A decision by the High Court of Australia has made shareholders equal to creditors in insolvency claims

The High Court of Australia handed down an important decision on 31 January, 2007, in Sons of Gwalia v Margaretic. By ruling that shareholders who have been misled or deceived by a company are able to claim compensation on an equal basis with creditors, they reversed the traditional position.

Sons of Gwalia was Australia's third-largest gold producer before its dramatic collapse in 2004, which caused around A$250,000 (£103,000) worth of losses.

Margaretic bought 20,000 shares in Gwalia for A$26,200 (£10,750) just 11 days before administrators were appointed and the shares became worthless. His case was funded by the largest litigation funder in Australia, IMF.

Mr Margaretic's claim was based on his statutory rights. In essence it was a claim for damages for a breach of Gwalia's continuous disclosure obligations. It was alleged that as a result of the non-disclosure, Gwalia had engaged in misleading and deceptive conduct.

The issue which the Australian courts had to grapple with was whether Margaretic's claim was to rank equally with the claims of other creditors or whether it was to be postponed to non-member creditors, as provided for in Gwalia's deed of company arrangement.

Upholding the decisions of the lower courts the High Court found in favour of Margaretic – by a majority of six to one – that he was to be treated as a creditor of Gwalia and that, if proved, his claim against Gwalia would rank equally with the claims of other creditors.

The upshot is that shareholders who have been misled or deceived by a company are able to claim compensation on an equal basis with creditors. This is at odds with the traditional position, where the rights of a creditor have been favoured in an insolvency situation over those of a shareholder where liability is limited to the amount unpaid on the shares. In return, the shareholder is entitled to the profits on shares without incurring any of the company's liabilities.

However, shareholders with claims for misleading and deceptive conduct will still need to establish a claim and an entitlement to damages as a result.

There is much debate as to whether the decision strikes the right balance between shareholders and creditors, even though it is correct as a matter of statutory interpretation. There are several key implications of the decision.

- The risk that shareholders of an insolvent company may be able to block repayment or reconstruction plans proposed to assist the company's creditors and employees.

- Significant practical problems for insolvency administrators. It is anticipated that the decision will add to the cost of such administrators – each claim made by a shareholder claiming that it has been misled may require a separate adjudication. It also allows shareholders to oppose collectively any proposal that is not in their interests and brings into sharp focus the differing interests between shareholders and creditors. The real concern is that the increased cost involved can only lead to a reduced return to the creditors.

- Litigation-funders now have added impetus to bring class actions against insolvent companies on behalf of both on-market share purchasers and subscribers, since the distinction has effectively been waived. Liquidators, administrators and financiers should give careful consideration to this decision and their approach to assessing the value of shareholders who allege they were misled into purchasing or refraining from selling the shares of a company.

- An increased focus on the continuous disclosure requirements imposed on companies under the Australian disclosure framework. This is already a contentious topic. The purpose of the disclosure regime is to protect shareholders (both actual and potential) from losses that might occur as a result of undisclosed matters by a system of protection and compensation. This is a particular issue for the volume of debt-financed takeovers and corporate restructuring transactions are currently rife in the Australian market.

- Investors are unhappy that Australian borrowers may now have difficulty in accessing international markets faced with the position that shareholders rank equally with creditors should the company face insolvency. It is unclear whether this will be reflected in the interest rates available to Australian borrowers as a result of the international market perceiving this as an additional risk.

- While similar principles are applicable in the UK (following a 1998 House of Lords decision), it is likely that creditors outside Australia will perceive themselves to be at a disadvantage as a result of the Gwalia decision.

- There is a marked contrast with the position under US law, where all such claims are postponed. This may cause problems for Australian companies wanting to raise funds in international markets particularly from American investors.

There has been considerable debate on the decision and the Federal Government is considering the implications. Whether the Australian Parliament acts to amend the legislation remains to be seen.