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Article Excerpt
[In Sons of Gwalia, the High Court of Australia found that shareholders who had been allegedly induced into purchasing shares in a company shortly prior to its insolvency by misrepresentations and inadequate market disclosure were able to lodge claims as creditors in the company's voluntary administration. The High Court interpreted the statutory subordination provisions in the Corporations Act 2001 (Cth) narrowly, with the result that many shareholders will be permitted to stand alongside non-shareholder creditors (as contingent creditors) in corporate insolvencies. Whilst this has the effect of diluting the returns to unsecured creditors, it also reinforces the importance of corporate disclosure and other consumer protection laws by providing misled shareholders with a remedy during the company's insolvency. This case note discusses the High Court's decision and comments on where the ruling fits into the broader corporate insolvency landscape. The case note then looks to the future to comment on where the law of shareholder subordination may be headed.]
CONTENTS I Introduction II Background to the Decision A The Facts B A Short History of the Legal Issue 1 The Media World Decision 2 Sons of Gwalia Ltd (admin apptd) v Margaretic 3 The Concept Sports Litigation 4 Sons of Gwalia Ltd v Margaretic III The High Court Decision .... A Should Section 563A Be Limited by Houldsworth? B The Maintenance of Capital Doctrine C The Role of Investor Protection Laws D Policy Issues E Alternative Legislative Models IV Implications V Commentary A Observations on Law and Policy B The Way Forward C Rejection of Blanket Subordination D Limited Shareholder Subordination E The Need for Law Reform F Evolution or Revolution? VI Conclusion
1 INTRODUCTION
The classic decision in Salomon v Salomon & Co Ltd ('Salomon') (1) is authority for the proposition that a properly registered company is a separate legal entity from its owners (the shareholders) and managers (the directors and executive officers). Despite the longstanding place of Salomon in Australian corporate law, (2) the ramifications of the separate legal entity principle have still not yet been fully absorbed by the business or legal communities. One of the important consequences of Salomon is that shareholders, regardless of their control through share ownership, are not to be equated with the corporate entity. (3)
This separation between the corporation and the shareholders has been facilitated by the legislative protection of limited liability for shareholders and the increasing size and importance of equity capital markets. The limited liability of shareholders allows the creation of diversified investment portfolios, which, when combined with the increasing activity of share market trading, has greatly contributed to a dispersed share ownership in most publicly traded corporations. (4)
The social, economic and legal climate has, since the first general private corporations legislation in 1862, (5) undergone dramatic transformation. (6) In recent times, government policies have favoured encouraging even greater private investment in businesses through the large pools of investments accumulated in superannuation and the 'Future Fund'. (7) As part of the changing economic landscape, the superannuation industry has become a 'permanent and essential' feature of the Australian financial system. (8) The Chairperson of the Australian Securities and Investments Commission ('ASIC') has recognised that '[n]ow, more than ever before, consumers must have confidence in the market in which they are investing and must be in a position to make informed decisions about what to invest in.' (9)
However, if equity capital markets are to operate efficiently, market investors must possess accurate information about the companies traded on the market. Indeed, the efficient market hypothesis involves the principle that market prices reflect the value of companies based on all of the available information. (10) Therefore, Australian corporate laws have generated a plethora of corporate disclosure requirements to ensure that price-sensitive information is released to the market in a timely manner and remains accurate. These requirements include continuous disclosure (11) and transaction-specific disclosure obligations. (12) The rules formulated in these disclosure laws are enforceable by a range of both public and private remedies. (13)
However, the creation of private remedies for defective disclosure generates a tension with longstanding priority rules in insolvency. Where a company enters insolvent administration, the law has a well-established system of priorities that favours unsecured creditors over members of the company (that is, shareholders). (14) Members of a company are prohibited from lodging proofs of debt if they have outstanding amounts owed to the company. (15) Furthermore, s 563A of the Corporations Act 2001 (Cth) prohibits the payment of debts owed to members, in their capacity as members, before creditors' claims have been fully satisfied. If the company is insolvent, it is therefore likely that debts owed to members will not be repaid, because an insolvent company is, by definition, unable to satisfy all of its creditors' claims with its assets.
