Creditors’ schemes of arrangement – a restructuring tool to pre-empt class action risks?

In recent years, Australian companies have been besieged by a proliferation of class actions, including shareholder class actions.  Australia's active litigation funding market has contributed to this phenomenon.  Class actions are inevitably costly, time-consuming and capable of posing significant disruption and irreversible damage to the defendant companies.  Moreover, they almost never result in a final judgment (most are resolved by way of settlement).^[1]

For directors of a company threatened with class action litigation, one possible solution – which this article seeks to explore – is to propose a creditors’ scheme of arrangement to compromise potential claims and forestall the commencement or continuation of court proceedings against the company.

As seen in the Lehman Brothers scheme approved in late 2013 (which was instrumental to the subsequent settlement of the investors’ class action commenced against it by various local councils and charity organisations);^[2] and, more recently, the Slater & Gordon schemes approved in December 2017 (which directly resolved a number of shareholder class actions vis-à-vis that law firm), schemes of arrangement (provided for by Part 5.1 of the Corporations Act 2001 (Cth)) can be a viable vehicle for resolving class actions. However, a critical issue here is timing – namely, whether a company can propose a creditors’ scheme as a standalone restructuring tool, and with sufficient expedition, so as to prevent a class action from being commenced.

The challenges facing Company A

Consider this hypothetical scenario:

• Company A, listed on the ASX, becomes aware that certain litigation funders or law firms have notified the market of potential shareholder class actions in respect of alleged misleading or deceptive conduct and breaches of its continuous disclosure obligations (ie. Sons of Gwalia style shareholders claims).
• Company A is aware that there were errors in its financial statements, which would more likely than not found an adverse judgment against it. However, the Company is not certain about the number of shareholders adversely affected, or the quantum of their claims.
• It is also not clear when (or how many) class actions will actually be commenced. Meanwhile, Company A's share price is plummeting by reason of the negative publicity.
• Company A is solvent and has an otherwise sound business. It is reluctant to spend a substantial amount of legal fees defending these class actions for an indeterminate period, and is cognisant that a large proportion of any adverse judgment will inevitably be paid to litigation funders. Rather than contesting liability, it is prepared to commit a defined sum to resolve the claims pre-emptively.

In this scenario, Company A could consider proposing a creditors' scheme of arrangement by which:

• The “scheme creditors” or “shareholder claimants” (who will be bound by the scheme, if approved) would be broadly defined as all persons who were shareholders of the Company during the relevant period in which the alleged misconduct occurred. 
• A “scheme fund” would be established for distribution to the shareholder claimants, comprising a specified amount to be paid by the company and any insurance proceeds that it might be able to claim from its insurers in respect of the shareholder claims. 
• All claims of each shareholder claimant against the Company and/or its directors or officers, arising from any dealings or transactions in the shares of the Company (“scheme claims”), will be: extinguished and replaced with an entitlement to share rateably in the scheme fund. 
• A “claims resolution process” will be established, and administered by “scheme administrators” (registered insolvency practitioners), whereby scheme claims would be adjudicated and quantified. 
• The shareholder claimants will covenant not to commence or continue any court proceedings in respect of the scheme claims.

Why use a scheme in this scenario?

The statutory regime under Part 5.1 of the Corporations Act has a number of features which may be beneficial to Company A, including:

1. Binding effect of schemes If approved at the scheme meeting by the requisite majority of shareholder claimants^[3] (being the relevant class of contingent creditors of the Company), and approved by the Court at the second Court hearing, the scheme will become binding on all shareholder claimants, including those who did not attend the meeting and those who attended but voted against the scheme.
2. Stay of proceedings under section 411(16) Once a scheme has been proposed, the Court may, on a summary application by the Company, make orders restraining further proceedings against the Company (whether or not such proceedings have already been commenced). In order to enliven the Court’s power to stay proceedings under section 411(16), there needs to be a scheme “proposal”. In Boart Longyear [2017] NSWSC 537, Justice Black observed that a “proposal” of a scheme may exist at least at the time when the draft scheme documents are submitted to ASIC.^[4]Further, when deciding whether to grant a stay on proceedings, the Court will consider whether the stay will be conducive to the orderly and efficient consideration of the proposed scheme.
3. Ipso facto stay With the recent introduction of the stay on enforcement of ipso facto rights against a company in respect of which a scheme has been proposed, there is a somewhat reduced risk of contractual counterparties terminating key contracts, or secured parties taking enforcement action against the Company, simply by reason of it proposing a creditors' scheme (for the limited purpose of compromising a potential class action).
4. Releases of third parties Unlike a deed of company arrangement (DOCA), schemes can be used to release creditors’ claims against both the Company as well as third parties, including, in this scenario, directors and officers of the Company. ^[5]
5. No requirement of insolvency It is not necessary for the Company to be insolvent, or likely to become insolvent at some future time, in order for it to propose a creditors’ scheme. 

