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Out with the Hould: landmark decision paves the way for shareholder misrepresentation claims against companies in liquidation

In a significant decision for the Cayman Islands in In The Matter of HQP Corporation Ltd (in Official Liquidation) (FSD 190 of 2021 (DDJ)), the Grand Court has clarified that there is no bar to shareholders bringing claims for misrepresentation against a company in liquidation and, further, that such claims (if admitted) will rank as unsecured debts of the company. In reaching this decision, the Grand Court was required to analyse and consider the century-long debate regarding the “Rule in Houldsworth”, concluding that the rule, which arises from a decision of the House of Lords in 1880, forms no part of the fabric of modern Cayman company law.

The Rule in Houldsworth

To understand the significance of the decision in Re HQP Corporation, it is first necessary to understand what the “Rule in Houldsworth” (the “Rule”) actually is. That, in itself, is no easy task; the Rule, which takes its name from the House of Lords’ decision in Houldsworth v City of Glasgow Bank (1880) 5 App Cas 317, has been described in the English High Court as being “of legendary impenetrability”[1] and Commonwealth courts have struggled for over a century with how to define it. In its most basic form, however, the Rule provides that a shareholder of a company cannot claim damages for misrepresentation once the company has entered liquidation, having by then lost the right of rescission.

The luckless Mr Houldsworth was a shareholder in the City of Glasgow Bank (the “Bank”) who (it was accepted) had been fraudulently induced by the Bank’s directors to buy shares. The Bank, an unlimited joint stock company, soon went into insolvency and Mr Houldsworth was faced with very significant calls on his shares, substantially in excess of the amounts he invested. Mr Houldsworth was too late to rescind the subscription contract, given the Bank had entered insolvency, but sought to claim damages instead of rescission.

The House of Lords held that an action for damages based on misrepresentation could not be maintained against the insolvent company. The reasons given by the different Law Lords for such prohibition were varied, but included, inter alia, that:

  1. Mr Houldsworth had not bought a chattel or property, but in subscribing for shares in the Bank he had merged himself into a society and had contracted with his fellow members (often described by the Law Lords as “partners”), such that if there were a deficiency in the assets of the Bank, that deficiency would be made good ratably by the members;
  2. a claim by one member against ‘the company’ for a fraud committed by the company is a claim against all members except himself, and would run directly against the nature of the “partnership contract” struck with his fellow members; and
  3. a member cannot approbate and reprobate his subscription contract in this way, or adopt two inconsistent positions (one of shareholder, and the other of creditor of the whole body of shareholders including himself).

 Houldsworth in context

The decision in Houldsworth needs to be understood in its proper context. It was determined at a time when shares in a company were not considered to be property and 17 years before the House of Lords’ seminal decision in Salomon v Salomon [1897] AC 22, when the concept of a company having a separate legal personality was in its infancy and there remained strong influences from the law of partnership; indeed, the House of Lords regarded the shareholders in the Bank as akin to partners subject to a partnership contract. The Bank was also an unlimited joint stock company such that its members were required to contribute without limitation to its liabilities (although, as noted by Justice Doyle, the Rule subsequently appears to have been interpreted by Commonwealth courts as applying to limited companies).

Given the substantial development of company law throughout the Commonwealth since Houldsworth was decided (including with the introduction of investor protection and misrepresentation legislation), it is unsurprising that the Rule has been a target of substantial jurisprudential criticism, being described as an obsolete and antiquated rule bearing the mark of its era.

The effect of the decision in Houldsworth has also been reversed or excluded by statutory provision in England & Wales,[2] Australia[3] and Bermuda[4]. The fact that these jurisdictions have decided to do so not only indicates that their legislatures considered the rule derived from Houldsworth to be wrong, irrelevant to modern company structures or unwelcome, but that it is perfectly possible (indeed, desirable) for company law to operate without the restriction imposed by that case.

Given its chequered history throughout the Commonwealth, it is perhaps surprising that Houldsworth has flown under the radar in this jurisdiction and has not been the subject of any meaningful judicial commentary[5] – until now.

