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Australia: The Sins of the Sons (of Gwalia) Are Visited on Creditors Yet Again

July 27, 2007

Australia is sometimes referred to as "down under" for obvious geographic reasons.  In the investment community, however, Australia is becoming known as "upside down" due to the Sons of Gwalia (SOG) insolvency proceedings, in which the alleged fraud claims of shareholders have been elevated to pari passu status with legitimate unsecured claims.  Now, the sins of SOG's fraud have been visited on SOG's creditors again, this time by permitting shareholders to outvote A$600 million in real creditors in deciding on the sale of SOG's operating businesses. 

When Is A Shareholder Not A Shareholder? 

Section 510(b) of the United States Bankruptcy Code provides that, generally speaking, a claim by a shareholder for damages arising from the purchase or sale of its shares should be subordinated to the claims of unsecured creditors in bankruptcy proceedings.  The thinking is that shareholders, in exchange for the ability to reap upside benefits, should also assume the possibility of downside risks, even if those risks arose as a result of an issuer's fraudulent misrepresentations.  Simply stated, "once a shareholder, always a shareholder." 

In Australia, Section 563A of the Corporations Act provides that, in an insolvency proceeding, the claim of a shareholder "in its capacity as such" is similarly subordinated to unsecured claims.  As many US investors are now aware, the High (i.e., Supreme) Court of Australia recently issued a decision concluding that a shareholder's claim against an issuer for damages caused by defective disclosure practices should not be subordinated to the claims of legitimate unsecured creditors.  Sons of Gwalia Ltd. v. Margaretic [2007] HCA 1.  The Court's rationale was that, when a shareholder is defrauded by an issuer's public statements, the shareholder is in the same position as any other victim of fraud and, accordingly, should have a general unsecured claim the same as any other fraud victim.  Stated differently, the shareholder's claim arose in the shareholder's capacity as a fraud victim, not in its capacity as a shareholder. 

The SOG administration will be familiar to many of you because of the substantial amount of claims against SOG held by US and other international investors (as represented by Bracewell & Giuliani).  Also familiar to you will be the two biggest practical consequences so far of the Sons of Gwalia decision:  the risk of substantial dilution from shareholder claims in fraud situations and the risk of substantial delay in distributions while shareholder claims are adjudicated by the insolvency administrators. 

But Wait, It's Even More Upside Down 

As troubling as the foregoing consequences may be, a new one has arisen that may be the most troubling of all.  Generally speaking, creditor votes in Australia are decided on the basis of a majority in amount plus a majority in number, in each case of those actually voting.  This is similar to the US, except that chapter 11 creditor votes normally require a majority in number and two-thirds in amount.  Where Australia really parts company with the US, however, is if there is a split vote.  In the US, a split vote means that the creditors have rejected the proposal.  In Australia, a split vote means that the insolvency administrators cast the deciding vote.  The theory is that Australian administrators are independent professionals with a fiduciary duty to all creditors, so they can be trusted to exercise appropriate business judgment in casting their deciding vote. 

In the SOG administration, the administrators proposed to sell the business for an amount that would yield a dividend to creditors of only 12 cents on the dollar.  A group of US creditors holding approximately A$300 million in undisputed claims against SOG believed that the sale price was far too low and they put together a competing bid that featured the upside potential of an equity distribution.  Without getting into unnecessary detail, suffice it to say that SOG's administrators rejected the competing bid because they applied a heavy discount to the equity component and a high risk factor to the conditions to closing.  Thus, when it came time to vote on the asset sale, a "yes" vote indicated support for the proposed sale recommended by the administrators, while a "no" vote implicitly indicated support for the highly-publicized competing proposal, even though the administrators refused to put it on the ballot. 

As part of the vote, the "claims" of the shareholders were permitted to be voted, even though fraud had only been alleged, not proven, and there had not yet been any showing of reliance on the fraud by any of the shareholders.  Equally disturbing, the shareholder "claims" were permitted to be voted at the full amount alleged by the shareholders, even when they alleged so-called "lost opportunity" damages, such as, "If I had known of the fraud, I would have purchased BHP shares instead of SOG shares and, therefore, my damages should be measured by the substantial increase in value of the BHP shares that I would have bought."  As a result, shareholders were deemed for voting purposes to hold A$250 million of the A$1.1 billion of claims eligible to vote. 

The substantial majority of the shareholders were individual investors, not institutions, so, as expected, they voted in favor of the administrators' proposal.  This assured that a majority in number of creditors favored the cash sale.  Even so, a full A$600 million of claims were voted against the sale, while only A$320 million were voted in favor. 

