Happy New Year, and welcome to my first post for 2014. At the end of last year, the Queensland Court of Appeal handed down judgement in a notable case, in favour of termination of a deed of company arrangement on public interest grounds. The DOCA had been approved by related party creditors, but their Honours took the view that it was detrimental to commercial morality by precluding public investigation into questionable related-party dealings of a company in administration – in Promoseven Pty Ltd v Prime Project Development (Cairns) Pty Ltd (Subject to a Deed of Company Arrangement) [2013] QCA 405.

Background

In 2005 Prime Project Development (Cairns) Pty Ltd (Prime) and Promoseven Pty Ltd (Promoseven) entered into a joint venture agreement to carry out a property development in Cairns. The joint venture vehicle was a company named Bluechip Development Corporation (Cairns) Pty Ltd (Bluechip). HSBC provided $21 million to fund the development, secured by a first registered mortgage. Both Prime and Promoseven advanced millions of dollars in funds to Bluechip to progress the development, some of which was secured by a second registered mortgage given by Bluechip over the development.

The development was completed in 2009, and was then progressively being sold down by Bluechip. HCBC’s indebtedness was discharged, save for the claim of one subcontractor. However by 2010 Prime and Promoseven were in dispute. Promoseven succcessfully applied to have Bluechip wound up in insolvency, and Prime was ordered to pay Promoseven’s costs (relevantly, making Promoseven a creditor of Prime).

At the heart of the case, was this:  In August 2011, Prime transferred all of its interest in the Bluechip mortgage – alleged to have been valued at some $9 million – to a related company Refund. This dealing is discussed in more detail below.

Prime went into administration in May 2013. It had eleven creditors on administration. One was Promoseven. Of the other ten creditors, nine were related parties. The related parties voted to adopt a DOCA which would give the unrelated creditors a return of 4.3 to 7.4 cents on the dollar. Without a liquidation, there would be no investigation into the affairs of Prime and no public examination of its directors.

Promoseven applied inter alia under s 445D of the Corporations Act 2001 (Cth) for an order terminating the DOCA on the basis that it produced an injustice, by precluding an investigation into Prime’s pre-administration related-party dealings.

Promoseven also relied upon s 600A of the Act, which deals with the powers of the court where the outcome of voting at a creditors’ meeting has been determined by related entities. Broadly, it empowers the Court to make certain orders, including an order setting aside the resolution, if it is satisfied inter alia that the resolution would not have passed without the related party votes, and that the voting outcome was contrary to the interests of creditors or a class of creditors as a whole, or is unreasonably prejudicial to the interests of the non-related creditors.

(It should be noted that under reg 5.3A.07(1)(a) of the Corporations Regulations (2001) (Cth), a company that has executed a DOCA that is later terminated under s 445D by the court, “is taken to have passed a special resolution under s 491 that the company be wound up voluntarily“.)

First Instance

As the Court of Appeal noted at [42], under s 445D there are effectively four grounds upon which a DOCA can be terminated. These are –

(a) if effect cannot be given to the deed without injustice or undue delay – s445D(1)(e);

(b) if the deed, or something done under it, would be oppressive, unfairly prejudicial to, or unfairly discriminatory against, one or more of the creditors – s 445D(1)(f)(i);

(c if the deed, or something done under it, is contrary to the interests of the creditors of the company as a whole – s 445(1)(f)(ii); and

(d) if the deed should be terminated for some other reason – s 445D(1)(g).

At first instance, Martin J of the Queensland Supreme Court noted that under sub-section 445D(1)(e) it is the “effect” of the deed rather than its purpose which is to be considered. The question, his Honour said, is whether the effect of the deed is unfair or inequitable in the impact it has upon one or more of the creditors bound by it (at [15]).

In considering s 445D(1)(f), his Honour said a court does not proceed “upon mere possibility or speculation, it makes a determination on the characteristics of the deed as they are seen to be at the date of the hearing“. One looks, his Honour said, to the effect of the deed as a whole and assesses its unfairness, if any, to the applicant being in mind the scheme of Pt 5.3A and the interests of other creditors, the company, and the public generally (at [16]).

The applicant Promoseven made two allegations –

(1) That the vast majority of creditors were related entities of Prime. The inference ought be drawn that the creditors who voted for the DOCA were either controlled by or friendly to Prime. This does not of itself require that anything be done, but it detracts from the arguments for the DOCA that a majority of creditors has made a commercial decision as to what is in the interest of creditors as creditors (at [23]);

(2) The DOCA would have the effect of precluding investigation into the transfer by Mr Knell of a chose in action (a second registered mortgage) valued at $9 million to a related company called Refund (at [24]).

