Federal Court Rules on Related Party Creditors in Scheme of Arrangement

Federal Court Rules on Related Party Creditors in Scheme of Arrangement

Federal Court Rules on Related Party Creditors in Scheme of Arrangement

The Federal Court in MDSA Resources Sdn Bhd v Adrian Sia Koon Leng has ruled on the issue of the votes of related-party creditors in a scheme of arrangement. This has an impact on the classification of related-party creditors for schemes of arrangement in Malaysia.

With the Federal Court’s 2-1 split decision, I share the majority judgment  and the dissenting minority judgment.

Summary of the Decision and Significance
Majority Grounds by: Nordin Hassan FCJ

The scheme company, MDSA Resources Sdn Bhd (MDSA), had undertaken a scheme of arrangement to restructure its debts of more than RM370 million.

Both the High Court and the Court of Appeal refused the sanction of MDSA’s scheme of arrangement.

The scheme of arrangement only had a single class of unsecured creditors. The High Court and Court of Appeal upheld the objection that related party creditors should not have been in the same class as the other unsecured creditors.

Leave to appeal to the Federal Court was allowed for 10 questions of law.

The Federal Court’s majority decision upheld the objection based on the related party creditors voting in the same class.

The Federal Court’s majority decision answered two questions of law as follows:

1. Whether the votes of related-party creditors are to be treated differently from the votes of other creditors in the same class in a scheme of arrangement.

[Answer: Yes]

 

2. If the answer to 1 is yes, whether the votes of related-party creditors in a scheme of arrangement should be discounted or not be counted altogether.

[Answer: Yes]

 

Malaysia’s law on schemes of arrangement would now require related party creditors to be placed in a different class from other creditors.

Background Facts

MDSA is a company engaged in property development and with several projects in Malacca.

In July 2020, MDSA initiated a scheme of arrangement by applying for permission to hold a scheme creditors’ meeting and also applied for a restraining order to restrain further legal proceedings against MDSA.

MDSA’s scheme of arrangement consisted of a single class of unsecured creditors.

There were related-party creditors of MDSA – being MDSA’s ultimate holding company, MDSA’s immediate holding company, related companies within the same group, and the directors of MDSA.

These related-party creditors constituted approximately 73% in value of the class of unsecured creditors.

The remaining third-party unsecured creditors were largely purchasers of the completed units of MDSA. The purchasers were owed monies under a guaranteed rental returns agreement with MDSA, which was essentially a buy-to-let arrangement. MDSA owed the purchasers the rental returns and these debts were then included into the scheme of arrangement.

The scheme of arrangement provided a 70% recovery rate to the third-party unsecured creditors compared with a 40% recovery rate if MDSA were to go into liquidation. This was also achieved by the related-party creditors having agreed to forego and lower their recovery under the scheme of arrangement in order to provide for the higher 70% recovery for the third-party creditors.

At the scheme creditors’ meeting held in January 2021, 90.4% of the creditors, present and voting, voted in favour of the scheme.

In January 2021, the High Court dismissed the application for sanction of the scheme of arrangement.

In March 2022, the Court of Appeal dismissed the appeal and upheld the dismissal of sanction.

In July 2021, the Federal Court granted permission to appeal to the Federal Court on 10 questions of law:

  1. Whether the votes of related-party creditors are to be treated differently from the votes of other creditors in the same class in a scheme of arrangement.
  2. If the answer to 1 is yes, whether the votes of related-party creditors in a scheme of arrangement should be discounted or not be counted altogether.
  3. Whether the issue of proper classification of creditors should be determined at the Court leave stage (following the English Court of Appeal decision in Re Hawk Insurance Co Ltd [2001] 2 BCLC 480 and AirAsia X Bhd v BOC Aviation Ltd & Ors [2021] 10 MLJ 942) or only to be determined at the Court scheme sanction stage (following the Hong Kong Court of Final Appeal case of Re UDL Holdings Ltd [2002] 1 HKC 172).
  4. Whether the Court at the scheme sanction stage should be slow to depart from its earlier determination on the proper classification of creditors unless there are material changes in circumstances (following the English High Court decision of Re Lehman Brothers International (Europe) (in administration) [2018] EWHC 1980 (Ch)).
  5. Whether the challenge to the adequacy of disclosure in the explanatory statement issued under section 369(1)(a) of the Companies Act 2016 (“Explanatory Statement”) should be at the stage before the Court approves the issuance of the Explanatory Statement or at the Court scheme sanction stage.
  6. Where the Court finds inadequate disclosure in the Explanatory Statement at the scheme sanction stage, whether the Court can order, as a remedial measure, a re-issuance of the Explanatory Statement and re-voting at the meeting of creditors in a scheme of arrangement.
  7. Whether the duty of disclosure in the Explanatory Statement would require the applicant company to objectively provide each creditor the genesis and extent of all the company’s debts (see the Singapore Court of Appeal decision in Wah Yuen Electrical Engineering Pte Ltd v Singapore Cables Manufacturers Pte Ltd [2003] SGCA 23, a decision cited by the Court below).
  8. Whether the Court hearing the scheme sanction is bound by the principles set out in the Federal Court case of Pacific Forest Industries Sdn Bhd & Anor v Lin Wen-Chih & Anor [2009] 6 MLJ 303 such that the Court should only decide on any scheme of arrangement objections based on the pleadings and after hearing parties on those objections.
  9. Whether the Court hearing the scheme sanction is entitled to apply Re Halley’s Departmental Store Ptd Ltd [1996] 2 SLR 70, as was applied by the Court below, to ignore separate corporate personality in considering any connection or motives of the creditors.
  10. Whether the Court hearing the scheme sanction should follow the principle that the Court ought not to embark on a dissection of the relative commercial merits of the scheme of arrangement (applying Transmile Group Bhd & Anor v Malaysian Trustee Bhd & Ors [2012] 9 CLJ 1071).