In the Matter of HQP Corporation Ltd: the Cayman approach to the Rule

Two preferred shareholders (the “Petitioners”) presented a just and equitable winding up petition against HQP Corporation Ltd (“HQP”) in July 2021 following disclosure of an admitted and pervasive fraud by HQP’s former chairman, Mr Chen, who had misrepresented financial data and falsified documents to obtain new investment. The Petitioners alleged that they were induced by Chen’s admitted fraud (i) to subscribe for preferred shares in HQP; and (ii) to accede to the issuance of new shares classes and the adoption of new articles which would subordinate their rights (and the rights of other earlier share classes) in the event of liquidation or redemption.

Following Mr Chen’s admission, there was predictably a run of redemption requests presented by all preferred shareholders. To prevent the newest class of preferred shareholders scooping essentially all of HQP’s assets and leaving nothing for earlier investors, the Petitioners urgently applied for and obtained an order (i) appointing joint provisional liquidators; and (ii) staying redemptions before the redemption date. HQP was subsequently wound up on 5 April 2022, following which the Company’s joint official liquidators (the “JOLs”) have been grappling with how to deal with threatened misrepresentations claims by the misled Petitioners.

The Petitioners contended that they could maintain misrepresentation claims against the company and that such claims would rank equally with any similar claims by other preferred shareholders induced to subscribe for shares in HQP.  Two of the later investors in HQP (“Access and AI Autoparts”), who stood to benefit substantially under the distribution waterfall in HQP’s Articles, contended that (i) all preferred shareholders had been redeemed; and, in any event, (ii) any misrepresentation claims were barred by the Rule, such that that any distributions to stakeholders could only be governed by HQP’s Articles.

The JOLs applied for directions as to:

  1. whether preferred shareholders who submitted redemption requests were creditors or shareholders in respect of their investments;
  2. whether preferred shareholders may in principle assert claims against HQP for damages for misrepresentation in respect of their subscription for shares; and
  3. if so, how such claims rank in the liquidation of HQP.

Access and AI Autoparts agreed before the hearing of the JOLs’ application that redemption had not occurred, so the Grand Court was only concerned with the second and third of these issues.

Treatment of Houldsworth
Before considering the difficult question regarding the availability of misrepresentation claims and the application of Houldsworth in the Cayman Islands, Justice Doyle spent considerable time in his judgment setting out the law related to judicial precedent, both in the Cayman Islands and in other Commonwealth jurisdictions, before detailing a myriad of circumstances where a Cayman Islands Judge may decline to follow an English Court (even at appellate level).[6] In a jurisdiction which relies heavily on English authority, attorneys will take great assistance from the Court’s extensive analysis in this regard.

Turning to Houldsworth itself, the Petitioners argued that Houldsworth should be distinguished, forms no part of Cayman Islands law, and cannot sensibly be sustained in view of developments in the law since 1880 and the very different context in which it was decided. Access and AI Autoparts argued Houldsworth was part of Cayman common law and should be followed.

In order to decipher the ratio of Houldsworth and determine its standing in modern jurisprudence, Justice Doyle embraced the challenge of analysing the judgments of the Law Lords in Houldsworth, its treatment in other prominent English[7], Australian[8] and Bermudan[9] decisions, legislative interventions throughout the Commonwealth, and a sea of textbook commentary over the past century. Having set out his analysis in a lengthy and carefully considered judgment, Justice Doyle determined that it was not appropriate to follow the House of Lords in Houldsworth, concluding at [162] that:

“Houldsworth can no longer be regarded as good English law (indeed it has been abandoned by the UK Parliament).  It is not a part of Cayman common law.  In my judgment, this is one of those rare cases where this court is justified, indeed obliged, to decline to follow an English decision.”

Justice Doyle rejected the suggestion that in not following Houldsworth he would be playing ‘judicial activist’, instead concluding that he was simply applying section 139 of the Companies Act (2023 Revision) (the “Act”)[10]untainted by a foreign judgment abandoned by its own Parliament”. His Lordship noted that decisions of the House of Lords (now the Supreme Court of the United Kingdom) are not technically binding on the Cayman Courts, and ultimately held that Houldsworth should not be followed because (i) it is arguably contrary to the plain wording of section 139 of the Act; (ii) it has been abandoned by the UK Parliament, has been heavily, persuasively criticised by others, and has not been followed in other Commonwealth jurisdictions; (iii) its reasoning is inconsistent with contemporary company law; (iv) it is an obsolete decision which has ceased to be authoritative in England, and (v) it is not persuasive in the present context.

