Overturning the legal order of debts

By Karen O'Flynn.

Key Points:
Who should benefit when directors inject money into a Deed of Company Arrangement? The Federal Court lays down some guidelines.

Two recurring complaints about Deeds of Company Arrangement (DOCAs) are that some creditors receive a smaller payout than they would in a winding up and that DOCAs are used by directors to avoid the personal legal actions they might face in a winding up.

The Federal Court recently faced a DOCA which had both features.

Background

Under the Corporations Act, the court has a discretion to overturn a DOCA that is unfair. But the Corporations Act recognises that sometimes the only way to save a company is to have a DOCA that discriminates against some creditors.

The problem for the court is determining just when a discriminatory DOCA has crossed the line into unfair prejudice. In a recent decision, Justice Finkelstein set out some principles to help answer this question.

Facts

The case involved a company that apparently had no money to pay unsecured creditors. The administrators' report had raised the possibility of actions against the company's directors (although they were fairly pessimistic about the chances of success). For their part, the directors put up a proposal to inject money into a DOCA, with the object of keeping the company afloat (and ultimately returning it to their control).

The problem was that the money to be injected by the directors was less than the company's debts. This meant that the DOCA would require some compromising of debts. That compromise would involve the Commonwealth's receiving $30,000, rather than the $100,000 it would have received if the DOCA were a winding up (the Commonwealth being a priority creditor).

The Commonwealth applied to have the DOCA set aside, on the grounds that it was oppressive or unfairly prejudicial to the Commonwealth as a creditor or contrary to the interests of the creditors as a whole

Principles

Justice Finkelstein set out the following principles:

1. There is no overriding requirement that the order of priority of debts in a DOCA should be the same as in a winding up.
2. When the object of a DOCA is to preserve the company’s business, the legislation does not assume that the creditors will be paid in full. On the contrary, Pt 5.3A assumes that it might often be necessary to extinguish a debt by composition or to bar certain claims. It also makes no assumption that the creditors will be treated equally or that they will be given the same priority as in a winding up. The reason it makes no such assumption is that the equal treatment of creditors or the maintenance of priorities when there is not enough money for everyone can easily thwart the attempt to revive an ailing company.
3. When the purpose of a DOCA is to provide for the orderly realisation of the company’s assets followed by the distribution of the proceeds between creditors, the DOCA puts in place a "de facto winding up". In such a case there is usually no reason to depart from the manner of distribution that would apply in an actual winding up. In that situation, departure from the winding up model is likely to be unjust or unfair.
4. However, (3) only applies where the DOCA deals with the distribution of the company's assets. The situation would be different where (as commonly happens), the DOCA deals with the distribution of cash injected by a third party. In that case, it would be difficult for creditors (or others) to insist that third party funds should be distributed in accordance with the winding up priorities. The reason why that position should be different is that the third party funds would not be available to creditors in a winding up, so that there is no good reason why all creditors should be better off under a DOCA. An attack on this type of DOCA would depend upon a whole host of factors and it is simply not possible to lay down any general rule.

Whose money is it anyway?

On the surface, this analysis looked good for the DOCA in this case, because the money was to come from the directors. However, that's not how the judge saw it.

In reality, he said, the directors had put up the money in order to regain control of the company and thus to ensure that the potential legal actions identified by the administrators wouldn't get off the ground. By taking control of the company, they ensured that no action would be brought against them.

Looked at from their perspective, for a payment of $400,000, the directors had blocked these causes of action. In effect, therefore, the money from the directors should have been regarded as compensation to the company for the loss of the possibility of a legal claim against the directors. The money would therefore really be the company's money, so that this case was closer to a category (3) "de facto winding up", with the result that:

"Fairness requires that the property be distributed as in an actual winding up. The radically different scheme adopted by the creditors is not an acceptable alternative and for that reason the deed should be terminated."

Comment

As mentioned at the start of this article, many creditors - particularly the Commissioner of Taxation - believe that DOCAs can be abused by directors. The balancing act that courts face when such claims are made usually involves having to choose between a winding up (with less money available for unsecured creditors) or a DOCA that offers the chance of saving the company from liquidation, but protects the directors from personal liability and discriminates against a few creditors (typically, the Commonwealth).

This decision is noteworthy for the court's attempt to lay down some rules for coming up with a solution to this problem.

More significantly, perhaps, it shows the court being prepared to go behind the DOCA proposal and to assign some commercial significance to the fact that it is a transaction for the benefit of the directors. It will be interesting to see if other courts follow this lead, or if they take the alternative view that the Commonwealth has deep pockets and that a discriminatory DOCA is acceptable if it delivers other creditors a better return than would a winding up, even if the directors also benefit.

For further information, please contact Karen O'Flynn.