Explanatory Memorandum

Revised Explanatory Memorandum

(Circulated by the authority of the Parliamentary Secretary to the Treasurer, The Hon David Bradbury MP)

Chapter 2 - Regulation impact statement

Background

2.1 Section 563A of the Corporations Act subordinates any claims made by a person in the person's capacity as a member of the company, whether by way of dividends, profits or otherwise, below the claims of other unsecured creditors against the company.

2.2 However, the High Court decision of Sons of Gwalia Ltd v Margaretic determined that a compensation claim for corporate misconduct made by a shareholder against a company was not subordinated by this section. The decision ran contrary to the meaning generally ascribed to the relevant provisions prior to the High Court's decision.

2.3 The decision of the High Court turned upon its interpretation of when a claim is made 'in the person's capacity as a member of the company'. The High Court held that for the purposes of section 563A a compensation claim for corporate misconduct made by a shareholder against a company is not such a claim.

2.4 The court considered the history of the language used in the section, including case law in respect of the equivalent provisions in law going back to 1880; the original introduction of the rule in the context of the preceding rule in relation to partnerships; the lack of explicit reference to compensation claims by shareholders in the provision, in contrast to equivalent provisions in the United States of America's Bankruptcy Code; the recent case of Soden v British Commonwealth Holdings on similar UK provisions, which held that the UK provisions did not subordinate shareholder compensation claims; the plain meaning of wording in the section; the consistency of various interpretations of the section with the rule in Houldsworth v City of Glasgow Bank ; and an assessment of the presumed policy behind the section.

2.5 The effect of the decision is that shareholders with compensation claims for corporate misconduct against a company are, irrespective of whether the claims arise in respect of their shareholdings or not, entitled to share in any proceeds of an external administration with the same priority as other creditors. In particular, as was the case in Sons of Gwalia Ltd v Margaretic , compensation claims against listed companies arising from the provision of misleading information or the failure to disclose information will gain equal ranking with creditors.

Problem identification

2.6 It has been asserted that the non-subordination of compensation claims for corporate misconduct by aggrieved shareholders may have significant implications for companies in respect of debt financing and the conduct of external administrations.

2.7 Sons of Gwalia v Margaretic gives rise to a number of problems in respect of debt financing for companies.

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The decision may reduce the likely return to unsecured lenders in the event of insolvency. The decision is likely to increase credit spreads for unsecured debt and to adversely affect the availability of credit, particularly in respect of distressed companies and companies where there have been concerns in respect of corporate disclosure.

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The decision is also expected to increase the complexity and cost to lenders of assessing risk; monitoring those risks to ensure that their positions are not eroded by corporate conduct that misleads investors; and putting in place legal arrangements to mitigate those risks. Borrowers would be subject to additional costs in complying with lender's requirements in respect of these matters.

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In addition to charging increased risk premiums, lenders may respond by imposing more burdensome restrictions or requirements on the provision of funds to companies, such as seeking or requiring security or guarantees. This may lead to greater costs and restrictions on the supply of credit.

2.8 Sons of Gwalia v Margaretic gives rise to a number of problems for the effective and cost efficient external administration of companies.

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For example, the costs and delays arising due to the complexities introduced in respect of identifying which parties are creditors and the quantification of their claims for the purpose of providing access to information, determining voting rights and making distributions of funds.

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The decision also has the potential to affect attempts at business rescue which depend upon debt funding to rehabilitate the business or company; due to its effect on credit costs and availability. This applies to attempts both prior to external administration and pursuant to rescue attempts via entry into voluntary administration.

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Delays in the business rescue process may adversely affect efforts to rehabilitate and reorganize the company. Sons of Gwalia v Margaretic , by adding complexity and delays, may interfere with the operation of this regime in respect of companies against which there are investor claims.

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One objective of an insolvency regime is to contribute to the efficiency of the economy by enabling assets to be reallocated to productive uses in an expeditious and cost-effective manner. Another objective is the promotion and preservation of employment. The non-subordination of shareholder claims interferes with the achievement of these objectives in so far as it delays and adds costs to insolvency administration generally and adversely affects reorganization attempts.

2.9 The extent and ongoing nature of the adverse reaction by those stakeholders who are subject to the effects outlined above is indicative that the effects are substantial.

2.10 The problems arising out of Sons of Gwalia v Margaretic will generally only arise in respect of the collapse of listed public companies. Where it occurs in other situations it is likely to have far less impact due to the small number of shareholders involved. The collapse of listed public companies is relatively uncommon, however when they do occur they tend to involve large numbers of creditors, shareholders and employees; and are likely to have a large financial impact. No statistics are collected on the number of external administrations in which shareholder compensation claims are asserted.

