NSW Court of Appeal, Schemes of Arrangement and Classes- the Boart Longyear case  NSWCA 116 (26 May 2017)
Schemes of Arrangement (under Part 5.1 Corporations Act) have had something of a revival, particularly among larger company or group restructurings. This is not unique to Australia. The Scheme derives closely from older English legislation, and applies to solvent and insolvent schemes. There has been a revival of its use for the last several decades in the UK. Recent law reform in Singapore and proposals in the EU build upon the scheme of arrangement as a central feature of business rehabilitation law, so its importance, and jurisprudence, will continue.
In Australia, we have seen Schemes used in some high-profile restructurings in very recent years, including Centro, 9 Network, Opes Prime, and Alinta. There are a number of pros and cons of Schemes compared with Deeds of Company Arrangement following on from a Voluntary Administration under Part 5.3A. One difference is that in a VA, creditors are not divided into different classes for voting purposes. Whether or not separate class meetings is a pro or a con depends on the circumstances, and the perspective of a particular creditor, and the company proponent.
Schemes under Part 5.1 require a two-stage court process. At the first hearing, the court considers the jurisdictional aspects, considers information to be disclosed to creditors and members, and orders the convening of meetings. Since the English Court of Appeal decision in re Hawk Insurance EWCA 241 it has been clear that the court has important work to do in this first meeting when it comes to confirming the constitution and number of separate classes of creditors and members to be convened. The decision of Barrett J in re Centro NSWDC 1171 also threw light on the relationship between the first and second meetings.
After the meetings have been held, and the requisite 75% of those present and voting in each class have approved the scheme, the court at the second hearing can still consider whether as a matter of substance the scheme is ‘fair and reasonable’ to creditors and members, so depending on the emphasis placed by different courts, there is the possibility for creditors or members objecting to class composition to have a ‘second bite of the cherry’ at the approval hearing, which also prevents a ‘veto’ effect of a decision at the first hearing. There are other implications, such as costs, complexity, including valuation issues, which impact on the balance between the first and second hearing deciding these issues (See further discussion in my article, Chapter 12 , ‘Equity’s Voice in Restructuring’ in Griffiths et al (eds) Exploring Tensions in Finance Law: Trans-Tasman Insights (Thomson Reuters/BFSLA 2014).
The test for determining the constitution of classes has an ancient lineage in the oft-cited statement of Bowen LJ in Sovereign Life Assurance Co v Dodd  2 QB 573, name whether the proposed class members comprise those ‘whose rights are not so dissimilar as to make it impossible for them to consult together with a view to their common interest’.
Several cases have emphasised that what is important is a of their legal rights, not commercial interests. (eg Primacom (2011) UK, re CSL(2010) in Australia. Nevertheless, there are also statements which emphasise that it is possible for creditors to consult even though their rights are not identical in every aspect. Secondly, the approach taken since re Hawk Insurance is to acknowledge that whilst the court must address class composition at the first stage when ordering class meetings to be convened, the court at the second stage can certainly consider the impact of the scheme on particular creditors or a class, when assessing whether it is ‘fair and reasonable’. On the other hand, courts at the second stage are respectful of the majority approvals at the meetings, unless there is clear discrimination or unfairness to a minority. For that reason, as Chadwick LJ in re Hawk and others too have emphasised, it is important to address any issue as to class composition at the first hearing. There is little doubt that the Sovereign Life test has held sway for over one hundred years. However, working out whether the legal interests are ‘so dissimilar that it is impossible to consult’ as a class, is the harder part.
Boart Longyear at first instance- Black J
The above is the context of the decision of Black J at the first-stage hearing under s411 (Part 5.1) in Boart Longyear Ltd. NSWSC 567, on 10 May, approved by the Court of Appeal when giving leave to, and then dismissing the, appeal on 26th May ( NSWCA 116).
Boart Longyear is a US group in drilling and mining equipment, its Australian operation being headquartered near Adelaide airport. After a number of years of financial difficulty and an initial restructuring, a fresh restructuring was announced to the market following default on note interest payments. Two interdependent schemes of arrangement, one for senior Secured lenders and noteholders, and one for senior Unsecured noteholders, were proposed. First Pacific Advisors LLC, a holder of 29% of Senior Secured Notes, objected to being put in the same class as other secured lenders under Term Loan A and Term Loan B notes. The objections were based on the different rights which these notes held both before and after the proposed scheme, and in particular, Centrebridge, which was Boart Longyear’s largest shareholder prior to the proposed scheme, was the lender in respect of all of the Term Loan A and B notes, and, in return for an interest reduction of 2% on the notes, was to receive a higher percentage of equity through the scheme and also a higher number of nominees on the board post-restructuring. Centrebridge, along with two other entitites, also held senior secured notes. Whilst not all the differences pointed out by First Pacific will be mentioned here, another important one, related to control by Centrebridge, was that under the scheme, the term loan note holders and the senior secured notes waived their rights in relation to change of control events. As Centrebridge gained control of the post-restructuring company, the waiver of these rights affected the secured note holders differently.
