To scheme, or not to scheme: Australia considers supercharging its scheme procedure

In early August 2021, the Australian Government released a consultation paper considering potential reform to improve the scheme of arrangement (scheme) regime pursuant to Part 5.1 of the Corporations Act 2001 (Cth) (Corporations Act). The release of the consultation paper followed Australia's recent introduction of the small business restructuring process with a view to ensuring more companies can benefit from improvements to the insolvency regime.

A number of international jurisdictions, including Singapore and the United Kingdom, have recently reformed their scheme processes and as such provide a roadmap for potential options for Australian reform. This article looks at the recent reforms in both Singapore and the United Kingdom and discusses the potential options for reform in Australia that could make Australia a competitive restructuring venue for distressed enterprises.

What is a scheme?

While the scheme regime in Australia can be utilised in both a solvent and insolvent context, the focus of this article is in respect of the use of schemes to restructure companies that are facing significant financial difficulty.

Schemes create a binding contractual agreement between the company and its creditors containing terms that allow the company to restructure and meet its debt obligations. Unlike other forms of restructuring processes in Australia, schemes are primarily "debtor-in-possession" (DIP) processes where the company's existing management is not displaced in favour of a court-appointed officer (i.e. an administrator, receiver or liquidator).

Due to the strict threshold and procedural requirements of schemes, and the resulting costs to implement them, schemes have traditionally been reserved for large scale corporate restructurings (for example the restructuring of the Nine Network, Boart Longyear and Slater & Gordon Ltd), with only 17 creditors' schemes being approved in Australia since the 2008-09 Global Financial Crisis.

What does the consultation paper seek?

The consultation paper seeks feedback on a number of possible changes to the Australian scheme process, but most importantly:

• whether to introduce an automatic moratorium or stay to allow "a company and its creditors the breathing space to create a binding agreement to ensure that restructure of economically viable companies is not disrupted by a minority of creditors"; and
• whether to introduce a "cross-class cram down", which would enable a scheme to be approved by a company's creditors irrespective of opposition from one or more classes of creditors.

What lessons can be learned from other international jurisdictions?

Singapore

In early 2017, the Singaporean Government introduced sweeping changes to Singapore's insolvency and restructuring regime (2017 Reforms). Schemes featured prominently in the 2017 Reforms as Singapore sought to bolster its attractiveness as an international centre for debt restructuring, competing with the likes of the United Kingdom and the United States. Central to these reforms was the use, with modification, of certain provisions from the United States Bankruptcy Code. As such, the reforms resulted in a hybrid system. Two of the key reforms introduced include an expanded moratorium and the ability to achieve a cross-class cram down. Today, these reforms now sit in an omnibus statute, the Insolvency, Restructuring and Dissolution Act 2018 (IRDA), with only minor modification.¹

Moratorium

Prior to the 2017 Reforms, a company could only apply for a moratorium if it had already made a scheme proposal. Practically speaking, this required the scheme company to undertake substantial work as quickly as possible in order to stave off potential proceedings. This was regarded as counterproductive as what the company truly needed was time to properly consider and propose a scheme to its creditors.

Since the 2017 Reforms, companies are now provided with an automatic moratorium of 30 days upon the filing of the application. Further, the moratorium is engaged even if the company only intends to propose a scheme. Importantly, Singaporean courts are also now empowered to grant moratoriums to cover a "corporate group", including any subsidiary or parent company, in order to facilitate group-wide restructurings. The moratorium available for these group-wide restructurings can also be ordered to apply extraterritorially, so long as the scheme company is in Singapore.

Cross-class cram down

A cross-class cram down is a mechanism which prevents a minority non-consenting creditor in another class from blocking a company's restructuring plan. This was introduced by the 2017 Reforms as it is often difficult to achieve total cross-class consensus in a restructuring, which created an obstacle to the implementation of a scheme. In order to achieve a cross-class cram down, at least 75% in value and a majority in number of all creditors attending and voting (across both consenting and non-consenting classes) must vote in favour of the scheme, and the court must be satisfied that the scheme is "fair and equitable" to each dissenting class of creditors and does not "discriminate unfairly" between two or more classes of creditors. Interestingly, the 2017 Reforms also followed the traditional scheme threshold, requiring 75% in value of claims in a class to approve the scheme rather than the United States Bankruptcy Code threshold of 66 2/3%, when addressing the issue of whether each class is deemed to accept the terms on offer. The 2017 Reforms resulted in a practical difficulty whereby shareholders, as "junior claimants", could not retain their shares unless the unsecured creditors, as the more "senior claimants", were paid in full (which is similar to Chapter 11's "absolute priority rule"). The IRDA clarified this and now provides that in a cross-class cram down shareholders do not need to be divested of their shares before the cram down can be made. Hence, shareholders can retain their equity in a plan that crams down a class of creditors.

United Kingdom

In the United Kingdom, schemes are statutory procedures carried out pursuant to Part 26 of the Companies Act 2006­ (Companies Act). Analogous to both the Singaporean and Australian position, a scheme must be approved by 75% in value and the majority in number of each class of the company's members and creditors. In late June 2020, the Corporate Insolvency and Governance Act 2020 (CIGA) came into force in the United Kingdom and introduced what has been termed the "super scheme", the restructuring plan. The new restructuring plan has already been utilised on a number of occasions since its introduction. Whilst the restructuring plan is primarily based on the existing scheme process, it benefits from cross-class cram-down provisions and the introduction of a standalone short-term moratorium mechanism that is intended to promote informal rescue.²

Moratorium

Prior to the introduction of the CIGA, a moratorium was not available as of right. Under the CIGA, an eligible company can now obtain a moratorium by filing an application to the court. Entities including financial institutions, insurance companies, those that have an outstanding winding-up petition and those that have entered into a moratorium in the previous 12 months, are not eligible for a moratorium without a further order of the court. Furthermore, in order to be granted the moratorium, the company must:

• supply a statement from the directors that the company is or is likely to become unable to pay its debts; and
• include confirmation by the monitor that the moratorium would likely result in the company's rescue.

