LEGAL SCHOLARS in several countries are now questioning whether the High Court’s Sons of Gwalia decision equating shareholder claims with unsecured creditors in insolvencies means legislators should reconsider assumptions on the allocation of risk in insolvencies.
At least one is also warning that should the government choose to override the decision and explicitly subordinate shareholder claims in legislation, it may in fact further expose directors to personal liability via a relatively obscure part of the Corporations Act.
Dr Janis Sarra, associate dean of the Faculty of Law at the University of British Columbia, told a meeting of corporate law teachers in Sydney this month that risk allocation at the point of insolvency was at the heart of the debate.
“Insolvency law allocates risk by the imposition of a hierarchy of claims to the estate of the insolvent or bankrupt firm,” she said.
“It is uncontested that in the ordinary course of business, equity claims come last in the hierarchy of claims. What is less clear is whether this should encompass all equity claims or whether claims arising from the violation of public statutes designed to protect equity investors ought to be treated differently.”
Following the collapse of the tantalum and gold producer, Sons of Gwalia in late-2004, 5,304 shareholder claims were made claiming combined damages of $242 million for violations of securities, corporate and trade practices legislation.
Dr Sarra explained that the case only established that shareholders will be treated equally to other unsecured creditors when they make a claim for corporate misconduct. She said the case had caught the attention of lawyers and legislators around the world as it ran counter to long-accepted conventions in many jurisdictions.
However, she said several countries do accept “parity” for shareholders with creditors, and Japan, Greece and Mexico had codified this policy. She stressed each jurisdiction has quite different regimes, however, and what works for one won’t necessarily be relevant for another jurisdiction.
In Canada, she said they were moving to a regime that subordinates all shareholder claims. She said in policy discussions she had been involved in, there had been little heed paid to the basic hierarchy of claimants, as it was assumed this had long been settled.
But she said it may now be worth reconsidering those assumptions and the differing capacities to take on risk between equity holders and creditors. “Institutional investors, [for instance], have a greater ability to monitor corporate governance,” she said. “The players that are at the table who are typically creditors may have already fully hedged their debt.”
Under the US Sarbanes-Oxley Act, she said the Securities Exchange Commission can “go after” companies and require them to pay penalties for breaches that are then allocated to equity investors.
According to another academic, directors should also be paying attention to a relatively obscure part of the Corporations Act.
In a paper presented to the Corporate Law Teachers Association conference held in Sydney this month, Dr Sheelagh McCracken from the Macquarie University Applied Finance Centre said section 197 may feature much more in conversations about corporate governance.
“If shareholders with misleading misconduct claims against a company are now to be regarded as creditors, section 197 may enable them to sue these directors personally,” she said.
“If this is the outcome in the aftermath of Sons of Gwalia, the potential impact on corporate governance makes it necessary to consider whether, as a matter of policy, these shareholders should be able to bring such claims. These claims are unlikely to have been contemplated by those who drafted section 197.”
Dr McCracken said that if the result of the ongoing inquiry into the High Court decision by the Corporations and Markets Advisory Committee was that the government should make amendments to the law making it clear claims for corporate misconduct from shareholders are subordinate to unsecured creditors, this may actually encourage the claimant to sue directors under section 197 as other avenues for compensation had been closed.
This article first appeared in Risk Management magazine. See www.riskmanagementmagazine.com.au