Consultation: Reforms to address corporate misuse of the FEG scheme

On 2 May the Senate Inquiry into Superannuation Guarantee Non-Payment released its final report (available here), discussed here.

For restructuring and turnaround practitioners one of the noteworthy recommendations was that:

‘the government consider amending the Corporations Act to ensure that the priorities in section 556 apply during all liquidations, regardless of whether the business being liquidated was operated through a trust structure.’

Only a fortnight later, the government has released a Consultation Paper: Reforms to address corporate misuse of the FEG scheme. Pleasingly, one of the issues raised is whether that Inquiry recommendation should be implemented, and so there is the possibility that the law will be amended a great deal more quickly than anyone expected.

Other significant areas of potential reform include:

Possible amendments to the Corporations Act so that receivers and liquidators may not deduct any part of their general costs from the proceeds from of realisations of circulating assets – unless employee entitlements have been paid in full.
Changes to reinvigorate section 596AB, which has not been used in litigation since its introduction in 2000. Section 596AB provides for criminal prosecution and civil recovery against someone who enters into a transaction with the intention of avoiding the payment of employee entitlement liabilities. Options here include:
- Changing the ‘fault element’ from ‘intention’ to ‘recklessness.’
- Increase the maximum penalty for criminal convictions.
- Sidestepping the difficulties with proving intent by adding a civil penalty provision based on an objective test.
Allowing parties other than a liquidator to initiate recovery action: including FEG, and in some specific circumstances, the Fair Work Ombudsman or the ATO.
Preventing abuse of corporate group structures, possibly by implementing a contribution regime similar to that in New Zealand – where parties may apply to Court for a ‘contribution order’ against solvent group members, where it is just and equitable to do so.
Modifying the existing director disqualification provisions to target behaviour which impacts FEG – for example reliance on the FEG scheme to pay redundant workers their outstanding employee entitlements where there is minimal or no return of the FEG advances on two more occasions.

However, there are other issues which could helpfully be addressed:

The ‘traditional’ view was that a liquidator’s job was to convert all assets into cash, and then allocate that fund in accordance with the priorities in section 556. A more recent alternative suggests that the section 556 priorities be applied in real time. That theory arguably results in the difficult proposition that a liquidator should close a business down rather than risk employee entitlements in trading a business on – even to achieve a sale which might avoid the need to pay entitlements at all!
Another problematic area is the question as to whether trading losses should be allocated against the circulating or non-circulating asset pools. Sometimes businesses are knowingly traded at a loss, to improve circulating asset recovery such as the conversion of WIP, or collection of debtors – however there seems to be a view more recently expressed that trading losses should not be allocated against circulating assets.

Interested parties are invited to make a submission by Friday, 16 June 2017.

Senate Inquiry into Superannuation Guarantee non-payment: Report released

The Senate Economics References Committee Inquiry into Superannuation Guarantee non-payment report was released on May 2nd 2017.

The committee recommended that “the government consider amending the
Corporations Act to ensure that the priorities in section 556 apply during all
liquidations, regardless of whether the business being liquidated was operated
through a trust structure” (for background see my submission, here).

If implemented as recommended that will address the priority of unpaid SGT, and it will also address the current gaps in the coverage of employee entitlements (ie amounts outside the FEG scheme caps). It should also significantly improve FEG’s ability to recover amounts paid to trust employees, from their former employers.

ARITA made a submission and appeared before the inquiry. Other recommendations reflecting ARITA input include:

R20 – Consideration of a Director Identification Number scheme.
R22 – Allowance of nominal interest on SGC up to the date of liquidation.
R23 – Enabling insolvency practitioners to pay outstanding SG contributions directly to an employee’s superannuation fund.
R31 – expansion of the Single Touch Payroll system to all businesses.

Of course there is no guarantee that these recommendations will result in legislation – but it is very encouraging to see them under serious consideration.

Restructuring Reforms: Safe Harbour and ipso facto

On 28 March 2017 the government released draft legislation for comment, to implement the Safe Harbour and ipso facto reforms, available here.

Safe Harbour proposal – simple, practical and useful

The Government has opted for a carve-out from the civil insolvent trading provisions – a ‘model B’ approach.

