Cozy relationships? Not much uncovering required!

Last week the Australian Financial Review reported the Small Business Ombudsman Kate Carnell as having said that the Banking Royal Commission had missed an opportunity to uncover ‘a cozy relationship’ between banks and the administrators and receivers who work for them.

Most service providers and suppliers work very hard to have a good relationship with their customers, and restructuring and turnaround professionals are no different – but presumably the ASBFEO is concerned with something improper.

Significantly, the ASBFEO Act requires (section 69, here) the Ombudsman to transfer matters to another agency if:

‘the request could be more conveniently or effectively dealt with by the other agency’

ASIC has both the legal powers of compulsion and the technical expertise to investigate the Ombudsman’s concerns. More importantly however, ASIC already receives copies of the Declaration of relevant relationships and declaration of indemnities (DIRRI)* which a registered liquidator must prepare on each occasion he or she is appointed as liquidator or voluntary administrator. The DIRRI – which is also given to creditors – provides considerable detail about an appointee’s relationship with those who appointed him or her, as well as relationships with significant creditors.

That wealth of public disclosure means that neither ASIC nor the Royal Commission would need to do a great deal of ‘uncovering’ to understand the nature and extent of the relationships between banks and the restructuring professionals they appoint, were either to decide that an investigation was warranted.

All of which stands in marked contrast to the situation as regards pre-insolvency advisers: no licensing, no regulation, no regulator, no standards, and no disclosure about their relationships!

*The DIRRI is now an online form accessible via a portal available to registered liquidators, but for those interested the ARITA Code of Practice includes a template (at page 100).

‘Timid’ regulators, ‘complicit’ auditors, ‘rotten culture,’ and ‘ineffective’ directors

When Carillion PLC collapsed in January 2018 it had 43,000 employees and owed more than £4.6 billion, including a pension liability of around £2.6 billion.

Carillion’s financial position was so dire that it went straight to liquidation. According to the 16 May report issued by the UK House of Commons Work and Pensions Committee, insolvency practitioners were unwilling to act as administrators because there was no ‘certainty that there was enough money left in the company to pay their costs.’

The report follows the collapse so quickly that it cannot reflect a full forensic analysis, and it is issued under Parliamentary privilege, but the criticisms are fierce. The report says:

The was a ‘chronic lack of accountability and professionalism’ and the board was ‘either negligently ignorant of the rotten culture at Carillion or complicit in it.’
The non-Executive directors were ‘unable to provide any remotely convincing evidence of their effective impact.’
The resignation and sale of shares by a former finance director ‘were the actions of a man who knew exactly where the company was heading once it was no longer propped up by his accounting tricks.’
The auditors ‘were complicit’ in the company’s aggressive accounting judgements through their failure ‘to exercise—and voice—professional scepticism.’
The Pensions Regulator ‘failed in all its objectives.’
The UK’s Financial Reporting Council was ‘too passive,’ and ‘wholly ineffective’ in taking the auditors to task.
The committee had ‘no confidence’ in the FRC or the PR, who it said shared ‘a passive, reactive mindset and are too timid to make effective use of the powers they have.’

The full report is available here, together with video of some of the key evidence.

UK Pre-Packs: where to next?

A “pre-pack” insolvency is one that involves a business sale negotiated in advance of a formal insolvency, implemented by the liquidator or administrator shortly after his or her formal appointment.

Pre-packs will achieve a quicker and cheaper sale than a full blown process by an insolvency practitioner – however if a related party ends up as the purchaser, questions are often asked about how the sale price was set. A report issued this week in the UK raises doubts as to the effectiveness of a voluntary regime intended to mitigate those problems, and further change now seems likely.

Pre-packs in different jurisdictions

In the US, pre-packs are used for the very largest insolvencies – such as Chrysler in 2009 – to try to avoid the worst of the time delays and runaway legal costs of their cumbersome Chapter 11 process (a recent example reported here).

In the UK, pre-packs are typically used to deal with the very smallest businesses, where the costs of a normal sale process and settlement would swallow most of the sale proceeds. Whilst they are an established part of the UK restructuring scene, pre-packs involving a sale to a related party – which most Australians would describe as a ‘phoenix’ transaction – have been controversial in the UK for precisely the same reasons that phoenix transactions are controversial here.