Given the 75% threshold required for class approval under Part 5.1, First Pacific would have been able to veto the Secured Creditors Scheme if they were just in a class of secured note holders, but clearly could not do so when placed with Centrebridge in its capacity as Term Loan A and B holders.
Black J applied the Sovereign Life test, and that required a focus on legal rights, not commercial interests. He emphasised two features in particular which justified a single class for the secured creditors. The group would go into liquidation if the schemes were not approved and secondly, because there were complex security arrangements, all secured creditors would have to negotiate in order to enforce their security over common assets on the event of liquidation. As for the other differences alleged by First Pacific, His Honour only found that one of them was actually a difference in legal rights, and even in respect of that one, the two common features referred to above, meant that he concluded that the secured creditors’ common interests outweighed the difference, which was about alteration to the means of payment of interest. In relation to Centrebridges’ post-restructuring control of the group, and right to nominate an increased number of directors, once again he did not think that these, in combination with the other matters alleged, outweighed the possibility of consulting on areas of common interest, particularly as the future equity value of the group was an uncertain matter.
Justice Black did not accept First Pacific’s submission based on Primacom Holding GmbH v Credit Agricole  EWHC 3746(Ch) that ‘a relatively narrow degree of differentiation in rights both before and after the scheme will be sufficient to require separate classes’. Yet this case ultimately turns on the degree of similarity or difference acceptable within the Sovereign Life test. It is arguable that this case goes much further than the types of smaller difference in rights found to have not led to convening of separate classes in earlier English authorities. In particular, Centrebridge gained a post-restructuring controlling equity position and greater board control. If the idea of the scheme was to avoid liquidation, that presupposed that there would be some equity upside post-restructuring, so it is hard to see that creditors who were not getting those advantages could consult with a common interest with the creditor who was.
Of course, since consultation just means talking, on a literal meaning it would be difficult to say it is ‘impossible’ for two groups to consult. But clearly that is not what the Sovereign Life test is getting at. In this case, there were clearly dissimilar rights, which had important outcome differences as between the Term Loan holders and other secured creditors. Whilst the secured creditors may have shared some ‘common interests’, that Black J found outweighed the dissimilarities, it is suggested that the purpose of the Sovereign test is subverted when construed in this way. Rather, if balancing is to occur, it should be the other way round. Their common interests (eg in the effect of liquidation on security over common assets) should not have outweighed their significantly dissimilar rights. This is more consistent with the purpose of separate classes, as identified in the statement from Primacom cited above.
Court of Appeal
Leave to Appeal
The Court of Appeal judgment was given by Bathurst JA. Normally, the Court said, as the matter can be reviewed at the second stage, that would provide a powerful case for refusing leave. The Court stressed that it has been repeatedly emphasised that the first hearing has a limited function, and that the position reached on class constitution will not preclude this being an issue for debate at the second hearing when considering whether a scheme approved by the requisite classes is ‘fair and reasonable’, particularly as many affected would not have had notification of the first hearing.
But that is not to say that the issue should not be dealt with if a ‘class creating problem is flagged’ Here, as Black J had fully heard the issue, and it would create uncertainty for all creditors and an indeterminate amount for an undertaking attached to any injunction sought by First Pacific, the Court allowed leave and went on to consider the substantive appeal.
Consideration of the appeal
The Court upheld Black J’s decision and reasoning, though with some differences of emphasis as to which rights and their effects, were the most important issues to focus upon. The Court cited Finkelstein J in re Opes Prime (2009) to the effect that the judge should adopt a ‘practical business-like approach’ to identifying classes, particularly bearing in mind the potential of a minority to veto the scheme.
The first observation about the Court of Appeal’s approach is that the Court placed significant emphasis, more so than Black J, on the context in which the test is applied and, in particular, cited passages from a number of recent English High Court cases where the comparator of the outcome on insolvent liquidation was emphasised (re APCOA Parking , re Telewest Communications . Secondly, the consideration is not of separate rights, but the bundle of rights held or to be held: re Cortefiel SA [2012). In this case, there was no alternative such as a DOCA or another restructuring proposal which could be put up as a comparison and, in the absence of that, the approach taken in the recent English cases, of a comparison with insolvent liquidation, was appropriate here.