There is an inherent tension involved in granting investors' rights to enforce proper disclosure practices and compensatory remedies for breach of those disclosure requirements on the one hand, with the subordination of debts owed to shareholders in insolvency on the other. After all, it is during the company's insolvency that shareholders misled into buying into a failing company by inaccurate, or even fraudulent market disclosure practices, will require protection as their investments will be lost as a result of the company's insolvency.
Several recent decisions have examined the scope of the rules subordinating shareholder claims in insolvency. The pinnacle of these developments has been the recent decision of the High Court of Australia in Sons of Gwalia. (16) That case decided that shareholders claiming damages for statutory misrepresentation which induced their purchase of shares over the secondary market were not owed a debt in their 'capacity as a member' (17) and therefore were not subordinated by s 563A. This decision allows shareholders of companies that breach corporate disclosure requirements to claim status as contingent creditors in corporate insolvency.
The implications of the High Court's decision in Sons of Gwalia are immense and are discussed below in Part IV. While the elevation of the status of shareholders to that of unsecured creditors where they have claims in certain circumstances for damage caused by defective disclosure practices has been welcomed by shareholder groups, it has drawn adverse reactions from other sectors of the commercial community. (18) Certainly, loud calls have been made in the media for law reform that models Australian insolvency law along the lines of [section] 510(b) of the United States Bankruptcy Reform Act (19) with its clear emphasis on a 'members come last' policy. The polarised reaction to Sons of Gwalia, together with the strong dissent of Callinan J, further demonstrates that parliamentary intention regarding the appropriate delineation between the rights of creditors and investors during insolvency remains unclear. This has led to the matter being referred to the Corporations and Markets Advisory Committee ('CAMAC'), which has been asked to consider what should be the appropriate balance between investor and creditor rights in insolvency, and will be discussed below in Part V.
The aim of this case note is to examine the High Court's reasoning in Sons of Gwalia and to discuss the possible impact of the decision on Australian corporate law. Furthermore, we will comment on the possible future development of the law regarding the treatment of shareholder claims in insolvency. However, first it is appropriate to discuss briefly the decisions of the lower courts leading to Sons of Gwalia, and other related cases, in order to properly contextualise the High Court's decision.
II BACKGROUND TO THE DECISION
A The Facts
The Sons of Gwalia litigation involved a damages claim made by a shareholder (Luka Margaretic) of the Sons of Gwalia Ltd gold mining company, a publicly listed company on the Australian Stock Exchange ('ASX'). The damages claim was based upon allegedly misleading or deceptive conduct and a failure to comply with the company's continuous disclosure obligations. The relevant conduct involved statements made by the company's management to the ASX regarding the level of the company's gold reserves. The accuracy of this information was relevant in the following way. The company had entered into a number of gold forward contracts, which required the company to supply gold to various parties in the future. However, the price of gold had risen dramatically. This would result in the company suffering substantial losses if it had to buy gold on market to satisfy its forward gold delivery contracts. The company, with its gold reserves being inadequate, found itself in this worst case scenario. The company subsequently announced that its statements regarding the gold reserves were incorrect. The share price collapsed, with disastrous consequences. The company could no longer continue as a going concern, prompting the directors to appoint a voluntary administrator. Subsequently, the ASX removed the company's shares from the official trading list, which reduced the value of Margaretic's share investment to zero.
Margaretic lodged a proof of debt with the company's administrators, claiming that the company's incorrect statements breached market disclosure laws, (20) including the obligation not to engage in misleading or deceptive conduct, (21) and had induced him to purchase shares in the company. His compensation claim sought to recover the cost of his shares plus brokerage (approximately $20 000). Margaretic's claim was supported by the publicly listed litigation funder, IMF Ltd.