In Australia, pre-packs are seen by many restructuring and turnaround professionals as problematic, because a practitioner who is involved in pre-appointment negotiations probably falls foul of the ARITA requirements for professional independence.

The Graham Review and its recommendations

In 2013 the UK government asked prominent Chartered Accountant Teresa Graham to review the use of pre-packs, and make recommendations to improve their outcomes. The recommendations in her 2014 Report (discussed here) included a process by which related-party transactions could be referred to a ‘Pre-Pack Pool’ – a panel of experienced business people – for review. Notably, this is a voluntary process, and those involved must choose to refer the transaction to the PPP.

As explained on the PPP website, a randomly selected panel member will provide an independent opinion to be shared with creditors. That opinion, provided within two business days and at a cost of £800, will not include any reason or explanation, but will simply set out one of the following three conclusions:

“Nothing found to suggest that the grounds for the proposed pre-packaged sale are unreasonable”
“Evidence provided has been limited in some areas, but otherwise nothing has been found to suggest that the grounds for the proposed pre-packaged sale are unreasonable”
“There is a lack of evidence to support a statement that the grounds for the proposed pre-packaged sale are reasonable.”

The 2017 Annual Report

This week the PPP issued its report for the 2017 calendar year (available on their website). Key statistics include:

28% of the 1,289 administrations in the UK were pre-packs (2016: 22%).
57% of those pre-packs involved sales to related parties (2016: 51%).
Only 11% of the related party pre-packs (28%) were referred to the PPP (2016: 28%).

Of those referrals:

49% received a ‘not unreasonable’ opinion (2016: 64%).
34% received a ‘not unreasonable but with limitations as to evidence’ opinion (2016: 25%).
17% received a ‘case not made’ opinion (2016: 11%).

What next for UK pre-packs?

The UK passed legislation in 2015 which created a framework to allow for later regulation if the process proposed by Teresa Graham did not deliver the hoped-for outcome.

The PPP’s 2016 Annual Report noted a slow take up rate in the first year of operation – but recognised that the program was still new. However, the 2017 report shows that against the hopes of the PPP, the referral rate has fallen, and fallen significantly.

It seems likely that a review announced by the UK Insolvency Service in December 2017 will conclude that the voluntary regime has not worked. The next step is less clear: will the UK endorse the referral regime but make it compulsory, restrict or ban related-party sales altogether, or find another option?

For further reading, Michael Murray has written an excellent article recently on pre-packs: here

Restructuring & Turnaround professionals and the Royal Commission

In December (here) I suggested that the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (‘FSRC’) had the potential to become the seventh inquiry in the last seven years to examine the conduct of Restructuring and Turnaround practitioners.

The third round of hearings which commence on 21 May specifically allocates time (the agenda is here) to considering the “approach of banks to enforcement, management and monitoring of loans to businesses.”

On 7 May the FSRC published its 10th background paper: Credit for small business – An overview of Australian law regulating small business loans. The paper does extremely well to condense a very broad subject into 41 pages but surprisingly makes no mention whatsoever of the PPSA – which is surely significant, if only for the fact that it imposes a duty comparable to section 420A.

Two days later the FSRC released background paper 11 (both papers are available here) prepared by Treasury at the request of the Royal Commission to provide an “overview of reforms to small business lending.” There is likewise no mention of the PPSA regime, but the paper does include comment about the ILRA legislation, as well as brief reference to safe harbour and ipso facto.

There have not yet been any reports of Restructuring & Turnaround professionals being asked to appear – but we may be getting closer.

1 year Bankruptcy and Debt Agreement Reform: The Senate Committee Reports

Today the Senate Standing Committee on Legal and Constitutional Affairs issued reports about two separate bills, both intended to reform personal insolvency regimes.

Debt Agreement Reform

Importantly, the Bankruptcy Amendment (Debt Agreement Reform) Bill 2017 (discussed in more detail here) will strengthen the regulation of Debt Agreement Administrators, more closely aligning it to the regulation of bankruptcy trustees.

Another, seemingly less well understood aspect will limit the length of payment arrangements to three years. It is a well intentioned measure, but there is a risk that in practice it will operate to restrict a debtor’s ability to negotiate a Debt Agreement, because many creditors will not vote for a proposal unless it meets a minimum return requirement.

