Differential treatment of creditors of an equal class?

In the matter of Academy Construction & Development Pty Ltd (subject to Deed of Company Arrangement) [2024] NSWSC 808
Will a court uphold a DOCA that differentiates between creditors of an equal class?

Overview

In this case, the Court considered whether a DOCA should be terminated on the basis that it unfairly prejudiced one unsecured creditor with a disputed claim by placing it in its own class and treating it differently from other unsecured creditors. The Court concluded that there was no rational distinction between the position of the unsecured creditors whose claims were allowed in full, and the position of the creditor with the disputed claim, who was set to receive a dividend of 2.4 cents in the dollar. As a result, the Court ruled that the DOCA unfairly prejudiced the creditor, and ordered that the DOCA be terminated.

Background

The Plaintiff Owners Corporation sought an order under s 445D of the Corporations Act 2001 (Cth) (“Act”) that a Deed of Company Arrangement (“DOCA”) entered into by the Second Defendant, Academy Construction & Development Pty Ltd (“ACD”), be terminated and an order that ACD be wound up. The Owners Corporation is the owners corporation in respect of a strata property situated in Botany in New South Wales, which comprises three separate buildings comprising 104 residential apartments that were designed and constructed by ACD under an agreement with a developer. The building works were completed in late 2014.

In March 2021, the Owners Corporation commenced proceedings against ACD and others alleging defects in the building arising from works performed by ACD. In August 2023, voluntary administrators (“Administrators”) were appointed to ACD. The Owners Corporation lodged a proof of debt in the voluntary administration in the amount of $7,127,600 plus GST and legal and expert costs.

A DOCA proposal was made in September 2023. It differentiated between Class “A” creditors (who were identified as ACD’s creditors other than the Owners Corporation, being the ATO, trade suppliers and a company associated with ACD) and Class “B” creditors (of which the Owners Corporation was the only member). The DOCA proposed that Class “A” creditors be paid in full, while Class B creditors (the Owners Corporation) would receive $200,000 (a dividend of 2.4 cents in the dollar) following payment of the costs and expenses of the administration. The DOCA proposal also contemplated the settlement of the defects litigation brought by the Owners Corporation, and therefore required that third-party releases be given by them. No other creditors of ACD were required to give a release as an element of the DOCA.

The Administrators summarised the DOCA terms and recommended its acceptance in a report to creditors. That summary did not refer to the differential treatment of the Owners Corporation and other creditors of the DOCA. The Administrators’ reasons for recommending the DOCA included that priority and Class “A” ordinary unsecured creditors were expected to be paid in full and Class “B” ordinary unsecured creditors were expected to receive a dividend of 2.4 cents in the dollar, while in liquidation they would likely receive nothing. In addition, ACD would be able to continue trading, there would be preservation of ACD’s subcontractors and continued business for trade and finance creditors, and all current taxes would be brought up to date.

The report included a copy of the DOCA proposal, as well as a comparison of the position on the DOCA vs. a liquidation. By the time this application was before the Court, the parties agreed that this schedule significantly understated the potential recoveries of a liquidation since it omitted potential preference claims against the Commissioner of Taxation and an associated entity of ACD, and that it overstated the advantage in a DOCA in consequence. The comparison also significantly overstated the savings of costs in a DOCA, because it allowed for the costs of adjudication of the Owners Corporation’s claim in the liquidation but not in the DOCA.

At the second meeting of creditors, six creditors (one of which was related to ACD) voted in favour of the resolution and the Owners Corporation voted against the resolution. The resolution was passed by a majority of creditors by number and not by value, since the Owners Corporation’s claim represented nearly 90% of the total value of admitted creditor claims, and one of the Administrators as chair exercised his casting vote in favour of the resolution.

The Administrators took no position on the Owners Corporation’s application, but contended that the Administrator exercised his casting vote appropriately by reference to several matters, including that:

• the Owners Corporation’s claim was vigorously disputed;

• the allocation of a set amount of money for the Owners Corporation’s claim (in this case, $200,000) may be seen as a way of avoiding further cost and disputes associated with the need to adjudicate the Owners Corporation’s proof for dividend purposes;

• creditors stood to receive a greater and more timely return under the DOCA as compared to the likely return in a winding up;

• the proposed DOCA was consistent with the objects of s 435A of the Act; and

• the Administrator had reference to the interests of creditors as a whole and the ARITA Code of Professional Practice in exercising his casting vote.

The Owners Corporation argued that the DOCA was against the public interest, oppressive and unfairly prejudicial to them since, among other things:

• there were significant defects in the information provided to creditors prior to the vote;

• there was no explanation of why the DOCA was structured with two classes of creditors and for the Owners Corporation to be the sole member of one class;

• the DOCA singled the Owners Corporation out for differential treatment in the distribution of funds, and there was no basis under the law for such differential treatment; and

• the Owners Corporation was the only party that was required to give releases of claims against “related parties” and “associated entities” under the DOCA.

The Court’s Decision

An order terminating a deed of company arrangement may be made under s 445D(1) of the Act if that deed is oppressive or unfairly prejudicial to, or unfairly discriminatory against, one or more of the company’s creditors, or is contrary to the interests of the creditors of the company as a whole. Section 445D of the Act involves a two-stage enquiry: first, whether one of the grounds referred to in section 445D(1) is established; and secondly, which arises only if the first is established, whether as a matter of discretion the deed of company arrangement should be terminated.