As noted above, in the US, the voting results would have meant that the sale was rejected (and resoundingly so).  Even in Australia, however, one would presume that the administrators would cast their deciding ballot in favor of the view of the holders of the overwhelming majority in amount of the undisputed claims.  Not so.  The administrators had repeatedly and publicly recommended the cash sale and were not about to let the vote of 65% in amount of the creditors stand in their way.  As a result, the administrators sided with the vote of the shareholders, even though not one of them actually had a proven claim yet. 

To put the final nail in the coffin, the US and international creditors opposing the cash sale were advised that a court challenge of the administrators' decision would be pointless, given that insolvency administrators are independent professionals and, therefore, there is an almost insurmountable legal presumption in favor of their exercise of their business judgment. 

Lessons Learned When Upside Down 

First, SOG does not alter the fact that the overwhelming number of Australian companies do not commence insolvency proceedings. 

Second, SOG does not alter the fact that, of those Australian companies that do commence insolvency proceedings, only a small minority are likely to involve listed companies where shareholders have potentially been defrauded by false or misleading public disclosures. 

Third, SOG does not alter the fact that, even in those few insolvency situations potentially involving false or misleading public disclosures, the shareholders still have to make a credible showing of the fraud and their reliance on it before they are entitled to receive a distribution. 

But fourth, where fraud has been alleged and there are thousands of shareholders (as is the case with SOG), it may prove less costly and time-consuming simply to make distributions to the vast majority of shareholders rather than to pursue objections to their individual small claims, just as one often does with "convenience class" creditors in the US. 

And fifth, the ability of allegedly defrauded shareholders in Australia to vote the full amount of their "claims" in insolvency proceedings and to override the views of undisputed creditors can dramatically affect recovery expectations. 

So What's an Investor in Australia To Do? 

The Sons of Gwalia High Court decision was front-page news and the Australian government has appointed several commissions to consider whether the law should be changed.  Given the conflicting constituencies in Australia, however, we think there is an equal likelihood that the law will be changed to subordinate shareholder claims OR the law will be changed to strengthen shareholder claims (or no change at all will be made).  In the absence of an assured legislative fix, it raises the questions of whether to continue to invest in Australian debt securities or other claims and, if so, whether there are structural precautions that an investor can take. 

As to the first question, most Australian companies will not end up in insolvency proceedings and most insolvency proceedings will not involve the shareholder issues present in the SOG matter.  Given the continuing robust Australian economy and very low percentage of corporate defaults, we see no reason to avoid original Australian investments.  A tougher question is whether to invest in distressed Australian securities and claims if there is even a hint of potential securities fraud.  In such circumstances, distressed debt investors may wish to consult with Australian counsel before plunging in or, at least, before finalizing pricing. 

As to the second question, one seemingly obvious fix would be to obtain guarantees from operating subsidiaries, thus providing structural seniority to shareholder claims against the parent issuer.  Unfortunately, this is not a fix at all.  Listed Australian companies typically report their group financial results on a consolidated basis.  For creditors who do business with only one member of the group, this raises a concern about the creditworthiness of the individual company in the absence of separate public financial statements.  The Australian solution to this concern is to require the members of listed corporate groups to cross-guarantee each other's debts, with the result being that, in insolvency proceedings, all of the assets and liabilities of the corporate group, including any shareholder claims, are essentially pooled on a pari passu basis.

Another possibility would be to obtain security.  This would seem unlikely for highly-rated public corporates, but might be more realistic with middle market "story" private placements.  At the same time, a middle market issuer's bank lenders will also be more likely to seek security for the same reasons, thus making equal and ratable security interests a legitimate option. 

In negotiated transactions, investors should also consider a more thorough investigation of internal controls and requiring more stringent reporting requirements signed off by two corporate officers.  Investors should also pay particularly close attention to hedging policies and controls, which seem to be at the root of the majority of fraud situations in the Australian mining and minerals sector.  Fraud can never be eliminated completely, of course, but greater scrutiny should help to reduce fraud opportunities (which is certainly one of the main theories of Sarbanes-Oxley). 

In sum, the challenge for investors in new Australian middle market transactions will be negotiating where possible for creative protections and stricter controls (and note that the same likely holds true for New Zealand transactions).  The challenge for distressed debt investors in unsecured claims against listed Australian companies will be to sniff out the potential for shareholder fraud claims before finalizing their purchase decisions.  Otherwise, in those few situations where a listed Australian company may have issued false or misleading public statements before ending up in insolvency proceedings, the priority and voting power of shareholder claims can truly turn the bankruptcy world upside down.