The New South Wales Court of Appeal has recently confirmed the circumstances in which companies seeking approval of schemes of arrangement will be required to convene separate meetings for different classes of creditors.
Class constitution: key principles
The Corporations Act 2001 (Cth) (the Corporations Act) provides that a scheme of arrangement cannot bind a class of a company's creditors unless a meeting of those creditors is convened and a majority of creditors who are entitled to vote and are present and voting (or vote by proxy), vote in favour and the debts and claims owed to those creditors comprise at least 75% of the total debts and claims. As the recent Boart Longyear dispute makes clear, the constitution of these classes can therefore be critical in respect to the success of a scheme proposal in two ways:
- each class of a company's creditors must approve the scheme before it can be presented to the Court for approval. Class constitution may therefore give minority creditors a "veto" over the scheme if in their own class;
- correct class constitution underpins the Court's power to approve a scheme. If the Court considers that creditors were inappropriately classified per class, the Court will not approve the scheme.
What, then, forms a "class" of creditors? In short, a class of creditors is a group of creditors who share a "community of interest", which is sufficiently dissimilar to the interests of other creditors. These interests are assessed by reference to the rights which creditors have against the relevant company and which may be affected under the scheme. Private, commercial or financial interests do not affect class constitution. As the creation of separate classes may inhibit "majority-rules" decision-making, Courts have closely scrutinised challenges to class constitution, requiring any proposed class demonstrate that its interests are so divergent from those of other creditors such that they could not sensibly assess the scheme as a group.
The Boart Longyear dispute
Boart Longyear Limited (Boart), an ASX listed global drilling equipment and services company, has faced ongoing liquidity issues of recent times. Following its default on a significant interest payment on 1 April 2017, Boart found itself in a parlous financial position with its debt of USD 779.6m far exceeding its enterprise value of USD 266.6m thus necessitating its proposal of two interdependent creditors' schemes of arrangement.
Most of Boart's liabilities arose in connection with its issuance of both secured and unsecured notes and two term loan agreements. Centerbridge Partners LP (Centerbridge), Ares Management LP (Ares) and Ascribe II Investments LLC (Ascribe) together held 50.8% of the secured notes, 88.4% of the unsecured notes, all of the term loan debt, and 48.9% of the issued shares in Boart. First Pacific Advisors LLC (First Pacific) held 29.07% of the secured notes.
Boart's proposed schemes of arrangement were complex. In essence, the schemes proposed:
- The Secured Creditors' Scheme: In the case of the secured notes, variation of the terms on which interest is payable; an extension of the maturity date to 31 December 2022; waiver of any creditor's right to invoke a change of control event arising from the implementation of the scheme and consummation of the transactions contemplated by it and amendment of the secured debt cap. In the case of the term loans, an extension of the maturity date from 4 January 2021 to 31 December 2022 and the same variation to the change of control provisions as in respect of the secured notes.
- The Unsecured Creditors' Scheme: The release of USD 205.9m of the outstanding debt (comprising principal plus interest) in respect of the unsecured notes; the issuance of 42% of the post-recapitalisation equity of the company to the unsecured noteholders; variation of the terms on which interest on the remaining principal (USD 88m) on the unsecured notes is payable and the issuance of warrants to the unsecured noteholders entitling them to subscribe for shares in the company.
- The Recapitalisation Transactions: The proposed schemes were subject to certain other recapitalisation transactions, including the entry into of a Subscription Agreement and subsequent amendments to the term loans pursuant to which Centerbridge would convert its preference shares into ordinary shares, and the interest payable on the term loans would be reduced in return for the issuance of 52.4% of the post-recapitalisation equity of the company to Centerbridge (as the term loan lender).
The net effect of the schemes would see Boart's debt reduced significantly, with Centerbridge, Ascribe and Ares respectively holding 56%, 19.2% and 18% of the company's ordinary shares. In addition, Centerbridge would obtain the right to nominate an additional person to stand for election to Boart's board, increasing from the four directors it was already entitled to nominate under restructuring arrangements agreed in 2015. Ares and Ascribe would each obtain the right to nominate one person to stand for election to Boart's board, as well as the right to jointly nominate a third person.