In the Inquiry hearings, one Debt Agreement Administrator referenced a minimum return requirement of 60 cents in the dollar. Using this as an example, a DAA would tell an debtor with liabilities of $70,000 that they need to create a fund of $42,000. A debtor with capacity to contribute $2,000 per month would be able to do this in 21 months – within the proposed three year limit, but a debtor who could only contribute $1,000 per month would need 42 months – outside the three year limit.

It may be that creditors will reduce their minimum return requirements, but if they do not, a measure presumably intended to offer debtors relief may operate in practice to stop some of them from entering into a Debt Agreement at all.

One Year Bankruptcy

The Bankruptcy Amendment (Enterprise Incentives) Bill 2017 (discussed in more detail here) will shorten the default bankruptcy term from three years to one year.

The proposal echoes a previous initiative which allowed some bankrupts to apply for discharge after six months. That measure was scrapped in 2001 due to concerns that early discharge did ‘not reflect the serious nature of the decision to become bankrupt’ and that an ‘easy way out’ acted to ‘discourage debtors from trying to enter formal or informal arrangements with their creditors to settle debts.’

The Government proposes to maintain the current three year term of the income contribution regime – ie two years post-bankruptcy – but will leave trustees without any practical measures to collect information about a debtor’s income in the two years after discharge. Without that information the trustee will be unable to calculate income contributions, none will be collected, and so returns to creditors will diminish.

The Report

The report (available here) does recognise that these issues, and others, were raised in the various submissions – but gives higher weighting to the original policy intentions. The committee recommended:

that the Government give positive consideration to ASIC greater scope to impose director disqualifications, discussed in more detail here.
that the government consider amending the debt agreement reforms to allow debt agreements implemented under a three year cap to be extended by up to two years, by agreement.
identification of a range of specific factors that should be taken into account when setting a maximum payment to income ratio for a debt agreement.
that with those adjustments made, the legislation should be passed.

Other posts about the Bankruptcy and Debt Agreement reforms:

Back where we started? Director disqualification

Last week the Senate Standing Committee on Legal and Constitutional Affairs conducted joint hearings into two separate pieces of personal insolvency legislation. One Bill (discussed here) is intended to implement Debt Agreement Reform and align the regulation of Debt Agreement Administrators to the regulation of bankruptcy trustees, the other will shorten the default bankruptcy term to one year.

Reducing the bankruptcy term to twelve months will implement the second and last stage of the 2016 National Innovation Agenda – improving Australia’s bankruptcy and insolvency laws program (the first stage was the Safe Harbour and ipso facto reform legislation, discussed here).

According to the original proposal paper the one-year bankruptcy measure is intended to promote entrepreneurship by reducing the penalty and stigma associated with business failure.

Notably, although the bankruptcy term will be reduced to one year the income contribution regime will continue to apply for three years – presumably reflecting an intention to maintain returns for creditors. However, as discussed in Q: How does a 3 year contribution regime fit into a 1 year bankruptcy? A: badly in practical terms a bankruptcy trustee will have very limited options to deal with a former bankrupt who ignores requests for information about his or her income, and so it is likely that a one year term will reduce returns to creditors.

Government submissions on the Government proposals

It seems that there are other concerns. The Australian Criminal Intelligence Commission made a submission which referred to intelligence suggesting:

“reducing the default bankruptcy period from three years to one year may increase the potential for serious and organised crime groups to exploit bankruptcy provisions for their own advantage.”

ASIC also made a submission expressing concern about what it described as the ‘possible unintended consequences’ of the proposed changes. It seems that the measures identified in the original proposals paper as a problematic ‘penalty and stigma’ are measures that the corporate regulator regards as sound policy, intended to keep an unsuitable person away from the ‘controls’ of a company, as well as to provide a deterrent effect.

ASIC told the inquiry that their enforcement activity took into account the fact that bankruptcy triggered an automatic three year director disqualification. They said that if the ‘automatic’ disqualification was reduced to only one year then they might need to take more active steps to seek longer disqualifications, and might ask Parliament to amend the Corporations Act ‘to extend the period of automatic disqualification where the person is an undischarged bankrupt.’

Right back to where we started from?

