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Words that come back to haunt: Ensuring company prospectuses comply

Feature Articles

Cite as: (2006) 80(12) LIJ, p. 50

The Full Federal Court decision in Cadence means shareholders can seek damages caused by defective prospectuses from their companies without rescission.

By Professor Paul von Nessen and Rachel Weeks

The Full Federal Court decision in Cadence means shareholders can seek damages caused by defective prospectuses from their companies without rescission.
By Professor Paul von Nessen and Rachel Weeks

Recent property development failures and company profit downgrades have focused public attention on the ability of investors to recover damages from either the company in which they invested or a third party associated with that company. It is well understood that directors and others who authorised a prospectus may be liable for misstatements and omissions in that prospectus.

With regard to the liability of the company itself, however, there has long been a question of how the statutory liability imposed on the company for misstatements and omissions reconciles with the limitation on company liability to shareholders as circumscribed by the 19th century English case of Houldsworth v City of Glasgow Bank (Houldsworth).[1]

This question has now been resolved by the Full Federal Court case of Cadence Asset Management Pty Ltd (as trustee for Cadence Capital) v Concept Sports Ltd (Cadence).[2]

The facts of Cadence[3] 

Concept Sports Ltd sought to raise $12 million. It issued a prospectus offering 24 million ordinary shares at an issue price of $0.50 each. The prospectus contained financial information about the company, including forecast sales revenue and forecast earnings before interest and tax.

In addition, there were several implicit representations in the prospectus, to the effect that all material information had been disclosed and that all reasonable investigations had been undertaken to ensure that the information in the prospectus was accurate.

The plaintiff, through a trustee, subscribed for shares in Concept Sports allegedly on the strength of the prospectus. The plaintiff asserted that the prospectus was defective because:

  • the prospectus did not contain information which the Corporations Act 2001 (Cth) (the Act) required it to contain;[4]
  • the forecasts for sales revenue and earnings and the statements about the company’s outlook were misleading and deceptive; and
  • the implied representations were false.

The plaintiff did not rescind the contract, instead selling the shares purchased to a third party at a loss. It then sought to recover its loss from Concept Sports Ltd under s729 of the Act.

Section 729 provides that if a prospectus omits information that is required by s710 or contains misleading or deceptive statements which are materially adverse from the point of view of an investor, the person making the offer will have committed an offence under s728. Under s729, any person who suffers loss or damage as a result may, subject to certain defences, recover that loss or damage from a number of persons, including the company making the offer.

The defendant argued that the principle espoused in Houldsworth[5] precluded any claim by the plaintiff under s729. The defendant asserted that, to avoid offending the rule in Houldsworth, the plaintiff should have rescinded the agreement to buy the shares rather than on-sell the shares to a third party and attempt to recover the loss from the company.

The rule in Houldsworth

The rule in Houldsworth provides that a shareholder cannot sue the company itself for damages for fraud or misrepresentation which induced the subscription for shares in the company, unless first renouncing the contract by which those shares were issued. The principal basis for the rule is that to allow a claim for damages by a member against the company would be inconsistent with the implied term of the statutory contract (now found in the Act, s140)[6] which binds all members and the company.

That statutory contract, among other things, indicates that the capital which the member has subscribed should be applied only in payment of the debts and liabilities of the company.[7] The rule was additionally justified by the notion that shareholders’ capital was committed, in the event of liquidation, until creditors had been fully paid. A shareholder’s ability to renounce or rescind cannot be exercised once a company goes into liquidation.[8]

Although the plaintiffs in Cadence were not dealing with a company in liquidation, they had already sold their shares. Since rescission was no longer possible, the plaintiffs sought to recover damages directly from Concept Sports Ltd, relying on the prospectus liability provisions.[9]

Developments since Houldsworth

While the rule in Houldsworth has been abolished in the UK,[10] no comprehensive statutory abrogation of the rule has ever occurred in Australia. However, some of its features have, over time, been legislatively recognised.

Section 563A of the Act, for example, assures that the claims of shareholders (in their capacity as shareholders) are subordinated in liquidation to those of creditors[11] and reflects the “postponement of shareholders to creditors” aspect of the rule in Houldsworth. On a number of occasions in recent years, the rule in Houldsworth has been considered. These cases, discussed below, have provided both useful clarification of the rule’s operation and the policy basis for its application.

Webb Distributors

Webb Distributors (Aust) Pty Ltd & Ors v The State of Victoria (Webb)[12] concerned claims in deceit or under s52 of the Trade Practices Act 1974 (Cth) (TPA) for unliquidated damages against certain building societies. These claims were pursued by shareholders who acquired their shares in the certain building societies in reliance on misleading and deceptive conduct by the societies themselves.

