Shareholders' rank behind creditors being questioned
By Stephen Bartholomeusz
February 12, 2005
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Less than a fortnight ago, a Federal Court judge handed down a highly technical ruling which is already sending shock waves through the international investment community and which could lead to US institutions placing a ban on investment in Australian corporate debt securities.
Justice Raymond Finkelstein had been asked by the administrators of Media World Communications to clarify the status of shareholders in the collapse. A number of subscribers to the float of Media World alleged that the prospectus contained false and misleading statements. Had they known the true position, they say, they would not have subscribed. They argue they have a claim for damages against Media World which they wish to prove in the administration - they wish to be treated as, and rank alongside, unsecured creditors.
As it happens, Justice Finkelstein found that a person who subscribes for shares could not recover damages from the company on the grounds that they were induced to subscribe by fraud or misrepresentation. What he did next, however, has sent ripples of fear and anger through US investment markets. The judge volunteered an opinion, in response to a question from the administrator, on the status of shareholders who had acquired their shares on the market rather than through the prospectus, even though no one who became a shareholder through the secondary market had come forward.
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AdvertisementCiting and quoting from a House of Lords decision in 1998, Justice Finkelstein said a claim for damages by a defrauded transferee shareholder was not of the same character as one from a defrauded subscribing shareholder. A claim by a subscriber was a claim for return of capital; a claim by a transferee was the same as any other civil claim a person could make against a company, and creditors would be in exactly the same position as they would have been had the claim been wholly unrelated to shares in the company. He said he agreed with that reasoning.
Those comments turn on its head one of the most established, and critical, tenets of the limited liability company - that shareholders rank behind creditors in all circumstances and that creditors have the comfort of the shareholders' capital in assessing the risk of lending.
News of the judgement has flown around the world, with US lawyers pouring out advice to their clients. One lawyer, Evan Flaschen, a partner in one of the biggest firms in the US, Bingham McCutchen, has already been asked to speak to a seminar of institutional investors on the implications of the Media World judgement.
Flaschen has a direct interest in the issue because he represents the US bond holders who lent $US170 million (about $220 million) to Sons of Gwalia, which collapsed unexpectedly, and controversially, last year with debts of nearly $900 million. With the listed professional litigation funder IMF Australia planning a class action against Sons of Gwalia on behalf of its shareholders, which would seek damages of at least $75 million and potentially far more, the prospect of having to share the returns from the company's administration with shareholders has alarmed the US institutions. Flaschen says he represents about 25 major US investors in Australian corporate bonds and many of them have told him they are considering whether to stop investing in Australian debt securities or to demand a greater risk premium for investment.
He has had an analogous experience, having represented US bond holders in the collapse of Parmalat. Their experience with Italian insolvency law led to Italian companies being shut out of the private placement market in the US for more than six months and a continuing ban by some big US investors on investing in Italian corporate debt.
The involvement by US investors in the private placement market for notes issued by Australian companies is significant, with more than $US13 billion of funds raised in four years. That doesn't include investment in public debt issuance, probably at least as large.
Flaschen says that unless and until the issue created by the Media World judgement and Sons of Gwalia litigation is resolved, there will be an enormous adverse effect on the ability of Australian companies to access the US capital markets.
The issue, of course, runs well beyond Media World and Sons of Gwalia. In almost any corporate collapse a case can usually be mounted by shareholders to allege that they were misled, deceived or not provided with information. If shareholders can sue for damages and become unsecured creditors, the risks for conventional unsecured creditors would rise immediately and dramatically, which would be reflected in their willingness to lend and their evaluation and pricing of risk.
It is peculiar that the courts may make a distinction between shareholders who are subscribers to a float and those who buy shares in secondary trading, although local lawyers say the logic of Finkelstein's reasoning and his interpretation of the House of Lords decision is robust even though the High Court has ruled previously that shareholder claims are subordinate to creditor claims.
They say the problem probably lies with legislative principles and precedents originally framed for a different era, before the advent of the modern corporations with their massive shareholder bases and securitised debt and equity traded in vast and anonymous global markets.
Whatever the reason, it is generating enormous uncertainty and concern within a key source of funding for Australian companies and, once local lenders and other creditors come to grips with it, could have huge implications for willingness to provide unsecured credit to Australian companies.
The Sons of Gwalia creditors aren't only bond holders but trade creditors and hedge book counter-parties, which would include some of the world's biggest banks and investment banks.
The issue will inevitably make its way to the High Court, but that could take a year or more. In the meantime, access to debt will be jeopardised and the cost of unsecured debt increased.
In the US, relatively recently, legislators provided statutory subordination of shareholder claims relative to other, ordinary, creditors. The Federal Government may have to consider legislative clarification, with some urgency, here. The implications of that Media World ruling could be enormously damaging and destabilising unless uncertainties and agitation it has provoked are dispelled quickly.
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