ASIC provided more detail at the Sydney hearing (the transcript is here). They propose that:

A person who becomes bankrupt should be unable to act as the sole director of a company for three years.
There should an extended disqualification period for ‘egregious conduct.’ It was not clear whether this would apply only to bankrupt directors, or to all directors.
Automatic disqualification should be applied to those involved in ‘repeat conduct’ – four corporate failures in seven years. Again, it was not clear whether this measure would relate to all directors or only bankrupt directors.

Implementation of the ASIC proposals would reverse some of the effects of the proposed bankruptcy changes. The net result would be measures that are a little more targeted, but some would argue that the overall outcome would be close to the position as it is today: back where we started from.

Bank support for small business turnaround

The ongoing political scrutiny of the treatment of distressed small business customers by the Royal Bank of Scotland (some background here) led to a letter from the Treasury Committee on 27 February 2018.

Amongst other things the committee asked RBS to confirm whether it supported the Principles for Best Practice in UK business support banking promulgated by the UK’s Institute for Turnaround.

The principles are:

i. The primary focus of Business Support Units is to protect the Bank’s capital by working consensually with customers to promote and support viable recovery strategies:

Business Support Units will work openly and constructively with customers, with the aim of returning the business to viability in a timely and cost-effective manner, wherever achievable.

The need for Business Support Unit involvement will be kept under continuous review.

ii. Business Support Units will treat customers fairly, sympathetically and positively, in a professional way with transparent processes and procedures.

iii. On transfer to a Business Support Unit, the Bank’s concerns and the proposed next steps will be clearly communicated to customers.

iv. Business Support Units will ensure that any formal property valuations required will be undertaken by independent advisers on the Bank’s panel.

v. Business Support Units will seek appropriate fees and margins taking account of the customer’s financial circumstances and ability to pay:

Fees and interest margins will be appropriately priced to reflect the risk, the additional management time required and the financial circumstances of the customer. These will be set out in writing, will be discussed with the customer and agreed with the customer wherever possible.

vi. Business Support Units will manage complaints in line with clearly defined policies and procedures:

The process for making a complaint will be clearly set out ensuring recognition and a timely response.

Customers should always feel able to complain (and know that any complaint will be treated fairly in accordance with published complaints protocols)

vii. Occasionally equity stakes in a customer may be acquired through a debt for equity restructuring. Business Support Units will handle equity stakes in customers under their management in the spirit of the ‘primary focus’ – to protect the Bank’s capital by working consensually with customers to promote and support viable recovery strategies.

viii. Business Support Units will monitor their turnaround statistics with a focus on returning customers to a normal banking relationship.

For some time Insol has provided guidance for the workout of large syndicated loans (discussed here) but these principles, supported by Lloyds, HSBC and Barclays, appear to be the only guidance for support of small business lending.

Superannuation Guarantee Integrity Package – consultation underway

On 24 January 2018 Treasury released details of a proposed ‘Superannuation Guarantee Integrity Package’ – including an exposure draft of the Treasury Laws Amendment (Taxation and Superannuation Guarantee Integrity Measures) Bill 2018 (available here).

The package includes some aspects that will be of interest to restructuring and turnaround professionals:

The ATO will have power to issue a notice to an employer requiring payment of a superannuation guarantee charge amount within a nominated period not less than 21 days. Failure to pay within time would be a criminal offence of strict liability by the employer – but not the individual officeholders. Liquidators undertaking a review for possible unfair preferences will be very interested in identifying such notices: it would seem hard for the ATO to argue that receipt of funds after such a notice was issued was ‘in the ordinary course of business.’
The ‘Single Touch Payroll Reporting’ system – which requires the real time reporting of withholding payments – will be extended. The regime currently applies to employers with more than 20 employees from 1 July 2018, but will apply to all employers from 1 July 2019. Insolvency appointees who continue the employment of staff will need to ensure that they also comply with these requirements.
The ATO will have power to issue a Directors Penalty Notice in respect of SGC amounts at an earlier point in time than is currently the case. This will be achieved by amendments that will impose a theoretical obligation to cause a company to pay an SGC estimate before the company has an actual obligation to pay the estimate!

Responses to the consultation should be submitted by 16 February 2018.

