Sons of Gwalia - hype or horror story?

By Karen O'Flynn.

Key Points:
The High Court's decision cleared the way for other issues to arise, some of which are known and others which are still emerging.

At a recent gathering of banking and insolvency professionals, the audience was asked to vote on the question, "Sons of Gwalia - Hype or Horror Story?" The vote clearly endorsed the view that Sons of Gwalia is a horror story.

Because it was only a straw poll, there was no opportunity to discover whether the audience's negative reactions all stemmed from the same concerns. Common sense would suggest that the two constituencies - banking and insolvency - could have quite different reasons for their views. Nevertheless, such widespread concern is a good indication that Sons of Gwalia is an issue that lenders and insolvency practitioners will have to address.

In this article, I will look at how the issue may play out in the short and medium term.

Everybody by now knows the story of the Sons of Gwalia case. The High Court held that a shareholder who bought shares from another shareholder did not rank behind unsecured creditors if he had a valid claim that the company had misled him into buying the shares.

But, while everyone knows that big picture stuff, the devil really is in the detail.

Who was Mr Margaretic?

Mr Margaretic was the shareholder who claimed that he had been misled into buying $26,000 worth of Sons of Gwalia shares at a time when they were (or were about to become) worthless.

By himself, Mr Margaretic and the value of his claim are not especially significant. However, by establishing an entitlement to rank equally with unsecured creditors, he has blazed a trail for around 5,000 other shareholders who claim to have bought shares worth $242 million.

Between them, the other 1,138 unsecured creditors of Sons of Gwalia (eg. trade creditors and lenders) are claiming $849 million. From this, it is easy to see why both creditors and liquidators are concerned about this type of claim:

• if all shareholders were successful in their claims, unsecured creditors would lose about 20 percent of their recovery from the company;
• the workload for the administrators has been increased dramatically - instead of dealing with 1,138 creditor claims, they're now dealing with around 6,400.

How much did Mr Margaretic win?

Contrary to the impression given by some media reports, Mr Margaretic didn't win any money in the High Court.

He claims that he lost money because, before he bought his shares, the company had failed to disclose its true financial position to the stock market. All the High Court said was that, if that claim is proved, he is entitled to rank equally with other unsecured creditors. The same, of course, would apply to all the other shareholders who are claiming to have been misled.

In other words, not one dollar has yet been paid out to Mr Margaretic, because neither the company's administrators nor a court have yet upheld his claim to have been misled.

It is, of course, impossible to predict how his or the other 5,000 shareholders' claims will pan out. Nevertheless, a few important points need to be made:

• shareholders' "misleading or deceptive" claims are not simply a matter of "ask and you shall receive" - in 2005, for example, a shareholder failed in a claim against collapsed insurer HIH because, the Court said, any misleadingly positive impression given by the company had been counteracted by consistently negative media reports about the company;
• the administrators may, therefore, have to assess the state of market knowledge, relevant media coverage and the personal position of shareholders in relation to each of 5,000 claims;
• those 5,000 claims relate to share purchases made between 1 January 2000 and September 2004 (when the company collapsed) - which is a very long timespan for a listed company and within which both external and internal circumstances may have changed quite significantly.

This does not add up to an easy ride for either the administrators or the shareholders!

What do administrators or liquidators do in these circumstances?

Before the Sons of Gwalia case, administrators and liquidators didn't have to worry about how to handle shareholder claims. Everyone assumed that shareholders would be postponed to ordinary unsecured creditors, so there would never be any money left for them (since there usually wouldn't be enough to pay the unsecured creditors in full). As a result, shareholders didn't bother submitting claims.

The new reality is that administrators and liquidators will now be faced with a choice.

After examining each shareholder's claim, they can choose to admit or reject it. Each claim that they admit will rank equally with other unsecured creditors (thereby diminishing the return to those creditors). If they reject a claim, the shareholder has the option of appealing to a court against that decision.

As a broad proposition, shareholder claims will presumably fall into three categories:

• the clearly admissible;
• the clearly inadmissible;
• the ones in between.

It is the ones in between which will cause the heartburn for administrators and liquidators. If they're admitted, the other unsecured creditors will suffer a diminution in their pay-out. On the other hand, a refusal to admit them could see the administrators or liquidators dragged into court, with a consequent delay in the finalisation of the company's affairs and the payment of the creditors.

Is Sons of Gwalia just a one-off?

Those who say that the Sons of Gwalia case is more hype than horror story say that there are a number of reasons why it won't lead to a flood of copycat cases:

• Sons of Gwalia was a listed company, and therefore subject to the ASX continuous disclosure rules - but listed companies account for a very tiny percentage of companies in Australia;
• although Sons of Gwalia suffered a financial collapse, it actually had (and has) some very valuable assets, so that creditors can expect to receive considerably more of a pay-out than in most other corporate insolvencies - in most other cases, it wouldn't be worth a shareholder's time and money to lodge a claim;
• shareholders in England have enjoyed similar rights for a number of years, and there hasn't been a flood of shareholder actions against failed companies there.

Each of these points is undoubtedly true as far as it goes, but:

• although not subject to continuous disclosure rules, unlisted companies are subject to misleading or deceptive conduct laws;
• assuming that the current economic boom doesn't last forever, there is no reason to believe that a future recession wouldn't result in the collapse of some significant listed companies - with resulting shareholder claims;
• several important aspects of the Australian legal system (such as "misleading or deceptive", litigation funding and class action laws) have been quite different from English law, which may, in part at least, suggest that the English situation is not a cast-iron predictor for Australia.

In reality, the major determining influence may turn out to be the commercial judgement of professional litigation funders. Before funding a class action, litigation funders assess the likely return (the share of the proceeds) on their investment (the legal costs of the action). Given that there's currently an economic boom, it may be expected that the funders are looking for quite substantial returns, and so would not be attracted to too many cases in which the defendant is an insolvent company. Should there be an economic downturn, however, smaller returns might start to look more attractive.

Why doesn't the Government just fix this up?

In the immediate aftermath of Sons of Gwalia, there were many calls for the Government to introduce legislation to overturn the High Court's decision.

Realistically speaking, there was very little chance of this happening. For the last 20 years, there has been a bipartisan government policy of encouraging Australians to become self-funded retirees. Given the resultant high level of mum and dad investors in the stock market at the moment, there was virtually no chance that the Government was going to leap in and overturn a High Court decision in favour of a small investor such as Mr Margaretic.

Instead, the Government has asked the Corporations And Markets Advisory Committee to look at three issues with a view to possible law reform. In plain terms, those issues are:

• should the High Court decision be allowed to stand?
• if it does stand, can insolvency laws be changed so that mass shareholder claims don't gum up the works?
• could this all be solved by tightening the disclosure requirements for companies?

Conclusion

The High Court's decision on Sons of Gwalia is by no means the end of this story. Realistically speaking, all that the High Court did was to clear the way for other issues to arise. Some of those issues, discussed above, are relatively clear. Others, such as lenders' strategies for taking security or the Government's ultimate response, are still being worked through.

For further information, please contact Karen O'Flynn.