Discriminating DOCAs: when the courts will terminate a deed of company arrangement that seeks to discriminate against particular creditors.
With rising levels of corporate insolvencies, it is no surprise that the use of the voluntary administration regime for the purposes of putting forward a deed of company arrangement (DOCA) has increased. DOCAs have proven to be a time and cost-effective tool to recapitalise or restructure a distressed business.
Recently, there has been a spate of cases involving aggrieved creditors seeking to set aside DOCAs that seek to treat different classes of creditors differently. The use of these types of DOCA is not uncommon in trade-on scenarios where the proponent seeking to recapitalise a distressed business will agree to pay essential or critical creditors close to 100 cents in the dollar, whilst using the DOCA to cram down on creditors who are considered less essential to the company’s future trading operations.
For an aggrieved creditor, its only recourse is to seek orders from the Court to set aside or terminate the DOCA on the grounds of oppression, unfair prejudice or unfair discrimination. Obviously, any out of the money creditors may be reluctant to pursue such orders given the costs and risks associated with litigation. Further, whilst an aggrieved creditor may receive different treatment under the DOCA, it may not be able to demonstrate that they are worse off than the liquidation of the company, thereby making any challenge to the terms of the DOCA unlikely.
However, the decisions in the NSW Supreme Court decision in Academy Construction & Development Pty Ltd [2024] NSWSC 808 (Academy Construction) and the Full Court of the Federal Court of Australia in Project Sea Dragon Pty Ltd (Subject to a Deed of Company Arrangement) v Canstruct Pty Ltd [2024] FCAFC 141 (Project Sea Dragon) highlight the limitations associated with DOCAs that seek to treat different classes of creditors differently.
The key takeaway from Academy Construction and Project Sea Dragon is that both State and Federal Courts have now consistently held that a DOCA cannot be used as a strategy, without having a rational or commercial basis, to cram down or compromise a claim of one or more creditors whilst the remaining creditors are to be paid in full. This is the case even if the disgruntled creditor may be better off under the DOCA than the counterfactual winding up.
Our case analysis is set out below.
Academy Construction
In Academy Construction, the DOCA proponent sought to use the DOCA to cram down on the claim of an Owners Corporation which asserted a contingent claim for an amount of $7,840,360 for alleged building defects, legal fees and expert costs. The terms of the DOCA sought to confine the Owners Corporation to its own class of creditors and cap its recovery through the deed fund to $200,000. All other creditors were expected to receive a full recovery under the DOCA.
Justice Black of the NSW Supreme Court was satisfied that the basis for termination of the DOCA under section 445D(1)(f) of the Corporations Act 2001 (Cth) (Corporations Act) was established on the ground that the DOCA was oppressive and unfairly prejudicial or unfairly discriminatory against the Owners Corporation.
In his decision, Justice Black found that the DOCA proponent made no attempt to establish that a pari passu distribution as between the Owners Corporation and other creditors, after the Owners Corporation’s claim was assessed, would result in a distribution of $200,000 or less to the Owners Corporation. Further, His Honour noted that there was no rational distinction established between the position of the creditors whose claims were allowed in full and the position of the Owners Corporation whose claim was materially compromised.
His Honour did not accept the submission that the DOCA would bring about a saving in the costs of adjudication as there is no basis for arbitrarily capping a creditor’s claim and that the Owners Corporation was still required to submit a proof of debt with supporting evidence and have its claim adjudicated in the ordinary course.
At the hearing, a further issue arose that third party releases contained within the DOCA were inconsistent with the operation of Pt 5.3A of the Corporations Act and the DOCA was invalid in its present form. Here, the third-party releases sought to impose an obligation on the Owners Corporation, and not any other creditors, to release associated entities of the Academy Construction, including its director and former director. His Honour considered the position to be similar to the well-established High Court of Australia authority in Lehman Bros Holding Inc v City of Swan (2010) 240 CLR 509 and held that the third party releases are not permitted under Part 5.3A of the Corporations Act.
The full decision can be found here: Academy Construction & Development Pty Ltd NSWSC 808
Project Sea Dragon
In a similar factual scenario to Academy Construction, the Full Court of the Federal Court in Project Sea Dragon dismissed an appeal against a decision to terminate a DOCA, which was determined at first instance to be an abuse of Pt 5.3A of the Corporations Act.
The first appellant, Project Sea Dragon Pty Ltd,was a special purpose vehicle that had no income stream or substantial assets of its own and relied on funding from its parent company, Seafarms Group Ltd (Seafarms Group).
A dispute arose between Project Sea Dragon and its contractor, Canstruct Pty Ltd (Canstruct), resulting in an adjudication determination in favour of Canstruct in the amount of approximately $14,000,000. Following the adjudication, Seafarms Group withdrew its financial support and a day later, Project Sea Dragon appointed voluntary administrators.
Project Sea Dragon entered into a DOCA proposed by Seafarms Group. Pursuant to the DOCA, all arm’s-length creditors were to be paid in full whilst Canstruct was estimated to receive a return of around 10 to 11 cents in the dollar. It was expected that Project Sea Dragon would then resume its ordinary operations, effectively in its pre-DOCA position except no longer having any liability to Canstruct.
At first instance, the primary judge made orders terminating the DOCA pursuant to sections 447A and 445D(1) of the Corporations Act, bringing the administration of Project Sea Dragon to an end and winding it up in insolvency. Project Sea Dragon appealed this decision.
The Full Court agreed with the primary judge’s finding that the evidence provided a compelling basis for concluding that the predominant purpose of putting Project Sea Dragon into administration was to avoid paying Canstruct. In his reasons, Justice Jackman, with which Justice O’Callaghan and Justice McElwaine agreed, noted the strong similarity between Project Sea Dragon and the termination of the DOCA as an abuse of Pt 5.3A in Academy Construction but considered Project Sea Dragon to be an even stronger case than Academy Construction as there was already a determination on the merits of Canstruct’s claim.
Justice Jackman held that the purpose of expunging a particular creditor’s debt while paying all other arm’s-length creditors in full and then restarting operations in an identical position to the pre-DOCA state, save for the unwanted debt, was in stark contrast to the objects of Pt 5.3A.
As for the DOCA being oppressive or unfairly prejudicial to, or unfairly discriminatory against, Canstruct, Justice Jackman again cited Academy Construction and considered that a lack of valid justification for discrimination against a particular creditor is capable in itself of constituting unfair prejudice or unfair discrimination, even if there is no realistic prospect of that creditor being better off in a winding up than under the DOCA.
The full decision can be found here: Project Sea Dragon Pty Ltd (Subject to a Deed of Company Arrangement) v Canstruct Pty Ltd [2024] FCAFC 141