residual income model of valuation, was less than that which Dr Coulter stated should have been announced. He therefore opined that one could not conclude that the earnings guidance proposed by the applicants and Dr Coulter would have had a significant negative impact on BBL’s share price as calculated by Dr Coulter.[1] Even using an alternative valuation method (the net assets method), Mr Potter considered that the impact of the postulated earnings guidance would have had little, if any, effect on BBL’s share price.
Finally, it is worth noting that Mr Potter was of the opinion that the circumstances of BBL and of the broader market during the Relevant Period were such that an events study, which is often used to calculate share-price inflation in securities class actions, was not likely to be meaningful.
The applicants did not seek to establish causation by adducing evidence of reliance on BBL’s compliance with the law or by seeking to establish a causal connection between the alleged contraventions and the claimed loss by reference to other idiosyncratic features of each applicant’s purchase decision. Rather, they relied on indirect causation – ‘market-based causation theory’ – in order to establish the fact that they each suffered loss and the quantum of that loss. The liquidator contended that, as a matter of principle, the Court ought not accept market-based causation as being an appropriate foundation for a claim for compensation for a contravention of s 674 of the Corporations Act.
Decision
Justice Foster dismissed the applicants’ applications.
Liability
As to the first alleged non-disclosure, his Honour observed that the applicants selected one item of information which appeared in the CFO’s 13 August memorandum without paying due regard to the context in which that item of information appeared, including the fact that the CFO himself expressed the opinion that no further earnings guidance was then warranted. His Honour held that whether one took the view that the information that the applicants alleged should have been disclosed on 13 August 2008 was not information which was material in the relevant sense or whether one took the view that it properly fell within the ‘generated for internal management’ exception or the exception for information that was insufficiently definite to warrant disclosure, BBL was not obliged to disclose to the ASX the information that the applicants alleged should have been disclosed on 13 August 2008: [319]-[320].
As to the second alleged non-disclosure, his Honour held that given that the guidance proposed in the CFO’s 20 August email proceeded on the basis that no account should be taken of the sale of the European wind assets and that the directors had formed the view that it was likely that those assets would be sold in the financial year and did so on a reasonable footing, providing guidance as to the forecast earnings of BBL for FY08 at $400 million was too uncertain to be appropriate. No contravention arose from this non-disclosure: [324]-[325].
As to the other alleged non-disclosures, his Honour held that by no later than the collapse of Lehman Brothers in mid-September 2008, it was apparent to any potential investor in BBL that its capacity to realise earnings of the order of $643 million for the year ended 31 December 2008 had been severely circumscribed by its own circumstances and by the global financial crisis, and such investors would not have been influenced at all by being provided with earnings guidance at the times and in the terms which the applicants alleged should have been announced to the market: [340].
Share price inflation and loss
Justice Foster concluded that, even assuming the correctness of Dr Coulter’s price-earnings valuation method, the use of the Bloomberg consensus data without adjustment to ensure that only relevant and up to date forecasts were used was apt to produce a false result: [238], [240].
In any event, his Honour came to the view that the price-earnings methodology was flawed, adopting the reasons Mr Potter gave for his disagreement with that methodology, including because it could not wholly explain the sharp decline in BBL’s share price during the Relevant Period and that it assumed that analysts’ expectations as to FY08 NPAT were an accurate proxy for the market’s expectation, which Mr Potter doubted (partly because analysts’ views were not consistent): [213(7.85)], [261]-[262].
Further, his Honour observed that Dr Coulter’s methodology calculated share price inflation on the basis that there was, in fact, such an inflation of the price and also that such inflation was caused by the alleged contravening conduct and nothing else, but that Dr Coulter had not sought to make good those assumptions: [264].
That said, Foster J did not accept Mr Potter’s calculation of the market’s expectation of BBL’s NPAT using the residual income model, which his Honour described as being a little too theoretical and subjective to be regarded as a sound basis for inferring the market’s expectation of future earnings of BBL for the second half of 2008: [256].