In Webb, the plaintiffs sought to establish that the rule in Houldsworth applied only to common law causes of action and did not extend to statutory actions, such as one arising under s52 of the TPA.

Although accepting that certain of the policy objectives of the rule in Houldsworth had been achieved by statutory postponement of shareholder claims,[13] the majority of the High Court in Webb concluded that the longstanding rule in Houldsworth was not able to be eliminated “by a side wind”[14] such as by the general remedial provisions found in the TPA. The rule in Houldsworth, according to Webb, bars not only common law claims but statutory causes of action, unless the statute itself overrides the rule with some specificity.

Media World

In Crosbie in the matter of Media World Communications Ltd (Administrator Appointed) (Media World),[15] subscriber shareholders sought damages claiming to have been induced to purchase shares in Media World Communications Ltd by false statements contained in the company’s prospectus.[16]

The company was in liquidation. The administrator asked the Court whether the shareholders could be treated as creditors of the company for the purposes of the administration.

Finkelstein J of the Federal Court applied the rule in Houldsworth and found that members of the company were not in such circumstances to be considered creditors in respect of their claims (likening these claims to those for return of capital or dividends in liquidation by shareholders). The Court left open the question whether claims by shareholders who had acquired their shares on market (rather than by issuance) on the basis of misstatements by the company, would appropriately be considered claims by shareholders in their capacity as shareholders or could be considered as claims by creditors.

Sons of Gwalia

In Sons of Gwalia Ltd (Administrator Appointed) v Margaretic (Sons of Gwalia),[17] Emmett J of the Federal Court allowed a claim by a shareholder to be provable in a deed of company arrangement. The claim was for misleading and deceptive conduct as a result of the defendant allowing its shares to be traded on the ASX when it was in breach of its continuous disclosure obligations.[18]

The Court affirmed the rule in Houldsworth; however, it found that the limitations imposed by Houldsworth should not be placed on shareholders who had purchased their shares from a third party. In such cases, the claim of the shareholder was not a claim owing to the shareholder in his capacity as a shareholder, and therefore need not be deferred until the company’s creditors were satisfied. Thus, shareholders who had acquired their shares from other than the company itself could make a claim in liquidation ranking equally as an unsecured creditor (as is the case in the UK).[19]

Sons of Gwalia was upheld on appeal by the Full Federal Court in February;[20] however, special leave to appeal to the High Court was been granted,[21] with arguments heard in August this year.

Judicial determinations in Cadence

Federal Court[22]

In reaching a decision at first instance, Finkelstein J considered the argument of Cadence that the rule in Houldsworth applied only to common law claims for damages and not statutory causes of actions and, in particular, not a claim under s729 of the Act.

Finkelstein J considered that the following factors pointed in favour of the plaintiff’s argument:

  • the cause of action conferred by s729 was remedial in nature and should therefore be given broad effect;
  • s729 was drafted in unrestricted terms and to impose a limitation would be inconsistent with its terms; and
  • if s729 had not overturned Houldsworth, it would have a reduced scope.
  • However, the factors which favoured upholding the Houldsworth rule were found to be more persuasive:
  • Parliament could have, but did not explicitly overturn Houldsworth (as had been done in the UK);
  • Parliament was aware of Houldsworth and could have overridden the implications of the case if it had wished to;
  • Webb made a similar argument and was rejected in relation to s52 of the TPA; and
  • s563A of the Act (postponing claims of shareholders in their capacity as shareholders to claims of creditors) gave effect to the Houldsworth rule and to overturn it would be inconsistent with that provision.

His Honour found in favour of the defendant Concept Sports, indicating that to do otherwise would be inconsistent with State of Victoria v Hodgson [23] and its appellate decision, Webb, by which he was bound.

Full Court of the Federal Court[24]

Cadence appealed the decision of the Federal Court and sought clarification of the following point:

“ ... [is] the statutory entitlement of a shareholder to recover compensation under s729(1) of the Act in respect of the prospectus issued by Concept Sports ... qualified by the rule in Houldsworth?”.

The Full Court (Merkel, Weinberg and Kenny JJ) answered this question in the negative. They concluded that under s729(1), a subscribing shareholder can recover the loss suffered from the company issuing a prospectus without rescinding the contract to acquire the shares.[25]

The Court found that there were no contextual or textual considerations that suggested the legislature intended to qualify the entitlement conferred by s729 by reference to the Houldsworth rule.