In relation to this last point, his Honour remarked pointedly that Promoseven did not allege that it was inevitable that this transaction would be unwound; rather it argued that the transaction “might be voidable” and “there is a prospect” that proper enquiries into Prime’s affairs would result in a greater return to creditors than that offered under the DOCA (at [25]).

He noted that even if the transfer were set aside, Promoseven had failed to demonstrate the unfairness or prejudice required to engage the various sections on which it relied – (at [31]). Martin J also observed that the administrators had recommended the DOCA, and there was unchallenged expert evidence that whilst the DOCA would result in a small dividend to creditors, under a winding up the likely return to creditors would be nil (at [27]).

Martin J cited the object of Pt 5.3A of the Act, set out in s 435A which provides –

“The object of this Part is to provide for the business, property and affairs of an insolvent company to be administered in a way that:

(a) maximises the chances of the company, or as much as possible of its business, continuing in existence; or

(b) if it is not possible for the company or its business to continue in existence – results in a better return for the company’s creditors and members than would result from an immediate winding up of the company.”

His Honour took the view that the orders sought by the applicant Promoseven would be inconsistent with the object of Pt 5.3A (at [31]), and that Promoseven could not demonstrate the effect necessary to engage s 445D or the prejudice which s 600A requires to be shown (at [32]). (There was also an issue as to whether the liquidators would be funded properly if the DOCA was set aside and the company was wound up – see [33]).

His Honour was in little doubt of the correct course to take on this application. He held that “the overwhelming weight in the balance of this application” was that even if the company was liquidated and the transfer was unwound, the creditors would suffer. In dismissing the application, he observed:

“While the public interest is an element to be considered, the applicant’s case did not rise high enough to demonstrate that it was sufficient to overcome the other factors to which I have referred.”

The Appeal Decision

The Court of Appeal disagreed, and took an entirely different approach.

The Court examined the dealings between the related companies Prime and Refund in greater detail, and had distinct reservations about the commerciality of the arrangement, in particular –

• on the face of the Agreement there was no attempt to quantify the value of Prime’s half interest in the second mortgage, making it difficult to conclude that it was sold for value, particularly between related entities (at [53]);

• the purchase price was difficult to identify. It was defined to mean “$3,710,701.23 plus any lawful adjustments to the loan account as at the date of completion or revision thereafter made hereunder“. The sum stated was acknowledged in Recital B to be simply the state of the loan account between the companies as at a certain date (at [54]);

• the purchase price was then met not in the form of money, but by the issuing of redeemable preference shares by Refund. The Agreement said nothing about payment being made that way. There was no evidence as to how that came to pass. However 3,710,702 shares were issued to Prime which, on the face of it, suggested that each preference share was worth one dollar. But there was no evidence that this was so (at [55]);

• the Administrators’ Report was the only source of evidence about the adjustments to the purchase price. It noted that a final accounting was completed on 21 March 2013, resulting in Refund being required to and issuing a further 4,668,658 preference shares to Prime. However there was no evidence to show that this equated to an advance of $4,668,658. And there was nothing to show why Refund was “required” to issue further preference shares (at [56]);

• the question of the value of the redeemable preference shares in Refund was unanswered. The Administrators’ Report was the only source of information on this, but it was not sworn and the basis for some of the information it set out was not apparent. What information there was, cast doubt on the true worth of the preference shares (at [57]);

The effect of the agreement was that Prime sold its interest in the mortgage – its only substantive asset – to Refund for a consideration, the value of which would be determined by Refund, and dependent on how Refund chose to structure its business affairs (impacting whether any dividends would become payable to redeemable preference shareholders, like Prime). Related though they were, Prime could not control how Refund went about its affairs. Their Honours concluded that the result was that the consideration was uncertain, if not illusory (at [58]).

What made it worse – particularly notable where transparency was a problem – was Recital G, which provided that the purchase price would be left outstanding, by way of loan or similar transaction, so that “the start up business activities of [Refund] may be funded“. Nowhere was it explained why it would be in Prime’s interest to defer receipt of the purchase price to this end. Prime was divesrting its only substantive asset. It was not at all clear why it had any legitimate interest in being Refund’s benefactor, the Court noted (at [59]).

