Creditors Vs Misled Shareholders: Finding The Right Balance

Introduction

The Federal Government’s Corporations and Markets Advisory Committee (CAMAC) recently released a discussion paper suggesting potential reforms to the Corporations Act 2001 (Cth) (Corporations Act) under which shareholders claiming that they have been misled by a company will no longer need to establish that they relied on misleading or deceptive information when purchasing shares.

The reforms are suggested as a means of strengthening the rights of shareholders who claim to have been misled if the controversial High Court decision in Sons of Gwalia Ltd v Margaretic (Sons of Gwalia) handed down in January of this year is reversed. In that case, the court held by a 6 to 1 majority that shareholders who establish a right to claim damages against an insolvent company for misleading and deceptive conduct or failing to disclose material information are to be ranked equally with other unsecured creditors in the administration of the company’s assets.

The discussion paper also suggests reforms in the event that the law established by the Sons of Gwalia decision is retained, with the aim of addressing several concerns held by critics of the decision.

Sons Of Gwalia Decision

Sons of Gwalia Ltd (Company) was an ASX listed Western Australian gold mining company. In 2004, Mr Luka Margaretic purchased 20,000 shares in the Company for $26,200. Eleven days after Mr Margaretic’s purchase, the Company went into voluntary administration and Mr Margeretic’s shares became worthless.

The Company executed a deed of company arrangement under which distributions were to be made as if the company were being wound up. The deed incorporated section 563A of the Corporations Act, which states that a debt owed by a company to a person in that person’s capacity as a shareholder is to be postponed until all debts or claims of other creditors have been satisfied.

Mr Margaretic commenced proceedings against the Company, alleging that when he purchased the shares the Company had breached its continuous disclosure obligations under section 674 of the Corporations Act by failing to inform the ASX that its gold reserves were insufficient to meet its gold delivery contracts. Alternatively, Mr Margaretic claimed that the Company’s non-disclosure constituted misleading and deceptive conduct.

The High Court held that:

• claims by purchasers of shares who rely on misleading or deceptive information, or material non-disclosure by a company are not claims of shareholders as shareholders within the meaning of section 563A of the Corporations Act; and (as a consequence)
• the claim that Mr Margaretic was making ranked equally with the claims of other unsecured creditors.

The Effect Of Sons Of Gwalia

The decision in Sons of Gwalia is clearly of wide-reaching effect. Administrators have already encountered practical difficulties and increased costs due to the need to consider the claims of shareholders who allege they have been misled before administering the company’s assets. There are also predictions that such concerns will rise in the event of an economic downturn and a resulting increase in insolvencies.

Others argue that the decision fails to strike the right balance between shareholders and creditors. The sole dissenting judge, Justice Callinan, noted that Mr Margaretic was prepared to invest in the Company and profit from any success, a benefit not available to other creditors, yet both parties would be ranked equally if the company were unsuccessful.

A further concern is the potential difficulty for Australian borrowers seeking loans from overseas lenders. These lenders may be put off by the increased risk due to the Sons of Gwalia decision and may choose to place their funds elsewhere, or may demand higher interest rates.

Recent Reform Proposals

In the aftermath of the Sons of Gwalia decision, the Federal Government asked CAMAC to consider whether the decision should be retained in addressing the following questions:

• Should misled shareholders rank equally with other unsecured creditors in an insolvency situation?
• If so, are there any reforms that would allow insolvency administrations to proceed more efficiently?
• If not, are there any reforms that would better protect shareholders from the risk that they may acquire shares on the basis of misleading information?

In September 2007 CAMAC released a discussion paper responding to those questions.

Current law retained

If the current law as determined by the Sons of Gwalia decision is retained, the discussion paper suggests that the efficiency of insolvency administrations could be increased by:

• stating expressly that administrators need not search out and identify those shareholders who may have a claim for the purpose of giving them written notice of creditors’ meetings;
• disregarding misled shareholders in assessing where a creditors’ meeting should be held;
• amending the law to give specific guidance to administrators in deciding how to make a ‘just estimate’ of the claims of misled shareholders in connection with voting at a creditors’ meeting; and
• expediting the process of determining the size of misled shareholders’ claims by, for example, providing for one judicial determination on a common issue.

If the current law is reversed so that claims of misled shareholders are postponed behind creditor claims, the discussion paper suggests compensating shareholders for the loss of rights by making it easier for them to establish that they have been misled. This would involve the adoption of a US-style ‘fraud on the market’ approach.

The ‘fraud on the market’ approach is based on an assumption that in an efficient market, a company’s share price will reflect all publicly available information. Under this approach, shareholders do not need to prove that they personally heard or read the inaccurate information before acquiring the shares. Instead, there is a rebuttable presumption of reliance if it is proved that the misrepresentations or omissions would have caused a reasonable relying investor to misjudge the value of the shares.

This would overturn the current position under Australia law, which requires a shareholder to prove that they relied on misleading information in purchasing the shares.

If the current law is retained and misled shareholders continue to rank equally with unsecured creditors, CAMAC’s suggestions may increase the efficiency of insolvency administrations. However, the proposals do not address the concerns expressed by Australian borrowers that overseas lenders will be reluctant to provide funds or that their cost of funds will be higher.

On the flip side, CAMAC’s suggestion of a fraud on the market approach if the current law is changed would have the effect of taking the law back to the situation that was (perhaps wrongly) treated as the norm prior to Sons of Gwalia. The reality is that it is relatively rare for an insolvency administration to end with a surplus available for distribution to shareholders. Reversing the effect of Sons of Gwalia, albeit with the introduction of a ‘fraud on the market’ approach, will still leave shareholders with deserving claims unsatisfied in all but the rarest of cases.

Moreover, adopting the ‘fraud on the market’ approach could create more problems than it would solve, as the concept would apply to both solvent and insolvent companies. As a result, US-style shareholder class actions, which currently are uncommon in Australia, could become the norm. In a recent development, a shareholder class action against gaming machine manufacturer Aristocrat Leisure will be decided before the Federal Court. The shareholder claim, alleging the contravention of disclosure obligations by Aristocrat Leisure, will give the Federal Court the opportunity to consider whether a ‘fraud on the market’ approach should be adopted.

While a ‘fraud on the market’ approach might benefit shareholders (and plaintiff law firms), at least in the short term, that benefit may well be outweighed by the burden (in terms of both time and cost) that would be placed on companies in contesting these kinds of lawsuits.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.