Effectively, the High Court held that aggrieved shareholders (shareholders whose debt arises as a result of misrepresentation or improper disclosure by the company causing the shareholder to acquire shares) would be ranked equally with the debts of other unsecured creditors.
Following the High Court’s decision, an expectation arose in the markets that the Government would overturn the decision to return to the traditional position where shareholders’ interests would follow those of the creditors in the event of company liquidation. As a result, the Government commissioned the Corporations and Markets Advisory Committee (CAMAC) to write a report discussing the Sons of Gwalia decision and the practical effects it would have on stakeholders of a company, including unsecured and secured creditors as well as the shareholders themselves. This report was released in January 2009.
Issues considered by the CAMAC report
The CAMAC report considered the shareholders, their present legal position after the abovementioned decision and whether there were adverse consequences that warranted further legislative intervention. The report concluded that CAMAC was not convinced that such action was necessary because “any move to curtail the rights of recourse of aggrieved shareholders where a company is financially distressed could be seen as undermining legislative initiatives to provide shareholders with direct rights of action in respect of corporate misconduct”.
Implications of the decision The CAMAC report outlines a number of implications of the decision including class action risk, the increased inefficiency of formal insolvency procedures and the effects felt by the financial markets.
Shareholder class action risk: In ranking the aggrieved shareholders equally with other unsecured creditors, CAMAC noted that it was foreseeable that shareholder class action claims would increase, particularly in light of access to litigation funding. This would deter “white knight” investors from investing in distressed companies subject to class actions to recover the combined equity invested by investors, affecting the ability for distressed companies to recover from their debts.
Complexity of law: CAMAC also acknowledged concerns in relation to practical difficulties of current law governing insolvent company administration and that shareholder claims may potentially add to its complexity. In response to this, the report expresses the opinion that the administrators of insolvent companies have adequate power to deal with the bulk of shareholders’ claims. However the CAMAC report also proposes a number of measures to allay these concerns, including giving the courts a general power to make orders in a liquidation in relation to creditors’ meetings and the determination of shareholders’ claims.
Market uncertainty: Finally, the CAMAC report indicated that the High Court’s decision was consistent with Legislature’s intention, in recent years, to improve investor protection and strengthen corporate disclosure. Although it would appear that the decision is a “win” for shareholders’ rights, it creates uncertainty in the market deterring lenders from lending and investors from funding corporate restructures. This results in an increase in the risk assumed by investors and an increase in the cost of capital borne by shareholders (in the form of decreased final returns on their investment in the company).
Protection against shareholder class action risk
Unsecured lenders, secured lenders and the company’s investors face shareholder class action risk when a company goes into external administration. There are several actions that can be adopted by them to minimise the risk of competition with other shareholder claims.
Solutions for unsecured lenders
Unsecured lenders face the problem of being ranked alongside shareholder claims so that the final dividends to unsecured creditors will be divided amongst a larger group of individuals, resulting in smaller dividends being paid.
Security: Unsecured lenders could consider taking security (though subordinate to other secured lenders) in order to elevate their claim above other shareholders if the company winds up.
Subsidiary advances: The finance to the company could be advanced to its subsidiary rather than the listed entity itself, making it more difficult for the investors to prove their claims.
Retaining title: The lenders could also incorporate effective retention of title clauses into the trade terms.
Solutions for secured lenders
Secured lenders are not directly affected by aggrieved shareholder claims, however unsecured lenders may seek their assistance in creating security interests in order to elevate their claims above those of the shareholders.
Consideration: Secured lenders should consent to creation of these security interests because it may allow for the company to recover, grow or maintain its business as a result.
Deeds of Priority: Secured lenders can further protect their rankings by entering into deeds of priority.
Solutions for debt and equity investors
Debt investors face risks of competition with the aggrieved shareholders if a company winds up and equity investors place their investments in the company at risk due to the inevitable shareholder claims regardless of whether the company emerges from its insolvent state.
Secured convertible notes: Secured notes could be considered as they would rank above shareholder claims in the event that the company winds up.
Sons of Gwalia was a landmark decision that strengthens the Legislature’s recent stance in favour of shareholders’ rights. Its full significance is derived from the fact that the High Court went against a well established understanding that, in the event of an insolvent company’s external administration, shareholders were the last in line to recover part, if any, of their equity holdings. In response to the suggestion that shareholders may, in fact, be worse off, CAMAC highlights a range of options that lenders and shareholders can take to counteract the effect that increased shareholder claims may have.