2.11 The decision may have some very minor negative influences on the level of deterrence existing for breaches of directors' duties; as a result of its peripheral effect on directorial liability. Potentially, any joint liability of a director and the company for misconduct will be more likely to be partially satisfied out of company funds if the shareholders' claim is not subordinated. Non-subordination would, in those circumstances, reduce the consequences to directors of any misconduct. However, given the large numbers of claimants, the size of the claims involved and the low distribution rates even when shareholder claims are not subordinated, it is questionable whether in practice the reduction in liability that might occur would materially alter director behaviour.

Objectives

2.12 The objectives of these reforms are to:

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facilitate the provision of credit to companies in an efficient way for the economic development of Australia;

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reduce the risk premiums charged and the extent of onerous terms and conditions in relation to credit providers;

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reduce the costs for insolvency practitioners to carry out external administrations; both costs that they ultimately bear themselves and those that they are able to pass onto creditors claiming in the administration (through reduced distributions); and

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improve the efficacy of external administration, both in terms of the reallocation of capital to productive uses and the promotion of business rehabilitation.

Options

Option A: Maintain Status Quo

2.13 Under this option, the non-subordinated status of shareholder compensation claims for loss due to misleading conduct or non-disclosure would have been retained.

Option B: Subordinate shareholder claims

2.14 Under this option, the law could be changed to subordinate claims for compensation by shareholders against a company for loss due to misleading conduct or non-disclosure below the claims of other creditors in the event the company is placed into insolvency administration.

Impact analysis

Option A: Maintain status Quo

2.15 This option would preserve the current effects of the law regarding the relative ranking of shareholder and creditor claims in external administration, as they are now understood to be as a result of the Sons of Gwalia v Margaretic decision.

2.16 The arguments that have been put forward by stakeholders in favour of this option (reproduced exactly as stated in the Corporations and Markets Advisory Committee (CAMAC) report Shareholder Claims against Insolvent Companies : Implications of the Sons of Gwalia decision at pages 48 to 51) are listed below. The term 'aggrieved shareholder' is used to refer to current or former shareholders making claims against companies for loss due to misleading conduct or non-disclosure.

Arguments for non-subordination:

'Limited impact of the decision

While aggrieved shareholder claims could potentially be made against any company, in practice they are most likely to arise in the external administration of disclosing entities. Shareholders in these publicly listed companies typically rely on the company for accurate information affecting the value of the investment.

Argument based on acceptance of risks invalid

The risk that equity investors take is that the venture in which they are investing will not succeed (including because the managers were incompetent). However, shareholders (and creditors) do not take on the risk that a company may have concealed information or provided false or misleading information affecting the investment decision.

Investor protection and market confidence

The High Court decision is consistent with the direction of investor protection law, including its extension to the financial services sector. Since the need for shareholder protection may be most marked in the event of insolvency, such protection may be illusory if relevant claims are subordinated to the claims of ordinary creditors.

One of the aims of the continuous disclosure provisions is to compensate shareholders and potential shareholders for the losses that might be suffered from undisclosed facts and to reduce the incidence of such losses. It may not encourage reliance on financial markets if, in the very situation (a voluntary administration or liquidation) in which investors may need to resort to relevant statutory remedies, their rights are postponed behind those of conventional unsecured creditors.

Another aim of the continuous disclosure, and other corporate disclosure, requirements is to promote a properly informed market, thereby enhancing the integrity and reputation of that market and encouraging investment. All things being equal, prospective shareholders will be more likely to invest in the share market if they feel confident that they will have a meaningful remedy should the companies in which they invest fail to make adequate disclosure. Promoting investor confidence in the equity market may generate greater liquidity in that market and offset, in whole or part, increased costs for companies in the smaller debt market.

Promote market neutrality

Both the debt and equity markets rely on the investor protection provisions and should receive the same protections in the event of corporate misconduct.

Corporate control

In some companies, such as large listed companies, ordinary shareholders, even institutional shareholders, have limited practical ability to direct the company and in reality may have no greater power than creditors. They therefore need a comparable level of protection in an insolvency.

Corporate culture

The Sons of Gwalia v Margaretic decision reminds boards of the importance of a culture of corporate compliance with disclosure obligations and the increased possibility of shareholder claims if these obligations are disregarded.

Private enforcement

Aggrieved shareholder claims can act as a form of private enforcement and help promote the integrity of corporate conduct, in particular the reliability of public disclosures, to the benefit of lenders and the market generally, not just shareholders.

Implications for debt markets

Lenders in the debt finance market can protect their interests in various ways, such as by adjusting the terms on which they provide finance to companies. In the United Kingdom, the House of Lords decision in Soden a decade ago (see Section A1.2 of Appendix 1 of CAMAC's report), which is similar in effect to that of the High Court in Sons of Gwalia v Margaretic, does not appear to have affected the market for corporate debt. There is some indication in American investor restitution legislation of a move away from blanket subordination of aggrieved shareholder claims.