Commentary on related reform, to address corporate misuse of the FEG scheme, is here.

Submission to the Legal & Constitutional Affairs Legislation Committee Inquiry into the Bankruptcy Amendment (Enterprise Incentives) Bill 2017

This is a copy of my submission to the Legal and Constitutional Affairs Legislation Committee Inquiry into the Bankruptcy Amendment (Enterprise Incentives) Bill 2017

Background

The amendments will reduce the default bankruptcy period from three years to one year, which is intended to ‘reduce stigma, encourage entrepreneurs to re-engage in business sooner and encourage people…to pursue their own business ventures.’

The ending of bankruptcy means that a debtor regains legal capacity to travel overseas, act as a director of a company, and incur credit without giving notice of their bankruptcy. As a consequence of the amendment, debtors will regain that capacity two years earlier than they do currently.

The income contribution regime – which currently ends when bankruptcy ends – will be extended to apply for two years beyond bankruptcy. This will maintain the current three year income contribution regime, presumably intended to ensure that the return to creditors is not reduced by the shorter term.

Bankruptcy trustees can only issue an ‘objection’ – which extends bankruptcy – during a bankruptcy. In the two year post-bankruptcy period trustees will therefore be unable to respond to the non-delivery of information or non-payment of contributions by lodging an objection, as they do now.

The effect of the amendments is therefore to remove the very effective and low cost administrative enforcement mechanism by which trustees currently deal with non-compliance in the last two years of the income contribution regime. The only course of action available to trustees will be to report non-compliance with the Bankruptcy Act to the Australian Financial Security Authority (AFSA) for prosecution.

Issues with the legislation as drafted

There are no anti-abuse protections – There are no restrictions on access to the shorter period, and no limitation on the number of times a person may access the shorter period.If the one-year bankruptcy is available without restriction then we risk a new form of ‘phoenixing’ whereby individuals incur credit, declare bankruptcy and then one year later repeat the cycle for as long as they wish.
Impact on the workload of AFSA, the DPP, and the Court System – Only a minority of bankrupts will have an actual liability to pay income contributions, but all bankrupts have an obligation to provide information so that an assessment can be undertaken. The course of action that was previously a last resort – referral to AFSA – will be the only available course of action for a trustee to deal with non-provision of information. In that sense the amendments will operate to effectively ‘criminalise’ non-compliance.If referral to the AFSA is necessary for only 2% of the more than 50,000 current bankrupts, there will be at least 1,000 referrals to AFSA for action by the Department of Public Prosecution, each year. It would be an unintended and regrettable consequence if other more serious offences were not properly addressed because DPP and Court resources were unnecessarily diverted.
Lower returns to creditors – Unless AFSA is able to action each and every referral on a timely basis – which seems unlikely – then income contribution collections will diminish. If it becomes widely known that non-compliance is not addressed on a consistent and timely basis then there is the risk that overall compliance will worsen, compounding the original problem.In other words, it seems likely that there will be an adverse effect on returns to creditors.

Suggested solutions

There is no compelling policy justification to proceed with the proposed shortening of the bankruptcy period – and there is a superior policy-based option.

A more direct path to achieve the legislators’ intention

It is not necessary to shorten the bankruptcy period to allow individuals to act as a director, travel overseas, and incur credit. The simplest and most direct way to achieve this is to amend the Bankruptcy Act (and the Corporations Act as regards capacity to act as a director) so that they may do whilst bankrupt, after twelve months have expired.

This would mean that the term of bankruptcy and the term of the income contribution regime would continue to align. This would preserve the current utility of the objection-to-discharge process, thereby maintaining returns to creditors without a significant uplift in the referral of Bankruptcy Act offences to AFSA.

Such a legislative change would clearly contribute to de-stigmatising bankruptcy.

However, if the bankruptcy period is to be shortened, then there should be:

Anti-abuse protections

If the shorter bankruptcy period is introduced then there should be some restriction on a debtor’s ability to access the shorter bankruptcy period, to avoid abuse – including the possibility of personal ‘phoenixing.’

I suggest that a debtor should not be permitted to access the shorter bankruptcy period more than once every ten years – except with the consent of the Court.

