Vol 2 (2005) - Issue 6

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Shareholder Damages Claims Against Insolvent Companies: Subordinated or Pari Passu with Unsecured Creditors?

In Sons of Gwalia v Margaretic the Federal Court of Australia recently held that claims by shareholders against an insolvent company for damages, arising from misleading and deceptive conduct inducing the purchase of shares on market, are to be treated equally with the claims of unsecured creditors. This is in contrast to the position of damages claims from shareholders who acquired their shares via subscription from the company – such shareholder claims will be subordinated to the claims of unsecured creditors. This article considers the Gwalia decision and this distinction in the context of the principle that ‘members come last in insolvency.’

The subordination of shareholder claims

An insolvent company has a deficiency of assets to pay its creditors, and insolvency principle dictates that those assets are to be distributed pari passu to admitted unsecured creditors. Shareholders (or members) are not entitled to receive any distribution from the assets of the insolvent company in their capacity as members unless creditors’ claims are first discharged in full. In other words, the rights and interests of members of an insolvent company come last and are not to compete with the rights of creditors.
It is uncontroversial that members’ claims which arise from their entitlements as members should be subordinated to the claims of creditors - for example, claims of members for dividends or for profits.
However, where a shareholder has a claim for damages against the insolvent company for being misled into acquiring or holding on to those shares (‘shareholder damages claims’), the issue arises whether that claim is entitled to treated as an ordinary unsecured claim (as with any other damages claim) or whether that claim, being a claim of a member, should be precluded or subordinated to the claims of the general body of unsecured creditors.
For a number of reasons described below, the common law historically in England and Australia treated such shareholder damages claims as either subordinated to the general body of unsecured creditors or incapable of being pursued at all against an insolvent company.
However, there is now a line of authority, stated most recently in the Gwalia decision, which provides that shareholders who have purchased their shares on market (‘transferee shareholders’) fall outside this principle (i.e. the subordination or preclusion of shareholder damages claims), and that the principle only applies to claims by shareholders who have been allotted their shares from the company via subscription (‘subscribing shareholders’). In other words, subscribing shareholder damages claims are subordinated or precluded, whereas transferee shareholder damages claims are not subject to subordination and rank equally with the claims of the body of unsecured creditors.
Before considering the Gwalia decision and the basis for this distinction, it is important to first consider generally the rationale for the subordination of shareholder damages claims and then the legislative regime which embodies this principle.

The rationale for the principle that shareholder damages claims come last in insolvency

There have been a number of different expressions for the rationale and legal basis for subordinating or prohibiting damages claims by shareholders against an insolvent company. Central to each of these is ensuring that shareholders, in their capacity as shareholders, do not compete with the rights of the general body of creditors. The justifications which are discernable from the case law include the following (noting that there is some overlap between them).