Directors will have a ‘safe harbour’ unless it can be shown that they had failed to start a course of action “reasonably likely to lead to a better outcome for the company and its creditors as a whole.”

That immediately raises the question: how will we know whether a course of action is reasonably likely to lead to a better outcome? Helpfully, the draft legislation set outs what amounts to a checklist for directors, as to whether they are:

taking appropriate steps to prevent misconduct that could affect the company’s ability to pay all its debts.
taking appropriate steps to ensure that the company is keeping appropriate financial records.
obtaining appropriate advice from an appropriately qualified person holding enough information to give appropriate advice.
is properly informing themselves of the company’s financial position.
is developing or implementing a plan for restructuring the company to improve its financial position.

There is disqualifying criteria: if the company is fails to provide appropriately for employee entitlements, or fails to attend to its obligations to lodge income tax returns or other tax lodgements then the safe harbour is not available – so we can add those to the checklist too.

Ipso Facto – Linkage to an appointment type rather than a state of insolvency?

The draft legislation provides a very precisely phrased stay, which blocks termination on the grounds of two specific types of formal insolvency appointment: voluntary administration and schemes of arrangement.

The legislation is silent about a termination on the grounds of insolvency. There is an argument that a termination on the grounds of insolvency – which is actually evidenced by the appointment of an administrator – is unaffected by the stay.

Termination at will remains

The implementation of a stay on ipso facto clause enforcement will make it easier for a voluntary administrator to keep a business together – an enhancement over and above the current moratorium – by preventing the termination of contracts simply by reason of the appointment. But the stay will end when the administration ends, meaning that the underlying insolvency event will provide the other party to the contract with a free option to terminate the contract at will. Knowing, for example, that a landlord will be able to terminate a lease if they ever receive a better offer will make it challenging to raise finance, secure equity or sell a business.

The better option would be to make the stay permanent, or introduce some kind of override so that if the insolvency has been cured by a restructuring, then it can no longer be relied upon for the purposes of an ipso facto clause enforcement.

Extension to schemes of arrangement

In a theoretical sense the extension of the ipso facto stay to Schemes of Arrangement is significant, because unlike voluntary administration there was no moratorium. In practice however this change will have little impact, because schemes are so slow and so hideously expensive that they are used only infrequently, to restructure the very largest companies.

No ipso facto stay for receiverships

The proposals do not extend the ipso facto stay to receiverships. Secured creditors will consider whether it is possible to access the stay by the parallel appointment of an administrator, just as they do now to access the voluntary administration moratorium, but [as Paul Apathy has pointed out] this may not be viable. A better option would be a stay which applies to insolvency rather than nominated appointment types. Not only would that apply the benefit of the stay to all forms of appointment type, it would avoid an argument that termination on the grounds of insolvency was unaffected.

Impact on a secured lender’s ability to appoint a receiver

In the 2015 NSW Supreme Court Bluenergy decision, discussed in more detail here the Court held that a deed of company arrangement limits a secured creditor’s security to those assets existing when the deed took effect – which means that the charge will no longer capture “future assets” (such as the receivable that is created when stock is sold).

As a result, the assets captured by a secured creditor’s security will steadily diminish over time. Currently, secured creditors can avoid the risk of diminution by appointing a receiver when a voluntary administrator is appointed, but they must do so within the 10 day decision period set out in section 441A.

The proposals appear to stop secured creditors making such appointments if relying solely on the grounds of the appointment of a voluntary administrator.

Secured creditors concerned that there is a risk that their security is trapped within a deed of company arrangement may decide that it is in their interests to:

Decline to waive defaults, so that they will not need to rely on an insolvency event to make an appointment
Take care not to alert borrowers that an appointment is possible
Seek to appoint receivers at an earlier stage, to avoid the risk that directors might “beat them to” an appointment.

In other words there is risk that measures intended to promote restructuring may provide secured lenders with reasons to refuse to waive defaults, be cautious about communicating their concerns, and appointing receivers at an earlier time.

Ipso facto commencement

It is proposed that the stay will apply only to contracts entered into after 1 January 2018. It will therefore operate fully for businesses that start up after that date, but for existing businesses there may be a very gradual transition.