A creditors’ scheme also has the following practical advantages for Company A:

1. Avoid or reduce litigation funders’ premium Very often, a settlement sum in respect of a class action will be inflated by reason of the premium payable to the litigation funder.^[6] By proposing a scheme to pre-empt one or more class actions, the Company may be able to circumvent the involvement of litigation funders and thereby settle the shareholder claims for a more manageable sum than would otherwise be possible if funders have become involved and entrenched.
2. Expedited payout and certainty A scheme of this kind has the attraction of a relatively quick payout for the shareholder claimants. It also provides certainty for both the claimants and the Company by removing litigation risks (namely, the possibly of the Court ultimately finding against them). From the Company’s perspective, the expedited resolution of class action risk could mean significant savings in legal costs, the cessation of business interruption and distraction and, potentially, restoration of the market’s confidence in the Company.
3. Direct interaction with shareholder claimants A scheme provides the Company with the opportunity to communicate directly with shareholder claimants and put forth the Company's perspective (including the commercial disadvantages of starting or continuing litigation and/or the advantages of a quick settlement).

Constraints and impediments

Notwithstanding the above, the Part 5.1 regime is not a panacea for class action risk.  In particular, there are legal impediments which could undermine the utility of a scheme for Company A, including:

1. No automatic stay of proceedings There is no guarantee that the Court will exercise its discretion under s.411(16) to stay proceedings against the Company after a scheme has been proposed. The Court may be sceptical about the use of a scheme to, in effect, stifle the Court's own proceedings.
2. Limitations of the ipso facto stay Given the numerous exceptions to the ipso facto stay, there are limits to its practical utility in this particular situation. For example, grandfathered contracts (entered into before 1 July 2018) are not subject to the stay and a secured party (with security over the whole of the Company’s property) may still appoint a receiver to the Company, even if a scheme proposal is on foot. This means the Company may still need to obtain the prior consent of, or enter into standstill arrangements with, key stakeholders, before proposing a scheme, in order to avoid the risk of ipso facto enforcements which, if materialised, could significantly impair the Company's enterprise value. 

In terms of practical constraints:

1. Uncertainty as to merit and appropriate settlement sum The lack of clarity as to the merits of any threatened or initiated action at such an early stage, may inhibit a compromise. Further, it may be difficult to determine the appropriate settlement sum that would be acceptable to the requisite majority of shareholder claimants. 
   
   However, these difficulties are not insurmountable. In each case, the Company will need to weigh up the risks, costs and benefits of an early scheme proposal, against the potential payout amount at the end of any class action (including the premium payable to the litigation funder), the potential legal costs and the broader commercial impact of a delayed resolution. In addition, there is room to negotiate and revise the terms of the scheme, including the proposed contribution to the scheme fund, even after a scheme proposal has been announced. For example, in Boart Longyear (No 2) [2017] NSWSC 1105, the terms of the schemes (ultimately approved by the Court) were substantially amended after they had been approved by creditors at the scheme meetings.
   
   
2. Time constraints and disclosure requirements As mentioned above, timing is critical – the Company will need to move quickly to put forward a scheme proposal, ideally before proceedings are commenced and/or before any litigation funder has committed resources and taken control of the dialogue. However, a substantial amount of information will need to be gathered and prepared. The process of preparing and verifying the explanatory statement, and the drafting of the scheme itself, will take time. And while it is important to complete that process in a speedy manner, it is also critical to ensure that, when recommending the scheme, the explanatory statement does not itself contain any:
         
   • misleading representations;
   • disclosures of legal advice which amount to a waiver of the Company’s privilege; or
   • admissions of liability or any other statements which could undermine the Company’s defence, in the event that the scheme fails and the Company is required thereafter to defend the class action(s).
     

   The Company must tread a fine line between recommending the scheme and being protective of its own legal position should the shareholder claimants ultimately reject the proposal. 

