Background to the class action

In 2018, a shareholder class action was commenced on behalf of persons who purchased ordinary shares in Quintis Ltd (Quintis), an operator of commercial sandalwood plantations, between 31 August 2015 and 15 May 2017, against Quintis, Mr Frank Wilson (Quintis' CEO and Managing Director) and Ernst and Young (EY) (Quintis' auditors in FY15 and FY16).

In essence, the applicants alleged that, among other things:

• Quintis materially overstated the value of its 'biological assets' (i.e. sandalwood trees) in its FY15 and FY16 financial accounts by reason of various inputs adopted in the discounted cash flow model (DCF Model) which it used to value those assets. In particular, it was alleged that the assumptions as to expected production of heartwood (the inner part of the trunk used to produce fragrant oils) per tree ("heartwood yield assumptions") were unrealistic and lacked reasonable foundation.
• Mr Wilson, by joining in the resolutions of the directors of Quintis in the FY15 and FY16 financial reports, represented that those financial reports provided a true and fair view of Quintis’ financial position and performance, and that he had reasonable grounds for making these representations. In doing so, he engaged in misleading or deceptive conduct in breach of the Corporations Act and ASIC Act.
• EY, by issuing an unqualified audit opinion that Quintis' financial reports gave a true and fair view of Quintis' financial position and performance and complied with the relevant accounting standards, engaged in misleading or deceptive conduct in breach of the Corporations Act and ASIC Act.

After a settlement was reached with Quintis, the case proceeded to trial against Mr Wilson and EY.

Liability: misleading and deceptive conduct

The Court found that the heartwood yield assumption that trees aged under 5 years (comprising 60% of Quintis' plantations) would produce 20kg of heartwood at 15 years was unrealistic and lacked reasonable foundation as it did not align with what was being seen in practice. However, the heartwood yield assumption represented only a single, albeit not an insignificant, input into the DCF Model, and its potential impacts on the fair value of Quintis’ biological assets had to be assessed against other inputs used in determining that value. Put it another way, adjustments to other assumptions, such as the assumed oil price, could have offset the impacts of the overstated heartwood yield assumption. Due to the applicants’ failure to establish that a reporting entity in Quintis’ position would have adopted all the same remaining assumptions in the DCF Model (had the heartwood yield assumption been different) Shariff J was not convinced that the fair value of Quintis' biological assets in FY15 and FY16 was overstated, and, therefore, that the respective financial year reports did not comply with the Australian Accounting Standards (Accounting Standards).

Mr Wilson

Shariff J held that by voting in favour of the directors' declarations in the relevant financial reports containing representations as to Quintis' financial position, each director (including Mr Wilson) made those representations in their individual capacity. The declarations “were not qualified in any way and did not contain any statement that one or more directors did not hold the opinions therein stated” ([1218]).

Having found that Mr Wilson made the declarations, Shariff J then turned to whether Mr Wilson had reasonable grounds for making the declarations at the time they were made. Despite the fact that the applicants did not establish that the FY15 and FY16 financial reports overstated the value of Quintis' biological assets, the Court found that Mr Wilson ought to have known that the heartwood yield assumption was unrealistic and, therefore, Mr Wilson did not have reasonable grounds for making the statements in the directors' declarations. While Mr Wilson relied on various expert opinions, including those of EY, in arguing that he had reasonable grounds for making the representations, the Court held that the other information available to Mr Wilson was "sufficient to incline Mr Wilson’s mind, or the mind of a reasonable person in his position" to the conclusion that the heartwood yield assumption was overstated (at [1303]). Accordingly, the Court concluded that Mr Wilson engaged in misleading or deceptive conduct.

EY

EY accepted that by issuing an unqualified audit opinion in each of Quintis' FY15 and FY16 financial reports, it expressly represented that it was of the opinion that both reports complied with the Accounting Standards and gave a true and fair view of the company's financial position and performance. However, EY denied that by making those express representations it also made implied representations that the opinions were held on reasonable grounds and were the product of the application of reasonable care and skill. Shariff J held that by making statements such as “we have audited the accompanying financial report” and “[w]e have conducted our audit in accordance with Australian Accounting Standards" in its audit reports, EY represented "that it had done that which it had been retained to do and in a manner required by the Corporations Act by exercising its professional skill and judgment" ([1394]), and by doing so, made the implied representations.