Overall

The draft legislation has appeared earlier than expected, with a short timetable for implementation – it is proposed that the new laws will take effect from 1 January 2018 – which is welcome. My view is that the safe harbour mechanism is very useful and very practical. The ipso facto regime has great potential, but there are a number of issues requiring further consideration and analysis, most notably the closing the gap which currently provides counterparties with a free option to terminate at will – even after insolvency has been cured.

The closing date for submissions on the proposals is Monday, 24 April 2017.

End of the line?…..should we ban receiverships?

[First published on Linkedin.com on December 17, 2016]

Following the Parliamentary Joint Committee Inquiry into Impaired Loans – established to investigate whether lenders had ‘manufactured’ defaults to enable them to call in loans – one of the questions being asked in insolvency and restructuring circles was: what if the Australian government acts to ban receiverships, as happened in the UK?

Why ban receiverships?

The critics of receivership argue one or more of the following:

Secured creditors ‘jump the gun’ and appoint too quickly – with the result that the business is either sold or closed, presumably whilst the owner still had a reasonable chance of turning it around.
Receivers sell the assets without getting the best price.
A failure to sell the business as a going concern means that jobs are lost and returns to creditors are lower.

The UK reforms

In 2003 the UK passed legislation to prevent secured lenders from appointing receivers to a business – apart from a specific exclusion for security created prior to the introduction of the legislation.

Although secured lenders with a charge over a business may not appoint a receiver, all other remedies remain unaffected. They may still:

Decline to provide any further funding
Take legal action to have the company wound up or have the court appoint a receiver
Most significantly, appoint an administrator.

Administration in the UK does not completely align to Australia’s Voluntary Administration process (most notably, a UK administration runs for twelve months, and does not lead to a DOCA), but the two processes share many similarities, and in both countries the administrator has a duty to act in the interests of all creditors – as compared to a privately appointed receiver whose primary duty is to ensure repayment of the lender.

Whilst the secured lender retains priority to the proceeds of the assets subject to its security, the administrator may sell the business as if it were not subject to the security – except for property secured by a fixed charge, or subject to a hire purchase agreement, which requires the administrator to seek court approval. A secured creditor may appoint an LPA receiver to specific assets, but has no capacity to appoint over a business.

Jumping the gun

If we followed the UK model where secured creditors could appoint an administrator, but not a receiver, would that result in appointments being made at a later time?

It is hard to think of a reason why it would, and it is quite possible that the reverse is true.

Firstly, because secured creditors typically underwrite receivers’ fees and expenses they will sometimes decline to appoint, or delay an appointment, to avoid the additional liability. There is typically no indemnity provided to an administrator.

Secondly, secured creditors will sometimes hesitate to appoint a receiver for reputational reasons – not wanting to be seen as the party forcing an insolvency appointment. Because an administrator is an independent person appointed for the benefit of all creditors, the appointment of an administrator may be seen as a less difficult from a reputational perspective.

For both these reasons, in practical terms it may be less onerous to appoint an administrator, meaning that a prohibition on receivership appointments might in fact lead to earlier insolvency appointments in some cases.

Selling Assets too cheaply?

Until 1993, Receivers in Australia were subject to a duty to get the ‘best price reasonably obtainable.’ This sounds like a simple and straightforward test but in practice it became a battle of competing valuations, conducted after the sale had already taken place and the outcome known.

In 1993, the Australian Parliament implemented the Harmer Report recommendations that there should be a focus on process rather than outcomes. The result, section 420A of the Corporations Act requires receivers and mortgagees in possession exercising a power of sale to take all reasonable care to sell the property for market value (or the best price that is reasonably obtainable if there is no market value). It is important to note that this is not a requirement to obtain market price but a requirement to run a process that should deliver that outcome – in practice a test that is far easier to assess, and litigate if need be.

A breach of the 420A duty is not of itself a criminal offence capable of prosecution by ASIC – unless it is so egregious as to constitute a breach of the receiver’s general statutory duties – but it gives rise to a potential claim of damages for loss suffered, which is available to the borrower but not a guarantor.

Although the number of 420A cases has fallen more recently, arguably this shows the impact of early litigation. There are early examples where receivers were not able to show that they had taken all reasonable care to sell assets for market value, and they (and their appointors) ‘paid the price’. The 420A duty is now clearly front-of-mind, referred to and measured against by secured creditors and their appointors, and the fact that sales processes have improved should not be taken as a sign that 420A is ineffective.