Thus, Bathurst CJ said that the right to call up loans, and the grant of additional equity to Centrebridge, were in practice of little relevance in a liquidation comparison where the loans could not be repaid and the equity would be worthless. Similarly with the differences in the treatment of interest between the senior secured noteholders and the term loan holders.
This approach should put valuation evidence front and centre. In this case, there was a report from Korda Mentha, which the Court said showed that on a liquidation, both secured note holders, and term loan holders, would be better off, whereas unsecured note holders would get nothing, meaning that shares would be worthless. The Court said that the question of whether the shares would have any value post implementation of the proposed schemes was ‘at best speculative’. However, the Court acknowledged that a KPMG report which had been prepared for non-associated shareholders (not Centrebridge and associated shareholders) ascribed a small value to the shares post-restructuring, compared to nothing on a liquidation.
The Court identified the increased equity given to Centrebridge as the most critical issue. Here, it thought that the fact that the other secured note holders, such as the appellant, were not holders of any equity at all pre-restructuring, was a relevant factor. Secondly, Centrebridge already controlled 48.9% of the shares so had de facto control of the general meeting. Thirdly, even on KPMG’s most optimistic valuation of any post-restructuring equity value, Centrebridge was not getting any financial advantage from the reduction in interest rate compared to the other senior secured note holders. All creditors in the suggested classes would do better than on a liquidation in this case, which was not the position in earlier cases relied upon by the appellant. The director nomination proposal did not make a real difference, because once Centrebridge had control, it could appoint or remove directors given its majority at the general meeting post-restructuring.
The Court noted that it was the totality of the rights and their effect that had to be looked at. Looking at the combined effect on the rights of the respective creditors, and the in the context of the company’s ‘parlous’ financial position, His Honour concluded that the ‘real rights of the creditors and the rights provided by the scheme are not so dissimilar as to require separate class meetings’.
Lastly, the Court, in addition to its comments on the nature of the first hearing in relation to the second, left these parting words:
“Some of the matters raised by the appellant may well be said to go to the fairness of the scheme rather than to the particular class issues. Nothing in this judgment should be taken as expressing a view one way or other on the fairness of the scheme”.
The reality is that creditors’ schemes of arrangement will usually be in the shadow of an alternative of liquidation, unless there is a group putting up an alternative restructuring proposal. The Court of Appeal has made it very clear that a narrow, almost literal, reading of the Sovereign Life test should be applied. If everyone is going to be better off than under a liquidation, then it seems that this fact is a ‘common interest’ outweighing a number of clear differences in the respective legal rights attached to debt or shares before and after the proposed scheme.
Two important points emerge from this. First, the Court has confirmed that the second bite of the cherry is available at the substantive hearing, to raise class composition as an issue of fairness and reasonableness. We can expect to see consideration given to this issue at the second hearing in this case, in light of the information about the majorities obtained in the class meetings.
Secondly, we have not seen in Australia any Part 5.1 cases where the court has had to examine contested expert valuation evidence brought forward for the purpose of valuing the rights before and after a proposed scheme, either at the first or the second hearing stage. The English re Bluebrook (IMO Car Wash) case (2010), Mann J, and a number of US authorities, show the way forward in that respect (See ‘Equity’s Voice in Restructuring’ above). In this case, the Court did rely on valuation evidence as to the value of equity post-restructuring compared to liquidation value, but the evidence was not prepared specifically for the purpose of addressing the value of the bundle of rights in issue, and in any event was not subject to the scrutiny before Black J as was the case in re Bluebrook. In relation to actions under section 444GA in a Deed of Company Arrangement, for permission to transfer shares, we have seen some references to valuation evidence to assess whether or not shares are under water or might have a post-restructuring upside. In some of those cases, the question has rightly been asked, if shares have no value now, why are they being granted to some stakeholders as part of the scheme/DOCA? That question could well be asked in the Boart Longyear case as to the equity rights which Centrebridge was being granted. In the s444GA context and in the UK scheme cases, the courts have rejected the argument that shares must have some positive value now just because they are being proposed to be issued as part of a restructuring.
In summary, it is suggested that the approach of both Black J and the Court of Appeal to application of the Sovereign Life test was too narrow or literal, in uniting stakeholders with clearly different rights, and different impacts of those rights in this particular case, purely on the basis that they have the alternative of insolvency as a common interest. However, it clearly leaves open the door to raise the class composition issue at the second stage of whether the proposed scheme is ‘fair and reasonable’. If, at either the first or second hearing, the issue is going to turn on a comparison with the liquidation outcome, more detailed valuation evidence should become the norm in such cases. Whilst there is a need for a policy of a ‘practical business-like approach’ to class composition and to avoid ‘veto’ by minority groups or single creditors at the first hearing, this should not obscure the fact that there may be property rights of (albeit contestable) value attached to such members or creditors’ rights.