Australia: The Court Of Appeal Decision In Sons Of Gwalia – ‘Rough Justice For Creditors’ Or ‘A Fair Go For Shareholders’

On 27 February 2006, the Full Court of the Federal Court handed down its unanimous decision in Sons of Gwalia Limited (Subject to Deed of Company Arrangement) v Margaretic [2006] FCAFC 17 (Sons of Gwalia decision).

The decision means that as matters presently stand (pending a possible appeal to the High Court), a shareholder who acquires shares in a company from a true third party (referred to as a transferee shareholder), has a right to claim against the company, post insolvency, for losses arising out of the shareholder’s acquisition of shares. The Full Court tested the rationale for their decision against centuries of decisions.¹ Broadly speaking, the Full Court deduced that statutory provisions such as section 563A of the Corporations Act 2001 (the Act), will not prevent claims by transferee shareholders for damages which flow from a claim for misrepresentation inducing the purchase of shares.²

In this, our second Insolvency Update for 2006, we break down the Full Court’s controversial decision and examine the factors the majority took into account in reaching its decision. In doing so, we also draw out why on one view, the High Court is likely to uphold the decision. We wrap up this Insolvency Update with a summary of the factors likely to give rise to an admissible claim by a shareholder.

In mid 2004, the directors of Sons of Gwalia Limited (SOG) completed a review of the affairs of the company and its subsidiaries. The review disclosed a serious deterioration in the group’s gold reserves and its ability to meet certain commitments, to the extent that the group was insolvent. Administrators were appointed to SOG and certain subsidiaries on 29 August 2004. The administrators’ investigations revealed that the group’s liabilities exceeded assets by several hundred million dollars.

At the recommendation of the administrators, the creditors of each company in the group resolved that ‘holding’ Deeds of Company Arrangement (DOCAs) be entered into to allow the administrators an opportunity to finalise a proposed plan for the restructuring of the group. A secondary purpose behind the holding DOCAs was to allow the administrators an opportunity to progress a test case which set out to consider the question of whether shareholders who may have been misled when buying their shares were creditors, and therefore entitled to prove in the SOG administrations.

At the centre of the appeal was the true effect of section 563A of the Act, which provides:

Statutory provisions such as section 563A are designed to protect creditors by ensuring that subscribed capital is available for their benefit, and because once a winding up has commenced, a shareholder is not entitled to rescind a contract to subscribe for shares because to allow that would defeat the rights of creditors.

Therefore, the key issue for determination on appeal (as at first instance) was whether, in a consideration of section 563A, there is a distinction to be drawn between ‘subscribing shareholders’ (those who contribute to the initial capital of a company) and ‘transferee shareholders’ (those who purchase their shares on-market from an existing shareholder). The primary reason being that section 563A had been incorporated into the holding DOCAs which meant that Mr Margaretic’s claim against SOG was subject to the operation of that section.

For these reasons, if it was found that claims held by both subscribing and transferee shareholders were caught by section 563A, then no claims by shareholders would be admissible against an insolvent company.

The Court had regard to a long line of seminal authority in determining whether Mr Margaretic’s claim (brought in his capacity as a transferee shareholder), was caught by section 563A, as discussed below.

For the most part, the Court focused on reconciling existing authority, and where appropriate, how that authority was distinguishable on its facts.

In his primary judgment, Finkelstein J concentrated on reconciling the House of Lords decision in Soden v British & Commonwealth Holdings Plc³, with the High Court’s decision in Webb Distributors (Aust) Pty Ltd v State of Victoria.⁴

The case of Soden involved a proof of debt lodged by a transferee shareholder for damages for misrepresentation which induced an on-market purchase of shares. In that case, the Privy Council held that a claim brought against a company by a transferee shareholder for damages arising from the company’s conduct, is distinct from a claim by a subscribing member seeking the return of a capital investment. The transferee shareholder’s right to lodge a proof of debt was upheld.

Webb Distributors on the other hand addressed the issue of whether certain shareholders could claim damages in the liquidation of Pyramid Building Society as a consequence of a breach of contract between the shareholders and the Building Society. The High Court held that the shareholders in that case were properly categorised as ‘subscribing shareholders’ and on that basis, they had no right to prove as a creditor in the liquidation of the Building Society.

After a ‘good deal of consideration’, Finkelstein J (with whom Gyles and Jacobson JJ agreed) ‘reached the firm conclusion that the principle laid down in Webb Distributors was confined to subscribing shareholders’.⁵ On that basis, His Honour found that there was no conflict between the decisions in Soden and Webb Distributors.

Having determined the scope of existing authority, Finkelstein J then focused on ‘the real point’ on appeal’.

Existing authority suggested that if a transaction involved a return of capital in whatever form, under whatever name, and whether direct or indirect, to the shareholder, the claim could be pursued in a liquidation. The real question therefore was whether Margaretic’s claim was brought in his capacity as a shareholder?

Finkelstein J considered various tests which could be used to determine this issue. He ultimately settled on the following test (extracted in part), which was formulated by the House of Lords in Soden, as follows:

‘Section [563A] requires a distinction to be drawn between, on the one hand, sums due to a [shareholder] in his character of a [shareholder] by way of dividends, profits or otherwise and, on the other hand, sums due to a [shareholder] otherwise than in his character as a [shareholder]…’

On that basis, it was held that ‘if Margaretic has a claim against SOG, it is not brought in his ‘capacity as a [shareholder]’ and so is not caught by section 563A.’

Pending any appeal to the High Court, as the law presently stands, a shareholder would have an admissible contingent claim against a company if:

1. the shareholder is a ‘transferee shareholder’ having purchased shares in the subject company on-market, from a third party; and
2. the claim asserted by the shareholder seeks damages flowing from a breach of contract separate from the contract to subscribe for shares, particularly, a claim for misrepresentation inducing the purchase of shares.

Given the high likelihood of an appeal to the High Court, we would recommend any adjudication on proofs of debt lodged by shareholders be postponed where possible until judgment in any appeal is handed down.

It is also worth noting that any claim of this nature will be contingent and regardless of the outcome in this case, difficult legal issues are likely to arise when determining liability and quantum in respect of a transferee shareholder’s claim. Such issues are likely to dominate the litigation landscape once any further appeal in Sons of Gwalia has been determined.

This publication is intended as a first point of reference and should not be relied on as a substitute for professional advice. Specialist legal advice should always be sought in relation to any particular circumstances and no liability will be accepted for any losses incurred by those relying solely on this publication.