Settling Gwalia for good

When the High Court handed down the Sons of Gwalia decision in 2007 it ignited an irreconcilable debate about the competing interests of creditors and shareholders and highlighted a conflict between corporate law reforms designed to empower shareholders and insolvency law reforms aimed at making it easier to rehabilitate troubled companies.

Today the minister for financial services, superannuation and corporate law, Chris Bowen, finally cut the Gordian knot created by the Gwalia decision, opting to protect creditors and administrations rather than shareholders of failed companies. That will delight insolvency practitioners and lenders, and deflate litigation financiers.

Bowen said the government would legislate to reverse the effect of the High Court decision, saying that any direct benefits to aggrieved shareholders arising from the judgment were outweighed by the negative impacts on shareholders generally as a result of restrictions on access to debt for companies and increases in its cost flowing from the ruling.

The court had determined that a claim by a shareholder on the basis of misrepresentations by the company wasn't brought in his capacity as a shareholder and therefore wasn't subordinate to the claims of conventional unsecured creditors.

That overturned long-held convictions that shareholders claims ranked behind creditor claims in an insolvency. It provoked a storm of protests from insolvency practitioners and lenders, who argued that not only would allowing shareholder claims to rank alongside those of unsecured creditors diminish the returns to credits and push up borrowing costs, but it would add to the cost and complexity of the administrations.

Creditor claims are generally relatively straightforward to assess. The complexity of trying to establish the validity of potentially thousands of individual claims by shareholders would not only add costs and delays to administrations but, because of their numbers, give shareholder creditors a disproportionate voice in the outcome of administrations.

The case has frequently been cited as an impediment to corporate reconstructions. An attempt by Centro Properties to raise equity, for instance, is said to have failed because of concerns by potential equity providers that their capital would be expropriated by existing shareholders as a consequence of the class actions that had been launched against the company.

At the heart of the debate about Gwalia were, as indicated, two major streams of corporate law reform.

Over the past two decades successive governments have sought to strengthen consumer and shareholder protections and empower shareholders to act as a disciplining force against their directors.

That stems from a view that, in modern large companies, ordinary shareholders have only notional ownership rights and power to direct the company and, in practice, have been more akin to financiers receiving equity returns than owners.

Much of the modern corporate law reform has been an attempt to rebalance the relationship between shareholders and their companies, to give shareholders a greater and better-informed and protected voice in their companies' affairs.

Over the same time frame there have also been significant reforms to insolvency law, in an effort to give administrators a greater prospect of saving companies, rather than simply liquidating them.

Those two major sets of reforms collided in the Gwalia case when the Federal Court decided, and the High Court confirmed, that while a shareholder can't bring a claim against a company in their capacity as a shareholder, they could do so on the basis that they had been misled by the company.

In effect, the plaintiff in the Gwalia case, Luka Margaretic, brought the action as a consumer who suffered loss as a result of misleading and deceptive conduct – Gwalia, it eventually transpired, didn't have the gold reserves to meet its forward sales commitments – rather than in his capacity as a shareholder.

Even the High Court was sympathetic to the view that shareholders knowingly expose themselves to risk in pursuit of profit, whereas unsecured creditors aren't necessarily as informed or empowered. Justice Michael Kirby argued that the risk of being deceived was inherent in an acquisition of shares and outlined how parliament could make it clear that shareholder claims were subordinate to those of creditors.

A review of the implications of the judgment by the Corporations and Markets Advisory Committee laws was similarly divided, although a majority of the committee took the view that shareholder empowerment was more important than the deleterious impacts on administrations and funding costs.

Bowen's decision was part of a larger package of proposed reforms to corporate insolvency laws, including a discussion paper which canvasses the possibility of creating a safe harbour to allow insolvent companies to keep trading while attempting an informal work-out, the adoption of a modified business judgment rule to provide greater protection for directors of companies on the verge of insolvency, and a potential moratorium for insolvent companies while an informal work-out was pursued.

The nature and breadth of the announcement signals Bowen's priorities, regarding trying to make it easier to save failing companies rather than facilitating the recoupment of losses by shareholders of failed companies.

In choosing creditors over shareholders Bowen has shown a preference for the US approach – where there is specific legislation providing for subordination of shareholder claims as part of a general emphasis on salvaging insolvent companies – over the UK approach, where the courts have come to the same conclusion as our High Court.

On balance, while it is a fine judgment, that probably is the right emphasis. There are other avenues for recourse for shareholders and/or the Australian Securities and Investments Commission, who can target directors and their professional advisers and service providers using the misleading and deceptive conduct provisions of both the Trade Practices Act and Corporations Act, rather greatly lengthening the queue of creditors fighting over the remaining pool of corporate assets.

It is also the case that, despite the fears – and the undoubted impact of the uncertainty created by the judgment for corporate reconstructions – the judgment only had implications for a relatively small number of large corporate collapses, where the costs and risks of mounting a class action funded by a litigation financier were justified by the potential returns.