The Court of Appeal remarked twice on the fact that even though the transaction was between companies controlled by “the one set of directors” (a husband and wife Mr and Mrs Knell), no director went on oath to depose as to the rationale of the agreement. It required explanation, and they did not explain it. The Court said it made it very difficult to reach a conclusion that there was commercial justification to the Agreement (at [50]-[51] and [60]).

There were also a series of related transactions, which raised concerns. In summary –

• Prime subsequently contracted with a company called Bypass to purchase $4.2 million worth of shares in Bypass, in part-payment of which it transferred to Bypass the 3,710,702 preference shares it held in Refund. (These were the shares Refund had issued to Prime, in part satisfaction of the price Refund had to pay to purchase Prime’s interest in the second mortgage over Bluechip.)
• Then in June 2012, Bypass transferred those 3,710,702 preferential shares in Refund to another related company called Radanco (owned and operated by Mr Knell’s nephew), purportedly for $10 million. The ASIC document detailing that transaction was signed by Mrs Knell.
• Less than 2 months later, those same shares were purportedly transferred by Radanco to MDA, another company controlled by Mr and Mrs Knell, for only $15,000. Mrs Knell signed the ASIC document for that transaction also. (It was this company – MDA – which had proposed the DOCA in question, proposing to contribute $80,000, most of which was to pay administration costs.)

There was no material put before the Court explaining how it could be commercially justifiable that the same shares which are transferred for $10 million in June 2012 could then be transferred for $15,000 two months later. Nor, in the face of allegations by the Knell family that Prime did not in fact contract to purchase Bypass shares and that there had been a fraud, did they explain why two Knell family companies would then seek to take transfers of shares which had been obtained from Prime in circumstances of fraud. The Court remarked that those unexplained transactions did little to dispel the sense that Prime had been involved in transactions without an apparent commercially justifiable basis.

The Court of Appeal concluded that the circumstances surrounding Prime’s transfer of its interest in the mortgage to Refund was such that an investigation by a liquidator should not be prevented by the related parties forcing a DOCA on the other creditors. A public examiation of the affairs was warranted, and the institution of claw back litigation may prove to be warranted. It would, in the sense of the terms used by the Full Federal Court in Emanuele v ASC (1995) 63 FCR 54 at 69-70, “be deterimental to commercial morality to dispense with the opportunity which the winding up law provides for the investigation of the affairs of Prime” (at [84]).

The Court of Appeal did not consider that the absence, at that point in time, of a final commitment to fund a liquidator in full to completion of the liquidation weighed against the conclusion.

Comment

This case illustrates how fine a line it can sometimes be between success and failure, on applications to terminate deeds of company arrangement. The Court at first instance took one approach and reached a firm conclusion that the DOCA should stand; the Court of Appeal took an entirely different approach, with a different emphasis and analysis, and unanimously reached the opposite conclusion.

Cases such as these tend to turn on their own facts in the same way that, for example, shareholders oppression actions do. In each case it will be a matter of evaluating and adding together the various aspects and circumstances of the pre-administration dealings in question to test whether, considered together, the balance is tipped in favour of scrutiny of what took place, over letting a decision of creditors to endorse a DOCA stand. If, as was the case here, there is a lack of transparancy or certainty about key aspects of an arrangement where a significant asset is being transferred away from the company, and questions are raised which are not answered or explained by those who could do so, it becomes more likely that a Court may conclude that the interests of the public require investigation into what took place. In Promoseven, the Court was so concerned that it gave precedence to the public interest in commercial morality, without requiring that it be satisfied as to the utility of the investigations and the likelihood of a satisfactory recovery and better return for creditors.

One example of a case where the balance tipped the other way, was the NSW Court of Appeal’s decision in Vero Insurance Ltd v Kassem [2011] NSWCA 381; (2011) 86 ACSR 607. There, although Young JA noted that the transactions had ‘some indicia that they are worthy of investigation‘, all three judges of the Court of Appeal declined to terminate the DOCA, considering that good reason is required to override the choice of a majority of creditors to enter a DOCA. An example of another case where, like in Promoseven, the balance tipped in favour of terminating the DOCA which was described by the Court as “a device by which Mr Triguboff and his associated companies are avoiding scrutiny of a number of highly questionable transactions the net effect of which is to allow TMPL to walk away from a tax debt of $19,551,033.77…” is Deputy Commissioner of Taxation v TMPL Pty Ltd (subject to a Deed of Company Arrangement)(No 3) [2011] FCA 1403.