In the UK the general duty of administrators to act in the best interests of creditors has been construed to require UK administrators to take steps to secure the best price reasonably obtainable, such as obtaining independent valuations and undertaking an appropriate marketing campaign. However there is no specific statutory duty in the UK for receivers or administrators, and no such duty for Australian administrators.

Australia now clearly holds receivers to a higher standard than administrators, and to a higher standard than UK receivers. To ban receiverships and place the asset sale process in the hands of an appointee with a lesser duty would not be a appropriate response to any concerns about the asset sale process.

If there is a view that there are 420A claims that could be pursued, but have not been, then that is far more likely to reflect an inability to fund a legal action – better addressed by providing funding and support through the Assetless Administration Fund which ASIC administers.

Failure to sell as a going concern

One of the challenges for secured creditors and the receivers that they appoint is the situation of a loss making business which may still be sold as a going concern, for example to a competitor that may have scope to further reduce costs by combining back-office functions. But this is a gamble – losing money knowingly in trading on, in the hope of a sale – and it often requires funding.

To Australian eyes one of the noteworthy aspects of a UK government proposals paper released in May 2016 (discussed in detail here) was identification of the need to promote the availability of ‘rescue finance.’ The proposals paper canvassed options to help administrators to obtain finance by mortgaging the assets of the company – effectively subordinating the prior mortgage held by the existing secured creditors – without their consent.

In Australia there is little need for a rescue finance regime – a secured creditor contemplating the appointment of a receiver will almost always make arrangements to provide the receivers with sufficient funding to allow the business to continue trading until at least the prospects of rehabilitation or sale have been explored.

In other words it seems that the UK reforms which stop secured lenders from appointing receivers may have made resulted in appointees that are less able to secure finance, because the party with the incentive and resources to provide rescue finance has been taken out of the picture – and the outcome in some of those cases is the earlier closure of businesses, and job losses.

What else can we learn from the UK experience?

In late 2013 a UK government adviser released a document that became known as The Tomlinson Report, named for its author.

There’s more detail about the report and its consequences here but in summary the report was highly critical of the conduct of the Loan workout team of the Royal Bank of Scotland and their advisers, in their dealings with borrowers post the GFC.

The report was arguably more an aggregation of bank complaints assembled by a person himself unhappy about his (earlier) treatment at the hands of RBS, rather than a structured review conducted by an impartial person. That said however, the complaints that it presents, and the public and political reaction to the report, far exceed the scope of complaints that lead to Australia’s 2015 Parliamentary Joint Committee Inquiry into Impaired Loans.

Discussion about whether all of the complaints were fully justified is beyond my scope here, but regardless, it seems that there are many UK bank customers who would say that they did not receive any better treatment at the hands of their banks as a result of the prohibition on receiverships!

The use of panels

The Wilmott Forests decision provides insight into another issue. In Wilmott Forests a sole practitioner accepted an appointment to a large agribusiness company, and later used his casting vote to defeat a resolution to replace him. An application to Court ultimately led to his replacement, with the Court determining that not only did the administrator lack relevant experience in the forestry industry, he lacked the financial resources to meet the costs of the business, and lacked professional indemnity insurance and staff resources to undertake such a large and complex assignment.

Directors confronting the appointment of an administrator are usually not well versed in assessing the capability and capacity of the proposed appointees. By contrast, as regular users of insolvency professionals, the major banks have panel arrangements which ensure appointees are free of conflict, appropriately resourced and experienced as to any industry issues, and holding appropriate professional indemnity insurance. For those concerned about the cost of insolvency proceedings it is worth highlighting that through the use of such panels, the banks have also negotiated discounted practitioner rates.

Lipstick on the pig?

Financial failure is devastating for the proprietors of a business, and often so for their employees, and their creditors.

Having a different title for the insolvency practitioner, and having them appointed by a different stakeholder, will have very little real impact – and a lesser duty of care, and additional costs imposed by an administrator’s mandatory investigation, may in fact be backward steps.