Ranking of shareholder misrepresentation claims

Having concluded that shareholders may submit proofs of debt for damages for misrepresentation, Justice Doyle was then tasked with determining how such claims, if admitted, would rank in a liquidation.

The focus of the debate turned heavily on section 49(g) of the Act,[11] with the Petitioners asserting that misrepresentation claims fall outside that provision and rank as ordinary creditor claims as, properly analysed, they are not claims (i) brought by a member in their character as a member; or (ii) founded on rights or obligations arising under the statutory contract, but are instead founded on a (pre-contractual) tort.

Access and AI Autoparts contended that (i) the prescribed waterfall in the Articles applied equally to the ranking of damages claims amongst shareholders inter se; or, alternatively, (ii) their claims ranked in priority to the claims of the misrepresentation claimants (which, it was said, were claims subject to section 49(g)), and neither pari passu with nor subordinate to them.

Following the judicial reasoning of the Australian High Court in Sons of Gwalia (and declining to follow obiter comments from the House of Lords in Soden), Justice Doyle concluded:

“Section 49(g) of the Companies Act (2023 Revision) does not apply to misrepresentation claims.  These debts are not debts due to Preferred Shareholders in their capacity as members and any sums due to those successfully advancing misrepresentation claims would not be due to them under the statutory contract between members and the company and the members inter se constituted by the relevant statutory provision. … A claim for misrepresentation as envisaged in the case presently before me arises from a tort independent to the statutory contract.”

His Lordship also held that the contractual waterfall in the Articles was not applicable, given that it applied to debts of members arising in their capacity as members. Claims of the type advanced by the Petitioners were not member debts, but were properly creditor debts based on misrepresentations made prior to them becoming members.

Protection and Certainty for Investors

The decision in Houldsworth has led to much uncertainty about the rights and remedies available to shareholders of companies in liquidation whose investments had been induced by misrepresentations. The decision in HQP Corporation therefore provides much needed clarity and confirms the right of victims of misrepresentation to obtain a more meaningful remedy against a company in liquidation. The decision will be welcomed by investors and should provide confidence that the Cayman Islands is a leading financial center with appropriate remedies for victims of misrepresentation.

This decision also highlights the flexibility of the Cayman Islands common law and its ability to adapt as necessary to changing social and economic conditions. As noted by the Learned Judge at paragraph 72 of his judgment, “as we develop and mature as an independent jurisdiction we should have the confidence to break the umbilical cord from the English common law and develop our own common law to suit the best interests of the Cayman Islands.”

Guy Cowan and Harry Shaw of Campbells LLP, together with Robert Levy KC, represented the Petitioners.

[1] See Soden v British & Commonwealth Holdings plc [1995] 1 BCLC 686 at 695
[2] Section 655 Companies Act 2006 (previously s.111A Companies At 1985).
[3] Section 247E Corporations Act 2001 (Cth)
[4] Section 54A Companies Act 1981
[5] Houldsworth was the subject of passing obiter comments from Smellie CJ, as he then was, in SPhinX Group of Companies 2010 (2) CILR 1.
[6] See paragraph 69 of the judgment.
[7] House of Lords decision in Soden v British & Commonwealth Holdings Plc [1998] A.C. 298
[8] High Court of Australia decision in Sons of Gwalia Ltd v Margaretic [2007] HCA 1; [2007] 3 LRC 462
[9] Televest Ltd (12 July 1995)
[10] Section 139(1) sets out the debts which are provable in a company’s liquidation and provides “all debts payable on a contingency and all claims against the company whether present or future, certain or contingent, ascertained or sounding only in damages, shall be admissible to proof against the company and the official liquidator shall make a just estimate so far as is possible of the value of all such debts or claims as may be subject to any contingency or sound only in damages or which for some other reason do not bear a certain value.”
[11] This provision states that in the event of a company being wound up “no sum due to any member of a company in that person’s character of a member by way of dividends, profits or otherwise, shall be deemed to be a debt of the company, payable to such member in a case of competition between that person and any other creditor not being a member of the company; but any such sum may be taken into account for the purposes of the final adjustment of the rights of the contributions amongst themselves.”

Guy Cowen - Senior Associate, Campbells Grand Cayman - Insolvency & Restructuring

Guy Cowan

+1 345 914 5876
Harry Shaw - Associate, Campbells Grand Cayman - Dispute Resolution

Harry Shaw

+1 345 914 5869