With ongoing volatility in global markets and levels of distressed debt at an all-time high, we will inevitably see a surge in bankruptcies in the coming months and years. The business uncertainty caused by a prolonged downturn may also expose or lead to an increase in fraudulent behavior as, under increasing pressure to hit earnings targets, management resort to improper means to replace lost revenue in the marketplace.
For investors who have suffered losses caused by securities fraud, recovering any value from an insolvent company can be challenging in some jurisdictions such as the United States, where securities fraud claims ordinarily stand last in line for payment from a bankruptcy estate. However, shareholders should not assume that they will be unable to recover any of their losses from a bankrupt issuer: There may be various routes to recovery in the United States and particularly in jurisdictions outside of the US that provide better treatment to defrauded investors.
The Common Approach to Securities Fraud in Insolvency
In nearly all jurisdictions, including the United States, the “absolute priority rule” or its local equivalent means that creditors rank ahead of equity investors when it comes to recovering assets in bankruptcy. The policy rationale for this is that equity investors reap the benefits of any of the wealth-generating activities of a company and also take on the risks of company failures.
However, the nature of equity investment has changed since the rule subordinating of investor claims was first established. On the whole, shareholders are no longer a small group of entrepreneurs but are a widely dispersed group that cannot easily monitor officer conduct. The modern day creditor, meanwhile, is often a large sophisticated financial institution that can monitor the activities of corporate officers through loan covenant compliance and other disclosure requirements. In recent years, many jurisdictions have to some extent tempered the absolute priority rule.
Under Section 510(b) of the U.S. Bankruptcy Code, common shareholders’ securities fraud claims are given the same priority as common stock, leaving defrauded shareholders little hope of recovering from the company while it is in bankruptcy. However, US securities laws do provide a narrow route to compensation through the fair funds provisions of the Sarbanes-Oxley Act—enacted in response to the Enron, WorldCom and other large corporate frauds and scandals in the early 2000s.
Although securities claims are still subordinated in bankruptcy proceedings, investors can receive remedies indirectly under powers granted to the Securities Exchange Commission. Because SEC claims rank equally with claims of unsecured creditors in a bankruptcy or restructuring proceeding, investors may be eligible for some recovery from the bankrupt company’s assets indirectly through the SEC, as seen in action in SEC v WorldCom.
The SEC secured an injunction against WorldCom and proposed a settlement agreement of a $2.25 billion monetary penalty—worth around 40% of the estimated liquidation value of WorldCom—to be satisfied by various mechanisms such as cash payment and company stock. The court held that the amount provided a sufficient penalty to deter corporate officers from future fraudulent conduct while also ensuring that the company was able to reorganize and continue to operate. The court recognized the tension between creditor interests and the investor claims, and balanced those interests by allowing shareholders to realize some value of their losses through the SEC action.
Obviously, this route to recovery relies upon the SEC bringing a claim and taking action on behalf of the shareholders—something that is, for the most part, out of the control of the defrauded investors. The SEC also establishes fair funds in only a small number of cases, and even in those cases investors must typically wait many years to receive a distribution of proceeds.
Another way that shareholders can still recover when a company goes bankrupt is by pursuing a claim directly against the directors and officers. For example, In re PG&E Corporation Securities Litigation—an ongoing securities class action against Pacific Gas and Electric Company challenging the company’s disclosures about safety and compliance prior to the wildfires that devastated Northern California in October 2017—the action was stayed as to the bankrupt company under the Bankruptcy Code’s mandatory stay provisions, but not against the company’s officers, directors and underwriters.
The availability in certain cases of directors and officers liability insurance or potential claims against solvent joint tortfeasors like auditors and underwriters can provide meaningful remedies to injured shareholders where claims against an insolvent issuer do not.
The statutory rule set out in section 74(2)(f) of the Insolvency Act 1986 is that shareholder claims are generally subordinated in insolvency proceedings. However, there is an exemption to this rule following a 1998 House of Lords ruling.