Causation
Finally, his Honour concluded that, even assuming it to be open to an applicant to rely on ‘market-based causation theory’ in a case alleging breach of continuous disclosure obligations (about which he expressed doubts), the applicants had not established that, had the information that they alleged ought to have been disclosed, been disclosed, the market price of shares in BBL would have been lower, and thus they had not satisfied a pre-requisite to the invocation of the theory: [386], [388]-[389], [394]-[395].
Comment
Given that the Relevant Period in this case coincided with the global financial crisis, which had hit BBL hard, establishing the materiality of the information that the applicants alleged ought to have been disclosed and the quantification of any share price inflation was always going to be a big ask. As such, it might be that Masters v Lombe is a legacy case that will quickly be forgotten in the wake of its more glamorous cousin, TPT Patrol Pty Ltd v Myer Holdings [2019] FCA 1747 and siblings, Grant-Taylor v Babcock & Brown Ltd (in liq) [2015] FCA 149 and Grant-Taylor v Babcock & Brown Ltd (in liq) [2016] FCAFC 60; 245 FCR 402. It may be a dead letter by the time the appeal from the judgment of Gleeson J in Crowley v Worley Ltd [2020] FCA 1522 is decided.
However, there are a couple of features of the case that may be of interest.
First, his Honour’s approach to liability (and in particular the application of the ‘generated for internal management’ and the ‘insufficiently definite’ exceptions in ASX LR 3.1A) was perhaps more forgiving than that taken by Beach J in Myer Holdings, who was prepared to draw robust inferences, based on the contents of draft documents, that Myer had formed disclosable opinions.[2] That is especially so given that the liquidator of BBL called no lay witnesses (for example, the CFO or members of the board). In this regard, it will be interesting to see how the issue of liability is dealt with in the appeal from Crowley v Worley Ltd [2020] FCA 1522, in which Gleeson J found against the applicant on all aspects of his liability case at trial.
Secondly, even though his Honour’s factual findings undermined the foundation for the applicants’ reliance on market-based causation theory, his Honour expressed misgivings about the application of the theory to a breach of continuous disclosure obligations case even assuming a sufficient factual foundation were established: [390]-[393]. In doing so, his Honour addressed, amongst other cases,[3] Re HIH Insurance Ltd (in liq).[4] In that case, Brereton J accepted that shareholders could rely on ‘market-based causation’ to found claims against the company for releasing misleading information to the market.
However, Brereton J recognised in Re HIH that there were difficulties with the theory, including that it allowed recovery by persons who actually knew the information which was not disclosed and also by persons who would have taken no notice of the information had it been disclosed. His Honour’s solution was to regard the impact of such knowledge or indifference as a novus actus interveniens, for which the respondent bore the onus of proof (see Masters at [390]). Justice Foster considered this solution to be “unsatisfactory”, which possibly indicated a serious problem with the theory: [392].
Further, Foster J noted that the theory did not comfortably accommodate subsequent sales of the shares made at a price that was no less than the price paid for the shares. In other words, it admitted of the possibility that persons who actually suffered no loss could obtain compensation: [393].
Accordingly, notwithstanding Beach J’s obiter conclusion in Myer Holdings that market-based causation theory was available for continuous disclosure shareholder class actions, Masters v Lombe may still offer a refuge for respondents in such actions, at least for the time being.
Daniel Lorbeer is a barrister at the Victorian Bar practising in commercial law, including in class actions.
Liability limited by a scheme approved under professional standards legislation.
[1] Readers will appreciate the similarity here with TPT Patrol Pty Ltd v Myer Holdings Ltd [2019] FCA 1747, a note of which can be found here.
[2] A note of this aspect of Myer Holdings can be found here.
[3] Including ABN AMRO Bank NV v Bathurst Regional Council (2014) 224 FCR 1, Caason Investments Pty Ltd v Cao (2015) 236 FCR 322, Grant-Taylor v Babcock & Brown Ltd (in liq) (2015) 322 ALR 723, Bonham v Iluka Resources Ltd (2015) 107 ACSR 75.
[4] Re HIH Insurance Ltd (in liq) [2016] NSWSC 482; 335 ALR 320. William Thomas’s note of this case can be found here.
