Allens

Insolvency & Restructuring

Focus: High Court leaves third-party release distinction between schemes and DOCAs unchallenged

19 August 2010

In brief: In two recent decisions, the High Court of Australia has refused to entertain criticism of the Full Federal Court's decision in Fowler v Lindholm, in which it was held that creditors can be bound by a scheme of arrangement under Part 5.1 of the Corporations Act in relation to debts owed by persons other than the company. Partners John Warde (view CV) and Michael Quinlan and Lawyers Catherine Zahra and Patrick Crisp report.

How does it affect you?

  • In Lehman Brothers Holdings Inc v City of Swan1, the High Court of Australia confirmed that creditors' claims against persons other than the company the subject of a deed of company arrangement (DOCA) cannot be released or extinguished by the deed.  Part 5.3A of the Corporations Act 2001 (Cth) (the Act) directs attention to the relationship between the subject company and its creditors.
  • In relation to the release of creditors' claims against third parties in the context of schemes of arrangement under Part 5.1 of the Act (as endorsed in the earlier decision of the Full Federal Court in Fowler v Lindholm2), the High Court in Lehman Brothers noted the 'sharp contrast' between Part 5.1 and Part 5.3A.
  • In Lehman Brothers, the High Court concluded that it was not necessary in the appeal before it to consider whether Part 5.1 could be engaged to achieve third-party releases.  However, there was no suggestion that the decision in Fowler was not good law.
  • In the recent Lift Capital proceedings3, the High Court refused three applications for special leave to appeal against a decision of the Full Federal Court, in which it had followed its previous decision in Fowler.  Given the relationships between the relevant parties, and the course of the litigation in the Federal Court, the High Court held that the Lift Capital proceedings were an inappropriate occasion to challenge Fowler.4
  • These decisions may result in an increased use of schemes of arrangement to achieve commercial outcomes in situations where there are multi-party claims against both an insolvent company and third parties.  In this regard, we note that the protections for individual creditors, or groups of creditors, in schemes of arrangement under Part 5.1 are extensive.

Background to the Lehman Brothers decision

In May 2009, a majority in number and in value of the creditors of Lehman Brothers Australia Ltd (Lehman Australia) voted in favour of a resolution to execute a DOCA proposed by Lehman Brothers Asia Holdings Ltd (Lehman Asia).  The administrators, on behalf of Lehman Australia and Lehman Asia, executed the DOCA and appointed themselves as deed administrators.  Under the deed, all of the property and assets of Lehman Australia were to comprise a 'deed fund' from which there would be created a separate pool of funds for distribution among 'litigation creditors' (the litigation creditors' fund).  The litigation creditors were all investors in CDO (or collateralised debt obligation) instruments marketed by Lehman Australia.  The CDO investors asserted claims against Lehman Australia and other Lehman entities in connection with their investment.  In return for rights against the litigation creditors fund, the litigation creditors agreed to compromise their claims against Lehman Australia and ultimately release other Lehman entities from claims arising from their investment.  In particular:

  • clause 7.1 of the DOCA gave the deed administrators sole conduct and control of any insurance claim and an absolute discretion regarding the prosecution and resolution of any insurance claim, which otherwise could have been conducted by a creditor of Lehman Australia in respect of any insurance policy which insures Lehman Australia or a Lehman Entity.  The clause specifically excluded any claim for indemnity under any insurance policy held by Lehman Asia;
  • clause 9 provided for a moratorium in respect of a claim by a litigation creditor against the Lehman entities; and
  • clause 11.5 provided that, upon payment to litigation creditors of the final dividend from the litigation creditors' fund, litigation creditors release all claims against the Lehman entities and all insurance claims.

The plaintiffs, three local government authorities who had voted against the resolution requiring execution of the DOCA, instituted proceedings in the Federal Court of Australia challenging the validity of the deed and the resolution to enter into the deed, and claiming an order that the deed be terminated under section 445D of the Act.  The plaintiffs were all CDO investors.

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The decision of the Full Federal Court

The Full Court of the Federal Court, comprising Justices Stone, Rares and Perram, held that the DOCA was void and of no effect.5 In particular, their Honours held that s444D(1) of the Act, which provides that a deed 'binds all creditors of the company, so far as concerns claims arising on or before the day specified in the deed', refers only to 'claims' against the company the subject of the deed.

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The High Court decision

The High Court of Australia dismissed an appeal from the decision of the Full Federal Court which was brought by Lehman Brothers Holdings Inc (the parent company of Lehman Australia and Lehman Asia) and Lehman Asia.6 Chief Justice French and Justices Gummow, Hayne and Kiefel delivered a joint judgment; Justice Heydon delivered a separate judgement.

