Dominic Emmett and Anna Ryan, Gilbert + Tobin
In the latest edition of WWL: Australia, Dominic Emmett and Anna Ryan from Gilbert + Tobin assess recent developments in the domestic restructuring market.
In recent years, creditors’ schemes of arrangement (schemes) have become an increasingly important tool in restructuring companies in financial distress; particularly large and complex restructures. The appeal of schemes for this purpose is clear: schemes are flexible and court-driven (they are considered by a court on at least two occasions as part of their implementation), and until recently have been relatively uncontroversial. For example, the test applied by courts in assessing the composition of classes of creditors, being that a class must comprise only those creditors that can consult together with a view to their common interest, is widely accepted as being settled.
However, recent case law suggests that such previously accepted notions regarding class composition, as well as the Court’s discretion regarding the fairness principle, may now be less clear. In this respect, the NSW’s Supreme Court’s recent decision in Re Boart Longyear Ltd (No 2) (2017) 323 FLR 241 (Boart case) appears to suggest that courts may, in certain circumstances, apply the common-interest test differently. If Black J’s reasoning is to be followed, traditional class considerations may be less important than the overriding interest of all creditors in avoiding insolvency.
Boart Longyear Limited (Boart) is an ASX-listed (but US-headquartered) mining equipment and services company, providing drilling services and equipment for mining and drilling companies globally. Despite a recapitalisation with entities affiliated to Centerbridge Partners in 2014, whereby a revolving credit facility was replaced with a “covenant-lite” term loan, Boart defaulted on an interest payment due on 1 April 2017.
Following the earlier recapitalisation, Boart’s debt structure was as follows:
The relevant creditors under each facility were as follows:
Term Loan A and Term Loan B: Centerbridge was the sole lender under both facilities.
SSNs: First Pacific Advisors LLC (FPA) held 29 per cent, Ascribe II Investments LLC (Ascribe) held 23.5 per cent, Ares Management LP (Ares) held 18.7 per cent, Centerbridge held 8.5 per cent and other noteholders held the balance.
SUNs: Held by holders of notes under a Senior Unsecured Notes Indenture (Ascribe and Ares held the vast majority of the SUNs).
Importantly, Centerbridge also held 48.9 per cent of the shares in Boart.
Shortly after the default, Boart entered into a restructuring support arrangement with Centerbridge, Ares and Ascribe, pursuant to which it agreed to propose two interdependent schemes.
The first was the Secured Creditors’ Scheme, pursuant to which:
In addition to the above:
It is important to note that, while not directly arising from the two schemes, Centerbridge had also agreed to receive certain benefits under the following documents which were conditions precedent to the schemes (FPA was not a party to either of these documents):
Subscription Agreement, under which interest rates on the term loan facilities would be decreased from 12 per cent to 10 per cent in consideration for Centerbridge receiving a right to receive additional equity, which would leave it with 56 per cent of shares in Boart (without this right the debt-for-equity swap effected under the Unsecured Creditors’ Scheme (discussed below) would have diluted Centerbridge’s equity ownership from 48.9 per cent to 3.7 per cent).
Director Nomination Agreement, under which Centerbridge would be granted the right to appoint a further director to the Boart board of nine directors (bringing its total to five directors).
The second scheme proposed was the Unsecured Creditors’ Scheme, pursuant to which:
FPA opposed Boart’s application for an order to convene a creditors’ meeting in respect of the Secured Creditors’ Scheme, arguing, among other things, that the SSNs should form a separate class to the term loan facilities due to the disparity in rights under the different debt facilities and the different treatment of the secured creditors under the Secured Creditors’ schemes. It was submitted that this disparity included Centerbridge, in its capacity as the holder of the TLA and TLB debt, receiving a 56 per cent equity interest post-restructure, whereas the SSN holders were to receive no equity. In addition, the SSN holders (including FPA) had no rights to nominate to the Boart board, whereas each of Centerbridge, Ascribe and Ares had such rights under the contractual arrangements associated with the Secured Creditors’ Scheme (see the above outline of the rights provided under the Subscription Agreement and Director Nomination Agreement).
Interestingly, FPA would have had veto power in voting on the Secured Creditors’ Scheme if the SSNs formed a separate class (as FPA held 29 per cent of the SSNs). In order to effect a scheme, inter alia, a 75 per cent majority in value in each class must vote in favour of the scheme.