In Soden v British & Commonwealth Holdings plc it was held that S74(2) of the Insolvency Act required a distinction to be drawn between sums due to a shareholder given its character as a shareholder, e.g., through dividends and profits, and sums due to a shareholder outside of its character as a shareholder. The decision clarified that if a shareholder has a cause of action independent of their position as a shareholder, then they should be in no worse position than any other creditor.
Following the decision in Soden, English law permits shareholders to claim directly as unsecured creditors for fraudulent acts and misrepresentations by an issuer. Shareholders’ claims of fraud therefore rank pari passu with the claims of other unsecured creditors.
The usual order under the Australian insolvency regime is for shareholders to be paid after all creditor claims are discharged in full. Prior to 2010, there was an exception for shareholder claims against the company for misleading or deceptive conduct as seen in the High Court decision in Sons of Gwalia v. Margaretic  231 CLR 160.
However, following this decision the Legislature amended s.563A of the Corporations Act 2001 (Cth) to subordinate shareholder claims for misleading or deceptive conduct beneath other ordinary creditor claims. This still does not completely debar shareholders from redress.
If a company’s directors and officers are insured, then shareholders may still be able to recover from insurance proceeds by suing the covered directors and officers. While there are a number of high-profile instances where this has occurred, a recent example pending before the New South Wales Supreme Court is the RCR Tomlinson Ltd Investor Class Action.
In the RCR class action, the plaintiffs alleged that, from late December 2016 up until the time at which RCR was placed into administration in November 2018, the defendants made various misleading representations and omissions to the market concerning RCR’s EPC Solar Contracts and RCR’s financial position generally. Further, the plaintiffs alleged that the Prospectus for an Entitlement Offer that occurred just before RCR entered into administration was misleading in various respects. The plaintiffs alleged that as a result of this conduct, the defendants contravened provisions of the Corporations Act, the Australian Securities and Investment Commission Act 2001 (Cth), and the Competition and Consumer Act 2010 (Cth).
Despite the company entering into administration and then liquidation, three class actions were commenced in late 2018 and 2019 seeking recoveries via coverage from various insurance policies. In August 2019, those class actions were consolidated and that case is still pending before the court.
The Continental Europe Claimant-Friendly Approach
Germany and the Netherlands are leading jurisdictions in continental Europe for private action redress for injured shareholders, and take a more shareholder-friendly approach when companies enter administration.
In Germany, while shareholders can only expect to receive value for their shares in the event of surplus after all other claims have been fully satisfied, the position is different for shareholders who have been the victims of fraudulent misrepresentations. Any securities fraud claims are treated as standalone tort claims that qualify as regular insolvency claims and therefore rank pari passu with claims of unsecured creditors.
For example, numerous current and former shareholders of Wirecard AG, which recently collapsed into insolvency following the disclosure of a multi-year accounting fraud, are preparing to pursue claims against Wirecard for violations of Germany’s Securities Trading Act in the company’s ongoing insolvency proceedings. Unlike in the US, where such claims would likely be futile, Wirecard’s defrauded shareholders stand to recover alongside unsecured bondholders and lenders if the insolvency administrator successfully monetizes the company’s remaining assets.
The position in The Netherlands is equally straightforward. Pursuant to Article 37 of the Dutch Bankruptcy Act, investors asserting fraud claims that arose prior to the issuer’s insolvency, may present themselves in the bankruptcy as unsecured creditors.
Although many investors accustomed to the U.S. approach to securities fraud claims may assume there is no point pursuing such claims if a company becomes insolvent, there are still ways that shareholders can seek redress for fraud and misrepresentation, particularly in Continental European jurisdictions like Germany and the Netherlands. Even in common law jurisdictions, courts and policy makers are increasingly recognizing that although shareholders take on a higher level of risk (and potential for upside in time of business growth) than creditors, they should not be expected to take on the risk of fraudulent behavior. And it must be taken into account that in modern capital markets the large financial institutions that typical provide credit to corporations often have more information than common shareholders do.
Shareholders should be able to recover losses that are suffered as a result of corporate wrongdoing, and caselaw and statutory trends worldwide suggest that legislatures are increasingly recognizing the importance of meaningful remedies for capital markets violations to global economies.
This article was originally published in the New York Law Journal and can be found here.