Sons of Gwalia Ltd. v. Margaretic: the shifting balance of shareholders' interests in insolvency: evolution or revolution?

Melbourne University Law Review, August, 2007 by Anil Hargovan, Jason Harris

[In Sons of Gwalia, the High Court of Australia found that shareholders who had been allegedly induced into purchasing shares in a company shortly prior to its insolvency by misrepresentations and inadequate market disclosure were able to lodge claims as creditors in the company's voluntary administration. The High Court interpreted the statutory subordination provisions in the Corporations Act 2001 (Cth) narrowly, with the result that many shareholders will be permitted to stand alongside non-shareholder creditors (as contingent creditors) in corporate insolvencies. Whilst this has the effect of diluting the returns to unsecured creditors, it also reinforces the importance of corporate disclosure and other consumer protection laws by providing misled shareholders with a remedy during the company's insolvency. This case note discusses the High Court's decision and comments on where the ruling fits into the broader corporate insolvency landscape. The case note then looks to the future to comment on where the law of shareholder subordination may be headed.]

CONTENTS

I   Introduction
II  Background to the Decision
      A The Facts
      B A Short History of the Legal Issue
          1 The Media World Decision
          2 Sons of Gwalia Ltd (admin apptd) v Margaretic
          3 The Concept Sports Litigation
          4 Sons of Gwalia Ltd v Margaretic
III The High Court Decision ....
      A Should Section 563A Be Limited by Houldsworth?
      B The Maintenance of Capital Doctrine
      C The Role of Investor Protection Laws
      D Policy Issues
      E Alternative Legislative Models
IV  Implications
V   Commentary
      A Observations on Law and Policy
      B The Way Forward
      C Rejection of Blanket Subordination
      D Limited Shareholder Subordination
      E The Need for Law Reform
      F Evolution or Revolution?
VI  Conclusion

1 INTRODUCTION

The classic decision in Salomon v Salomon & Co Ltd ('Salomon') (1) is authority for the proposition that a properly registered company is a separate legal entity from its owners (the shareholders) and managers (the directors and executive officers). Despite the longstanding place of Salomon in Australian corporate law, (2) the ramifications of the separate legal entity principle have still not yet been fully absorbed by the business or legal communities. One of the important consequences of Salomon is that shareholders, regardless of their control through share ownership, are not to be equated with the corporate entity. (3)

This separation between the corporation and the shareholders has been facilitated by the legislative protection of limited liability for shareholders and the increasing size and importance of equity capital markets. The limited liability of shareholders allows the creation of diversified investment portfolios, which, when combined with the increasing activity of share market trading, has greatly contributed to a dispersed share ownership in most publicly traded corporations. (4)

The social, economic and legal climate has, since the first general private corporations legislation in 1862, (5) undergone dramatic transformation. (6) In recent times, government policies have favoured encouraging even greater private investment in businesses through the large pools of investments accumulated in superannuation and the 'Future Fund'. (7) As part of the changing economic landscape, the superannuation industry has become a 'permanent and essential' feature of the Australian financial system. (8) The Chairperson of the Australian Securities and Investments Commission ('ASIC') has recognised that '[n]ow, more than ever before, consumers must have confidence in the market in which they are investing and must be in a position to make informed decisions about what to invest in.' (9)

However, if equity capital markets are to operate efficiently, market investors must possess accurate information about the companies traded on the market. Indeed, the efficient market hypothesis involves the principle that market prices reflect the value of companies based on all of the available information. (10) Therefore, Australian corporate laws have generated a plethora of corporate disclosure requirements to ensure that price-sensitive information is released to the market in a timely manner and remains accurate. These requirements include continuous disclosure (11) and transaction-specific disclosure obligations. (12) The rules formulated in these disclosure laws are enforceable by a range of both public and private remedies. (13)

However, the creation of private remedies for defective disclosure generates a tension with longstanding priority rules in insolvency. Where a company enters insolvent administration, the law has a well-established system of priorities that favours unsecured creditors over members of the company (that is, shareholders). (14) Members of a company are prohibited from lodging proofs of debt if they have outstanding amounts owed to the company. (15) Furthermore, s 563A of the Corporations Act 2001 (Cth) prohibits the payment of debts owed to members, in their capacity as members, before creditors' claims have been fully satisfied. If the company is insolvent, it is therefore likely that debts owed to members will not be repaid, because an insolvent company is, by definition, unable to satisfy all of its creditors' claims with its assets.