Shareholder claims against insolvent companies: does Sons of Gwalia have implications for New Zealand?

New Zealand's increasingly robust investor protection legislation may be good news for some aggrieved shareholders, but in this article Bell Gully senior associate Tim Clarke outlines why, based on overseas experience, it could also result in a slower, more complicated liquidation process and diluted returns for unsecured creditors.

A recent decision of the High Court of Australia has brought into focus some important issues about the status of shareholders who have claims against insolvent companies.

Background

One of the basic distinctions between an equity investment and a debt investment in a limited liability company is that:

• shareholders participate in the upside potential of the company (through dividends or capital gain) and their exposure to downside risk is limited to the extent of his or her investment in the company's shares; and

• lenders receive a return on their capital contained in the contract governing the debt, subject to the downside risk of losing their principal.

In the event of the company being liquidated, shareholders rank behind creditors in the distribution of the company's assets and are therefore likely to lose some or all of their equity investment. Nevertheless, a person who holds shares in a company may also be a creditor in respect of that company. For example, a shareholder may prove in the liquidation as a creditor where that person brings a claim:

• for recovery of a bona fide loan to the company;

• for remuneration as an employee or independent contractor;

• for breach of a supply contract for the cost of goods sold to the company.

In these examples, the ability to bring a claim does not depend upon the claimant being a shareholder or relate to their shareholding.

The position is less clear cut, however, where a shareholder makes a claim against the company for losses incurred in acquiring shares in the company. The principal objection is that a damages claim for the purchase price of the shares is inconsistent with the shareholder's obligation to contribute capital to the company. As a result, the assets of the company will be depleted to the prejudice of other unsecured creditors.

This issue has assumed some prominence in the context of securities and consumer protection legislation creating statutory remedies for shareholders who either subscribe for securities or acquire previously allotted securities in the secondary market. Under such legislation, shareholders who suffer loss resulting from the company's non-compliance with the regulatory regime may have claims against the company and, to that extent, are contingent creditors as well as shareholders.

Sons of Gwalia case

In Australia, the Sons of Gwalia litigation¹ concerned an application by the administrators of a mining company (Sons of Gwalia Limited) for a declaration that an aggrieved shareholder did not have a provable claim against the company as a creditor in the proposed deed of company arrangement for the purposes of the company's voluntary administration. The claimant, Mr Margaretic, had bought 20,000 shares in the company. Approximately one week later, the company was put into voluntary administration. Mr Margaretic presented a claim to the administrators that the company had failed to disclose that its reserves of gold were insufficient to meet its contractual obligations in terms of on-going delivery contracts. On that basis, Mr Margaretic claimed an entitlement to the difference between the purchase price of his shares and the true value of the shares, which he alleged was nil.

Mr Margaretic claimed that Sons of Gwalia had engaged in misleading and deceptive conduct and breached its disclosure obligations under Australian consumer and investor protection statutes.

The administrators of Sons of Gwalia, Ferrier Hodgson, considered that Mr Margaretic's claim ought to be postponed on the basis of section 563A of the Corporations Act, which provides:

"Payment of a debt owed by a company to a person in the person's capacity as a member of the company, whether by way of dividends, profits or otherwise, is to be postponed until all debts owed to, or claims by, persons otherwise than as members of the company have been satisfied."

The preliminary question of whether Mr Margaretic's claim arose "otherwise than as a member" of the company for the purposes of section 563A was heard at first instance in the Federal Court of Australia. Emmett Justice concluded that the claim arose from the consumer protection legislation rather than from his membership in the company. Accordingly, section 563A did not operate to postpone Mr Margaretic's claim who therefore ranked with other unsecured creditors in the course of the administration.

The administrators appealed to the Full Federal Court, which dismissed the appeal. As in the court below, the Full Federal Court concluded that Mr Margaretic's claim arose from statutory causes of action, as opposed to being conferred by virtue of his membership in the company. Accordingly, the claim did not engage section 563A and could therefore be admitted to proof in the course of the administration.

The administrators appealed to the High Court of Australia, which dismissed the appeal by a majority of six to one. The majority, in separate judgments, rejected the suggestion that the Corporations Act (Cth) embodies a general policy of "members come last" in corporate insolvency and concluded that the expression in section 563A "in the capacity as a member" suggested that shareholders may have claims in a capacity otherwise than as members. Section 563A therefore simply operated to subordinate claims by shareholders qua shareholders, such as a debt owed to a member by way of dividend.

The decision has caused considerable concern in Australia and the Australian Corporations and Markets Advisory Committee (CAMAC) is currently considering the implications of this decision and has called for submissions on law reform options.

Implications of Sons of Gwalia for New Zealand

The Companies Act 1993 does not contain a counterpart to section 563A of the Corporations Act, so there is no equivalent statutory basis in New Zealand for subordinating claims for debts due to shareholders to debts owed to other creditors.

Under New Zealand's statutory framework, a person who acquires publicly listed securities in circumstances where the company has breached its continuous disclosure obligations by failing to disclose materially price sensitive information may have a claim against that company. Therefore, that person might qualify as an unsecured contingent creditor (i.e., that person's claim would not be subordinated to the claims of other creditors in the event of liquidation).