Fairness and workability in an external administration

Aggrieved shareholders should be in no worse a position in an external administration than holders of options or convertible notes who have been similarly deceived into acquiring their securities at the same time by means of the same faulty disclosure or non-disclosure (option and note holders have never been considered to be postponed to other creditors under section 563A). Although aggrieved shareholder claims may add a layer of complexity to external administrations, administrators already have to deal with complex situations, including determining certain claims by conventional unsecured creditors (for instance, product liability claims). Making external administrations simpler, quicker or more expedient does not justify postponing a category of shareholder creditors. Any procedural difficulties may be ameliorated by appropriate administrative reforms.'

Arguments against the status quo include:

Financing concerns

2.17 The effect of Sons of Gwalia v Margaretic is to shift losses suffered by shareholders, due to misleading conduct or non-disclosure, from shareholders to unsecured creditors.

2.18 By reducing the likely return to unsecured lenders in the event of insolvency, the decision is likely to increase credit spreads for unsecured debt and to adversely affect the availability of credit, particularly in respect of distressed companies and companies where there have been concerns regarding corporate disclosure.

2.19 The decision increases the complexity and cost to lenders of assessing risk; monitoring those risks to ensure that their positions are not eroded by corporate conduct that misleads investors; and putting in place legal arrangements to mitigate those risks. Borrowers are subject to additional costs in complying with lender's requirements in respect of these matters.

2.20 In addition to charging increased risk premiums, lenders are expected to respond by imposing more burdensome restrictions or requirements on the provision of funds to companies, such as seeking or requiring security or guarantees. This is expected to lead to greater costs and restrictions on the supply of credit.

2.21 There are particular concerns regarding the effect of the decision on the corporate bond markets as bonds are typically unsecured (and sometimes subordinated).

2.22 The decision has resulted in Australian law differing from that in place in the United States (where case law to similar effect was reversed in 1978 by the introduction of section 510(b) of the US Bankruptcy Code).

2.23 Concerns are held regarding how the decision may be perceived by potential American credit providers who are accustomed to such claims being deferred; and who, due to their exposure to the American litigation landscape, may be highly sensitive to the threat posed by shareholder class action damages claims.

2.24 Inconsistencies in business laws between Australia and the United States may be expected to increase business costs for enterprises operating in both jurisdictions, due to the need to maintain knowledge and processes to meet the needs of both laws.

Investor protection

2.25 If shareholder claims are not subordinated, the burden of meeting compensation claims does not fall upon those who are responsible for or benefited from the misconduct of the company. Instead they are met by another class of stakeholders (unsecured creditors), who may also have suffered loss as a result of the breaches of disclosure obligations or misleading conduct giving rise to shareholders' claims.

2.26 As a mechanism that may operate to deter negative corporate conduct, it is noted that Sons of Gwalia v Margaretic does not transfer losses arising from misconduct to those responsible for misconduct (or who take advantage of that misconduct). It does not, therefore, create any incentive for those who are responsible for misconduct (or who take advantage of misconduct) to adopt alternative behaviour.

2.27 It may be argued that the negative effects on financing referred to above may result in investors generally being worse off, for example, due to increases in financing costs and lost investment opportunities by companies due to restrictions on access to finance.

2.28 Any positive investor protection effects apply only to equity investors who have compensation claims against a company; investors in debt are adversely affected in a similar way to other creditors.

Corporate governance

2.29 Some stakeholders have asserted that, from a corporate governance perspective, as the stakeholder group that is best able to manage the risk of management misconduct, shareholders as a group should bear the cost of failing to manage this risk. The inappropriate allocation of credit risk away from those who are best able to manage that risk may have the potential to contribute to suboptimal economic outcomes.

External administration and corporate rescue

2.30 The decision has had a negative effect on costs and delays in the conduct of some external administrations, and consequentially a diminution of returns to creditors.

2.31 Costs and delays arise due to the complexities introduced into external administration in respect of identifying which parties are creditors and the quantification of their claims for the purpose of providing access to information, determining voting rights and making distributions of funds.

2.32 Although there can be significant complexities in determining certain creditor's claims, ordinarily this process will involve the insolvency practitioner making an assessment of written agreements and records setting out the quantum of credit provided by them to the company.

2.33 Sons of Gwalia v Margaretic creates a new class of creditors the claims of which are inherently difficult to determine. Claims are unliquidated and involve the resolution of complex factual and legal issues of alleged conduct, causation, reliance and quantification of damage. Where misleading conduct has occurred there may be expected to be large numbers of claims to be processed and, depending on the circumstances, case by case assessments may be required.