There is no doubt that insolvency and restructuring law is due for reform, but we need real reform that will improve returns and restore equality – measures such as those identified here, rather than the adoption of measures from overseas jurisdictions which may not in fact impact the issues that we are trying to address.

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!

UK Restructuring Reforms: A Review of the Corporate Insolvency Framework

[First published on Linkedin.com on 14 June 2016]

Within a month of the Australian Government’s Improving bankruptcy and insolvency laws Proposals Paper, the UK government has released a comparable document – A Review of the Corporate Insolvency Framework – available here:

A quite formal, and public, moratorium

The measures include a proposal for a three month moratorium against recovery actions by creditors. The moratorium is intended as a step prior to a formal insolvency appointment, but nonetheless it will be initiated by a Court filing and overseen by a “Supervisor.”It appears that the fact of a company entering a moratorium will be disclosed publicly, which will certainly present challenges for the business. A visible signpost to financial difficulties will surely lead to suppliers tightening credit terms, perhaps requiring cash on delivery, and some customers of the business may turn to competitors seen as more financially stable.

Eligibility to enter and remain in the moratorium

To enter a moratorium a company must be in “financial difficulty,” or insolvent, with a “reasonable prospect” that a restructuring can be agreed with its creditors. At the same time however, it must “be likely” to have sufficient funds to carry on its business during the moratorium, and be able to meet any new obligations that are incurred.

An independent supervisor must be appointed, who will be responsible for ensuring that the company meets the eligibility criteria, and continues to meet the eligibility criteria.

It is clear that there will be a need for some concentrated and urgent due diligence prior to entering the moratorium, perhaps also requiring disclosure of the possible moratorium to key creditors. The company and the supervisor will need to urgently determine how bad things are, whether there is in fact a reasonable prospect of restructuring, and precisely what resources will be required to allow a conclusion that it is “likely” that moratorium creditors will be paid.

Presumably the company will then work to create a fund for the expected moratorium creditors, quite possibly by short-paying current creditors – where would funds come from otherwise?

The role of the moratorium supervisor

It is proposed that the supervisor will be a solicitor, accountant, or insolvency practitioner meeting minimum standards including expertise in restructuring. The proposed supervisor will be nominated by the company, but presumably there might be circumstances when the Court will overrule that nomination.

It appears that the supervisor is not intended to take over the management of the company – the directors’ powers remain undisturbed. The supervisor’s role is specifically to monitor the company’s ongoing compliance with the eligibility criteria, and report to Court if a restructuring no longer seems a reasonable prospect or if the company no longer appears likely to be able to pay moratorium creditors. The supervisor will also act as a contact point for creditors, providing information that is reasonably requested and not commercially confidential.

The ipso facto problem

The UK paper refers to “termination clauses,” in Australia we describe them as “Ipso facto” clauses – contractual provisions which allow contracts to be terminated if there is an insolvency appointment, even if there is no other breach of the contract.

In Australia the proposed response is a blanket restriction against such ipso facto clauses. The UK proposal is that businesses entering into a moratorium, formal insolvency, or a restructuring plan will be able to make an application to Court to have specific contracts designated as “essential,” and thereby protected from termination for insolvency for a period not exceeding twelve months.

The applicant will need to show that the continued provision of the essential supply would contribute to the success of the rescue plan, and that it is not possible to make alternative arrangements at a reasonable cost within a reasonable time. The supplier will be able to challenge that application, but would need to provide objective evidence that the criteria was not met.

The UK model would therefore only disturb specific contracts, and is therefore lower impact for that reason. However it will require an application to Court and therefore impose legal costs on a company which by definition has limited financial resources, as well as on the supplier.

Notably, it is proposed that the moratorium will have a limited life, as is likewise proposed in the Australian version. Unless the prohibition is permanent, it means that those suppliers will be able to wait out the moratorium, and terminate later – not at all a foundation for a stable business.

A flexible restructuring plan

Like its Australian counterpart (a Deed of Company Arrangement) the UK Company Voluntary Arrangement currently does not bind secured creditors without their consent. The Government proposes a statutory multi-class restructuring procedure that will bind a 75% by value majority of class creditors, and cram down of out-of-the-money classes – provided that those creditors will not receive less in a restructuring than they would in liquidation.