The Majority Decision

The Federal Court’s majority decision of Justice Nordin Hassan FCJ first analysed the issue of classification of creditors in a scheme of arrangement.

While finding that creditors should have the same rights to be in the same class, the Court held that it should not disregard the interest of the group of creditors in the said class. The class of creditors should uphold their common interests.

Next, the Court held that it is accepted that a related party has a special interest to achieve in the proposed scheme and may disregard the interest of other creditors.

A wholly-owned subsidiary or a related party of a scheme company should not be placed in a single class of creditors. This is due to their special interest in promoting the scheme. There is no community of interests between the subsidiary and the other creditors.

Next, the Federal Court considered the issue of discounting or giving less weight to the votes of related-party creditors. The Court held that the votes of related-party creditors must be discounted as they have a special interest in promoting the proposed scheme with the propensity to disregard the interests of the other creditors in the scheme.

On the facts of the case, the Federal Court also considered and found that there had been a failure to disclose material facts and that the proposed scheme was not reasonable.

In answering the first two questions of law, the Federal Court found it unnecessary to answer the remaining questions of law.

The Minority Decision

In the dissenting minority decision, Justice Zabariah Mohd Yusof FCJ considered all the questions of law posed to the Federal Court.

On the issue of classification of creditors, the authorities speak with one voice i.e. that related-party creditors who have similar legal rights against the company as other creditors, not based on interests. If they are all unsecured creditors, generally they should all be grouped within the same class.

On the separate issue of the appropriate weight to be given to the votes, it is an exercise of discretion by the Court at the sanction stage. At that stage, the Court determines whether the class was fairly represented.

The “but for” test provides a useful guide to determine whether there were adverse interests of the related-party creditors which had driven their votes. There must be some direct causal link between the special or adverse interests and the related-party creditors’ decision to support the support where those interests are adverse to the interests of other creditors in the class.

The Federal Court minority decision, therefore, held that the Courts below had conflated the determination of the classification of creditors and the determination of the weight to be accorded to the votes.

On other areas of law, the minority decision touched on the following:

  • The issue of the proper classification of creditors should be determined at the Court leave stage (following the English Court of Appeal decision in Re Hawk Insurance Co Ltd [2001] 2 BCLC 480 and AirAsia X Bhd v BOC Aviation Ltd & Ors [2021] 10 MLJ 942).
  • The Court at the scheme sanction stage should be slow to depart from its earlier determination on the proper classification of creditors unless there are material changes in circumstances (following the English High Court decision of Re Lehman Brothers International (Europe) (in administration) [2018] EWHC 1980 (Ch)).
  • The challenge to the adequacy of disclosure in the explanatory statement issued under section 369(1)(a) of the Companies Act 2016 (“Explanatory Statement”) should be at the stage before the Court approves the issuance of the Explanatory Statement.
  • Where the Court finds inadequate disclosure in the Explanatory Statement at the scheme sanction stage, the Court can order, as a remedial measure, a re-issuance of the Explanatory Statement and re-voting at the meeting of creditors in a scheme of arrangement.
  • The Court hearing the scheme sanction is bound by the principles set out in the Federal Court case of Pacific Forest Industries Sdn Bhd & Anor v Lin Wen-Chih & Anor [2009] 6 MLJ 303 such that the Court should only decide on any scheme of arrangement objections based on the pleadings and after hearing parties on those objections.
  • The Court hearing the scheme sanction should follow the principle that the Court ought not to embark on a dissection of the relative commercial merits of the scheme of arrangement (applying Transmile Group Bhd & Anor v Malaysian Trustee Bhd & Ors [2012] 9 CLJ 1071).

Comments

First, the Federal Court’s majority decision touched on the appropriate test for the classification of creditors for schemes of arrangement.

The legal test now appears to be that of dissimilarity of commercial or special interests of the creditors.

The majority decision took into account these factors for the classification of creditors:

  • The class of creditors should uphold their common interests ([23] of the majority decision).
  • Related-party creditors should not be placed in a single class of creditors due to their special interest in promoting the scheme ([32] of the majority decision).
  • There is no community of interests between the related-party creditor and the other creditors ([32] of the majority decision).
  • The weight to be attached to the related parties’ vote is pertinent in the classification of the class of creditors ([32] of the majority decision).
  • The legal rights of the third-party creditors with outstanding rentals are dissimilar with the related-party creditors which had a special interest in promoting the scheme ([33] of the majority decision).
  • The terms “rights” and “interest” are used interchangeably ([34] of the majority decision).

The above test for the classification of creditors may have wider ramifications for schemes of arrangement in Malaysia in the future. It remains to be seen if this decision has introduced more certainty or less certainty for the issue of classification of creditors.

Second, the practical approach for the treatment of related-party creditors votes in schemes of arrangement from now on.

It is clear that related-party creditors must now be in a separate class. However, with a separate class of creditors, I see little justification for there to be any discounting or disregarding of their votes. After all, the votes of the related-party creditors are now ring-fenced within their own class.

 

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