A case of preferences

Professor Bob Baxt reports on a recent High Court decision that examines whether a company has to first issue ordinary shares if it wants to also issue preference shares.

LW Furniture (Australia) was a company belonging to the Weinstock and Beck families. It is very unusual for a private company such as this one to throw up not one but two problems that finished up in the High Court of Australia, requiring decisions on what the law governing a particular issue should be.

In my last column (Company Director, July 2013), we considered the case of Weinstock & Anor v Beck & Anor [2013] HCA 14, in which the High Court had to interpret the powers a court had under section 1322(4)(a) of the Corporations Act 2001 to correct a mistake made by the company or an oversight in its administration. In this case, it was the appointment of directors to the company.

The second case the High Court had to consider was Beck v Weinstock [2013] 93ACSR 251. It concerned a very different, but important, question of law, particularly for smaller companies – that is, whether it was possible for a company to issue only preference shares (indeed, redeemable preference shares) and operate successfully under the relevant legislation.

In this case, when the company was placed in liquidation (which was also the event that triggered the queries arising in the earlier case referred to above), the question was whether the remaining shareholders on the company’s shareholders register, who held redeemable preference shares, were entitled to receive the remaining assets available to members of the company once liquidation was completed.

This case was first considered by Justice Hamilton in the New South Wales Supreme Court, then by a Court of Appeal in the New South Wales Supreme Court and finally, leave to appeal was granted to argue the case in the High Court of Australia.

The High Court decision was delivered via three separate judgments: one by Chief Justice French; another by justices Hayne, Crennan and Kiefel; and a third by Justice Gageler.

LW Furniture was basically a family company. Two sets of families, which were related to each other, prospered from its operations for a number of years.

Regrettably, over the years disputes arose and once the founders of the company had passed away, the surviving members of the company became entangled in the disputes.

The critical question arising in Beck v Weinstock was whether a company could organise its capital in such a way that only redeemable preference shares remained outstanding in the company’s "books" when the time came for the company to be liquidated

Readers will be aware that preference shares (in this case, redeemable preference shares) are issued at a time when a company may not wish to incur debts through a loan, for example, but needs additional funding to progress its activities.

The company can arrange for shares with preferential dividends and other rights attached to them to be issued to persons who might otherwise have become lenders or have provided some other form of financial support to the company.

Usually the rate of dividend return on these shares is higher than the rate ordinary shareholders might receive. Dividend rates would typically be decided by the company in each case.

Nonetheless, shareholders would enjoy a priority right to a return of capital, with the ordinary shareholders being provided with the balance available once all debts had been paid and the preference and other similar shareholders had been reimbursed.

The preference shareholders normally only receive the face value of the amount they have subscribed for in relation to the shares issued by the company.

They are not usually entitled to receive any extra capital that may be available. The ordinary shareholders usually receive any balance of the assets once all debts have been paid, and sometimes this is a very small amount.

When LW Furniture was placed into liquidation, it was discovered that only one set of shares had been issued – the redeemable preference shares – and that these belonged to one part of the family group, much to the chagrin of the others who challenged the availability of these funds being distributed to the other family group. The main argument was that this was not legally possible as the company had to have had ordinary shares issued.

There was a considerable amount of disagreement in the lower courts as to whether it was legally "proper" for companies to be set up with only one class of shares, and this was the basic question the High Court had to consider.

In one sense, the most interesting judgment was that of Chief Justice French. He outlined a short but interesting history of how companies had been developed in terms of the issue of share capital and the evolution of preference shares in English company law, which was copied by Australian company law.

It is unnecessary for our purposes to discuss this early history; suffice it to say that under the current legislation operating in Australia, the Corporations Act, specific provisions allow for the issue of redeemable preference shares without any precondition that ordinary shares must also have been issued.

Section 254A(3) defines what a redeemable preference share is and sets out the rights that need to be attached to preference shares, noting that it is essential that those rights are set out with reference to the preference shares to be issued.

As noted earlier, there is no provision in the legislation requiring the company to issue ordinary shares or other types of shares, "nor is there anything in the Act to proscribe the redemption of redeemable preference shares in the absence of issued ordinary shares" (see para [42]).

Chief Justice French also discussed the rules that operate in company law for the maintenance of share capital (companies must not allow their share capital to be diminished or reduced without going through proper procedures).

However, he again emphasised there was nothing in the legislation or in the developed case law to prevent companies from issuing only redeemable preference shares.

He upheld the earlier decision justifying the payment to the redeemable preference shareholder.

The judgment of Justice Gageler is also very interesting.

In his view, the critical question was whether preference shares alone could be issued by the company. He noted that under the relevant legislation "a company must have at least one member, but need only have one member".

He added: "A company comes into existence on the day on which it is registered, at which time shares to be taken up by members, as specified in the application for registration, are taken to be issued to members.

"For a company limited by shares, the application for registration must state ‘the number and class of shares each member agrees in writing to take up’. At the time of registration, a company limited by shares must therefore have at least one share of at least one class but need only have one share of one class" (see judgment at [82]).

Justice Gageler also noted that companies enjoy a very wide range of powers and choices that they can make in relation to shares. A company has the power to issue and cancel shares. It has the power to issue new shares with different rights attached to the different shareholders. There are rules in the legislation to control the right of companies to vary the rights of existing shareholders when new shares are issued with preferential or different rights. There have been many cases in which companies have ignored those particular obligations and have issued shares with different rights with consequences that have led to those rights being reviewed and cancelled.

Justice Gageler noted that the power to issue preference shares was one that was, and is, clearly recognised by the relevant legislation and therefore, in his view, the appeal should be dismissed.

His decision, a very short one, is an important one.

It is interesting to note some other arguments put forward by the opponents to this interpretation.

In its constitution, the company only documented the rights attached to preference shareholders. There was no discussion in the constitution of the rights attached to other shares (none were on issue at the relevant time).

In the view of justices Hayne, Crennan and Kiefel, the redeemable preference shares had been validly issued. The company’s articles of association (constitution) had been drafted in such a way that the preference shares "had rights which preferred the holder of those shares over the holder of any ordinary share in the company".

They added: "That no ordinary shares would have been issued does not deny that the disputed shares were preference shares. The company’s articles of association provided that the disputed shares were liable to be redeemed. They were redeemable preference shares" (at [75]).

It was suggested that as the company had only one class of shares on issue – redeemable preference shares – when they were redeemed, the company would have no shareholders or members left.

While justices Hayne, Crennan and Kiefel agreed such a result was possible, this did not mean the issue of the shares was invalid.

Although the case is of greater relevance to smaller proprietary companies, it is an interesting one.

As it is a decision of the High Court of Australia, its importance acquires a more significant stature.