The administrators rejected Margaretic's proof of debt and sought court declarations in the Federal Court that his claim was either prohibited by the rule in Houldsworth v City of Glasgow Bank ('Houldsworth'), (22) or was otherwise subordinated by s 563A of the Corporations Act 2001 (Cth). Margaretic filed a cross-claim seeking a declaration that he was a creditor for the purposes of the company's voluntary administration and was therefore entitled to vote at the creditors' meeting. The administrators' actions were part of a test case to decide on the status of close to 1000 shareholders in a position similar to that of Margaretic. The findings of the trial judge and the appeal court in the Sons of Gwalia litigation in the Federal Court are outlined below. (23)
B A Short History of the Legal Issue
The High Court's decision in Sons of Gwalia is significant because it overturns the conventional view that shareholders should not be permitted to prove in a winding up in competition with the rights of non-shareholder creditors. This view is encapsulated in the rule in Houldsworth which prohibits shareholders who have not rescinded their shares and removed themselves from the register of members prior to the winding up from proving in a winding up until creditors' claims are fully satisfied. (24) The rule in Houldsworth had been accepted in Australia for the past 120 years, and was applied in the past by a differently constituted High Court in Webb. In that case, the majority of the High Court ruled that subscribing shareholders involved in the collapse of the Pyramid Building Society could not lodge proofs of debt in the company's liquidation due to the equivalent of s 563A, which the Court said embodied the rule in Houldsworth. (25)
However, in 2004, doubts began to develop among some members of the judiciary about the continuing application of Houldsworth in Australia. The doubts arose out of obiter comments made by Finkelstein J in Re Media World Communications (admin apptd) ('Media World'), (26) where his Honour stated that Houldsworth only applied to shareholders who subscribed for shares from the company, and did not apply to transferee shareholders who purchased their shares over the secondary market. These comments were soon picked up in the subsequent Cadence Asset Management Pty Ltd v Concept Sports Ltd ('Concept Sports') (27) class action and ultimately the Sons of Gwalia litigation.
In order to better appreciate the significance of the High Court's reasoning in Sons of Gwalia, it is appropriate to highlight the case law developments that preceded the High Court's decision.
1 The Media World Decision
In this case, the voluntary administrator of the Media World Communications technology company sought directions in the Federal Court in relation to subscribing shareholders who claimed damages as a result of alleged misrepresentations made by the company in its prospectus. The administrator applied for directions that the shareholders were precluded from lodging proofs of debt as a result of the rule in Houldsworth. (28) Finkelstein J granted declarations that the subscribing shareholders were not 'creditors' of the company and could not, therefore, lodge a proof of debt in the company's administration. (29) The rationale for the decision was founded on the rule in Houldsworth which prevents a shareholder from seeking damages without first rescinding their shareholdings (which is impossible once the company becomes insolvent). (30)
Having granted the declaration, Finkelstein J then addressed a further question raised by the administrator regarding the status of transferee shareholders. This was, of course, strictly obiter given the initial order was already granted, and there were in fact no transferee shareholders that had sought to lodge proofs of debt. However, his Honour stated that any transferee shareholders that may come forward would not fit within the scope of the rule in Houldsworth, and would not therefore be prevented from lodging a proof of debt. (31) This was based on the fact that a transferee shareholder could not rescind their share purchase because their contract was not with the company, but with another shareholder. Secondly, the rule in Houldsworth is based (at least in part) on the maintenance of capital doctrine, and (so stated his Honour) a claim for damages by a transferee share holder does not involve a reduction of capital so the company's creditors are not prejudiced. This point drew support from the House of Lords' decision in Soden v British & Commonwealth Holdings plc ('Soden'), (32) where it was held that a transferee shareholder is not subordinated under the English equivalent of s 563A.
The decision in Media Worm created a storm of controversy, with major corporate debt providers arguing that allowing transferee shareholders to claim as unsecured creditors would substantially dilute returns. (33) This, they alleged, would make unsecured lending more risky and would raise the cost of corporate debt in Australia, particularly from US lenders because the US Bankruptcy Code strictly subordinates both transferee and subscribing...
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