3. No guarantee of creditors' approval In the context of a (conventional) debt restructuring scheme, companies would typically secure the support of key creditors and document that support in advance of the scheme meeting. In our hypothetical scenario – where the class action has not formally been commenced – it may be difficult for the Company to identify the key (or sufficiently representative) shareholder claimants with whom to negotiate and obtain assurance of support for the scheme. Absent that dialogue with key stakeholders, the Company runs the risk of the scheme being voted down at the scheme meeting.

Other considerations

The Company should also be mindful of:

• any consent-to-settle stipulations in its insurance policies;
• the need to keep key stakeholders informed, or even enter into standstill arrangements with them, given the broad exceptions to the ipso facto stay;
• its ASX disclosure obligations, and consider whether an application should be made to the ASX for a trading halt during the key junctures of the scheme process; and
• the overall message it sends to the market (including the way in which it justifies the scheme proposal) to ensure that it is not perceived as a "soft target" for shareholder activism or future litigation.

Final twist – What if the Company is insolvent?

Importantly, the course discussed above is only available where the Company is solvent. Where the Company is insolvent or nearing insolvency, the directors should instead consider:

• placing the Company into voluntary administration with a view to compromising all creditors' claims against the Company though a DOCA; or
• proposing a broader creditors' scheme whereby all claims against the Company (including, but not limited, to the shareholder claims) are compromised - in which case, by utilising section 411(5A) of the Corporations Act, it may be possible to release the shareholder claims (as subordinated creditor claims under section 563A(2)) against the Company, without those shareholder claimants being entitled to vote on, and potentially frustrate, the broader creditors' scheme.^[7]

Conclusion

The proliferation of class actions, the ready availability of litigation funding and the recent reforms to insolvency laws in Australia necessitate a rethink of the utility and application of schemes of arrangement – in particular, whether a creditors' scheme may be effectively deployed as a restructuring tool for pre-empting class actions and compromising Sons of Gwalia style shareholder claims, even in a solvent scenario. Obviously, this tool may not be applicable in all circumstances. However, when faced with multiple class action threats, there is little downside in companies giving consideration to this potential avenue for a quicker and cheaper resolution of the underlying claims.

^[1] Discussion Paper: Inquiry into Class Action Proceedings and Third-Party Litigation Funders (June 2018), pp.40 – 41.^{Back to article}

^[2] Wingecarribee Shire Council v Lehman Brothers Australia Ltd (In Liq) (No 9) [2013] FCA 1350.^{Back to article}

^[3] In order for a resolution approving the scheme to pass, a majority in number (ie. >50%) of the scheme creditors present at the meeting and voting must vote in favour of the scheme; and the same majority must have debts or claims against the company representing at least 75% of the total amount of debts and claims of the creditors present and voting.^{Back to article}

^[4] In that case, it was ultimately not necessary to determine at what precise point a “proposal” existed, because it seemed plain to Justice Black that a proposal existed where: a detailed announcement had been made to ASX that set out the substance of the proposed schemes; detailed explanatory memoranda had been provided to ASIC, including draft independent experts' reports; and creditors had been aware of the substance of the proposed schemes at least since the date of the ASX announcement and it was readily possible to identify the detail of the schemes from the explanatory materials.^{Back to article}

^[5] (Lehman Brothers Australia Ltd, in the matter of Lehman Brothers Australia Ltd (in liq) (No 2) [2013] FCA 965).^{Back to article}

^[6] By way of illustration, Standard & Poor’s recently paid $215m to settle a lawsuit in Australia brought by councils which suffered investment losses during the GFC. Of the settlement amount, it was reported that $92m (ie. 42%) was paid to the litigation funder.  ^{Back to article}

^[7] See, for example, Atlas Iron Limited, in the matter of Atlas Iron Limited [2016] FCA 366, where the Court approved a creditors' scheme that relied on section 411(5A) to release (subordinated) shareholders' claims, without requiring a meeting of those subordinated creditors to be convened to consider or vote on the scheme. The reason why it would be difficult to utilise section 411(5A) in a situation where the Company is solvent, is because, where shareholders claims (albeit subordinated) are still likely to have some residual value in a liquidation scenario, the Court is unlikely to preclude those shareholder claimants from voting on the scheme, in which they may have a real financial interest.^{Back to article}