Rather, the Court found that supporting material pointed strongly away from any such qualification. This was supported by the section’s natural and ordinary meaning, its context in the Corporations Act, its history and the state of the law at the time, as well as the purpose which the enactment sought to achieve.[26]

The explanatory memorandum accompanying the Bill which recast ss728 and 729 into their current form indicated that the purpose of the sections was: “ ... to ensure that issuers continue to provide full disclosure in the associated prospectus, issuers will be liable to investors in relation to the prospectus”.[27]

One rationale for the Houldsworth rule had been to prevent shareholders, directly or indirectly, from receiving back any part of their contribution to the capital of the company, thereby defeating the interests of creditors. This objective is now dealt with by statute, in particular s563A of the Act.[28]

The Court found that, under the Act, all shareholders in Concept Sports were entitled to bring and prosecute their claims under s729(1), but that in the event of liquidation, the rights of subscribing shareholders (other than those who may have rescinded their contract prior to liquidation) would be governed by s563A.

Allowing the appeal, the Court found no reason for qualifying an entitlement to a claim under s729 by the Houldsworth rule, as this would have been inconsistent with the section.[29] It was further stated that any contemporary application of the Houldsworth rule must be in the context of the Act, including ss729(1) and 563A.

Implications of Cadence

It is now clear that claims in respect of losses suffered by shareholders who subscribed under defective prospectuses will not be prohibited by any necessity to rescind a contract of subscription. The abrogation of Houldsworth will undoubtedly be quite significant.

That some ambiguity remains about the consequences of this determination are clear, however, from observations expressed in the Full Federal Court in the appeal decision of Sons of Gwalia.[30]

Claims against a company based on a defective prospectus can be pursued by both subscribing and transferee shareholders before winding up occurs; however, subscribing shareholders’ claims, though a debt, will be subject to postponement on liquidation. These ambiguities and any possible anomalies will hopefully be resolved by the High Court when it considers the appeal in Sons of Gwalia in early 2007.

Despite lingering ambiguities, the determination in Cadence may in future lead to the greater use of class actions by shareholders against companies where this has occurred. This highlights the need for companies releasing prospectuses to ensure compliance or suffer private enforcement of the prospectus disclosure obligations by those shareholders.

In addition, Sons of Gwalia, as it currently stands, confirms that shareholders have the right to claim compensation on an equal basis with creditors if they can prove they were misled into buying the shares on market. This development, if confirmed by the High Court, may adversely affect the ability of companies to raise debt finance with creditors not being assured of top rank in liquidation.

It may also have significant flow-on effects in company insolvency.

PROFESSOR PAUL VON NESSEN is Professor, Business Law and Taxation, Monash University and a consultant with McCullough Robertson, Brisbane.

RACHEL WEEKS is a senior associate with McCullough Robertson, Brisbane.

[1] (1880) 5 App Case 317.

[2] [2005] FCAFC 265.

[3] From the judgment of Finkelstein J [2005] FCA 1280.

[4] Corporations Act, s710.

[5] Note 1 above.

[6] Per Finkelstein J, [2005] FCA 1280 at [5].

[7] Note 1 above at 325 per Earl Cairns LC; Re Addlestone Linoleum Co (1887) 37 Ch D 191, at 205-206 per Lindley LJ.

[8] Oakes v Turquand (1867) LR 2 HL 325.

[9] Corporations Act, ss128-9.

[10] Section 111A of the Companies Act 1985 (UK).

[11] Corporations Act, s563A provides that 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 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.

[12] (1993) 179 CLR 15.

[13] Companies Code (Vic), sub-paras 360(1)(e) and (k), which are in similar terms to the current Corporations Act ss516 and 563A.

[14] Note 12 above, at 37.

[15] [2005] FCA 51; (2005) 52 ACSR 346.

[16] Per Finkelstein J, note 15 above, at 3.

[17] [2005] FCA 1305; (2005) 55 ACSR 365.

[18] Corporations Act, s674 and the ASX Listing Rules.

[19] Soden v British Commonwealth Holdings Plc [1998] AC 298.

[20] The Federal Court upheld the decision on appeal in February 2006.

[21] Special leave to appeal to the High Court granted 16 June 2006, High Court Bulletin 5 of 2006; the High Court heard arguments on 7-8 August 2006, with judgment reserved, High Court Bulletin 8 of 2006.

[22] [2005] FCA 1280; (2005) 52 ACSR 346.

[23] State of Victoria v Hodgson [1992] 2 VR 613.

[24] [2005] FCAFC 265.

[25] Note 24 above, at [49].

[26] Note 24 above, at [46].

[27] At para 8.1.

[28] Note 24 above, at [43].

[29] Note 24 above, at [43].

[30] [2006] FCAFC 17 at [33] (per Finkelstein J, Gyles and Jacobson JJ concurring), currently on appeal to the High Court. Cadence was not considered in the initial appeal of Sons of Gwalia because it was handed down after arguments.


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