Sons of Gwalia Restoring the Balance

In 2007, the High Court in the landmark decision of Sons of Gwalia v Margaretic determined that certain compensation claims by shareholders against an insolvent company were not subordinated to the claims of other creditors, and ranked equally with unsecured creditor claims.

For the first time, unsecured creditors of listed companies in an insolvency process faced the prospect of substantially reduced recoveries as they would potentially have to share the company’s insufficient assets with its shareholders. That risk manifested where shareholders claimed they had been misled by a company’s failure to meet its disclosure obligations when they acquired or dealt with their shareholdings.

On 19 January 2010, Minister Bowen announced that the Government would amend the Corporations Act to reverse the effect of the High Court’s decision in Sons of Gwalia.

The Government’s initiative is a victory for common sense and reinstates a fundamental principle of insolvency. The majority of the High Court in the Sons of Gwalia decision had adopted a strict reading of s563A of the Corporations Act, and in doing so, upset the long-accepted principle that shareholders rank behind creditors in an insolvency, even if those shareholders can establish a claim against the company for being misled.

Some commentators, and even surprisingly, the Corporations and Markets Advisory Committee itself, had expressed support for the Gwalia decision. Some of this support appeared to be based on the view that the decision reinforced corporate disclosure obligations. In our view, that was misguided. The effect of Gwalia was to adversely impact a company’s creditors − it did nothing to reinforce the obligations on directors to ensure a company meets its corporate disclosure obligations. That is quite properly dealt with in other sections of the Corporations Act and not by varying the distribution principles upon which creditors rely and which insolvency law is based.

It is not only unsecured creditors who will benefit from the Government’s welcome move to overturn the effect of the Gwalia decision. Other key stakeholders, from secured creditors to employees, will experience more efficient insolvency administrations of listed companies and the increased prospect of implementing a restructuring in a timely fashion. The delay and expense associated with dealing with thousands of potential shareholder claimants was amply demonstrated in the Sons of Gwalia administration where, following the High Court’s decision, shareholder claims of some $450 million were admitted to compete with the claims of the unsecured creditors, substantially reducing creditor returns.

Andrew Love from Ferrier Hodgson, one of the administrators of Sons of Gwalia, estimates that the cost and complexity of dealing with and adjudicating the claims of thousands of shareholder claims was greater than $5 million and added around 12 months delay to the administration of the estate. Mr Love commented that this complexity and expense arose in part because of the many variations of claims from individual shareholders, each of which had to be separately adjudicated. Needless to say, Mr Love also welcomes the Government’s
steps to amend the law.

As a direct consequence of the Sons of Gwalia decision, many other claims were instigated through class actions organised by litigation funders. Numerous claims have been asserted against companies already in insolvency, and also companies in the process of restructuring attempts. It is clear that the impact of Sons of Gwalia was not isolated and was having, and would continue to have, a substantial impact on financially distressed listed companies, both inside and outside a formal insolvency process.

Market commentators and stakeholders have already substantially covered the adverse effects of the Gwalia decision including that it brought us out of step with the other key countries, increased the cost of credit, discouraged foreign investment and increased the use of secured finance. Certainly, our experience of trying to describe the effect of the decision to our offshore clients was frequently met with disbelief and incredulity. Now the Government has announced its decision, hopefully these concerns will be confined to history.

There remain however, some critical questions on how the legislation will be implemented. These include the following.

  1. Timing – when will the legislation be introduced and to what matters will it apply?  To what extent, if any, will the amendment be retrospective? Will it be operative only to affect those companies already in administration at the time of the Minister’s announcement on 19 January 2010 or only from the time the legislation is passed? Will the old law continue to apply where claims have actually have been brought or alleged by shareholders by one of those dates? These questions may have significant implications for companies such as Centro Properties, which currently has a substantial class action being pursued in the court against it whilst being in the midst of an ongoing debt restructuring. 
  2. Subordinated Creditors – should the principle of subordination for shareholders in respect of misleading claims or aggrieved shareholder claims also be applied to subordinated debt? That is, would a creditor who has contractually agreed to be subordinated to unsecured creditors within the terms of s 563C of the Corporations Act be able to bring a misleading or deceptive claim against the company that ranks equally with the general unsecured creditors and effectively unsubordinate that debt?
    Although the justification for ensuring the continuing subordination of subordinated debt providers is less compelling than with shareholder claims, there is no reason why the principle should not be extended in this way. It is merely a further application of the principle of “no queue jumping for subordinate creditors” where they claim to have been misled into acquiring their securities.
  3. Derivative Claims – if shareholders sued a third party for their loss for being misled into acquiring shares (ie an auditor or promoter), and that third party then cross-claimed against the insolvent company for contribution, should that contribution claim by the third party (being based on a shareholders claim) also be subordinated? This is a complex issue and also requires consideration of the operation of the proportionate liability legislation. In theory, however, not capturing this concept in the legislation could lead to a situation where shareholders were receiving distributions from an insolvent company equally with unsecured creditors, albeit through derivative claims of third parties.
  4. Subsidiary Claims – should the claims of shareholders be subordinated in circumstances where a claim is made that the subsidiary participated, and is therefore liable, in the provision of misleading information by the listed parent which is said to cause the shareholders’ loss? An example would be where a claim is made against an operating company which is a subsidiary of the listed entity. Obviously, the consequence of not subordinating any such claims would be to potentially undermine the principle of shareholder subordination in most corporate groups, however, that said, it would be difficult for an operating subsidiary to be sued by a parent company’s shareholders as the disclosure obligation vests solely with the listed parent.

Each of these questions should be carefully considered in framing the legislation overturning the effect of the Sons of Gwalia decision. If the intention of the Government’s announcement was simply to return to the legal position prior to Sons of Gwalia, then it may be unlikely that the amendment will deal with issues 2 to 4 above. However, this would be a lost opportunity if the different situations in which the Sons of Gwalia issue might manifest itself are not carefully considered.

The US Bankruptcy Code expressly deals with questions 2 to 4 in the affirmative. The US Code is aimed at enshrining the position that an investor stays in their section of the capital structure of the company notwithstanding claims they may have for being misled into acquiring (or even holding) those securities or shares. So the effect of these provisions is that a shareholder (or other subordinate security holder) remains subordinated to claims of unsecured creditors and cannot elevate their claim through derivative claims or other tactics. Such a legislative approach is based on a risk/reward analysis of investing. In addition, and very importantly, it limits the cost, expense and practical difficulties for insolvent estates associated with investors (sometimes in their thousands) attempting to jump up the capital structure by asserting such claims.