The UK proposes to allow flexibility to determine voting classes by either by “rights” or “treatment,” on a case by case basis, rather than specify a mechanism in the legislation. For mine, this is a very significant missed opportunity. In Australia, classes for schemes of arrangement are, bizarrely, constituted by treatment rather than rights, allowing promoters to bundle together creditors with different rights to ensure a majority. It is hard to understand why legislators would want to replicate such an inequitable mechanism.

The restructuring plan must be approved by the Court, which must be satisfied that:

The restructuring plan is fair and equitable, and will last no more than twelve months
There was proper notice and each class was fairly represented by those voting
Voting requirements have been met
Junior creditors have not received a treatment worse than liquidation.

Valuations are key

The proposals recognise that the test of whether junior creditors are worse off requires a careful assessment of value. The proposal is that valuations be conducted on the basis of the current value of a company’s assets without adjustment for the value of any potential future earnings they may provide. The proposal notes that there are a number of valuation methodologies, and suggests but does not conclude that the Government should legislate the use of a minimum liquidation valuation, with flexibility for the use of other methods of valuation where appropriate.

Rescue finance

Although CVA administrators already have statutory powers to borrow funds and grant security, the UK Government has formed the view that they are rarely used because existing secured lenders will not agree to any subordination of their security.

Under the regime in the proposals paper, if a secured creditor declines to give consent, the borrower can advise the secured lender that at they intend to proceed without consent, which gives the secured creditor a 14 day window to apply to Court to challenge the financing proposal. If challenged the burden of proof would fall upon the borrower to satisfy the Court that:

Obtaining the rescue finance is in the best interests of creditors as a whole
The new security was necessary to obtain the rescue finance
The interests of existing secured creditors will be “adequately protected”

The paper seeks any alternative options to enhance the take up of rescue finance.

Conclusion

Although we deal with a different regulatory and legislative framework, the Australian and UK proposal papers have the same objective – to improve the prospects for business turnaround and rescue – and it is interesting and useful to see how another jurisdiction is attempting to solve the same problem.

A far-distant observer should be cautious in criticising, but I do think that the proposals are flawed in making the moratorium public, and by specifying entry requirements which may deny protection to companies unless they demonstrably have a level of funding. The limited term of the ipso facto restriction is likewise problematic, but other parts of the proposals are well thought out such as the capacity to bind classes of creditors, which could also be considered in the Australian context.

Of course this is a proposals paper, with an extensive consultation process intended to allow market participants to identify and address any shortcomings, and it will be interesting to see how the proposals continue to evolve.

The National Innovation Agenda – improving Australia’s bankruptcy and insolvency laws

[First published on Linkedin.com on May 24, 2016]

On 29 April 2016 the Federal Government released a Proposals Paper which follows up on the National Innovation Agenda commitment to improve Australia’s bankruptcy and insolvency laws.

There are three areas of focus:

Reducing the default bankruptcy period from three years to one year

The proposal is more nuanced than a simple reduction in the bankruptcy period. Critically, the Income Contribution regime will continue to apply for three years i.e. potentially for two years after the bankruptcy itself has ended. However, there would be no restrictions on overseas travel or incurring credit after the initial twelve month period had expired.

The trustee will retain the ability to object to the bankrupt’s automatic discharge – thereby extending the period of bankruptcy to eight years – but it appears that it would be necessary to file that objection in the initial twelve month period. Such a change will mean that trustees need to accelerate their investigation to ensure that misconduct is identified before the initial period expires. It may also mean that in the last two years trustees must collect information and contributions without the benefit of what is currently an inexpensive and practical avenue to ensure compliance.

Safe Harbour

The current insolvent trading regime imposes personal liability on company directors if their company incurs credit whilst it is insolvent. The practical effect of the regime is that it provides a strong incentive for company directors to place an insolvent company (or a company that may become insolvent) into administration – even though a restructure might offer the prospect of a better return to creditors.

The proposal outlines two alternative methods of dealing with that statutory conflict of interest. The first approach – Model A – will create a “safe harbour” by establishing an additional defence to the current insolvent trading regime, whereas Model B will create a safe harbour by identifying circumstances in which the insolvent trading regime will not apply. Probably more significantly, Model A requires the directors to formally engage a “restructuring adviser,” whereas Model B does not.

