Rising From The Ashes: A Legitimate Restructuring Strategy for An Insolvent Business
In our previous post released on 3 September 2013, we discussed the tell-tale signs of fraudulent ‘phoenix’ activity as well as the legitimate use of new entities to assist in a business turnaround process.
It was timely post, as ASIC issued a media release on this very issue titled ““ASIC surveillance targets illegal phoenix activity”. In summary, this release advised that ASIC are targeting company directors with a history of failed companies as part of a surveillance program to combat illegal phoenix activity.
The release supports the view that there is clear difference between legitimate use of the corporate form to restructure a business that has legitimately failed from fraudulent phoenix activity.
In this post we’re looking at an example of using the corporate form legitimately to restructure an insolvent company or business.
Mr Hard Worker, Director of I’m A Hard Worker Pty Ltd (“the Company”), becomes aware the company can no longer pay its debts (it is insolvent). Mr Hard Worker consults his advisor and they seek advice from a Liquidator about the Company’s solvency and potential options.
The Liquidators outline all options and risks associated with the Company’s insolvency.
Mr Hard Worker subsequently decides to place the Company into liquidation.
The Liquidators obtain an independent valuation of the Company’s assets, and Mr Hard Worker arranges to purchase some of those assets from the Liquidator at market price. Mr Hard Worker then sets up a similar business using another company of which he is also a Director.
The Liquidator pays the creditors on a pro-rata basis from the funds they received from the sale of these and other assets. Unfortunately the assets realised are only sufficient to pay the company’s outstanding creditors a dividend of 50 cents in the dollar.
This is only a general example of using the corporate legislation legitimately to restructure an insolvent entity. Every situation is different, so they always need to be considered on a case-by-case basis.
Key issues to consider when restructuring an insolvent entity due a genuine business failure
Asset Transfers – Assets, including any contracts for service, must be transferred for market value and on commercial terms.
Related parties can’t offset prior debt against the purchase of the assets.
Section 588 of the Corporations Act 2001 (“the Act”) states that a liquidator has the power to challenge:
- uncommercial transactions (section 588FB)
- unreasonable Director-related transactions (section 588FDA)
- transactions to defeat creditors (subsection 588FE(5)).
Any new structure must be profitable and comply with all its statutory obligations. Is the new venture really feasible? Do you have a business plan, cashflow and budgets?
Support from secured creditors such as banks and other financiers may be needed in a restructure that could include transferring facilities to a new entity. When considering a restructuring plan, it’s important for Directors and their advisors to communicate openly and honestly with their financiers.
A party with a security interest in the whole (or substantially the whole) of a company’s property has the right to appoint an administrator or a receiver over the company’s assets.
Stigma of Liquidation
Give consideration to wider public perception of an insolvency appointment or turnaround plan on creditors, suppliers, employees and customers.
Breach of Director Duties
The Corporation Act imposes duties on Directors (including de facto and shadow Directors) including:
- acting with care and diligence section 180 of the Act.
- acting in good faith and for a proper purpose section 181 of the Act.
- not improperly using their position, or any information obtained because of their position, to gain advantage for themselves or cause detriment to the company sections 182 & 183 of the Act.
They also have a positive duty to prevent insolvent trading (section 588G of the Act.).
It is important Directors make decisions with their duties in mind when considering a restructure.
Disqualification of Directors
Section 206D of the Act provides that a Director may be disqualified from managing corporations for up to 10 years if they have been involved in the failures of at least two corporations within a seven-year period where poor management was wholly or partly responsible for the corporation’s insolvency.
Section 588G of the Act imposes liability on a company’s Director who allows the company to incur a debt when:
- the company is insolvent
- at the time the debt was incurred, reasonable grounds existed to suspect the company:
- was insolvent
- may become insolvent as a result of incurring the debt.
A company will be insolvent if it can’t pay their debts as they fall due.
Potential liability under the ATO’s Director Penalty Notice (DPN) regime
The DPN regime was amended on 29 June 2012 to reduce the scope for companies to engage in fraudulent phoenix activity. The amendments expand the DPN regime to:
- include liabilities to pay superannuation guarantee amounts; and
- remove the ability for Directors to extinguish personal liabilities to pay penalties if PAYGW and Superannuation have remained unpaid and unreported for more than three months.
Contracts and leases
Most contracts and leases contain “insolvency clauses” or Ipso Facto clauses that state the contract is automatically terminated in the event of insolvency.
Proposed legislation to watch out for
The Corporations Amendment (Similar Names) Bill 2012 (“Similar Names Bill”) introduced by the federal government will expose directors to personal liability for their company’s debts, should they start a new entity carrying on a similar business using a similar name.
The Bill provides that a director of a failed Company A can be held liable for the debts of a new Company B that has a similar name to that of A. However, the director of B can apply to the liquidator of A, or the court, for an exemption from liability.
Public comment on the Similar Names Bill closed on 29 February 2012. There has been no activity since this date and we will watch to seek what the new government’s intention is on this draft Bill.
As mentioned in our earlier post, advising insolvent entities involves a lot of complex issues. Advisors must take care when determining the correct course of action for their clients, which is where an experienced Liquidator can help create the best possible outcome for the business, its Directors, employees and suppliers.
If you’d like to confidentially discuss any of your clients’ situations regarding potential (or current) insolvency, contact us and we’ll make a time to step you through the options and our process.