Commercail Law

4-Jan-2008

The Sons of Gwalia decision вЂ" causing waves or a ripple?

The general disquiet with the decision in Sons of Gwalia is due to its potential to both create increased cost or reduced availability of finance for companies and overturn the debt/equity distinction, says Tim Sheehy, chief executive of Chartered Secretaries Australia.

The High Court decision in the Sons of Gwalia case reinterpreted a longstanding provision of the law, making it easier for shareholders to recover funds in circumstances where they acquired shares as a result of misleading conduct prior to a company becoming insolvent.

In Sons of Gwalia, a shareholder alleged that he had been induced to buy shares in an ASX-listed company as a result of the company’s misleading conduct. The High Court held that the shareholder had the same rights as an unsecured creditor on the subsequent winding up of the company to lodge a claim against the company’s assets for the shares’ loss in value. In this case, the company’s alleged misconduct arose from a breach of its continuous disclosure obligations in failing to advise the ASX of changes in its operations that meant it could no longer operate as a going concern.

At first glance, it would appear that those involved in governance would hail the decision, seeing it as deterring companies from deliberately misleading investors. However, when surveyed by Chartered Secretaries Australia, the majority of respondents signalled that legislators should amend Sons of Gwalia, with 56 per cent supporting a complete reversal of the decision.

There is strong concern that the current law as determined in light of the High Court decision could not only diminish existing creditors’ rights and create uncertainty for external administrators in adjudicating the claims of aggrieved investors, but also split the rights of shareholders, favouring some to the disadvantage of others. The general disquiet with the decision in Sons of Gwalia is due to its potential to both create increased cost or reduced availability of finance for companies and overturn the debt/equity distinction.

Governance professionals are keen to ensure that shareholders’ rights are protected. But they are equally keen to prevent ongoing uncertainty concerning shareholders’ rights, and they see that privileging the claims of aggrieved investors over those of other shareholders would do just this. It is hard to see why recent purchasers of shares with a claim because of inadequate disclosure should have more extended rights than longer-term shareholders who may have sold if such information was disclosed. Nor should the law reduce the opportunity for Australian shareholders and the companies in which they invest to compete with shareholders from other jurisdictions in relation to securing finance.

Potential lenders to any Australian company will be confronted with higher risk on unsecured debts than before. That means interest rates charged on unsecured debt will increase to compensate for the increased risk. On top of that, debt investors, both in Australia and overseas, may be unlikely to acquire some corporate bonds in Australia, as such an investment would heighten their exposure to risk.

The bottom line here is that by affecting the opportunities for Australian companies to obtain debt finance or credit in the US the law disadvantages Australian shareholders, as increased cost or reduced availability of finance would have implications for companies.

And what of the tradition of a debt/equity distinction in a limited liability company, which underpins the operation of capital markets? It has been long accepted that shareholders risk losing their equity investment but can participate in the distribution of dividends and capital gains, whereas creditors can only recover from the company their principal and any interest provided for in the contract. It is difficult to see why shareholders should have a claim to the upside in the event that the company prospers and participation with creditors if it fails, that is, a claim to the upside in good and bad times. Meanwhile, creditors get access to diluted capital reserves in the case of company failure.

Good governance tells us that shareholders should continue to be required to absorb the risk of insolvency as part of the risks they take in acquiring shares, that is, they should be liable for their equity investment if a company fails for whatever reason. Companies fail for multiple reasons, and non-disclosure by directors of price-sensitive information should not be singled out as requiring creditors to underwrite investors’ speculative risks.

Tim Sheehy is the chief executive of Chartered Secretaries Australia. The survey of governance professionals on the Sons of Gwalia decision can be accessed at www.csaust.com.

The facts and issues:

Sons of the Gwalia Ltd was a gold mining company listed on the Australian Stock Exchange (ASX). The plaintiff shareholder purchased shares in the company on the ASX. Shortly thereafter, the company went into voluntary administration and the value of the shares held by the shareholders was reduced to nil. The company subsequently executed a deed of company arrangement arising from the voluntary administration that provided for distribution from the company’s assets to take place in the same order of priority as would apply if the company were being wound up. The relevant cause in that deed expressly incorporated s 563A, to rank payments to shareholders in their capacity as members behind of all other corporate debts and claims against the company.

The shareholder commenced an action against the company, claiming that at the time of his share purchase the company was in breach of the continuous disclosure requirements, in that the company had failed to notify the ASX that it’s gold reserve were insufficient to meet its gold delivery contracts and therefore it could not continue as going concern. Alternatively, the shareholders claimed that, in consequence of the non-disclosure, he was a victim of misleading of deceptive conduct by the company, involving breaches of s 52 o the Australian Securities and Investments Commission Act 2001.

The shareholder claimed to be entitled to compensation from the company for the difference between the purchase price of his shares and their value after the company went into voluntary administration, there were other shareholder with similar claims.

The shareholder lodged a proof of debt with the administrator. The issue for judicial determination was whether the shareholder should be admitted as an unsecured creditor