Missing Pieces

[First published on Linkedin on 2 October 2016]

The Australian Government’s Improving bankruptcy and insolvency laws Proposals Paper has a much narrower focus than the comparable UK proposals A Review of the Corporate Insolvency Framework.  The Australian proposals are quite tightly focused on three aspects: one-year bankruptcy, ipso facto, and safe harbour; but there are other aspects of restructuring that would benefit from reform. This below is a personal wishlist of further reforms in the restructuring and insolvency space.

Voting rights where debt is sold

Under current law, corporate debt is voted at face value in all types of formal corporate insolvency appointments. One of the most striking examples of the current position was in the Walton Constructions administration – discussed in the Senate Economics References Committee Report into Insolvency in the Australian Construction Industry (available here).

In Walton an associated party purchased a debt for $30,000, which it then voted for the full $18.5m face value, arguably resulting in a different outcome for a key resolution. Some might argue that voting rights are a just another form of asset, and that parties should be free to buy and sell at any value, however there are other considerations at play. In my view decisions about restructuring a company should be made by the most significantly affected creditors, not arbitragers who chose to enter an impaired capital structure, or parties associated with former owners or management who may have access to inside information. For that reason I strongly support recommendation 42 of the Senate Committee Report – that the law should be changed to align with the position in personal insolvency so that the voting value is the price paid, not the face value of the debt.

Where do employees stand?

Whilst liquidation and restructuring are clearly two very different processes, the position in liquidation is important in restructuring. Not only does the legislation mandate the liquidation position as a formal reference point for Deeds of Company Arrangement, creditors themselves use it as a reference point in assessing whether or not to accept a compromise or support a restructure.

The New South Wales Supreme Court recently held that the priorities set out in section 556 of the Corporations Act ‘do not apply in respect of trust assets’ if the employer is a trust (see in the matter of Independent Contractor Services (Aust.) Pty Limited), and that determination has since been followed by the Federal Court (re Woodgate, in the matter of Bell Hire Services Pty Ltd). Without intending to make any comment on the correctness of that decision; its consequences – that statutory priorities will apply to some employers, but not all, in such a way that it may be quite difficult for employees to understand where they stand – is quite problematic in a practical sense.  It makes sense to change the law so that position is consistent and predictable for all employers and employees.

Multi-class restructuring

Voluntary Administration has several advantages as a restructuring tool. It has an administrative rather than a courtroom focus, so it avoids the delays and costs of legal proceedings unless there is a specific reason to invoke them. It offers creditors a very wide flexibility to negotiate whatever arrangement suits all parties. And, with a twenty three year “life” the procedure is well understood, with precedents that mean most interpretative issues have already been resolved. However, there is a significant gap – the absence of a capacity to bind secured creditors or owners of property (such as intellectual property licensors, or landlords) unless they themselves agree to be bound.

The requirement for unanimous agreement means that any single lender or property owner has leverage conferred by the ability to veto a restructure. The only current statutory restructuring option to address this is a scheme of arrangement, which have proven to be extraordinarily expensive, and quite slow. It would be relatively simple to create a low cost statutory multi-class restructuring option by applying the UK proposals that so that creditors in a class statutory are bound by a 75% by value majority of class creditors, with a cram down of out-of-the-money classes – provided that those creditors will not receive less in a restructuring than they would in liquidation.

Fix scheme classes

As discussed above, Schemes of Arrangement are currently the only option to deal with multi-class restructuring – but the composition of those classes is problematic. In Australia, classes are constituted by grouping together those creditors treated in the same way by the Scheme rather than by grouping together based on common rights. In practice this allows scheme promoters the scope to manufacture a majority by bundling together creditors with different rights. In my view we need reform to ensure that voting classes are determined by rights, not treatment, to avoid such contrived outcomes.

Debt for Equity

Debt for equity can be a very effective restructuring tool. Permanent balance sheet repair addresses any going concern and solvency issues, making it easier secure trade credit and win tenders, and long term contracts. However there are constraints which make it difficult for banks to enter into such arrangements. The restrictions that quite properly limit the ability of Authorised Deposit-taking Institutions to invest in non-banking ventures apply equally to debt for equity restructures. This means that ADIs must consult with APRA before committing to any proposal to hold more than 20 per cent of equity interest in an entity.

If ADIs had the capacity to more easily take equity stakes below a minimum value, and hold them off balance sheet, then a rarely used restructuring tool might be more widely deployed.

Rescue Finance

In Australia rescue finance is typically provided by existing lenders either through informal workouts, or by providing finance to the receivers they appoint. Administrators are free to incur credit but they cannot grant a priority security over circulating assets (such as book debts and inventory) without the consent of existing security holders.  If there is a change to allow multi-class restructuring on a majority, then there should be a similar change to the rules allowing an administrator to pledge security to secure rescue finance with the consent of a majority of existing security holders.

The Bluenergy decision

A charge over a future asset is a very clever, and very useful idea. It means that a security arrangement will automatically adjust when assets change form – from raw materials into finished goods when manufacturing is complete, from finished goods into a receivable when the goods are sold, from a receivable into cash on collection, and back into raw materials when the cash is reinvested into the working capital cycle. Without such a flexible device lenders would need to either scale back their lending, or impose restrictive conditions and require additional paperwork to track assets through the cycle.

In July 2015 the Bluenergy decision (in the matter of Bluenergy Group Limited here) imposed a significant rider to the well-understood rule that a Deed of Company Arrangement did not bind a secured creditor – unless they agree, or vote in favour of the deed. In Bluenergy the Court held that whilst a Deed will not bind the secured creditor, it limits their security to precisely those assets that it captured at the time that the deed released creditor claims: in other words the security will no longer be a charge over future assets, which means that the assets captured by the security will steadily diminish through the normal operation of the working capital cycle.

In practice, the consequence of the Bluenergy decision has been a universally acknowledged change in position for secured lenders: rather than give an administrator the opportunity to negotiate a deed of company arrangement, there will now be times when they should appoint ‘over the top’ to preserve their security. That is the antithesis of encouraging restructuring, and in my view we should be looking for legislative change to reverse the practical consequences of the Bluenergy decision.

Conclusion

The changes to Australia’s restructuring laws under the National Innovation Agenda proposals are significant. The safe harbour reforms will symbolise a new restructuring mindset, and the ipso facto changes have the potential to impact every formal insolvency and restructuring. However, there is significantly more that could be done, and it would be a crying shame if those were the only reforms for a further twenty-three years!