If successful, the order allows for a moratorium of 20 days which can be extended by a further 20 business days on a subsequent application. The moratorium period can then be extended for a further period by support of creditors (12 months) or by order of the Court (indefinite). The moratorium regime provides for a modified DIP model in that during the period of moratorium, the company is supervised by a "monitor", a licensed insolvency practitioner, to provide oversight and safeguards for creditors.

Cross-class cram down

The United Kingdom's restructuring plan provides for two ways of imposing a plan on creditors without their consent. The first is if the court is satisfied that the creditors have no "genuine economic interest" in the company. Whilst the court has wide discretion as to the assessment of what is classified as "economic interest", courts will likely have to make determinations on commercial issues and matters of valuation, which in turn will require the provision of expert evidence.

The second is if the court is satisfied that:

• if the scheme is approved, no members of the dissenting classes would be any worse off than they would be in the event of the "relevant alternative"; and
• at least one class of creditors or members, which would receive a payment or have a "genuine economic interest" in the company in the event of the relevant alternative, has approved the restructuring plan.

As the CIGA does not prescribe examples of alternatives, it will be interesting to see how the "relevant alternative" test is developed by the courts. This may be a decisive aspect of the cross-class cram down mechanism in the restructuring plan, as there is considerable flexibility for debtors, or dissenting creditors, to frame the relevant alternative using valuation evidence. As such, the courts have considerable discretion in developing the law in this area.

Australia

Before turning to considering the potential changes that may be implemented in the future, it is important to understand the current position in Australia.

In respect of the two issues expressly identified in the consultation paper we note that:

• Currently, where multiple classes of creditors are affected by a scheme, the requisite majority approval must be obtained from each class. This allows one dissenting class the ability to block the scheme and strongarm the company. The underlying rationale for the existing regime is to ensure that minority interests are adequately protected. However, this safeguard can be exploited by a dissenting class (e.g. by withholding approval of the scheme until the company provides more favourable conditions).
• Australian schemes are also not subject to an automatic moratorium on enforcement and proceedings prior to the commencement of the court process. Rather, there exists a discretionary power under section 411(16) of the Corporations Act which allows a court to stay actions by creditors upon application by the company. This existing provision is somewhat similar to the CIGA moratorium provision, in that it does not arise automatically. It also arises too late in the process to be of real benefit.

The current complexity and rigidity of the Australian scheme process is one of the reasons that it is such an underutilised restructuring process in Australia.

Our view on the consultation paper changes

With the consultation process now closed, we eagerly await confirmation that the Government will move forward with reforms to the scheme regime. While the scheme regime will remain of limited use to companies other than large distressed corporates, we consider that there is real utility to reform the regime to make it more closely aligned with other jurisdictions. In so doing, it is hoped that increased flexibility and the introduction of measures to counter issues that currently deter the use of the scheme regime, will provide for better outcomes for a range of stakeholders.

Moratorium

The proposed automatic moratorium in the consultation paper appears to contemplate something similar to what was introduced in Singapore. As mentioned above, the United Kingdom did not see the need to introduce an automatic moratorium as part of its recent reforms under the CIGA. Instead, a standalone provision has been created whereby companies must make a separate application to the court. This also provides benefit outside of the scheme context and promotes informal restructuring more generally.

Whilst there is already an existing power under section 411(16) of the Corporations Act for a court to stay actions by creditors, the introduction of an automatic stay or a standalone moratorium would give Australian companies beginning the scheme process some respite from proceedings and allow the company time to focus on restructuring its liabilities.

While there are obvious benefits of the introduction of an automatic moratorium in conjunction with scheme reform, we consider that a better and more flexible approach would be to adopt a standalone DIP moratorium regime akin to that adopted in the United Kingdom. This would support informal restructuring with appropriate supervision by the Court and a registered liquidator acting as monitor. It would also incorporate a structure for the payment of debt during the moratorium period thereby providing certainty for directors and creditors. Finally, we consider that it would be necessary for the moratorium to incorporate protection for directors from insolvent trading liability during this period.

Cross-class cram down

If properly implemented, a cross-class cram down mechanism would be a valuable addition to the Australian regime. Given that the Singaporean courts have provided greater clarity, primarily due to the 2017 Reforms taking place a number of years prior to the introduction of the CIGA, we are of the view that the "fair and equitable" test would also be appropriate for Australian scheme cross-class cram downs. In considering the content of "fair and equitable", courts focus on whether the dissenting creditor would receive, under the proposed scheme, an amount less than what such a creditor would receive if the proposed scheme was not approved. Furthermore, in order to be consistent with the existing threshold requirements, we believe that if a cross-class cram down mechanism is introduced, the traditional 75% requirement of creditor value approval will be incorporated (as in Singapore).

Additional potential amendments

While the consultation paper focuses on the moratorium and cross-class cram down issues, there is opportunity to consider other amendments that may enhance the utility of the scheme regime. We consider that reform in respect of the protection of employee entitlements and the provision of additional finance during any moratorium ought to be considered. In particular, in circumstances of severe financial distress, the provision of additional working capital may prove critical to the ultimate outcome for all creditors and the regime ought to appropriately incentivise this.

The waiting game

We look forward to further developments pending review of the submissions received during the consultation process and hope that Australia will, in the not too distant future, join other international jurisdictions in modernising the scheme process. Stay tuned.

Special thanks to Sydney lawyers Alexander Proudford and Sophie Timms for assisting in the preparation of this content.