My own experience with large corporate turnarounds is that the range of issues can be very broad – from balance sheet restructure to operational turnaround – and that in many cases there will be a team of advisers assisting the directors rather than a single person. I believe that the focus should be on what the directors do, rather than whom they appoint,

A process that requires the appointment of a restructuring adviser will almost certainly trigger the rigorous continuous disclosure requirements that apply to ASX listed companies. This will present additional challenges in a restructuring because publicity about possible financial difficulties can become self-fulfilling as suppliers rein in credit terms, and customers take their business elsewhere. For this reason it is important that any Model A approach also includes a prohibition on disclosure, otherwise there is the risk that directors of ASX listed companies will not take advantage of the safe harbour.

Ipso facto clauses

Ipso facto or insolvency event clauses allow contracts to be terminated if there is an insolvency appointment, even if there is no other breach of the contract.

In my view, restricting the operation of ipso facto clauses is the most significant of the proposed reforms because it will make it far easier for administrators and receivers to maintain a business as a going concern without losing the benefit of key contracts

It is essential that the restriction be permanent rather than a temporary stay (which in any event is the current position for voluntary administration), otherwise there is the risk that the clause can be invoked even after the insolvency has been ‘cured’ by a restructuring.

One of the key questions is whether the restriction on ipso facto clauses would operate to prevent a secured lender from appointing a receiver. Lenders will often waive defaults under loan agreements in the knowledge that the insolvency ground will provide a ‘reserve’ capacity to act. If the ipso facto restriction eliminates that reserve capacity, then secured creditors may be less willing to waive defaults – which would be problematic for both directors and auditors. Clearly I have an interest in this point, but it would be disappointing if a law reform intended to encourage restructuring instead had such an effect

The government is seeking feedback by Friday 27 May. I encourage everyone with an interest in the area to read the Proposals Paper and respond on points that concern them. For more information: see here.

Pre-pack Administrations – would they work in Australia?

[Originally published in the September 2014 issue of the Australian Insolvency Journal, and reproduced here with permission]

One of the regular discussions among insolvency and workout professionals is whether we need the capacity to undertake pre-packs in Australia, with the UK experience often used as a reference point. Unavoidably but unfortunately, most of that debate has been undertaken in the absence of meaningful data.

Now, following the June 16 release of the Graham Review Report[i] which is supported by a large scale study undertaken by the University of Wolverhampton, we have hard data. As a consequence we now have far greater insight into the background and outcomes of the pre-pack process.

The Graham Review

In mid-2013 the UK government commissioned a review of pre-packs by Teresa Graham CBE to assess the usefulness and impact of pre-packs and consider any aspects or practices which cause harm, with special attention to the position of unsecured creditors. A prominent accountant, Graham was the former head of the Business Advisory practice for accounting firm Baker Tilly and has been appointed to a number of advisory and statutory boards.

Critics of pre-packs in the UK point to a lack of transparency, with limited details provided to creditors only after a sale has been concluded. Pre-packs involving sales to connected parties come in for particular criticism as at best they allow ‘bad businesses’ with poor business models to continue to operate and that at worst they are a sham to avoid debt i.e. a phoenix.

What is a Pre-Pack?

Although UK legislation does not make any reference to pre-packing it is universally accepted that pre-packing is permitted by the law, and since 2009 it has been the subject of a guidance note issued by the insolvency regulatory authorities: Statement of Insolvency Practice (SIP) 16.

SIP 16 defines a pre-pack as ‘an arrangement under which the sale of all or part of a company’s business or assets is negotiated with a purchaser prior to the appointment of an administrator, and the administrator effects the sale immediately on, or shortly after, his appointment.’[ii] The practitioner has a level of involvement with the company prior to his or her appointment which in Australia would probably amount to ‘a professional relationship’ in the two years prior to appointment, sufficient to prevent the practitioner from accepting the appointment under the ARITA Code of Conduct – but which is acceptable in the UK.

According to Graham, around 3.5 percent of the around 20,000 insolvency procedures each year in the UK are pre – packs.

