By Blossom Hing SC, Chan Wei Meng, and Mitchell Yeo (Drew & Napier LLC)
Introduction: An Emerging Practice in Singapore
Traditionally, for the purposes of voting in schemes of arrangement, secured creditors are classed separately from the unsecured creditors. In recent years, a new practice has emerged in Singapore schemes of arrangement. Secured creditors’ claims that are larger than the value of the security (“Undersecured Creditors”) were often bifurcated into claims covered by the estimated value of the security ("Secured Portion”) and deficiency claims which represent the shortfall of the security against the total claim (“Unsecured Portion”). During voting, Undersecured Creditors (to the extent of their deficiency claims) are placed in the same class as creditors without any security (“Unsecured Creditors”).
As to the origins of this practice, some have pointed to the US Chapter 11 Bankruptcy Code, which statutorily provides for bifurcating partly secured claims. However, unlike in the US, this is generally not expressly provided for in Singapore legislation, save for the upcoming amendments relating to creditor classification under the re-constituted Simplified Debt Restructuring Programme regime.
Singapore Case Studies
As a matter of jurisdiction, the Singapore courts have to determine if the scheme creditors are correctly classed. This involves identifying the comparator (commonly but not always an insolvent liquidation), assessing whether the creditors' relative positions under the scheme mirror their positions in the comparator, and determining if any differences are significant enough to prevent the creditors from consulting together with a common interest (see Pathfinder Strategic Credit LP v Empire Capital Resources Pte Ltd [2019] 2 SLR 77 at [88]).
None of the reported Singapore cases on schemes of arrangement has dealt with the issue of classification of deficiency claims. The outcomes of the unreported decisions on Singapore schemes of arrangement that involved deficiency claims have gone both ways.
Hoe Leong Corporation Ltd: The High Court allowed Undersecured Creditors (in respect of the Unsecured Portion) to vote with Unsecured Creditors, and approved the scheme of arrangement. The High Court accepted the arguments that the legal rights of the Undersecured Creditors regarding the Unsecured Portion and of the Unsecured Creditors were sufficiently similar, that the Undersecured Creditors had no additional interest or incentives in relation to the Unsecured Portion as compared to the Unsecured Creditors’ claim against the scheme company, and that the scheme of arrangement did not favour nor prejudice any particular group of creditors in respect of their unsecured claims, as in a liquidation all these claims would be similarly unsecured.
Pacific International Lines (Private) Limited: In contrast, the High Court in this case did not allow Undersecured Creditors (in respect of the Unsecured Portion) to vote with Unsecured Creditors. An opposing creditor had argued that the overall recovery for the Undersecured Creditors far outweighed that of the Unsecured Creditors, that the Undersecured Creditors would act to protect the Secured Portion of their claims, and that the liquidation scenario would be particularly destructive to the value of the Undersecured Creditors’ security.
Conceptual Underpinnings and Case Law from Other Common Law Jurisdictions
Cases from other common law jurisdictions also do not speak with one accord.
In the reported common law cases, the justification for placing Undersecured Creditors (with respect to the Unsecured Portion of their claims) in the same class as Unsecured Creditors is that, if the scheme of arrangement does not purport to affect the security interests themselves, the Undersecured Creditors and Unsecured Creditors receive the same treatment in respect of the Unsecured Portion and the unsecured claims respectively. The mere presence of the security interest should not be considered a dissimilarity that would make it impossible for the Undersecured Creditors to sensibly consult with the Unsecured Creditors in the same class.
This is the kind of reasoning adopted in the cases where Undersecured Creditors (in respect of the Unsecured Portion) were allowed to be classed together with the Unsecured Creditors (see for example the line of cases leading up to Re UDL Holdings Ltd [2002] 1 HKC 172 in Hong Kong, and Re Hong Kong Airlines Limited [2022] EWHC 3210 (Ch) in England).
In contrast, the argument against classing the Undersecured Creditors (in respect of the Unsecured Portion) together with Unsecured Creditors is that the substance of the Secured Portion and Unsecured Portion cannot be analysed independently of each other.
The act of bifurcation of secured claims itself compels the Undersecured Creditor to shed some security rights. This might arguably be a sufficiently significant dissimilarity from the rights that the Unsecured Creditors have in the corresponding scenarios, since in the comparator of insolvent liquidation, the Unsecured Creditors do not have security rights. The Unsecured Creditors will not have to consider the potential impact of the proposed scheme on security rights. Such was the kind of reasoning adopted by the Supreme Court of Western Australia in Re Bond Corporation Holdings Ltd (1991) 5 ACSR 304.
Discussion
Conceptually, it must be remembered that the whole of the Undersecured Creditor’s claim (both the Secured Portion and the Unsecured Portion) is secured by the security. The moment a scheme of arrangement bifurcates the Undersecured Creditor’s claim, the Undersecured Creditor is, going forward, only able to look to the security for recourse in respect of a smaller sum. Furthermore, the Undersecured Creditor loses the potential benefit of any future appreciation in the value of the security asset. This is all the more so for more complex schemes of arrangement that spell out specifics of how the security asset is to be treated and how the Secured Portion of the claim will be restructured.
