Don’t Come The Raw Prawn With Me – Court Terminates DOCA, Finds Abuse Of Pt 5.3A

In the recent decision in Canstruct Pty Ltd v Project Sea Dragon Pty Ltd (Subject to a Deed of Company Arrangement) (No 4) [2024] FCA 112, the Federal Court considered an application by an aggrieved creditor to terminate a deed of company arrangement (DOCA) under section 447A and/or section 445D of the Corporations Act 2001 (Cth) (the Act).

The creditor claimed that it had been unfairly prejudiced and discriminated against by the DOCA, and that the DOCA was an abuse of process.  This was in circumstances where all other creditors were to be paid in full under the DOCA, and the applicant creditor was only to be paid around 10c-11c in the dollar for its claim.

Derrington J carefully considered the facts of the case, including some very interesting issues regarding the corporate and funding structures involved and the circumstances in which the DOCA was entered into, before concluding that the DOCA should be terminated and that the company should be wound up in insolvency.

Background

Project Sea Dragon Pty Ltd (PSD) is a special purpose vehicle that was established in 2015 to construct and operate a major prawn aquaculture project spanning five operational sites in Western Australia and the Northern Territory, including at the remote Legune Station site in the Northern Territory. 

However, since its incorporation, PSD had not had any income of its own (or owned any substantial assets) and had at all times been entirely reliant on ad hoc funding from its parent company Seafarms Group Limited (Seafarms).  This funding was ad hoc as there was no agreement or arrangement in place by which Seafarms had committed to or was obliged to provide funding to PSD.  However, there was evidence of an established practice by which PSD would submit invoices to Seafarms in a weekly “payment run” to deal with contract, employee and tax payments due by PSD, and by which Seafarms would provide PSD with funds to make these payments.  The funding resulted in PSD accruing substantial liabilities to Seafarms (and to other related companies in the corporate group).

At all relevant times, the directors of PSD and Seafarms were identical (save for a small number of immaterial exceptions).

As part of the project, and in around May 2021, PSD engaged Canstruct Pty Ltd (Canstruct) to carry out various construction works at the Legune Station site.  In 2022, a dispute arose between PSD and Canstruct as to the amount to be paid by PSD to Canstruct, and on 3 February 2023 Canstruct obtained an adjudication determination against PSD under the Construction Contracts (Security of Payments) Act 2004 (NT) in the amount of approximately $14 million.

At around the time of the dispute between PSD and Canstruct, Seafarms was itself going through a period of growing financial difficulties, and the Seafarms FY22 annual report included a note by the directors of Seafarms as to “material uncertainties relating to the decision to continue with Project Sea Dragon”.

After the Canstruct adjudication was handed down, and in the period between 3 February 2023 and 13 February 2023, the directors of PSD (who were also the directors of Seafarms) considered and resolved to pursue a course of action whereby:

• Seafarms would cease to fund PSD;
• PSD would be placed into voluntary administration;
• Seafarms would propose a DOCA under which Seafarms would contribute $3.5m;
• the $3.5m would cover the costs and fees of the administrators, a return of 100c in the dollar to all unrelated creditors of PSD other than Canstruct, and a return of about 10c in the dollar to Canstruct on the adjudication debt;
• the return to Canstruct was intended to reflect what the directors thought that Canstruct was actually owed; and
• if the DOCA was approved and completed, then control of PSD would be returned to the directors and Seafarms would resume funding of PSD to continue its operations.  

The following events then took place:

• on 13 February 2023 the board of Seafarms resolved to withdraw funding to PSD, and the board of PSD resolved to place PSD into administration;
• on 14 February 2023 administrators were appointed to PSD (Administrators);
• on 17 February 2023, Seafarms entered into a funding agreement with the Administrators for provision of $1.65m to fund the continued operation of the PSD business;
• on 13 March 2023, Seafarms submitted a DOCA proposal to the Administrators pursuant to which:
  • Seafarms would provide $3.5m;
  • after repayment of the Administrators’ funding agreement, Seafarms expected around $2m to be available for creditors;
  • employee claims and “Small Claim Creditors” (which turned out to be all non-related creditors other than Canstruct) would receive 100c in the dollar;
  • all remaining funds would be paid to the “Balance Creditors” (which turned out to be Canstruct), which Seafarms expected to result in a return of 10c-11c in the dollar;
  • Seafarms and the other related creditors would not receive anything from the deed fund; and
  • upon effectuation of the DOCA, all claims against PSD would be extinguished except for certain claims by any landlords in respect of premises occupied by PSD;
• on 14 March 2023, the Administrators issued their report to creditors which recommended the DOCA and which noted that all creditors including Canstruct would receive more under the DOCA than they would in a liquidation scenario.  The report also noted that there would not be any potential recovery claims as PSD only became insolvent on 13 February 2023 when Seafarms withdrew its funding;
• on 21 March 2023, the second meeting of the creditors of PSD was held at which the creditors resolved to approve entry into the DOCA; and
• the DOCA was entered into on 23 March 2023 and in accordance with its terms control of PSD was immediately returned to its directors.

