Australia: "Future" Creditors and Insolvent Companies

In two recent decisions the New South Wales Supreme Court has considered the position of "future creditors" in deciding whether to allow an insolvent company to resume trading.

Ferretti Pty Ltd was in liquidation. The directors developed a proposal for a Deed of Company Arrangement ("DOCA") with the object of allowing the company to resume trading.

Subsequently, the liquidator appointed himself as administrator of Ferretti under section 436B(2) of the Corporations Act 2001, having obtained the Court's leave to do so.

The liquidator/administrator recommended that the creditors enter into the DOCA. The creditors approved the DOCA. The liquidator then applied to the Court to terminate the winding-up.

Broadly, the proposal was that:

• the directors would pay money into a fund to satisfy the claims of Ferretti's existing creditors (apart from the claims of the directors);

• under a separate debt subordination deed (which is defined as an agreement or declaration whereby a company creditor agrees not to be repaid (either wholly or partially) until other specified company debts are repaid to a specified extent) the directors' claims of $993,335 (out of total unsecured claims in the liquidation of $1,094,041) would be subordinated, until such time as:

• the claims of the other existing creditors were paid from the fund; and

• Ferretti was "able to pay such claim or any part thereof" (at some future time);

• the DOCA would terminate once the existing creditors, and the liquidator, were paid their agreed share of the fund;

• the directors would provide undertakings to the Court not to:

• amend or breach their subordination deed in the future; nor

• pay their subordinated claims until all creditors of Ferretti (at any given future time) had been paid, and Ferretti was in a position to pay all of its debts as and when they fell due.

Where termination is sought of the winding up of a company that is subject to a DOCA, the court in exercising its discretion will consider the interests of:

• existing and future creditors of the company;

• the liquidator;

• the company's shareholders; and

• the public - including the public interest that insolvent companies should be wound up, and the public interest in matters of commercial morality.

The Court will also consider the objects of voluntary administration set out in section 435A of the Act, and in particular whether the arrangements are likely to maximise the company's prospects of continuing in existence.

Here, the Court was satisfied that the interests of existing creditors, the liquidator and the shareholders were adequately protected. There was also no issue of commercial morality, and the Court recognised that Ferretti would not (strictly speaking) remain insolvent under section 95 of the Act after the arrangements were implemented.

However, the Court was seriously concerned about the position of people who might deal with the company in the future, and become creditors. There were a number of concerns about these "future creditors", namely that:

• they would have no way of knowing about the existence of the subordination arrangements;

• there was no direct legal mechanism for them to enforce the directors' obligations not to repay themselves until Ferretti was "able" to do so;

• the requirement for the directors not to repay themselves until Ferretti was "able to pay " was uncertain. It effectively allowed the directors to decide whether Ferretti was "able to pay" their claims (without any restriction to stop them from inappropriately paying themselves ahead of "future creditors");

• the company would have no real assets after the termination of the DOCA; and

• the directors' subordinated claims were very substantial.

Ultimately, the Court held that it had to conduct a balancing exercise - weighing up the advantages to the existing creditors, the shareholders and the liquidator, and the objects in section 435A, against the risk of prejudice to future creditors, and the public interest in companies trading solvently.

In this particular instance, the Court preferred the perceived interests of the future creditors over the clear interests of the existing creditors and stakeholders. Accordingly, it refused to terminate the winding-up.

It also suggested that a more "secure" alternative should have been explored by the directors - namely the capitalisation of their related party debt.

In this case, the creditors entered into a "creditors' trust" arrangement to permit a company to resume trading.

This type of arrangement involves a company entering into a DOCA which provides for the establishment of a separate trust, and the injection of money into that trust. Upon the injection of funds into the trust, the DOCA terminates.

The separate trust then deals with the payment of creditors' claims (rather than the DOCA itself), with the company's creditors no longer holding a claim against the company itself, only the trust.

The rationale for the arrangement is usually that the "shell" company can be sold to another business venture, unencumbered by previous liabilities. This is particularly common for listed companies that have become insolvent, with the listed "shell" being one of the principal assets of the company.

Usually the implementation of a creditors' trust arrangement does not involve the court. However, here the relevant company had been in liquidation before administrators were appointed; and the termination of the DOCA (and the creation of the creditors' trust) could not affect the winding-up. It was therefore necessary to obtain a court order to terminate the winding up.

Upon examining the overall arrangements, the Court noted that the trust complied with ASIC's "requirements" for creditors' trusts (promulgated in May 2005) and agreed that the creditors would receive more under the trust than if the company were liquidated.

Further, the Court was satisfied that the interests of future creditors would be protected because, unlike the situation in Vero, the company was released from any liability to pay its pre-existing debts. Therefore, their position would not be compromised.

On this basis, the Court upheld the arrangements, and terminated the liquidation, thereby allowing the company to resume trading.

Vero is part of an increasing tendency in insolvency law to look at the interests of a wider range of stakeholders (rather than just the company's current creditors). This is particularly evident in the Government's current proposal to draft legislation to protect the interests of those who may have future personal injury claims against insolvent companies.

Another emerging stakeholder group is people who have brought equity in the company on market. Class actions by these investors (most prominently in the recent Sons of Gwalia line of decisions) are challenging the traditional view that shareholders must always take a back seat to creditors, potentially requiring them to be considered when a DOCA is formulated.

Further, while the Vero decision itself only directly relates to an application to terminate the winding-up of a company, it may also conceivably permit challenges to any DOCA that involves the subordination of debt by a related party. That decision suggests that courts will be reluctant to allow a company to continue to trade if a substantial amount of subordinated debt will potentially impact on the interests of future creditors.

Rupert Co v Chameleon Mining deals with a different aspect of the future creditors issue: the length of time required to expunge the company's existing debt. By transferring the company's liabilities to a separate trust fund, a creditors' trust ensures that the company can, relatively quickly, achieve the degree of solvency that would allow it to re-enter the marketplace without any threat to the interests of its future creditors hanging over it.

Finally, the Vero decision is also of general relevance to (third) parties who wish to enforce a subordination arrangement. There is little law in this area, but the Court did express the view that a third party may have no standing to enforce such an arrangement itself.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.