Two court decisions handed down this year have important implications for investors and investment professionals who buy and sell shares in publicly listed companies.

Sons of Gwalia Ltd v Margaretic, [2007] HCA 1

In the Sons of Gwalia case, the High Court decided that a shareholder who acquires shares because of misleading or deceptive conduct on the part of a company can claim for loss and damage suffered when the company later goes into liquidation.  As well, such a claim, if it stands up, is provable in the winding up of the company, or if the company enters into a deed of company arrangement.

Previously a claim by a shareholder might have been thought to rank after secured and unsecured creditors of the company.  That is because of section 563A of the Corporations Act 2001, which provides that a debt owed by a company to a member, in the member’s capacity as such, is to be postponed until all debts owed to non-members have been satisfied.

In Sons of Gwalia, the High Court found that the debt payable by the company to its shareholder for misleading and deceptive conduct was not due to the shareholder in his or her capacity as a member – even though the misleading and deceptive conduct was the cause of the member taking up the shares.  As a result the shareholder’s claim ranked equally with the claims of other unsecured creditors, and ahead of any return of capital to the shareholders that might come at the end of the winding up.

The case was reported in some media articles as representing an upheaval in the relative ranking of shareholders and outside creditors.  In fact, it was decided on its own particular circumstances and doesn’t really depart from a literal application of the corporations legislation to the facts.

There are however a few practical implications that will affect companies, their lenders and administrators and liquidators as they go about their business:

·         there may be increased complications, costs and time for administrators and liquidators in assessing the merits of claims that happen to come from shareholders;

·         there is the potential for reduced returns to unsecured creditors, which may lead to additional costs for unsecured borrowing;

·         there is the possibility of similar claims against other insolvent companies being actively pursued, perhaps under the class action provisions in the Federal Court;

·         there is increased pressure on listed companies to make more effective material disclosures so that no-one who takes up their shares can be said to have been deceived into doing so.

There has also been some talk of an amendment to section 563A, along the lines of a US corporate bankruptcy provision which subordinates all claims by shareholders, regardless of their basis, to claims by outsiders.  There are no legislative proposals at the moment, but it remains possible.

ASIC v Citigroup, [2007] FCA 963

In March 2006 ASIC commenced action in the Federal Court against the Australian branch of the international financial services conglomerate Citigroup.  ASIC’s claim alleged unlawful conduct by Citigroup arising out of the ultimately successful takeover bid by Toll Holdings Limited for Patrick Corporation Limited.

Citigroup was involved in the takeover in 2 separate capacities.  One was through a so-called public side employee who purchased over one million shares in Patrick on the last trading day before Toll announced its bid for Patrick.  The shares were bought for Citigroup’s own account.

The other capacity was through Citigroup’s private side employees who were advising and acting for Toll in relation to its bid for Patrick.

When the private side employees became aware of the share purchase, they took steps to prevent the public side trader from buying any more shares in Patrick, though without disclosing the reason for that requirement.

ASIC had several related claims against Citigroup:

·         that Citigroup had failed to disclose to Toll that Citigroup was trading in Patrick shares on Citigroup’s own account.  ASIC said that such non-disclosure put Citigroup in breach of its obligations to manage conflicts of interest – a duty arising under section 912A(1)(aa) of the Corporations Act 2001;

·         that the same circumstances gave rise to misleading and deceptive conduct, in breach of section 1043H of the Corporations Act, and that it amounted to insider trading, in breach of section 1043A of the Corporations Act.

When Justice Jacobson delivered his judgement on 28 June 2007, he dismissed all of ASIC’s claims.  Central to the outcome was the finding that there was no fiduciary relationship between Citigroup as advisor and Toll as client.  The terms of Citigroup’s letter of engagement to Toll expressly excluded a fiduciary relationship.  ASIC said that this particular advisor-client relationship was such that certain fiduciary obligations could not be excluded.  The court disagreed, and said that the law does not prevent an investment bank from contracting to exclude or modify fiduciary obligations which would otherwise arise.  Effectively, this disposed of ASIC’s conflict of interest claim against Citigroup.

The other principal claim by ASIC – that of insider trading – also failed.  There were a number of reasons:

·         the trader who had purchased, and been instructed to stop purchasing, the Patrick shares was found by the court not to be an officer of Citigroup.  Under the relevant section of the Corporations Act – section 1042G – information is imputed to a corporation if an officer of the corporation holds that information.  Here, Jacobson J. found that the trader was merely an employee with no management function, and wasn’t therefore an officer;

·         Citigroup had established effective Chinese walls between its separate divisions, which qualified it for the defence to insider trading found in section 1043F of the Act.  Jacobson J. emphasised the procedures which Citigroup had laid down to ensure that price sensitive information was vetted by legal or compliance officers before being communicated between divisions.  In this situation the Chinese walls worked – the public side trader was ordered to cease buying shares in Patrick without being told the reason for the order.

So the decision provides some comfort and protection for investment firms who run large and complex businesses for multiple clients.  As long as they maintain sufficient safeguards and separations, they will be protected from claims of insider trading and conflict of interest.  ASIC has accepted the decision in view of the light that it throws on these matters and, on 18 July 2007, indicated it wouldn’t appeal Jacobson J’s decision.