Old rule, new relevance: The Court of Appeal reaffirms the Houldsworth principle

• Walkers represented the joint official liquidators of HQP Corporation Limited (in Official Liquidation)¹ in a landmark decision² in which the Court of Appeal (the 'CICA') held that the Houldsworth principle remains part of Cayman Islands law.

• The CICA has held that the Houldsworth principle still applies in the Cayman Islands to prevent shareholders who claim damages for misrepresentation against a Cayman Islands company ('misrepresentation plaintiffs') from being admitted to proof in its liquidation – but only until all non-shareholder claims have been paid. The CICA held that such misrepresentation plaintiffs are permitted to prove in the liquidation thereafter.

• Both misrepresentation plaintiffs and redeeming shareholders claim in their capacity as members of the company and are, therefore, subject to the subordination provisions of section 49(g) of the Companies Act. 

Background

The judgment related to two appeals from the orders of Doyle J in Re HQP Corporation Limited (in Official Liquidation) dated 19 July 2023 and Segal J in Re Direct Lending Income Feeder Fund Ltd. (in Official Liquidation) dated 8 May 2024 following applications to the Grand Court by the liquidators of the two companies for directions.

The applications concerned the treatment in the liquidations of claims by investors who were said to have been induced to subscribe for shares by misrepresentations by the companies.  In both cases, the represented value of the companies had been misleadingly inflated, and financial records of HQP had also been falsified. The appeals in HQP and Direct Lending were heard together, following conflicting rulings at first instance. 

Overview of the CICA Judgment

In both appeals, the CICA determined the following two key issues:

1. whether claims for damages for misrepresentation inducing a subscription for shares in a company can be admitted to proof in a liquidation or whether such claims are barred by the English decision of the House of Lords in Houldsworth v City of Glasgow Bank (1880) 5 App Cas 317 (the 'bar on proof issue'); and

2. if such claims are provable, where do such claims rank in a liquidation in relation to other claims made by members, former members and unsecured third party creditors? In particular, do they fall within section 49(g) of the Companies Act so that the claims of members and former members are subordinated to the claims of external unsecured creditors (the 'priority question').

With respect to the bar on proof issue, the CICA held that:

1. The Houldsworth principle remains part of the common law of the Cayman Islands.

2. The effect of this long-standing (since 1880) English common law rule (until its abrogation in England and Wales in 1989 by legislative intervention) was that a shareholder was precluded from proving in a winding up for damages for a misrepresentation which induced him/her to enter the subscription contract.

3. The common law rule in Houldsworth (which operated alongside the statutory regime governing the right to prove in a winding up) was soundly based on the principle of the maintenance of capital to protect the interests of non-shareholder creditors.

4. However, where the company’s creditors have been paid or dealt with, the Houldsworth rule should not prevent a misrepresentation plaintiff from proving in the winding up of the company in competition with other shareholders. Whilst this had not been contemplated by the existing Houldsworth rule as developed, the CICA found Segal J's reasoning for this conclusion to be compelling.

5. Such misrepresentation plaintiffs are creditors of the company and if the external creditors have been paid or dealt with they ought to be able (consistently with sections 49(g) and 37(7) of the Companies Act) to prove for their claims (including, rescinding their subscription contracts, if necessary). In those circumstances, misrepresentation plaintiffs would not be competing with external creditors.

With respect to the priority question, the CICA held that:

1. Redeeming shareholders³ and misrepresentation plaintiffs claim in their capacity as members and are subject to section 49(g) of the Companies Act (which subordinates the claims of members to the claims of external unsecured creditors).

2. With respect to misrepresentation plaintiffs, their claim is essentially for the return of the contributions to the company’s capital which the member is required by the subscription contract and the articles to make. Such claims are brought 'in that person’s character of a member by way of dividends, profits or otherwise' under section 49(g) of the Companies Act and are, therefore, deferred to those of 'any other creditor not being a member of the company'.

3. The fact that the redeeming shareholders have become creditors does not require that they be given priority over the misrepresentation plaintiffs (who are themselves creditors). Misrepresentation plaintiffs and redeeming shareholders have priority over the general body of shareholders, but not over other creditors, and hence not over each other.