Canstruct commenced proceedings on 5 April 2023, claiming that:

• entry into the DOCA constituted an abuse of process and of the provisions of Part 5.3A of the Act;
• the DOCA was unfairly prejudicial to or unfairly discriminatory against Canstruct;
• effect could not be given to the DOCA without injustice; and
• misleading information was provided to the creditors and there were material omissions from the information given to the creditors.

Decision

The Court considered each of the component arguments by Canstruct separately.

Abuse Of Pt 5.3A By Use Of The VA And DOCA Process

The Court accepted the argument by Canstruct that the predominant purpose of the use of the administration process and of the DOCA was to avoid PSD having to pay the adjudication debt to Canstruct.  The Court acknowledged that this is a matter that must be assessed on a case by case basis and that care must be taken not to conflate the outcome of a DOCA with the predominant purpose, but found that no other purpose could be properly discerned in this case when the evidence was considered in its totality.

The Court held that this purpose was improper and alien to that for which Pt 5.3A is to be used, and was not a bona fide attempt to use Pt 5.3A to achieve an arrangement by which PSD could continue in existence and by which creditors could obtain a better outcome than in a liquidation.  Accordingly, the Court was satisfied that the use of the VA and DOCA process in this case constituted an abuse of the provisions of Pt 5.3A.

In addition to these matters, the Court also considered Canstructs’ argument that by reason of the nature of the ad hoc funding structure, PSD had in fact been insolvent since 2020 and therefore the DOCA would result in an additional abuse, namely avoiding scrutiny into PSD’s insolvent trading.

It is not possible to do justice to the detailed analysis undertaken by the Court on this issue within the scope of this paper.  However, it is worth noting the following observations and findings by the Court:

• the Court noted that while the use of special purpose vehicles (SPVs) was not unusual, this did not mean that the test for insolvency for these companies should be applied any differently;
• if a group uses a SPV as a ‘stalking horse’ to shield the group from liability associated with the SPV and its obligations (for example, by the SPV assuming the risks of a venture but having no assets of its own), this will necessarily give rise to the risk that the SPV might be left in a state of permanent insolvency because as a matter of commercial reality it will not have access (or sufficiently assured access) to sufficient funds to be able to pay its debts as and when they fall due;
• in this case, there was no commitment or assurance that Seafarms would fund PSD.  Further, even if Seafarms was funding PSD to pay its debts, this just meant that PSD was merely substituting one liability for another, which as the authorities confirm does not enhance a borrower’s solvency.  Finally, the circumstances of the case prove that Seafarms was not committed to funding PSD because as soon as a liability arose that Seafarms did not agree with (ie the Canstruct liability), it withdrew its funding;
• as a result of the above, the Court was satisfied that PSD had been insolvent from at least June 2020, and that there was a real risk of liability for both the directors and for Seafarms (as holding company) in relation to insolvent trading claims; and
• in the circumstances, it should be accepted that entry into the DOCA had the effect of preventing a liquidator from examining the conduct of PSD’s directors and of Seafarms (as the holding company of PSD) in relation to potential insolvent trading, giving rise to a further abuse of Pt 5.3A.   

The Court ultimately held that the fact that the DOCA was entered into for an improper purpose enlivened the power to set the DOCA aside under sections 447A and 445D(1)(g) of the Act, and the fact that the DOCA produced the consequence of avoiding scrutiny of any insolvent trading claims provided an added justification for doing so.

Termination Under Section 445D(1)(f)

The Court also considered whether the DOCA was unfairly prejudicial to or unfairly discriminatory against Canstruct, and unsurprisingly held that the DOCA’s true purpose, to cause the release of Canstruct’s debt, had the consequence that the DOCA was of course unfairly prejudicial to or unfairly discriminatory against Canstruct within the meaning of section 445D(1)(f).

Termination Under Sections 445D(1)(e), (b) and (c)

For many of the same reasons outlined above, the Court was also satisfied that the power to set aside the DOCA was enlivened on the basis that effect could not be given to the DOCA without causing injustice, and that there were material misstatements and/or omissions in the information given to creditors (namely as to the true purpose of the DOCA, the potential insolvent trading that had occurred, and as to the lack of any proper basis for the discriminatory treatment of Canstruct under the DOCA).

DOCA Terminated

The Court summarised its views in [260] of the judgment, when noting the following considerations that weighed heavily in favour of the termination of the DOCA and the winding up of PSD:

• that the DOCA was an abuse of Pt 5.3A;
• that it was unfairly prejudicial to Canstruct;
• that it was entered into after false or misleading information was given to the creditors, and after relevant information was not given to them;
• that the setting aside of the DOCA is likely to lead to recovery actions against Seafarms and PSD which have reasonable chances of success; and
• importantly, that it will prevent Seafarms and the Seafarms Group from using insolvent companies to assume the risks of its business to the potential wider prejudice of future creditors.

Lavan Comment

This decision raises some very interesting questions regarding the use of SPVs and ad hoc funding arrangements in high risk business ventures in Australia.

These structures are not uncommon, and while it is unclear whether many would have precisely the same features as those described in this case, the points made by the Court as to the assessment of the solvency of SPVs supported by ad hoc funding arrangements are likely to be of significant interest to the business and insolvency communities.

The decision also provides useful guidance as to the limits on the use of the VA and DOCA process to restructure a company’s debts.

If you have any questions regarding this complex decision or the matters summarised in this paper, the experienced Lavan team is here to help.