Buying shares in a "lemon"

A recent High Court decision Sons of Gwalia Ltd v Margaretic [2007] HCA 1 has established by a majority that shareholders rank equally with other unsecured creditors in a voluntary administration.

At first blush, the decision has an immediate appeal. On 18 April 2004, Magaretic purchased 20,000 shares in Sons of Gwalia Ltd, a publicly listed gold mining company, at a cost of $26,200. 11 days later, on 29 August 2004, voluntary administrators were appointed to the company. At the time Magaretic bought the shares in the company, they were worthless. Magaretic claimed that Sons of Gwalia breached the stock exchange listing rules by failing to tell the Australian Stock Exchange that its gold reserves were insufficient to meet its gold delivery contracts, and that it could not continue as a going concern. Accordingly he brought a claim for misleading and deceptive conduct pursuant to the Trade Practices Act, the Corporations Act and the ASIC Act. He seeks compensation for the amount he spent on the valueless shares). Many other shareholders have similar claims.The High Court has decided that Magaretic is indeed a creditor, and that his claim ranks equally with other unsecured creditors.

Section 563A of the Corporations Act essentially provides that payment of a debt to a person in his or her capacity as a shareholder (whether dividends, profits or otherwise, will be postponed to any other claims of any other creditors. The practical effect of this is that claims by shareholders rank last – they can only get the money (if any) which is left over after all the other secured and unsecured creditors have taken their slices of the asset pie. A majority of the High Court decided that Magaretic’s claim could not be described as arising from his capacity as a shareholder (Calllinan J dissented). Strictly speaking, Margaretic’s claim arose before he became a shareholder at all, for that was when the misleading and deceptive conduct occurred. Section 563A of the Corporations Act can be contrasted with §510(b) of the United States Bankruptcy Code which specifically subrogates a shareholders claim “for damages arising from the purchase or sale of such a security”.

The practical effect of the decision is that Magaretic and all the other shareholders with claims for misleading and deceptive conduct will now be able to claim with all the other unsecured creditors (trade creditors, employees and lenders). This will substantially enhance the shareholders’ chance of recovery, but it will also reduce the amount available for distribution to other creditors. In this instance, there are apparently many other shareholders with claims for misleading and deceptive conduct. An administrator will find it difficult to ascertain which shareholders’ claims have validity, and the amount of damages to which they are entitled. This will significantly increase the length of voluntary administrations. Further such claims are not included as listed liabilities when a potential lender tries to ascertain whether it should lend money to or invest in a company. Mark Korda has noted that this may make some US companies wary of investing in Australian companies.

Although one’s immediate sympathies lie with Magaretic, who bought worthless shares eleven days before the administration, investment on the share market is a risky business. The broader practical implications of the decision may be to make the administration of insolvent companies much more difficult and costly, and result in less money for all creditors. Already, according to the administrator of car-part manufacturer Ion, payouts to creditors will be delayed by a year by the decision in Margaretic.

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6 Comments

Filed under criminal law, high court, insolvency law, law reform

6 responses to “Buying shares in a "lemon"

  1. cherry ripe

    It seems to me that one of the problems of this decision is that it has little public policy value. There is no deterrent effect against ignorance in buying shares, nor are negligent or knowingly insolvent company directors deterred from acting badly because they suffer no direct loss as a result of the cause of action in this case. The only thing that suffers is the effectiveness of administration, and the ability of companies to seek investment from creditors.

    Applying consumer legislation to the share market makes no sense. Consumer protection laws are premised upon the imbalance of knowledge between supplier and consumer, and facilitates confidence in a retail environment. The share market is premised entirely differently: it runs on the basis of the free flow of information. Indeed, some have argued that even insider trading laws aren’t justified on an economic basis.

    Anyone who’s had anything to do with shares (or just listened to Sat morning radio) knows that it’s a fairly clear risk-return equation, but you need to do your homework. The tragedy of the situation is that ordinary people who invest in shares don’t have the same access to expertise and knowledge as institutional investors. As a result, bad decisions are made. So perhaps this is a problem of the “share consumer” – the encouragement of so-called Mums and Dads investors, who compete in a market where massive super funds and others have vastly more resources and information at their disposal.

    Buyer beware…

  2. Legal Eagle

    Very perceptive comment, Cherryripe! If there was some deterrence for negligent or fraudulent company directors, it might be different.

    The other thing I was thinking is: what if Magaretic had bought his shares 11 weeks rather than 11 days before SOG went into administration? Or 11 months? How would that change his claim? When precisely should directors place their company in voluntary administration?

  3. Paul

    Hiya, interesting blog you have here (I’m another lawyer who has recently begun blogging about similar-ish stuff).

    Although I agree to a certain extent that this decision complicates the status of ordinary creditors in an insolvent company, by the same token it’s important to remember that the element of ‘misleading and deceptive conduct’ remains at the heart of the decision. The judgment doesn’t mean that in respect of every company that goes insolvent, anyone who has recently bought shares will be able to launch a successful claim.

    When you look at it carefully, it is apparent that if the directors had fully complied with their quite plain duties (i.e. to disclose certain information) then there would have been no claim. This should not produce too much uncertainty for companies who are committed to fully complying with the law.

    Additionally, in a practical sense how does one differentiate between the risk taken by a shareholder who makes a decision assuming they have true and complete information about the company, and an creditor? Both surely have certain expectations about the company and take a calculated risk that they will recoup their investment.

    However I totally agree that the appropriate remedy should be against the directors – an interesting (and obviously untested at the moment) question is whether, in fact, the company in administration now has a cause of action against its directors in personam. Surely the answer is yes?

  4. Legal Eagle

    I like your suggestion that the company should have an in personam action against the directors of the company. Certainly, the directors would have breached their fiduciary duties towards the company by their actions.

  5. Paul

    Yes, on further reflection that seems to be something that must follow almost as a matter of course. The only scenario in which that might not be the case is where the relevant conduct is carried out by an employee, rather than director, and even then there might be circumstances where the directors are liable.

    It’d be interesting to know what, if any, further litigation is planned in relation to this particular case.

  6. Bozo

    I can never understand how you would value these claims. Wouldn’t the punter have been just as likely to put their dosh into some other speculative penny dreadfull offering high returns? So either they were kept out of losing their money some other way or making a fortune.

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