An aggrieved investor would have a number of bases for lodging a claim with the liquidator based on a breach of a publicly listed company's continuous disclosure obligations:

• First, one source of the continuous disclosure obligations for listed companies is the contract between New Zealand Exchange Limited (NZX) and each listed company. Rule 2.1 of the NZX Listing Rules provides that the provisions of the Rules (which form the contractual basis of the relationship between a listed company and NZX) are "enforceable against each issuer for the benefit of every person who is or was a holder of Quoted Securities of that issuer in the period in which the issuer is or was listed, and the Contracts (Privity) Act 1982 shall apply accordingly".

• Secondly, any person may bring an application under the new section 19M of the Securities Markets Act 1988 for a compensatory order against a public issuer that has contravened its continuous disclosure obligations. Under that provision, the court has a very broad power to make compensatory orders.

• Thirdly, a claim may be brought for misleading or deceptive conduct in trade under the Fair Trading Act 1986².

• Fourthly, an aggrieved shareholder may be able to bring a claim at common law for the tort of deceit or for negligent misstatement.

Owing to the potential difficulties in establishing tortious claims for deceit or negligent misstatement, it is likely that many aggrieved shareholders would prefer the more broadly based statutory and contractual avenues for redress under the Securities Markets Act, the Fair Trading Act, and the NZX Listing Rules. This accords with the overseas experience where claims under investor protection legislation tend to be more frequent than common law claims.

Since a New Zealand court is unlikely to create a distinction between shareholders who have a claim as a subscriber of shares and those who have a claim as a transferee of previously allotted shares, it is also likely that a subscriber would qualify as contingent creditors on the following bases:

• the Securities Act 1978;

• pre-contractual misrepresentations that induced the shareholder to subscribe for the shares;

• the tort of deceit; and

• the tort of negligent misstatement.

Where such claims are brought against a company by a body of aggrieved shareholders, there may be significant implications for the liquidation process:

• Complexity. The assessment of claims under either the continuous disclosure obligations by transferees of shares or by subscribers for shares have the potential to create substantial costs and delay for liquidators (and a corresponding diminution in the funds available for distribution to creditors and shareholders).
  
  Evaluating the materiality of information is notoriously complex and requires expert evidence on the hypothetical price implications of releasing information to the market at a particular time. Moreover, information that is not released through the market but has been ascertained, for example, by broker analysts or major shareholders may have been impounded into the price of securities by virtue of trading activity, notwithstanding the absence of disclosure through the market.³
  
  Accordingly, in many cases, it will be appropriate and necessary for the liquidator to refer the matter to the court for a decision on the claim under section 307 of the Companies Act.

• Dilution of recovery. By elevating their position to contingent creditors, aggrieved shareholders will swell the number of creditors, with the result that other unsecured creditors are likely to have their returns diluted. While secured creditors will not be prejudiced by the increased number of unsecured creditors, the implications for unsecured creditors (such as trade creditors) could be very serious, especially in the context of large shareholder claims.

• Voting. Shareholders who elevate their position to contingent creditors will enjoy voting rights in the course of liquidation. This entails some risk that shareholder claimants may affect voting outcomes to the detriment of other creditors, who may have diverging interests. In the context of very large shareholder claims, there is a material risk of shareholders "swamping" the vote.

• Lending strategies. There is potential for this result to have an impact on the debt capital markets and the lending strategies of lenders in an effort to mitigate the impact of the decision.

Future implications

Under New Zealand's statutory regime, a shareholder's claim against a company would not be subordinated to the claims of other creditors in the course of liquidation. Therefore, in terms of pure legal doctrine, Sons of Gwalia does not raise substantial implications for the approach of a New Zealand court.

However, Sons of Gwalia does raise significant concerns about the implications of shareholders elevating their position in the course of liquidation. In this practical sense, Sons of Gwalia is highly relevant from a New Zealand perspective.

In the context of increasingly robust investor and consumer protection legislation, it is likely that more claims will be brought by aggrieved shareholders against companies in liquidation. Based on the overseas experience, it appears that this improvement in the position of misled shareholders will be accompanied by a corresponding increase in the delay and complexity of the liquidation process and a dilution of the funds available to unsecured creditors.

This article is based on a paper Tim Clarke presented at the annual Corporate Insolvency Conference in October and has been adapted with the assistance of Jesse Wilson. To view the paper in full visit our website for the publication "Investor protection for shareholders might come at a cost" or click here.

 

¹ Sons of Gwalia Ltd v Margaretic (2005)55 ACSR 365; Sons of Gwalia Ltd v Margaretic (2006) 149,56 ACSR 585; Sons of Gwalia Ltd v Margaretic [2007] HCA 7

² Note however that when new section 5A of the Fair Trading Amendment Act 2006 is implemented, the Fair Trading Act will not be able to be used to establish liability for a person's conduct if that conduct is already regulated under the Securities Act 1978 or the Securities Markets Act 1988 and the person would not be liable for such conduct under the relevant provisions in those Acts.

³ See Harris and Hargovan "Sons of Gwalia: Navigating the line between membership and creditor rights in corporate insolvencies" (2007) 25 C&SLJ 7 at 28.

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