Construction of s444D(1)

The joint judgment observed that the determinative issue in this case was what is meant by the words 'so far as concerns claims' in s444D(1) of the Act.  According to the joint judgement, the words 'so far as concerns' limit the extent to which creditors of the company, the subject of a deed, are to be bound.  In particular, their Honours held:

  • there is no textual footing for reading the word 'claims' as including claims against persons other than the subject company; and
  • even if it were accepted that it would be sensible to recognise that a creditor of one of a group of companies may have interlocking and dependent claims against one or more of the other companies in the group (as occurred in this case), Pt 5.3A directs attention only to the particular subject company; it does not deal with groups of companies.7

Their Honours concluded that the Act does not bind creditors to give up a claim against a person other than the subject company.  The effect of section 444D(1) in this case was that clauses 9 and 11.5 of the DOCA did not bind creditors.  While their Honours held that it was open to argue that clause 7 of the deed bound creditors in respect of their claims against Lehman Australia, it was not necessary to decide this question because it was not submitted that any part of the deed should be given effect if clauses 9 and 11.5 were not binding on creditors.  As such, their Honours concluded that the deed as whole failed.

Justice Heydon, while ultimately adopting a construction of s444D(1) which was consistent with the joint judgment, took a slightly different approach.  His Honour referred to the rule of construction evinced by Justices Deane and Gaudron in Mabo v Queensland [No 2], that 'clear and unambiguous words be used before there will be imputed to the legislature an intent to expropriate and extinguish valuable rights relating to property without fair compensation'.8  According to Justice Heydon, on the arguments advanced by the appellants, it would be open to a company and its creditors to enter a DOCA which extinguished the rights of minority creditors to sue persons other than the company, the subject of the deed, without fair compensation.  His Honour held that the relevant inquiry in this case was whether, according to the rule of construction stated by Justices Deane and Gaudron, there were clear and unambiguous words supporting that outcome.  His Honour found that there was not.  Justice Heydon held:

  • the length and detail of the provisions in Part 5.3A on the position between creditors and the subject company is in 'sharp contrast' with the void on the position between creditors and third-party debtors;
  • the absence of any explicit indication that Part 5.3A was intended to confer upon a majority of creditors the power to take away the rights of minority creditors against persons other than the subject company points against the view that such an outcome was intended;
  • there is no express suggestion in any other part of the Act that creditors claims against third parties have any materiality in relation to DOCAs.9

Furthermore, Justice Heydon held that the tests propounded by the appellants – to the effect that the words 'so far as concerns claims' in s444D(1) require the existence of a connection or association between the claim in question and a claim against the insolvent company – would be very difficult for proposed deed administrators and creditors to apply, and would place a burden of proof on minority creditors many of which would lack the resources to institute proceedings.10

Arrangements under Part 5.1 versus Part 5.3A of the Act

The joint judgement held that Part 5.3A stands in 'sharp contract' with Part 5.1 of the Act.11 In particular, their Honours observed that s411 (unlike s444D), which provides that certain compromises or arrangements are binding on creditors, does not qualify the extent to which creditors are bound.  Beyond noting this contrast, their Honours held that it was unnecessary to go on to consider whether Part 5.1 could have been engaged to effectively release creditors' claims against the Lehman entities in this case.12  Importantly, it was held that nothing in the joint judgement should be understood as endorsing the criticisms made by the Full Federal Court of the decision in Fowler.13

While also noting the substantial differences between Part 5.1 and Part 5.3A, Justice Heydon went one step further.  His Honour held that 'there is no inconsistency between the proposition that under Part 5.1 creditors can be bound in relation to debts owed by persons other than the company, and the proposition that under Part 5.3A they cannot'.14  Significantly, however, his Honour held that it was unnecessary to decide whether Fowler was incorrect, and that his Honour was not suggesting that it was incorrect in any way.15

The Lift Capital proceedings will be the subject of a separate Focus in the near future.

Footnotes
  1. [2010] HCA 11; 84 ALJR 275.
  2. (2009) 259 ALR 298; 178 FCR 563.
  3. No S131, S132 and S133 of 2010.
  4. Special leave was also sought to consider the nature of an 'appeal' under the Corporations Regulations 2001 (Cth): see Ruhani v Director of Police (2005) 222 CLR 489.  However, leave was also refused on this ground owing to the approach taken by the parties in the Federal Court, and the insufficient prospects of success in overturning the primary judge's final decision.
  5. City of Swan v Lehman Brothers Australia Ltd (2009) 260 ALR 199.
  6. Lehman Brothers Holdings Inc v City of Swan; Lehman Brothers Asia Holdings Ltd (in liq) v City of Swan [2010] HCA 11.
  7. Ibid at [50].
  8. (1992) 175 CLR 1 at 111.
  9. Lehman Brothers Holdings Inc v City of Swan; Lehman Brothers Asia Holdings Ltd (in liq) v City of Swan [2010] HCA 11 at [69].
  10. Ibid at [71].
  11. Ibid at [54].
  12. Ibid.
  13. Ibid.
  14. Ibid at [73].
  15. Ibid.

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