Chris Bowen MP, the Minister for Financial Services, Superannuation and Corporate Law, announced in January that the Government intended to overturn the High Court’s decision in Sons of Gwalia v Margaretic (2007). This comes amid the backdrop of the global financial crisis and is part of a broader package of corporate reforms being introduced by the Federal Government.

The Sons of Gwalia case

The decision in Sons of Gwalia has attracted media attention since it was first handed down by the High Court in 2005. The case concerns the way in which an insolvency practitioner, typically a liquidator or a voluntary administrator, must deal with a proof of debt lodged by a shareholder wanting to claim compensation for loss and damage caused by making an unwise investment because of improper conduct by the company.

For many years, the courts refused to allow such investors to be classed as creditors in the liquidation, because such claims were necessarily subordinated by the operation of section 563A of the Corporations Act 2001. However, Sons of Gwalia changed all of that. It made the headlines because the High Court gave the green light for disgruntled shareholders to rank alongside unsecured creditors when receiving dividends in the liquidation (under specific circumstances).

Mr Bowen’s announcement means that shareholders will no longer be entitled to prove along side other unsecured creditors if they wish to claim for loss and damage caused by being improperly induced to invest. The government’s unusual (but perfectly legal) move to overturn the High Court’s decision has been generally welcomed by industry experts and corporate commentators but, not surprisingly, has been met with strong criticism from shareholder groups.

The difficulty created by Sons of Gwalia, which this reform intends to address, is the increased burden placed on insolvency practitioners when dealing with shareholder claims. It is widely accepted that insolvency practitioners and their lawyers have been required to use significant amounts of precious company funds in dealing with such claims, depleting the amount that is ultimately available to pay a dividend.

The reform will mean that more funds will be available for dividends, but fewer stakeholders will be entitled to share in them.

Importantly, the reform will mean that voluntary administrations are simpler and cheaper, and hopefully lead to an increase in the use and success of the key means available to implement an effective work-out solution for a distressed business entity. Some corporate commentators have argued that the inability for shareholders to make these claims will improve the chances for companies to obtain credit and debt financing, as funders will no longer have to compete with shareholders at an unsecured creditor level.

Of course, there are two sides to every argument, and some stakeholders are bitterly opposed to the government’s proposal to pull rank on the unelected lawmakers in the High Court.

One thing is clear – you simply cannot please all of the people all of the time.

Reasons for overturning the High Court decision

Mr Bowen noted that the Federal Government’s decision to overturn the Sons of Gwalia ruling would help address the following issues:

• The concern that the High Court ruling in Sons of Gwalia has undermined the distinction between debt and equity;
• The potential for the decision to further increase uncertainty and costs associated with external administration; and
• The need to encourage lenders to continue debt funding and restore certainty with respect to priority ranking.

Mr Bowen suggests that any perceived benefits that may have been derived from shareholders ranking equally with unsecured creditors “are outweighed by the negative impacts on shareholders generally as a result of restriction on access to, and increases in, the cost of debt financing for companies”.

Aggrieved shareholder groups have criticised the decision to overturn the ruling, as they fear it “will turn back the clock by removing a protection for investors who suffered at the hands of misleading company directors”. However, as one corporate commentator remarked, “corporate disclosure should be directed at the directors, rather than reducing the return to creditors, where there is a failure of those directors to ensure that the company met its disclosure obligations”. This view was clearly reflected in Mr Bowen’s announcement.

Looking to the future: other reforms

The overturning of Sons of Gwalia is part of broader package of corporate reform. It is clear that the Government is hoping to strengthen Australia’s economic recovery and Sons of Gwalia is the first of what is anticipated to be many corporate regulatory reforms to help achieve this.

Mr Bowen’s announcement coincided with the release of a discussion paper titled “Insolvent trading: A safe harbour for reorganisation attempts outside of external administration”. The discussion paper is open for submission to the Treasury until 2 March 2010 and is expected to be introduced into Parliament in September this year.

Discussion paper: insolvent trading reform

The discussion paper proposes to build on the existing general business judgment rule and tailor it to apply to insolvent trading. It suggests that the rule would operate so that directors would be relieved of the duty not to trade while insolvent if the following elements are satisfied:

• The financial accounts and records of the company presented a true and fair picture of the company’s financial circumstances at the time the rule was invoked;
• The director was informed by restructuring advice from an appropriately experienced and qualified professional, with access to those accounts and records, as to the feasibility of and means for ensuring that the company remains solvent, or that it is returned to a state of solvency within a reasonable period of time;
• It was the director’s business judgment that the interests of the company’s body of creditors as a whole, as well as members, were best served by pursuing restructuring; and
• The restructuring was diligently pursued by the director.

The discussion paper suggests that this business judgment rule would provide a higher degree of protection for directors from the threat of personal liability for insolvent trading, while making genuine attempts at company reorganisation outside of formal external administration.

Insolvent trading law reform is a difficult task. There is much debate as to the effectiveness of our current laws, and it is a difficult philosophical question as to whether such laws should be relaxed or made tougher.

On one hand, it is clear that the risk of insolvent trading liability, both criminal and civil, is a real deterrent to entrepreneurship in general, and the implementation of informal work-outs in particular.

On the other, there is now a growing discontent with corporate largess and irresponsibility, and many are quick to support the idea of punishing those who incur debts that cannot be repaid and arming insolvency practitioners with better means of increasing funds available to pay dividends to creditors.

For more information on insolvency, please contact Paul Betros in HopgoodGanim’s Insolvency practice. For any corporate enquiries, please contact Liz Cameron or Emily De Boo in HopgoodGanim’s Corporate Advisory and Governance practice.

Paul Betros, Partner
Liz Cameron, Associate
Emily De Boo, Solicitor