The primary decision
At the first scheme hearing, First Pacific opposed Boart's proposed schemes on the basis that the secured creditors' scheme envisioned all of the secured creditors voting as a single class. First Pacific submitted that the secured noteholders should be treated as a separate class to the term loan creditors because:
- the creditors in each of these classes had different rights in relation to priority, types of interest and maturity dates which would be differentially affected by the schemes; and
- Centerbridge was to be issued a majority shareholding in the company and obtain nomination rights which the other secured noteholders were not offered.
If the creditors were classified as First Pacific submitted, First Pacific would have enjoyed the ability to veto the scheme (and First Pacific indicated that it would do so).
In Re Boart Longyear Limited  NSWSC 567, Justice Black in the Supreme Court of New South Wales rejected First Pacific's submissions, finding that the matters raised did not demonstrate a sufficient divergence in interests such that the creditors could not consult together as to the secured creditors' scheme.
Although his Honour accepted that First Pacific had identified some notable differences in the existing rights of creditors, and their treatment under the secured creditors' scheme, Black J considered that two key factors, both related to Boart's impending insolvency, outweighed these differences:
- first, all of the creditors shared an interest in avoiding the company's insolvency. In these circumstances, Boart's current financial condition meant that Black J placed little weight on the different rights which First Pacific identified. For example, his Honour considered that Boart was incapable of paying interest, any additional equity was of limited value, and the noteholders enjoyed no real prospects of recovering their funds at maturity; and
- second, all of the secured debt shared the same group of assets as security. Accordingly, in the event of any insolvency, the creditors would have been required to negotiate between themselves as to the realisation of that security. For Black J, this suggested that the parties were capable of conferring to protect their shared interests.
Nevertheless, his Honour observed that the secured creditors' scheme did raise suspicion as to the design of the scheme, and whether Centerbridge, Ares and Ascribe took collateral benefits under the scheme. Although not considering that these matters alone justified the constitution of a separate class, his Honour indicated such matters were relevant to the global assessment of the scheme's fairness at the second scheme hearing. Accordingly, the Court ordered that the votes of those creditors be tagged to enable them to be analysed at the second scheme hearing.
In the New South Wales Court of Appeal
First Pacific appealed Black J's decision, suggesting his Honour misapplied the relevant legal principles by failing to find that the issuance of equity and directorship rights to Centerbridge, or the differential interest regimes for the secured notes vis-à-vis the term loans, justified the existence of an independent class. The Court of Appeal unanimously affirmed Black J's judgment and dismissed the appeal: First Pacific Advisors LLC v Boart Longyear Ltd  NSWCA 116.
In doing so, Bathurst CJ (Beazley P and Leeming JA agreeing) confirmed that class constitution requires a three-step analysis (at ):
"First, what are the rights which existing creditors (or members) have against the company and to what extent are they different. Second, to what extent are those rights differently affected by the scheme. Third, does the difference in rights or different treatment of rights make it impossible for the creditors (or members) in question to consider the scheme as one class."
Bathurst CJ held (at ) that key to that assessment is the context in which the scheme is propounded. For Boart, this meant construing the creditors' interests in the context of what would occur if the schemes were not approved, namely insolvency. Financial analysis indicated that all of the creditors would be in a better position under the schemes than in the event of insolvency.
Indicating that the Court's key concern was what the creditors' bundle of rights effectively contained, the Court found (at ) that his Honour was correct to place little weight on the grant of equity and directorship rights to Centerbridge. In this regard, the Court noted that Centerbridge already possessed de facto control of the Board, and the shares proposed to be issued had limited value. Although the Court accepted that the respective rights to receive interest were different both before and after the scheme, the Court did not consider this divergence to be significant given the alternative of imminent liquidation. Accordingly, any differential treatment under the scheme would not mean that the creditors could not negotiate or no longer possessed any common interest.
Following the Court of Appeal decision:
- First Pacific filed an application for special leave to appeal the Court of Appeal's decision to the High Court of Australia; and
- on 30 May 2017, meetings of Boart Longyear's creditors were convened and the proposed schemes were approved.