Additional administrative remedy to address non-compliance

If the income contribution regime is to extend beyond the term of bankruptcy then we should look for a low-cost administrative process by which trustees can address the non-provision of information or non-payment of contributions, to avoid excessive additional workload for the AFSA, the DPP, and the Court System, and diminution of returns to creditors.

For example, granting bankruptcy trustees the power to issue a notice to a debtor which clearly identifies any non-compliance with the income contribution regime. On receipt of such a notice, the debtor loses the capacity to act as a director, travel overseas, and incur credit (i.e. the current position), until they have remedied the non-compliance.

As a safeguard against misuse, such a regime should be subject to appeal to the Administrative Appeals Tribunal and/or the Inspector-General in Bankruptcy, to provide affected debtors with access to a low cost dispute resolution process.

For some comments on the draft legislation see here.

For my commentary on the Bankruptcy Amendment (Debt Agreement Reform) Bill 2018, also referred to the Senate Standing Committees on Legal and Constitutional Affairs, see here.

Q: How does a 3 year contribution regime fit into a 1 year bankruptcy? A: badly

The legislation to shorten the default bankruptcy term to one year will maintain the three year term of the current income contribution regime. There is no particular policy reason why the two should align, and presumably those responsible believed that maintaining the three year period would maintain returns to creditors.

However, ending bankruptcy at the one year mark will remove a key point of leverage which assists trustees with the collection of information – and income contributions. The absence of any replacement mechanism means that unless there is significant additional resourcing to AFSA’s enforcement function, returns to creditors probably will be affected.

Collection of information

Not all bankrupts will have a liability to pay income contributions – in fact, most will not, but all bankrupts have an obligation to provide information so that the trustee can complete an income contribution liability assessment.

Currently if a bankrupt does not provide the information, the normal course is to file an objection to discharge which extends the term of bankruptcy; usually reversed when the information is received. The more draconian step – which trustees avoid if possible – is to ask the Australian Financial Security Authority (AFSA) to prosecute the debtor.

With the income contribution regime extending beyond bankruptcy, trustees will no longer have the ability to extend bankruptcy after the first twelve months. Because the legislation does not introduce any replacement mechanism, the only course of action available to trustees will be to report non-compliance with the Bankruptcy Act to AFSA for prosecution, in effect ‘criminalising’ non-compliance that was previously dealt with administratively.

How often will trustees need to request prosecution?

It seems likely that under the new model there will be greater non-compliance with the rules to provide information:

There will be some debtors who will not realise that they need to notify the trustee of a change of address after bankruptcy, who will simply be uncontactable.
There will be some debtors who won’t open or read correspondence from their trustee, because they are no longer bankrupt.
There will be those who – regardless of the the truth of the statement- will follow the advice of the unscrupulous non-mainstream advisers – to just ignore any correspondence because “the trustee can’t do anything about it.”

If referral to the AFSA is necessary for only 2% of the more than 50,000 current bankrupts, there will be at least 1,000 referrals to AFSA for action by the Department of Public Prosecution, each year.

Perhaps AFSA will have capacity to deal with each and every referral, but if not, returns to creditors will be adversely affected.

Possible Alternatives

If the objective is to allow individuals to act as a director, travel overseas, and incur credit within 12 months of being made bankrupt, then the simplest and most direct way to achieve this is to amend the relevant legislation to permit it – there is no need to shorten the term of bankruptcy.

Such a legislative change would clearly contribute to de-stigmatising bankruptcy.

However, if the length of bankruptcy must be shortened then we should look for a low-cost administrative process by which trustees can address the non-provision of information or non-payment of contributions. This would avoid excessive additional workload for the AFSA, the DPP, and the Court System, and likewise avoid diminution of returns to creditors.

For example, trustees could be given the power to issue a ‘non-compliance notice.’ On receipt of such a notice, the debtor loses the capacity to act as a director, travel overseas, and incur credit (i.e. the current position), until they have remedied the specified non-compliance.

As discussed here, the draft legislation is subject to review by the Senate Standing Committees on Legal and Constitutional Affairs. Submissions can be lodged via the process explained here, but must be received by 31 January 2018.

Commentary on the Bankruptcy Amendment (Debt Agreement Reform) Bill 2018, also referred to the Senate Standing Committees on Legal and Constitutional Affairs is here.

A copy of my submission is here.