The exercise of discretion in any given case depends on all the various considerations before the Court, including:

• the objects of Pt 5.3A (including a creditor’s right to be paid or wind up a company or have the company administered by the administrator in a way which will see the creditor paid from the company’s property);

• the interests of other creditors, the company and the public; the comparable position of the creditor on a winding up compared with their position under the DOCA; and

• other relevant facts such as the relative position of all creditors under the DOCA (that is, whether they are better off), the existence of a collateral benefit to the shareholders and the whole of the effect of the DOCA

Where, as here, a deed of company arrangement operates to the advantage of the majority of creditors, and the substantial disadvantage of a single creditor or minority creditors, then the advantage of the deed of company arrangement for creditors generally is of lesser relevance, and issues relate to the proper use of Pt 5.3A of the Act are of greater significance.

Justice McKerracher set out the relevant principles succinctly in Decon Australia Pty Ltd v TFM Epping Land Pty Ltd (No 2) [2021] FCA 32, some of which are outlined below:

• Part 5.3A of the Corporations Act assumes that the creditors are best placed to judge their interests so a setting-aside will not be ordered lightly;

• the mere fact that a creditor is prejudiced by the operation of the deed is not a sufficient reason to terminate a deed. The mere existence of the deed procedure usually means that some creditors will gain something and some creditors will lose something out of the arrangement;

• the test under s 445D(1)(f)(i) is not merely discrimination or prejudice, but unfair discrimination or unfair prejudice. Some degree of discrimination is not necessarily unfair. Thus, it is clear that a DOCA may provide for differential dividends among creditors. Part 5.3A does not require a pari passu distribution. What is required is a better return to creditors than an immediate winding up. That object is met if some creditors are better off than in a winding up and none are worse off under the DOCA than they would be under a winding up;

• when deciding whether a deed unfairly prejudices or discriminates against a creditor or group of creditors, consideration must be given to what those purportedly prejudiced creditors would receive, or would be likely to receive, on a winding up, and the reasonableness of any conclusions reached by the administrator on that question;

• in determining what is unfairly discriminatory, there must be reasonable grounds for differentiation between creditors of an equal class;

• there will be circumstances when ordinary commercial common sense will demand, in the case of priority creditors, a loss of priority and, in the case of unsecured creditors, some degree of discrimination;

• the test is not merely discrimination or prejudice, but unfair discrimination or unfair prejudice. Some degree of discrimination is not necessarily unfair; and

• ultimately, if there is no prima facie evidence of misfeasance, concealment or a materially inadequate preliminary examination, and the DOCA offers both real financial benefits credibly estimated on preliminary investigation to exceed those available on liquidation, and indirect or collateral benefits from the survival of the company’s business; and no worthwhile avenues for further recovery in liquidation are identified, a major creditor’s curiosity or preference for further exploration of speculative claims is unlikely to render termination of the DOCA in the interests of the creditors as a whole.

Here, the Court concluded that the DOCA was unfairly prejudicial to the Owners Corporation and that it should exercise its discretion to terminate the DOCA. The Court found that there was no rational distinction between the position of Class A creditors whose claims were allowed in full, and the position of the Owners Corporation, where any uncertainty in the amount recoverable by the Owners Corporation would necessarily have been addressed in the valuation of that claim in the proof of debt process.

The Administrators’ report also significantly overstated the savings of costs in a DOCA, because it allowed for the costs of adjudication of the Owners Corporation’s claim in the liquidation but not in the DOCA. There was no basis for that approach, where the Administrators would also need to undertake a proper adjudication of the Owners Corporation’s claim under the DOCA, where that was required by the DOCA to admit that claim, and could not fail to do so merely because the amount that would ultimately be payable to the Owners Corporation would be so heavily discounted by the DOCA.

It was true that the Owners Corporation’s claim would potentially have been admitted for a lesser amount than the face value of that claim, on the adjudication of that claim for the purposes of the DOCA. However, the Administrators and the ACD Parties made no attempt to establish that a pari passu distribution as between other creditors and the Owners Corporation, after the Owners Corporation’s claim was properly assessed, would result in a distribution of $200,000 or less to the Owners Corporation.

A deed proponent is not free to determine, without any proper commercial basis, that one creditor should receive a minimal return so that other creditors may be paid in full, and that the other creditors are then free to approve that result at the second meeting of creditors. That approach is potentially oppressive, irrespective of whether it is directed to a majority or minority creditor.

The Administrators raised the possibility that the Court would exercise its discretion not to terminate the DOCA on the basis that creditors other than the Owners Corporation will definitely be worse off in a liquidation than under the DOCA and the Owners Corporation will likely be worse off under the DOCA, and financial contributions to the deed fund have been made which exceed $500,000. This was not a sufficient basis to refuse to terminate the DOCA, as the structure of the DOCA involved a high level of oppression and discrimination against the Owners Corporation.

The Court also concluded that the DOCA should be terminated on the basis that the inclusion of third party releases was not authorised by Pt 5.3A of the Act.

Conclusion

As a result, the Court ordered that the DOCA be terminated.

Judge: Black J

Counsel for the Plaintiff Owners Corporation: Geoffrey McDonald of Windeyer Chambers

Solicitor for the Plaintiff Owners Corporation: O’Neill Partners

Counsel for the First Defendants (the Administrators): Daniel Krochmalik of 3 St James Chambers and APF Ryan

Solicitor for the First Defendants (the Administrators): Holman Webb

Counsel for the Second and Third Defendants (Academy Construction & Development Pty Ltd and a director): Ralphed Notley of University Chambers

Solicitor for the Second and Third Defendants (Academy Construction & Development Pty Ltd and a director): Piper Alderman