Sunset of Gwalia
The Federal Government’s decision to reverse the High Court’s Sons of Gwalia judgement was a “slap in the face for shareholder rights”, according to some commentators.
It’s true this reversal is bad for some shareholders: those who buy an insolvent company’s subsequently worthless shares off the back of a wrongly bullish corporate announcement. Reversing the High Court decision shoves them right to the back of the insolvency queue, behind creditors and licking their wounds alongside the rest of the company’s hapless shareholders.
Here are three reasons why the Government’s decision is correct on balance: fairness to creditors, its effect on the economy and lowering the cost of capital.
When focusing on creditors, think first about unsecured ones, especially the many small and medium-sized businesses that themselves risk going bust if they’re not paid on time for their goods or services.
Not only would these trade creditors get less in a company’s insolvency if shareholders could claim equally with them, they’d be waiting for their money for years while liquidators dragged these complex shareholder claims through the courts.
Delay and uncertainty are bad enough, but the main reason why even misled shareholders shouldn’t move up the queue is that it snaps the long-standing compact between debt and equity. Suppliers (creditors) only ask to be paid for their goods or services. If their corporate customers do well, suppliers don’t hold out their hands for a cut of the equity spoils. They know that’s the reward for those who supply the risk capital, the shareholders. So the reverse is also inequitable, that is, for shareholders — even misled ones — to swoop in on a busted corporate carcass and wrest it from creditors.
Now to the economy. If the High Court decision stood, it would raise the risks for creditors.
Common sense says they will raise their prices or toughen their terms. Ultimately, this could increase the pressure on inflation. Not only would purchasing companies be worse off through margin squeeze, their own consumers would be worse off after price increases. Yet, since this inflationary effect wasn’t visible during the two years the High Court decision was law, is it a furphy? No. During that time everyone was suffering from the far greater shock of the global financial crisis and also hoping (with some cause) that the Government would act as it now has.
Last, the cost of capital. Not only would higher supplier prices lower corporate profitability, but trade creditors would also start insisting on earlier and greater comfort about a debtor’s solvency. Companies would need to raise more capital to run the same business, or do less business with the same capital. Further, unsecured lenders would either increase their rates or hang onto their money. Return on equity, an important market benchmark, would slump and shareholders as a whole would suffer. This could even induce some Australian companies to migrate to, say, the more creditor-friendly US, where the High Court’s view would be laughed out of court.
Another reason given to reject the High Court’s approach is it unfairly pits shareholder against shareholder: that those who bought their shares after a misleading company announcement could claim alongside creditors in the winding up, but investors who had bought in earlier couldn’t. This was one of the reasons why former High Court judge Ian Callinan was the lone dissenter in the case. He was right to do so, but not for this reason.
Investors who had bought their shares before an inaccurate announcement, he asserted, could fairly say they suffered from the same deceptive conduct as shareholders who bought in afterwards. Wrong. If the announcement had been accurate, it would have disclosed that the company was bust, the share price would then hit the floor, and the existing shareholders would have nothing. Though shocking and unexpected, it wasn’t the wrongful announcement that harmed them. Assuming no fraud, it was the company’s true state of affairs they suffered from, one of the core risks of equity ownership.
Arguably, pre-existing shareholders even benefit from a misleading announcement — though they wouldn’t know it at the time — since it gives them a temporary chance to sell out at a inflated share price before the truth is known. The investors they sell to, who do buy on the faith of the wrong information, clearly pay too much.
Yet, even though these “newer” shareholders are truly wronged, the wider damage done by letting them jump the queue is too great. The Government has made the right decision.
John M Green
Company director and former investment banker