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Introduction
The controversial High Court decision in Sons of Gwalia Ltd v Margaretic,1 which permits claims brought by shareholders to rank equally with those of unsecured creditors, has promoted shareholder claims, including class actions, while challenging certitudes in the corporate entity and debt capital markets, the role of investor protection laws in corporate regulation and the process of conducting external administrations.2
On 19 January 2010, almost three years after the High Court's ruling, the Government announced its intention to reverse the effect of the decision in order to prefer claims by creditors to those of shareholders in the event of a corporate collapse. This, in addition to other proposed reforms on restructuring the company and a "moratorium" period, signifies a positive development for company directors, giving them more protection when faced with the need to restructure a financially troubled company.
Australian company law has in recent times seen an extension in scope for shareholder claims against corporations, and enforced most of their rights in corporate insolvencies – at the expense of unsecured creditors – so it is significant that the government has taken action to keep private class actions by shareholders within bounds so that they do not threaten the efficiency of securities markets and the insolvency regime.
Action for shareholder loss
In more recent times, certain rights of action against a company have been conferred on shareholders under the provisions for the protection of investors and consumers generally.3 That is, as well as the positive requirements of continuous disclosure of materially price-sensitive information, Australian securities legislation provides a great deal of scope for private enforcement by shareholders to impose civil liability on disclosing entities in various situations, including where shareholders have suffered loss to the value of their shares through the misconduct of the company.
Both the Corporations and the ASIC Acts include broad prohibitions on misleading and deceptive conduct. These Acts adopt the civil misleading and deceptive conduct provisions originally contained in the Trade Practices Act 1974.4 The prohibitions have a very wide ambit, are not fault based and permit any shareholder who has suffered loss through a breach of these provisions to claim damages from the company in breach and also against any person who was involved in the breach. They have led, in recent years, to increased litigation by disgruntled shareholders against the corporation, often utilising the procedural machinery for the commencement of a class action, contained in Part IVA of the Federal Court of Australia Act 1976.
The Sons of Gwalia decision
The treatment of claims by shareholders under such investor protection provisions in an external administration were considered in the Sons of Gwalia litigation, a claim that arose out of the fraudulent representations that surrounded the purchase of shares. The shareholder in this case, Luka Margaretic, bought 20,000 shares on market in Sons of Gwalia Ltd (Company) on 18 August 2004. Administrators were appointed to the Company 11 days later, rendering shares in the Company worthless on the open market. Mr Margaretic claimed compensation from the Company for failure of its disclosure obligations to the market on the basis that, had it made adequate disclosure, he would not have purchased the shares.
The High Court, by 6:1 majority (Callinan J dissenting), held that Mr Margaretic was at least eligible to prove his claim for damages in the liquidation and, if his claim were admitted, it would rank equally with the claims of other unsecured creditors. In doing so, the Court adopted a statutory interpretation of s.563A of the Corporations Act 2001 (Cth) (Corporations Act) which construed such debts as falling due to the member under "the statutory contract" or by virtue of membership, including the entitlements of members conferred by the Act such as dividends or profits, or other sums constituting the ordinary revenue (and possibly the capital) of the company. They were not claims based on rights conferred outside the Act for false and misleading conduct.
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Restoring the efficiency of the insolvency regime
There is no doubt that Sons of Gwalia imposed significant delay and costs on the efficiency of an external administration, thereby further reducing the return to other unsecured non-shareholder creditors. Increasing the potential for shareholders to initiate class actions and securities fraud litigation during the insolvency process left administrators with a vast increase in both potential proofs of debt and monstrous practical problems (generally, each of liability, reliance, causation and quantum) requiring resolution.
To address the potential threat to the efficiency of the administrative process of winding up of the insolvent company, the Federal Government reversed the effects of Sons of Gwalia as part of a set of more extensive reforms to corporate insolvency laws. The other proposed reforms to corporate insolvency also include:
1. a relaxed "business judgment rule" giving greater protection to directors, who would not be deemed
to have breached their duties of trading whilst insolvent if they attempted to restructure the company
based on a "true and fair picture" of the company's financial accounts; and
2. a "moratorium" period in which directors would be able openly to inform the market that their
company was insolvent for the purpose of attempting a reorganising the company outside of external
administration.
The Government's decision to overturn the Sons of Gwalia ruling comes despite recommendations made by the Corporations and Markets Advisory Committee (CAMAC) and the corporate regulator, ASIC, essentially supportive of the High Court's decision. CAMAC was asked to consider whether any reforms were needed and what, if any, additional shareholder protection might accompany such reform. The majority of the Advisory Committee recommended that the law remain unchanged, taking the view that "any move to curtail the rights of recourse of aggrieved shareholders where a company is financially distressed could be seen as undermining legislative initiatives to provide shareholders with direct rights of action in respect of corporate misconduct".5 The ASIC Commissioner, in her submission to the Advisory Committee, agreed that shareholders should not bear the risk of corporate misconduct.
Although the majority of the High Court ultimately decided in favour of shareholders, several judges commenting on the modern trend towards enhanced investor protection in the Australian corporate landscape recognised the competing policy considerations relevant in weighing up consumer protection for shareholders and practical implications for insolvency law.6 Of course, the general nature of this policy conflict has fundamentally changed once again following the Government's reversal of the Sons of Gwalia decision.