The issue for the court to determine was whether the SSN holders should be considered a separate class with respect to voting at a scheme meeting. Justice Black of the NSW Supreme Court applied the common interest test from Sovereign Life Assurance Company v Dodd, which compares the similarity of creditors’ legal rights and whether those creditors are able to consult together with a view to their common interest. The oft-cited passage of Bowen LJ from Sovereign Life referred to by Black J is set out as follows:
It seems plain that we must give such meaning to the term “class” as will prevent the section being so worked as to result in confiscation and injustice, and that it must be confined to those persons whose rights are not so dissimilar as to make it impossible for them to consult together with a view of their common interest.
In his judgment, Black J considered in detail how the common-interest test from Sovereign Life has been applied and further developed by the courts. As a starting point, his Honour noted that the common interest test from Sovereign Life is directed to “differences in the rights of the relevant creditors against the scheme company as distinct from their commercial or financial interests”. His Honour then turned to consider the more recent consideration by Lord Millet in UDL Argos Engineering & Heavy Industries Co Ltd v Li On Lin, where his Lordship emphasised the distinction between legal rights and interests and noted that the common interest test is “based on similarity or dissimilarity of legal rights against the company, not on similarity or dissimilarity of interests not derived from such legal rights”.
Black J also referred to, among others, two separate decisions by Barrett J of the New South Wales Supreme Court who emphasised that the focus is on the effect of the class differentiation, not the existence of the differentiation itself. It is apparent from the various decisions referred to by Black J in the Boart case that when considering class composition, the courts will critically assess whether the existence of differing legal rights warrants the need for separate creditor meetings to be called.
When applying the principles from the common-interest test, particularly the reference to, and emphasis on, creditors’ rights against the company (as opposed to their distinct commercial or financial interests) his Honour gave specific attention to Boart’s solvency. The court, unsurprisingly, was required to consider the alleged differences in legal rights claimed by FPA to determine whether they amounted to a difference in legal rights, and, if so, whether they were significant enough to warrant a separation of classes between the SSNs and the term loan facilities. In this respect it was FPA’s assertion that the difference in existing rights warranted a separate class for the SSNs.
FPA, in asserting this, made reference to the following:
FPA further asserted that the arrangements that lay outside of the schemes, but acted as conditions precedent to them, also warranted a separation of classes – for example, the rights of Centerbridge, Ares and Ascribe to nominate one director to the Boart board pursuant to the Director Nomination Agreement.
The Court did not fully accept FPA’s position regarding existing or the additional (equity and director nomination) rights. In the court’s view, while there were several differences in legal rights, only the change from 10 per cent interest payable in cash on the SSNs to 12 per cent interest payable in PIK, at Boart’s option, amounted to a substantial difference in legal rights (given that the interest on the term loan facilities was already payable in PIK) that would have an economic impact. However, in applying the Sovereign Life test, the court held that it was still possible for the creditors to consult in respect of their interests, and that their common interest in avoiding insolvency in respect of Boart outweighed this identified difference in rights.
The Court left open the question of whether the equity rights had any value given the financial position of Boart. Nevertheless Justice Black concluded that even if the equity did have value, this conferral of rights was not enough to prevent consultation between FPA, Centerbridge, Ares and Ascribe. As to the director nomination rights, the court conceded that these were likely to have practical significance given that Centerbridge would have control of Boart’s board. However, Justice Black concluded that this too did not prevent consultation among the creditors and did not warrant the formation of a separate class for the SSN holders.
FPA subsequently appealed the first instance decision, which was unanimously dismissed by the NSW Court of Appeal.
Subsequent to FPA’s appeal, the schemes were agreed to by the requisite majorities of creditors at the relevant creditors’ meetings; however, importantly, only Centerbridge, Ares and Ascribe voted in favour of the schemes with all other creditors (including FPA) voting against the schemes.
At the second court hearing, FPA raised objections to the original schemes on grounds of fairness, including that Centerbridge would receive a large increase in shareholding (3.7 per cent to 56 per cent), would control Boart, have an ability to appoint a majority of directors, and would give up very little (the only real concession was pushing the maturity date for the Term Loan A and Term Loan B facilities to 4 January 2021). This was in contrast to the SSNs that received no equity upside post-scheme, had their maturity dates pushed significantly further back, their interest PIKed and only a moderate increase in interest rate from 10 per cent to 12 per cent.
