Vol 8 (2011) - Issue 4

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Creditors versus Shareholders: Primus Inter Pares?

Legislation recently passed by the Australian Parliament aims to restore the traditional subordination of shareholders to the creditors of failed companies.

The legislation is designed to overturn the 2007 High Court of Australia decision in Sons of Gwalia Ltd v Margaretic; ING Investment Management LLC v Margaretic [2007] HCA 1. The High Court held that shareholders who claimed to have been misled into buying shares in a company could rank equally with unsecured creditors in the company’s liquidation.



Slow death of a doctrine

The theoretical basis of the doctrine of the maintenance of capital of corporations was the bargain between equity investors in, and creditors of, limited liability companies. Equity investors gained protection from personal liability, but had to accept that, if the corporation failed, creditors had first call on the capital that the investors had invested in the company.

The underpinnings of this theory are amply illustrated by Oakes v Turquand (1867) LR 2 HL 325:

'it would be monstrous to say that … a shareholder … having held himself out to the world as such, and having so remained … could, by repudiating the shares on the ground that he had been defrauded, make himself no longer liable.'

Of course, the doctrine of maintenance of capital has not always been applied in any absolute way. In Australia, for example, the closing years of the 20th century saw considerable erosion in the form of the legalisation of share buy-backs and the issue of no par value shares. Nevertheless, the doctrine has never been fully and officially overturned.

At the beginning of the 21st century, the doctrine manifested itself in two important ways:

– s 563A of the Corporations Act 2001 (Australia),1 which postponed payment of the claims of shareholders qua shareholders until all other creditors have been paid out in full;

– the rule in Houldsworth’s case (Houldsworth v City of Glasgow Bank (1880) 5 App Cas 317), which was that a subscribing shareholder could not recover damages from the company for fraudulent misrepresentation in connection with the subscription for the shares – the shareholder’s only remedy was to seek rescission of the contract of allotment of shares (which would remove his name from the shareholders’ register of members) and thereby to receive restitution of his application money.



In Australian company law, all unsecured creditors rank equally in a liquidation (with a few exceptions, such as the costs of winding up or the payment of employee entitlements). If there are insufficient funds to pay all creditors the full amount of the debts owed to them, the creditors are paid 'pari passu'. However, as mentioned above, this general proposition was altered by s 563A. At the beginning of the 21st century, this read as follows:

'Payment of a debt owed by a company to a person in the person’s capacity as a member of the company, whether by way of dividends, profits or otherwise, is to be postponed until all debts owed to, or claims made by, persons otherwise than as members of the company have been satisfied.'

Section 563A was traditionally regarded by liquidators as being a rule that 'shareholders come last'.