Perhaps another more practical way to approach this issue is to recognise that “[a]s a matter of commercial reality, creditors decide whether to support a scheme by reference to the whole package of rights received for releasing or varying their existing rights” (Stephanie Yeo, “Class Composition in Schemes of Arrangement” [2022] SAL Prac 13 at para 19).
On the whole, how to class Undersecured Creditors’ claims is probably better understood as a matter of judgment and degree, i.e. the degree to which that affects the creditors’ relative positions and rights in respect of their claims. It should be recalled that overly technical or theoretical differences will not in themselves fracture a creditor class. Even if an Undersecured Creditor may conceivably consider its returns from the Secured Portion when determining how to vote in respect of the Unsecured Portion, the same can be said for any scheme creditor with cross-holdings (having more than one type of claim against the scheme company) but yet such creditors with cross holdings are typically allowed to vote in each separate class (see for example Re ColourOz Investment 2 LLC [2021] 1 BCLC 5 at [88]).
Guiding Principles
Some principles may be gleaned from the decided cases in analogous situations:
(a) Valuation: There ought to be scrutiny of the valuation of the Undersecured Creditor's security assets. Inaccurate valuations can distort the creditor's incentives and voting decisions.
(b) No disguised consideration: Drawing from cases regarding giving of payments outside of the scheme, the bifurcation of Undersecured Creditors’ claims should be for legitimate reasons. The benefits conferred in respect of the Secured Portion and Unsecured Portion should be genuinely independent of each other. Payments on the Secured Portion should not be disguised consideration offered in respect of the Unsecured Portion (see for example In re Noble Group Ltd [2019] Bus LR 947 at [132]).
(c) Impact of additional benefits received by Undersecured Creditors: It should be considered whether any additional benefit conferred on the Undersecured Creditors is so sizeable that it would have a significant influence on the decision of a reasonable Undersecured Creditor when voting on the Unsecured Portion together with the Unsecured Creditors (see for example Re Brightoil Petroleum (S’pore) Pte Ltd [2022] 5 SLR 222 at [46(a)]).
(d) Holistic assessment: It should be considered if any matter raises a risk that the majorities in the class for Unsecured Creditors have been obtained as a result of the Undersecured Creditors voting together in that class so as to promote the Undersecured Creditors’ interests in another class rather than in the interests of the class for Unsecured Creditors (see for example Re ColourOz Investment 2 LLC [2021] 1 BCLC 5 at [88]).
A simple illustration is as follows. An Undersecured Creditor with a $1 million claim has security assets of $600,000 of actual realisable value, but in a scheme of arrangement those assets are erroneously ascribed with $700,000 of value. With bifurcation under the scheme, the Undersecured Creditor would vote together with secured creditors for $700,000 and with Unsecured Creditors for $300,000. The outcome is that this Undersecured Creditor may be said to have received an additional benefit of $100,000 in respect of the Secured Portion of its claim, which is additional incentive or disguised consideration to vote in favour in respect of the Unsecured Portion. That Undersecured Creditor’s vote might also be taken as promoting its own interests as a secured creditor rather than the interests of the class for Unsecured Creditors.
The illustration above, though simplistic, does its job at highlighting one instance of the kind of potential injustice that takes place when scheme companies negotiate scheme terms with Undersecured Creditors, particularly as to the valuation of security assets.
Practical Considerations and Concluding Thoughts
Insolvency practitioners should consider the practical implications of the approach above, which arguably limits the utility of bifurcating Undersecured Creditors’ claims and classing the Unsecured Portion together with unsecured claims of Unsecured Creditors. Costs increase due to the increased need to obtain independent valuations. The vote solicitation process may also be more protracted and expensive with additional negotiation over what is an acceptable range of valuation(s) for the collateral. On the whole, it would also be harder to obtain Undersecured Creditors’ support given the restrictions on the extent and kind of incentives that may be legitimately offered to the Undersecured Creditors.
Insolvency practitioners can consider a two-stage approach where a first scheme of arrangement is proposed to bifurcate and resize Undersecured Creditors’ claims to the value of the collateral. The residual Unsecured Portion then becomes wholly unsecured, and can be subject to a subsequent scheme of arrangement together with the unsecured claims of Unsecured Creditors. The sequential nature of the two schemes, however, results in additional execution risk that might not be commercially acceptable to stakeholders.
In any event, applicant scheme companies hoping to class Undersecured Creditors’ Unsecured Portion claims together with ordinary unsecured claims of Unsecured Creditors will, going forward, need to be careful to ensure that, under their proposed schemes of arrangement, there is proper and objective basis for the ascribed value of the security collateral. The schemes of arrangement should also not afford significant special treatment or additional benefits to the Undersecured Creditors, as that might be taken as influencing their votes in respect of the Unsecured Portion.
* The full article was published in the Singapore Academy of Law Journal Special Issue on Insolvency 2023.
