New rules on company creditor compromises

Two High Court decisions setting aside creditors' compromises give new guidance on the parameters of Part 14 of the Companies Act 1993. 

The regime:

  • cannot require the release of the company's guarantors (but that may not be the case under Part 15), and
  • requires separate classes of creditors based on a pragmatic, business-oriented approach with regard to both the legal rights and economic interests of creditors.  

No release of the company's guarantors

Public Trust v Silverfern Vineyards Ltd

Having obtained a summary judgment against those Silverfern Vineyards Ltd directors who had given guarantees, Public Trust issued bankruptcy notices when the sum remained unpaid. 

Silverfern proposed a compromise with creditors under Part 14 of the Companies Act. The proposal separated creditors into two classes: those with guarantees from the directors and those without. 

A condition of the compromise was that the directors would be released unconditionally from their guarantees. A letter by way of background advised creditors that the alternative to the compromise was they would receive nothing at all. 

Public Trust and another creditor voted against the proposal but the necessary majorities were obtained without their support. The dissenting creditors then sought declarations that the compromise was void and that they were not bound by it.

They argued successfully that:

  • Part 14 of the Act did not permit confiscation of stand-alone rights of creditors against third party guarantors, and
  • the compromise was unfairly prejudicial to the plaintiffs.

The Court agreed. It said a compromise between a company and its creditors is not a tripartite agreement involving the guarantors and that the creditors' rights against the guarantors were acquired by their position as creditors of individuals - not by their position as creditors of the company.

It also found that the compromise could not purport to release the directors from their guarantees to the Public Trust as the debt now stood as one owed under a judgment and not under contract. 

And it found that the requisite majorities were secured only because the major creditor voted in a way that seemed designed to secure a collateral advantage for itself rather than in the interests of the class as a whole. The Court held this unfairly prejudiced the plaintiffs as minority creditors. 

Chapman Tripp comment

Silverfern follows the approach of the Full Federal Court of Australia in the Lehman litigation.1 That litigation concerned a deed of company arrangement (DoCA) under Australia's voluntary administration regime. The Full Federal Court held that a DoCA cannot affect creditors' property rights against third parties. The decision was upheld by the High Court of Australia.

A contrasting approach was taken by the Full Federal Court in the Opes Prime litigation.2 There, the Full Federal Court permitted a third party to be released from its liability under a scheme of arrangement, broadly equivalent to Part 15 of New Zealand's Companies Act. 

These contrasting decisions may be explained by the different role of the Court under the relevant regimes. In voluntary administration (VA) the Court is involved only if a dispute arises. In a Part 15 style process, the Court has a supervisory role throughout the process. The Australian decisions suggest that the less the Courts are involved, the less likely will creditors be bound to surrender their property rights against third parties.

In rejecting further arguments against the compromise, the Court did not find material irregularities in the background information provided by Silverfern or in how the classes of creditors were constituted. In relation to the latter, the Court favoured a test based on dissimilarity of rights rather than on dissimilarity of interests. That conclusion may have been different had it been determined in line with a later decision, which we discuss next.

Key point

Part 14 cannot be used to release directors etc from personal guarantees.

A more general test for creating classes of creditors

Advicewise People Ltd v Trends Publishing International Ltd

In this case, the High Court put forward a more general and inclusive test, which allows the court to consider both the legal rights and economic interests of creditors.

Directors of Trends made a proposal to its creditors. Trends owed 75% of its debt to related companies. Trends' largest related creditor waived its security so that it could vote on the proposal as an unsecured creditor.  

The insider creditors were included in the proposal for voting purposes only – meaning that they did not receive any distribution from it. The insider creditors voted in favour of the proposal and alone obtained the requisite majorities.

Dissenting creditors argued that the adopted compromise was invalid or, alternatively, that it should not bind the dissenting creditors, alleging that:

  • the insider creditors should have been excluded from the vote, or put into a separate class of creditors, because they were not affected economically by the compromise, and
  • failure to separate insider creditors into their own class was unfairly prejudicial to the dissenting creditors.

The Court considered the fundamental question to be whether Trends manipulated the voting procedure in order to manufacture a successful outcome. That turned on whether the dissenting creditors were unfairly prejudiced by the insider creditors' ability to vote in favour of the compromise even though they were to receive no distribution.

The Court found that classes of creditors should be created using a pragmatic, business-oriented approach, which is based on considering both the legal rights and the economic interests of the creditors.  Accordingly, creditors should be separated into different classes if their legal rights or economic interests are so different that they cannot meaningfully consult with each other.

The Court found the insider creditors' interests were too dissimilar from the other creditors, and that they should have been put into a separate class for the purpose of voting on the compromise. Their differing interests meant the insider creditors could not consult with the other creditors for a common purpose. Consequently, the compromise unfairly prejudiced the dissenting creditors.

This case marks a departure from current overseas authority where the focus is more strictly on differences in legal rights.

Further, the Court found that the inclusion of insider creditors for voting purposes only was a deliberate manipulation of the voting procedure and abuse of the Part 14 process. The Court set aside the compromise.

Key point

In establishing classes for voting, economic interests as well as legal rights need to be considered. Insiders should usually be in separate class.

[1]     See our discussion of that litigation here.

[2]     See our discussion of that litigation here.

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Related topics: Deeds of Company Arrangement; Restructuring & insolvency; Creditors

Restructuring & insolvency; Finance

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