Since 1 January 2009, SIP 16 has required the administrator to provide creditors with specific information including the price obtained, details of valuation of the assets, and whether the purchaser was connected. These SIP 16 statements are sent to creditors after the sale and provided to the UK Insolvency Service. It is this disclosure which provided the base data for the quantitative analysis by the University of Wolverhampton.

The University of Wolverhampton research

The Graham Review commissioned this research into data extracted from SIP 16 statements for a sample of 499 pre-packs implemented in 2010.

That research found that the typical pre-pack:

Was a small business (81 percent having turnover below £6.5m), at least five years old (a median age of 8.6 years), with median debt of £565,000 (about $1.02m at the time of writing).
Was not marketed by the Insolvency Practitioner – with either no marketing at all (39 percent) or marketing conducted prior to the IP’s involvement (21 percent).
Was sold to a connected party (in 63.3 percent of cases), [iii] probably for less than £100,000 (60 percent of cases) which was often part- deferred (more than 50 percent of cases).
Was almost always tested against an independent valuation (91 percent of cases) however those valuations were often desk-top valuations, and limited to tangible assets only.
Provided unsecured creditors with a ‘paltry benefit’ – no distribution in 60 percent of cases and a median return of 4.3 percent for those where a distribution was made.
Survived for longer than three years (76 percent of cases). Notably, connected party purchasers had a failure rate almost twice the rate of that with an unconnected purchaser.

The Wolverhampton University research team expressed concerns about the quality of information about marketing, describing the standard of reporting as ‘very variable,’ with practitioners sometimes doing nothing more than accepting the view of directors that there was no ready market for the business without testing that assumption.’

Report Conclusions and Recommendations

Graham made a number of recommendations to improve the pre-pack process, most noteworthy:

A voluntary process by which connected parties would be required to provide details of their offer to a member of a panel of experienced business people. After a review that would not exceed half a day, the panel member would provide an opinion that would be included in the SIP 16 statement. Critically, a negative opinion would not block a deal.
Marketing should comply with six principles identified by Graham, with any divergence to be detailed in the SIP 16 statement.
Greater detail about the valuation process should be disclosed in the SIP 16 statement, with a firm requirement that valuers hold professional indemnity insurance.

Graham did not recommend any regulatory change – but this was only because there is already a separate review into the regulation of insolvency practitioners and their remuneration underway[iv] and she noted that absent that review she would have made further recommendations.

Overall Graham was reasonably positive about pre-packs: she found that there were ‘significant’ cost advantages of a pre-pack over formal procedures, and said that although the SIP 16 information regarding employment preservation was ‘often poor’ she was able to conclude that they helped to preserve employment.

Pre-packs Down Under?

The picture presented by the University of Wolverhampton research is that of a process which provides a moderate enhancement to the recoveries of secured small business lenders in the 3 percent to 4 percent of formal insolvency procedures where they are deployed.

Tangible assets are sold for a price close to their standalone value without any deduction for auctioneers costs and commission, and the insolvency practitioner’s fees are minimised. Unsecured creditors typically won’t see a return – but they would not have received a dividend anyway.

UK practitioners have raised queries about the practical working of the panel referral process, but have welcomed Graham’s views that a pre-pack option should continue to be available.

Using the UK experience as a template, pre-packs are certainly one option to facilitate the relatively quick and inexpensive sale of a small business. A key point however is that almost two-thirds of sales are made to connected parties. Given the widespread concern and black and white views around phoenix transactions in Australia, a change to a process that accommodates sales to connected parties may meet stiff resistance, and require careful justification and management.

Postscript – 16 August 2017: SiN reports Moves afoot to propel pre-packs onto political agenda

[i] Both the report and the statistical analysis are available at (see: Graham Review into Pre-pack Administration).

[ii] Available at http://www.gov.uk (see SIP 16) updated in November 2013 to expand the requirements for disclosure around valuations and marketing of the business.

[iii] The connected party sale rate is remarkably consistent with a the 62 percent rate reported in a 2007 study ‘A preliminary analysis of pre-packaged administrations’ by Dr Sandra Frisby (available at http://www.r3.org.uk/publications) and 65 percent reported in a 2010 survey conducted by the Association of Business Recovery Professionals (65 percent) available at http://www.r3.org.uk

[iv] Details at http://www.gov.uk (search for ‘Insolvency Practitioner regulation and fee structure’).