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What do you need to do?Review your position in light of the decision
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John Stumbles
Consultant
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Are misled shareholders now to be treated equally with ordinary creditors in insolvency? For the moment, the answer is yes.
Background
Small shareholder Luke Margaretic had the misfortune to have bought his shares in Gwalia some 11 days before that company went into voluntary administration which rendered his shares valueless. He wished to recover some of his loss based on rights given to him by statute and he made a claim against Gwalia for damages on the grounds that the company had breached its continuous disclosure obligations and, by reason of the non-disclosure, had engaged in misleading and deceptive conduct. The essential question for the decision in the case was whether Margaretic’s claim was to rank equally with other creditors of that company or was to be postponed to its “non-member” creditors under Gwalia’s deed of company arrangement. Section 563A of the Corporations Act subordinates a claim by a person as member to the claims of ordinary creditors and was incorporated into the deed.
The decision
In confirming the decisions of the lower courts, the High Court has now ruled by a majority of six to one that Margaretic was to be treated as a creditor of Gwalia and that, if proved, any claim which he may have against Gwalia was to rank equally with its other creditors.
No difference between subscriber and on market buyer
In reaching these conclusions, the court made some important observations. First, the rights under which Margaretic was claiming were expressly conferred upon him by statute. Secondly, the so-called rule in Houldsworth’s case, namely that rescission of the contract under which the investor acquired their shares was a necessary precondition to any action against the company, was inapplicable. Up until this decision, it was thought that Houldsworth had at least applied to subscribers for shares as distinct from investors who had bought their shares on the open market. Houldsworth was thus an effective procedural barrier, at least for subscriber shareholders, against a claim which they may wish to bring against an insolvent company. Rescission was not available once a company had become subject to insolvency proceedings. Thirdly, and while possibly not necessary for the decision, the court rejected the subscriber/buyer distinction with the result that claims by misled subscribers and on-market buyers should now be treated in the same manner.
Impact on insolvency administrations
Unless the law is changed urgently, the decision presents significant practical problems for current insolvency administrations and future administrations.
Litigation funders will now have an added impetus to bring class actions against insolvent companies.
Such claims may now be expected to be filed on behalf of both on-market buyers and subscribers. The pool of assets previously thought to be available for creditors will now be shared with all classes of misled shareholders, thereby diluting the return available to ordinary creditors.
The decision will also add considerably to the cost of insolvency administrations. In theory, each claim by a misled shareholder will require separate adjudication occasioning delay and costs thereby further reducing the return to creditors. Overall, the general management of insolvency administrations will be made more difficult.
Although it may fairly be said that the High Court decision is correct as a matter of statutory interpretation, when viewed in the light of existing precedent it is legitimate to ask whether such an outcome strikes the right balance between shareholders and creditors. In his dissent, judge Ian Callinan was clearly alert to these considerations when he noted that Margaretic was prepared to invest in Gwalia and take any upside should that company have been successful (a benefit in which ordinary creditors would not share) but that should Gwalia prove unsuccessful his loss should be borne equally by shareholders and other creditors.
Is legislative reform required?
In many respects, such a comment resembles the debate which took place in the United States in the 1970s. Up until that time, in certain circumstances shareholders did rank equally with creditors in insolvency administrations. However, in 1978 section 510 (b) was inserted into the US Bankruptcy Code subordinating shareholder claims associated with their purchase of securities to the claims of ordinary creditors. A provision to similar effect is now being considered by the Canadian parliament.
When the Australian legislatures provided shareholders with additional remedies for misleading and deceptive conduct and more recently for breach of the continuous disclosure rules, no real consideration was given to the impact which these additional remedies would have on the priority of ordinary creditors in insolvency administrations. The Corporations and Markets Advisory Committee should be instructed to prepare an urgent report on the issue addressing the relevant policy considerations.
In October 2005 I suggested such action to the Australian Treasurer. At that time, the federal government did not wish to consider legislative reform until it had “the benefit of further judicial consideration”. This reason is no longer available.
Impact on borrowers
Even though similar principles are applicable in England, it can be expected that the High Court’s affirmation of the decision of the lower courts will result in further criticism from overseas creditors who perceive they are disadvantaged by the decision. When the first Margaretic decision came down in 2005, there were loud complaints from such investors to the effect that Australian borrowers would experience difficulty in accessing overseas markets if shareholders were to rank equally with creditors in the insolvency. It was also suggested that Australian borrowers would be required to pay a higher interest rate to take into account this extra level of risk. Rating agencies will also be concerned.
What should lenders do?
In the meantime, lenders to companies are faced with the dilemma and insolvency administrators with an administrative nightmare. Pending legislative clarification, lenders to both listed and unlisted companies should consider taking security. Alternatively, such potential lenders should consider the provision of the financial accommodation at a level below the holding company so that creditors of the holding company in respect of shares acquired in the holding company are structurally subordinated to the claims of direct lenders to subsidiaries. This could be supported by cross guarantees by other subsidiaries within the group.
However, this approach may be of limited assistance if the group with which a creditor deals has given a class order guarantee. Class order guarantees involve each company in a corporate group guaranteeing the obligations of other companies within the group to external creditors. They are commonly provided to obtain relief from certain accounting provisions of the Corporations Act. If a shareholder has a claim against a holding company and if the holding company is a member of a group which has provided a class order guarantee, then this would be a means whereby those shareholders could obtain access to other companies’ assets within the group and thereby destroy any structural priority accorded to financiers who had lent to subsidiaries within the group.
Extended right of proof
Finally, there is another unexpected but important aspect of the decision. Margaretic’s loss and as a consequence his claim, crystallised on the date Gwalia went into administration. The court found that Margaretic could prove because the circumstances giving rise to his claim (the alleged misleading conduct and resultant loss) arose before the administration commenced. Up until now, there has been no clear decision on this point. However, its implications in other areas could be significant. For example, the claim by an individual against a company in respect of cancer caused by circumstances of his employment (but which does not emerge until after the insolvency proceedings have commenced) may be capable of proof. This possibility raises another set of significant administrative challenges for insolvency practitioners.