As FPA opposed the court’s subsequent approval of the scheme, the court determined that it was appropriate to make an order that FPA and Boart mediate (as well as other interested parties including Centerbridge, Ares, Ascribe and the “Snowside companies” (shareholders who also objected to the schemes)) before the conclusion of the second court hearing – a highly unusual step for a scheme hearing.
This resulted in the parties settling by way of an agreement that substantially altered the original schemes – largely attributed to the settlement terms agreed at the court ordered mediation. The changes to the original Secured Creditors’ Scheme (set out above) were as follows:
It is worth noting that the amended scheme was supported by all voting creditors of the Secured Creditors’ Scheme and Unsecured Creditors’ Scheme, including Centerbridge, Ascribe, Ares and FPA. The only issues for the court were whether it could approve the proposed amendments pursuant to section 411(6) of the Corporations Act and whether the schemes (both the original and the amended schemes) satisfied the requirement of fairness.
The issue of approval under section 411(6) arose following arguments put forward by the Snowside companies (who still objected to the schemes) that the amendments went beyond the scope of the statutory power to sanction schemes where the terms of the scheme had been amended from the terms approved at the preceding creditors’ meeting. Prior to these proceedings, this power had typically been used only for “peripheral” or “minor and technical” changes. The Court emphasised that all creditors whose interests were affected by the scheme supported the changes and that section 411(6) was the proper mechanism to use and that the legislative power in this respect is unconstrained. The Court held there was no reason to confine the power under section 411(6) as Boart was almost insolvent and “did not have the luxury of restarting their restructuring”.
Despite the Court only considering legal interests to decide on the issue of creditor classes, it acknowledged the commercial disadvantages present in the original proposed schemes. Justice Black noted that FPA’s objections to the schemes prior to the amendments were “strongly arguable”, suggesting that the court may not have approved the original schemes on fairness grounds. Citing Re Alabama, the Court noted that the proposed amendments were required to meet the objective criteria that an intelligent and honest member of that creditor class, acting alone in their interest and in that capacity, would approve of the scheme. The court affirmed FPA’s assertions that the original schemes favoured Centerbridge, Ares and Ascribe with respect to the grant of equity and director rights – even though the equity had little to no present financial value – because it had real “option value” in the case that Boart made a successful post-restructuring recovery. Other factors that the court considered to fall short of the fairness test included: the conversion of interest payable under SSNs to PIK interest for two years (the present right to receive cash interest was of greater value than a future right to receive interest payable in PIK at a higher rate given imminent risk of insolvency); the relative difference in the effect of moving the maturity date between SSNs and the term loan facilities; and the waiver of SSN holders’ rights upon a change of control (given that Centerbridge was to obtain legal control of Boart). It was clearly central to the Court’s analysis that, in the original scheme, those parties that gave up very little received most of the benefits whereas those who were required to give up rights had burdens imposed on them. Undoubtedly the amended schemes ironed out some of these plainly unjust elements of the original scheme.
In determining whether the amended schemes met the fairness requirement (set out above), the Court gave considerable weight to the agreement of the creditors to the amended schemes, noting that “properly informed creditors are generally the best judges of their own commercial interests”. The fact that all secured creditors (including FPA, Centerbridge, Ares and Ascribe) aside from one minority SUN holder (whose view was unknown) supported the altered schemes warranted the Court’s approval.
Black J’s decision in the Boart case demonstrates that creditors can have very different views regarding the appropriate composition of classes in the context of creditors’ schemes. This is particularly evident where there is a complicated capital structure with various levels of debt and potentially disparate interests (and rights) of the debt holders.
It is evident from the decision that the test for class composition remains the same as it has for over 100 years. However, it seems the lens through which a court will consider that test is subject to various prevailing factors.
Going forward it will be interesting to see if any judges adopt Black J’s reasoning and, even where the rights of creditors appear to be objectively different, deem that a common interest may be enough to class them together. In the Boart case, the common interest was avoiding the insolvency of the debtor company.
In any event, given the numerous positive attributes of schemes, we consider that schemes will continue to be utilised to effect complex restructures of distressed entities in Australia going forward.