2.34 The decision also has the potential to affect attempts at business rescue which depend upon debt funding to rehabilitate the business or company; due to its effect on credit costs and availability. This applies to attempts both prior to external administration and pursuant to rescue attempts via entry into voluntary administration.

2.35 The primary method of reorganising and rehabilitating insolvent companies is the voluntary administration process. Voluntary administration takes place in a relatively short timeframe, although the deadlines imposed by legislation can be extended by the Court. Delays in the business rescue process may adversely affect efforts to rehabilitate and reorganize the company. Sons of Gwalia v Margaretic , by adding complexity and delays, may interfere with the operation of this regime in respect of companies against which there are investor claims.

2.36 Insolvency administration is not purely directed at maximising the amount of any distribution to creditors and investors. One objective of an insolvency regime is to contribute to the efficiency of the economy by enabling assets to be reallocated to productive uses in an expeditious and cost-effective manner. Another objective is the promotion and preservation of employment. Factors that delay the conduct of insolvency administrations and interfere with business rehabilitation processes obstruct the achievement of these objectives.

Other

2.37 There is significant potential for the effect of Sons of Gwalia v Margaretic to be avoided, at least by some creditors in some circumstances. For example, by lending to subsidiaries of listed entities rather than those entities themselves any compensation claims by shareholders of the listed company would (in the absence of cross guarantees or similar arrangements) remain subordinated. Such avoidance arrangements have the potential to create additional costs and distort financing arrangements from what may be economically optimal.

2.38 In practice, some creditor groups, such as trade creditors, may have little scope for protecting themselves by such arrangements and may therefore be more exposed than other categories of creditors to the consequences of aggrieved shareholder claims.

2.39 The impact of Sons of Gwalia v Margaretic is mainly upon business (debtors, creditors and employees) and investors. There is minimal impact on Government. Through its effect on business activity and employment, it may have a minor impact upon the community. To the extent that it adversely affects business rescue procedures it may also have a minor impact upon consumers.

Option B: Subordinate shareholder claims

2.40 This option (to 'reverse' Sons of Gwalia v Margaretic ) will negate both the positive and negative effects arising out of the Sons of Gwalia v Margaretic decision, as detailed above.

Consultation

2.41 The primary stakeholders affected by the Sons of Gwalia v Margaretic decision are: equity investors in companies; unsecured non-priority creditors of companies; businesses operating under corporate structures; and corporate insolvency practitioners.

2.42 In February 2007, the previous Government referred the High Court's decision to CAMAC for its analysis and advice. CAMAC issued a public discussion paper in September 2007.

2.43 Those making submissions to CAMAC who supported a reversal of the decision included: the Australian Financial Markets Association (AFMA), the Australian Bankers' Association (ABA), Chartered Secretaries Australia (CSA), the (self described) 'vast majority' of the Law Council of Australia's Insolvency and Reconstruction Committee, the Law Council of Australia's Corporations Committee, the Law Institute of Victoria, the NSW Law Society Business Law Committee (divided opinion), the Insolvency Practitioners Association (IPA); and academics from the University of Melbourne, the University of Western Sydney and Central Queensland University.

2.44 Those making submissions to CAMAC who supported retaining the decision included: Law Council of Australia Insolvency and Reconstruction Committee (minority opinion), NSW Law Society Business Law Committee (divided opinion), the litigation funding firm IMF Australia, the Australian Securities and Investments Commission (ASIC); and an academic from Monash University.

2.45 CAMAC issued its report Shareholder claims against insolvent companies : Implications of the Sons of Gwalia decision in December 2008.

Conclusion and recommended option

2.46 The adopted option is that claims for compensation by shareholders against a company be subordinated below the claims of other creditors in the event the company is placed into insolvency administration.

2.47 This position arises out of an assessment of the pros and cons listed above in respect of maintaining the status quo, weighing each consideration against the significance of its likely impact on stakeholders and the economy as a whole.

2.48 This option is preferred primarily due to the negative effect that non-subordination of shareholder compensation claims would have on the cost and access to debt financing for companies, particularly companies in distress.

2.49 The additional costs, complexity and delays to insolvency administration arising from the decision also argue strongly for subordination, in particular in relation to its expected impact on attempts at business rescue.

2.50 Investor protection arguments against subordination are significantly weakened by the fact that the status quo does not result in a shift of the losses from shareholders onto those responsible for the conduct that caused their loss; instead losses are transferred onto unsecured creditors. Any investor protection benefits are likely to result from redistributions of losses amongst those suffering from a corporate collapse, rather than through deterring misconduct and reducing the risk of loss.