Shariff J then turned to considering whether EY had reasonable grounds for making the implied representations. His Honour concluded that, based on the requirements imposed on EY as an auditor by the Accounting Standards and having regard to the information available to EY at the time, EY should have recognised that the heartwood yield assumption was overstated in relation to the trees aged under 5. EY's failure to do so, combined with the significant risk of overstating the value of Quintis' biological assets – given the assumption applied to most of Quintis' plantations – led to the conclusion that EY did not exercise the care and skill expected of a reasonable auditor and, therefore, EY failed to comply with the Accounting Standards. Consequently, the Court concluded that EY engaged in misleading or deceptive conduct.

Causation and loss

The applicants' case on causation and loss depended on their ability to prove their counterfactual (alternative) case, being that a hypothetical market participant would have concluded that the correct average heartwood yield assumption was 6-8kg per tree (as opposed to 20kg per tree). The applicants' counterfactual was based on the opinions of their sandalwood expert (Dr Barbour) who formed those opinions by relying on several published studies and trials. Shariff J did not find Dr Barbour's expert evidence to be compelling or persuasive. In particular, the Court held that the studies and trials were of limited use in estimating the heartwood yield of Quintis' plantation – particularly because of the factual difference in the conditions faced by Quintis and those described in the publications.

Nevertheless, the Court briefly considered the applicants' direct and indirect causation cases for completeness.

(1) Direct causation

The applicants argued that they would not have acquired Quintis shares at the time or price that they did, but for Mr Wilson's and EY's conduct. If the applicants' counterfactual case had been accepted, the key question would have been whether they could prove that they would not have acquired any Quintis shares after the counterfactual FY15 Financial report was published. Shariff J observed that this proposition did not align with the applicants' actual investment decisions at all. The applicants engaged in involved multiple transactions over several years, rather than a single transaction upon the publication of the relevant financial reports. Additionally, after the release of the FY16 financial report, all of the applicants' acquired shares were sold for profit via an automated 'stop-loss' mechanism, before more Quintis shares were purchased again. Ultimately, due to the applicants' failure to establish their counterfactual, the Court concluded that the direct causation case could not be answered in the abstract.

(2) Indirect or market-based causation

The applicants also argued that Mr Wilson's and EY's conduct caused the market price of Quintis' shares to be substantially greater than the price they would have traded, had Quintis' true financial position been disclosed. In support of their indirect causation case, the applicants attempted to establish a causal connection between movements in Quintis’ published asset value and its share price over time, using a methodology developed by one of its experts. The applicants' rationale was that because Quintis' biological assets were central to its cash flow, a reduction in those assets would inevitably lead to a proportional reduction in its share price. The Court rejected this logic as being too simplistic and ignorant of the realities of the share market, where different investors take different approaches to forecasting a company's future cash flows and ascribing value to its shares on this basis. For example, the Court noted that some investors may have analysed the market for sandalwood products at the time and assessed Quintis' share value on the basis that only a certain percentage of its assets would generate cash flows, while others could have taken a different view. His Honour observed that the share price of a listed company “reflects the coalescence of the expectations of all the market participants wishing to trade at that time” ([1703]) and cannot neatly be tied to the value of its assets. In these circumstances, his Honour rejected the applicants' methodology and accepted the evidence of Mr Wilson's expert that an event study would have been more appropriate to determine alleged share price inflation.

Key takeaways from the decision

Despite being another case where the applicants in a shareholder class action failed to establish loss and damage, Shariff J's judgment offers significant learnings with respect to both liability, causation and loss including:

• Directors’ declarations (and other documents created by the Board) if signed by each individual director may, depending on the circumstances, be construed as conveying representations made by each individual director.
• It may not be a complete defence for directors to rely only on internal and external expert advice to demonstrate they held reasonable grounds for making certain representations – particularly if there is other evidence available to the directors which may indicate matters to the contrary.
• The applicants’ failure to prove their counterfactual was a complete bar to their ability to recover loss and damage. This continues to be a prevalent issue for applicants (and their solicitors) in shareholder class actions.
• A "no-transaction case" in the context of a shareholder class action requires the applicants to establish that they read and relied on the alleged contravening conduct in deciding to acquire the company's shares, and would not have acquired the shares at all, but for the alleged contravening conduct – taking into account the pleaded counterfactual.
• A share price of a listed company reflects a coalescence of expectations of all market participants trading at the time and is conceptually different to a company's asset value.

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