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Absorbing the costs of contravening conduct
It is a well accepted principle of corporate law that shareholders provide capital for shares understanding that they are exposing themselves to risk of loss. At the same time, as a group, they benefit if the entity proves to be profitable. Should shareholders have a claim to the assets of a corporation, in participation with creditors, if it fails rather than prospers? Companies fail for multiple reasons and, arguably, this should not require creditors to underwrite investors' speculative risks.
An alternative approach would categorise this group with creditors: each invests for gain and there is no reason in principle (although there may be practically in equity markets) to differentiate.
Present insolvent trading laws impose a high standard on directors when their companies face financial difficulty. If found to be in breach, directors are exposed to personal liability for any debts incurred for trading whilst insolvent with the prospect of both civil and criminal penalties. To supplement the insolvent trading provisions, Australia has a regime of mandatory disclosure in place that is aimed at reducing fraud and enhancing the efficiency of the market. Directors are also exposed to civil liability for aiding and abetting a contravention of the disclosure regime. The price of this regime is paid by companies through the cost of compliance, and thus, by shareholders through the resulting reduction in equity returns. Responding to the concern that a shareholder is a victim of misleading and deceptive conduct and therefore deserving of protection in insolvency, Justice Kirby in Sons of Gwalia argued that an investor engages in a risk that is inherent in the very acquisition of shares in a company by which that investor has become a member.7
Nonetheless, there has been judicial support in Australia for the idea that the absorption by shareholders of losses caused by illegality is unfair. This was of course illustrated by the majority's finding in Sons of Gwalia that Margaretic was not claiming in his capacity as a shareholder, but rather as a market participant with statutory rights to damages for improper disclosure practices. By arguing against shareholder subordination, the High Court in Sons of Gwalia sought to reformulate the traditional perception as to the kinds of losses appropriate for a shareholder to absorb.
In comparison, in the case of Enron members with stockholdings in the corporation lost their investment as a direct result of the misconduct of its fraudulent executives. Despite the potentially harsh consequences for shareholders, the US Bankruptcy Court was eloquent:
”Equity favours general creditors rather than the allegedly defrauded securityholders in bankruptcy for the simple reason that, inasmuch as the securityholder enjoys the benefit of share price gains, he should also bear the burden of insolvency, whether such insolvency is the result of fraud or not".8
In announcing its decision to subordinate claims by shareholders to claims by creditors in insolvency, the Government has shown a preference for that US approach; salvaging insolvent companies is assisted by legislation specifically subordinating shareholder claims, irrespective of the conduct of the corporation, and so given proper recognition to the present mechanisms regulating the securities market and adequate disclosure of material information by public companies. It has placed its faith in the protection afforded to investors by the Corporations Act and the courts – shareholders will not be empowered at the expense of legal certainty and the efficiency of the insolvency regime.
Implications
Litigation funder IMF (Australia) Ltd says that the practical affect of the government's action will be limited. IMF has suggested that, because it is unlikely that the government will introduce retrospective legislation, none of the securities claims currently on foot will be affected and in any event the number of companies caught by the Sons of Gwalia ruling in the future would have been minimal.
Indeed, IMF asserts that "in circumstances where an insolvent company has insurance against causing damage by non-disclosure it is the current law that the benefit of that insurance flows solely to the persons suffering that damage".
Thus, the effect of the government's decision may well be that shareholders, backed by litigation funders, will instead attempt class actions only against directors (to implicate their insurers) rather than companies themselves. If there is any satisfactory policy response, shareholders will not rank alongside creditors in the general pool of assets,9 but will have access to quarantined insurance funds pursuant to s.562 of the Corporations Act.
For insurers, the Government's decision is likely to prove useful where securities cover has been taken out and it is unlikely materially to increase the number of successful claims against directors.
Conclusion
On balance, the Federal Government's important decision to overturn the Sons of Gwalia decision, in conjunction with the other proposed reforms, is a sensible one that places the right emphasis on protecting directors acting in the best interests of companies capable of being rescued from a formal insolvency, in good faith and with appropriate care and diligence some respite from the threat of personal liability for insolvent trading. In so doing, the government has addressed concerns as to whether the High Court's emphasis on shareholder rights in this case was, or ought to have been, permissible. Going forward, it will be interesting to see how the changes to the provisions that have governed the corporate sector from some time will be drafted; which of the current insolvency reform proposals will be enacted; and whether the government will initiate any amendments to the substantive laws that potentiate with the class action procedure.
Further Information
James Tully | Special Counsel
+61 3 9269 9187
jtully@landers.com.au
Eliana Katsavos | Lawyer
+61 3 9269 9445
ekatsavos@landers.com.au
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1 [2007] HCA 1
2 Corporations and Markets Advisory Committee (CAMAC), 'Shareholder Claims Against Insolvent Companies – Implications of the Sons of Gwalia decision', Discussion Paper, September 2007, at http://www.camac.gov.au
3 Ibid.
4 Section 1041H of the Corporations Act 2001 (Cth), section 12DA of the ASIC Act 2001 and section 52 of the Trade Practices Act 1974 are commonly referred to collectively as the 'Consumer Protection Provisions'.
5 n 2.
6 [18], per Gleeson CJ
7 [110 and 111]
8 Re Enron Corp, Case No 01-16034
9 An action against directors may arguably not come within the administration or liquidation in any event.
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