On 17 July 2017, the Supreme Court of New South Wales adjourned the second scheme hearing to allow Boart to meet the remaining conditions precedent to the schemes, and to require the parties to attend mediation in an attempt to resolve the ongoing dispute in relation to the secured creditors' scheme. The dispute was resolved at mediation. It was agreed that in exchange for First Pacific withdrawing its opposition to the schemes, the terms of the schemes and recapitalisation transactions would be altered. The key alterations can be summarised as follows:
- The Secured Creditors' Scheme: In respect of the secured notes, a premium is to be payable at maturity and in certain circumstances if the secured notes are redeemed early (with the amount payable to be determined at the relevant redemption or maturity date or the date of completion of certain prescribed asset sales); upon any acceleration of the maturity of the secured notes following an Event of Default, the secured notes are payable at par plus accrued but unpaid interest (without the payment of any premium); if there is a change of control event under the terms of the secured notes, the company is required to make an offer to redeem the secured notes at 101% of the par value plus accrued but unpaid interest (without the payment of any premium) and the secured noteholders (including Centerbridge, Ares, Ascribe and First Pacific) receive a total of 4% of Boart's post-recapitalisation issued share capital on a pro rate basis.
- The Unsecured Creditors' Scheme: The ordinary shares to be issued to Ares and Ascribe (as holders of the unsecured notes) to be reduced by an amount equal to 1% of the company's post-recapitalisation issued share capital.
- The Recapitalisation Transactions: The ordinary shares to be issued to Centerbridge to be reduced by an amount equal to 2% of the company's post-recapitalisation issued share capital.
Approval of the schemes
On 14 August 2017, the Supreme Court of New South Wales approved the schemes with the proposed alterations: In the matter of Boart Longyear Limited (No 2)  NSWSC 1105.
In approving the schemes, Black J found that the proposed alterations to the schemes, which were substantive and material in nature, fell within section 411(6) of the Corporations Act (which grants the Court the power to approve a scheme subject to such alterations or conditions as the Court thinks just) albeit the proposed alterations likely went beyond the scope of any application of section 411(6) of the decided cases and involved a novel application of the section. His Honour held (at ) that:
"It seems to me that the Court could, in principle, think it "fit" to approve the schemes with material alterations where the schemes and those alterations provide a proper mechanism to implement a complex compromise or arrangement; substantial costs and resources have plainly been devoted to developing them; the Plaintiffs are insolvent or near insolvency and would likely not have the luxury of restarting their restructuring again from the beginning; the Plaintiffs and all voting secured creditors and substantially all voting unsecured creditors affected by the alterations support them; and there would be no utility in ordering further creditors' meetings where it is already clear that an overwhelming majority of the voting secured creditors and voting unsecured creditors support the alterations."
Relevantly, the Court held that the votes of Centerbridge, Ares and Ascribe at the secured creditors' scheme meeting, although sufficient to meet the statutory majorities, must be discounted when the fairness of the secured creditors' scheme was assessed. However, the Court held that it was satisfied that the schemes and recapitalisation transactions, as altered, met the fairness standard so as to warrant their approval by the Court.
Where to from here?
The Boart Longyear decisions confirm that class constitution remains a fact-specific inquiry. The key points which emerge from these cases confirm the underlying principles which govern the preparation of scheme proposals are:
- in assessing the rights which creditors have for the purposes of class constitution, regard must be had to the bundle of rights which each creditor enjoys against the company, and how those rights will be affected both individually, and holistically, under the proposed scheme;
- theoretical differences as to the effects of a scheme on creditors' rights are not sufficient to justify separating a class. What is required is some practical impact upon the effective content of the creditors' rights such that they no longer share a common substratum of interest upon which consideration of the scheme may be based; and
- where the likely alternative to a scheme is imminent insolvency, great weight will be placed on the creditors' very substantial shared interest in avoiding that insolvency.
In light of the Boart Longyear decisions, Courts will continue to vigorously adjudicate class constitution challenges. We may see a gradual broadening of creditor classes, grouping creditors with more disparate interests in light of the common interest in avoiding insolvency shared by the creditors. More significantly, these decisions are likely to encourage Courts to examine any disenfranchisement caused by class constitution as part of their assessment of the scheme's substantive fairness at the second scheme hearing.
These effects are likely to increase the burden which a company seeking scheme approval must discharge when persuading the Court that the scheme is fair and appropriate. Companies seeking to propose schemes of arrangement should monitor this space for further developments.
This article first appeared in Volume 14, Issue 5 of International Corporate Rescue and is reprinted with the permission of Chase Cambria Publishing - www.chasecambria.com.