Restricting Related Creditor Voting Rights

One of the worst problems caused by the Insolvency Law Reform Act 2016 – the ability to remove an insolvency appointee without Court scrutiny – appears to have been partly addressed by changes to the Insolvency Practice Rules effective from 7 December 2018.

It will no longer be possible for related parties to buy debt cheaply and then vote the full face value to replace an external administrator.  Instead, the related parties’ voting rights will be limited to the amount paid to acquire the debt.

This will be similar to the long standing position in personal insolvency – however in personal insolvency the restriction to the amount paid to acquire the debts applies to all debt sales, not just debt acquired by related parties.

Replacement by non- related creditors

There is still no Court scrutiny on liquidator replacement, so those unrelated creditors who work together to replace liquidators seen as too aggressive in pursuing preferences will not be affected by the changes.

Is ‘assignment’ broad enough?

The rules only apply to assignment of debt.  In modern financial practice there are a range of ‘sub-participation’ and risk sharing arrangements which may achieve a similar outcome but perhaps be outside the scope of the rules as drafted.

Impact on debt traders

Some active debt traders will take equity positions as well as acquiring debt.  In some cases that could mean that they have become a ‘related party,’ with the consequence that their voting rights will be very different under a scheme of arrangement (i.e. intact) compared to a deed of company arrangement (reduced).

Some market participants will recognise the differential treatments, and adjust their strategies to take advantage.  The form of restructuring vehicle may become the next battlefield!

What’s next?

It’s pleasing to see an effort made to fix some of the damage done by the ILRA.  Hopefully work is now underway to fix the other problems such as the  impractical cash handling rules and the odd requirement for registered liquidators to have bankruptcy experience, to name a few.

The impact of draft anti-phoenix measures on restructuring and corporate turnaround

‘Phoenixing’ – the process by which the assets of an insolvent company are transferred to another company so that creditors miss out – is a significant problem in Australia.  On budget night the government announced several headline anti-phoenix measures, with greater detail provided last week through the release of draft legislation for consultation.  Although the measures are aimed at those who act unscrupulously, they have a wider ambit, and there is the potential for them to have a broader impact if they do become law.

Overview of the measures

There is more detail here but in summary, the key concept is a ‘Creditor Defeating Disposition’ (‘CDD’).  A CDD is a transaction entered into either:

  • when the company was insolvent; or
  • in the twelve months prior to the company entering formal insolvency administration;

which prevents, hinders or significantly delays the property of a company from becoming available for the benefit of creditors.

If there is a CDD:

  • Officers whose conduct resulted in a CDD will commit an offence.
  • Those involved in ‘procuring, inciting, inducing or encouraging’ a company to engage in a CDD will commit an offence
  • Both ASIC and the Courts will have power to make orders to reverse the transaction to recover the property.

A CDD will not be voidable if the sale was for market value consideration, or was entered into by a liquidator, under a deed of company arrangement or scheme of arrangement, or as part of a Safe Harbour restructuring plan.

Market value

‘Market value’ sounds like an objective measure but in the absence of a public sale process it will be assessed retrospectively.  By comparison, the duty of care imposed upon receivers requires them to conduct an effective sale process but it does not mandate an outcome.

Safe Harbour is a defence

Specific protection for transactions entered into by liquidators and deed administrators is obvious and as expected.  A similar exemption for companies in Safe Harbour (more detail here) is a sensible and consistent policy alignment.

Application to transactions with third parties

Many would think of a phoenix transaction as a sale to a related party, but significantly it seems that the draft legislation has the potential to apply to sales to third parties, if the proceeds of sale are ‘diverted.’

The type of transaction described in an extract from hypothetical email from a CFO to a CEO highlights some of the real world issues:

We have a received an unsolicited offer for our New Zealand operations.  The offer is less than I think we would get if we took the business to market but that would take another six months, and a sale now would leave us one less headache to manage, so I recommend that we accept….

If those sales proceeds are used to pay the trade creditors of the New Zealand business, and the Australian business collapses a month later with employees unpaid, should that transaction amount to a CDD which can be reversed?  Is that email the ‘smoking gun’ which might expose directors and advisers to the transaction to the risk of prosecution?

Potential purchasers who believe a vendor to be under financial pressure may be concerned about whether they can take clear and irreversible title to business assets, or whether there may be a risk of later claw back.  Such a purchaser has a theoretical access to the general good faith defence that is available to purchasers without ‘knowledge of insolvency’, but they may need to think carefully about when exactly a suspicion about financial stress might amount to ‘knowledge of insolvency.’   Some potential acquirers may decide they need more information, or details of how the funds will be dispersed, and some may decide that it is safer to walk away and wait for a formal insolvency to deliver clear title.

Conclusion

Measures to address the serious problem of phoenixing are appropriate, and alignment with Safe Harbour measures is commendable. However, phoenixing by its very definition involves transaction with related parties. Extending the ambit of anti-phoenix measures so that they also apply to transactions with third parties risks the ability of stressed companies to promptly execute genuine sales, and should be implemented with great care.  If anti-phoenix measures need to be applied beyond those currently defined as ‘related parties,’ perhaps a better approach might be to broaden that definition.

Anti-phoenix measures open for consultation

On 16 August the government released draft legislation intended to implement the anti-phoenix measures that were announced on budget night.

The legislation does not include the widely supported idea of a Directors Identification Number – but that is as expected, the DIN was the subject of an earlier consultation process which ended on 16 August.

The draft legislation does not go beyond the measures announced on budget night so in that sense there are no surprises. but there are some noteworthy aspects of the implementation of those headline measures.

A new type of voidable transaction

The legislation will create a new type of voidable transaction, a ‘Creditor Defeating Disposition’ (‘CDD’), defined as a transaction which has the effect of:

(a) preventing the property from becoming available for the benefit of the company’s creditors in the winding‑up of the company; or

(b) hindering, or significantly delaying, the process of making the property available for the benefit of the company’s creditors in the winding‑up of the company.

which will be potentially voidable if one of the following applies:

(i) the transaction was entered into, or an act was done for the purposes of giving effect to it, when the company was insolvent;

(ii) the company became insolvent because of the transaction or an act done for the purposes of giving effect to the transaction;

(iii) less than 12 months after the transaction or an act done for the purposes of giving effect to the transaction, the start of an external administration (as defined in Schedule 2) of the company occurs as a direct or indirect result of the transaction or act;

The absence of any requirement to prove insolvency in relation to transactions entered into in the twelve months before formal insolvency may assist liquidators – although they may still need to disprove solvency if the other party claims the good faith defence.

Administrative Recovery process

The proposed amendments will create a regime by which a liquidator can ask ASIC to make administrative orders to recovery property that was transferred as a result of a CDD.

Liquidators will welcome a recovery regime which has the potential to avoid the costs and delays of Court processes, but there is little detail here about what ASIC’s own processes will be.  For example, the legislation does not seem to require ASIC to allow the other party a ‘hearing’ – but ASIC may form the view that it should.

Also worth noting is that a failure to comply with such an administrative order will expose a party to the civil penalties and offence regimes, which should assist with a more cost-effective and timely recovery.

New Offences

The draft legislation will introduce new offences for:

  • Officers who engage in conduct that results in a CDD.
  • Non-compliance with administrative orders.
  • ‘Procuring, inciting, inducing or encouraging’ a company to engage in CDDs.  This is a measure specifically targeting those Pre-insolvency Advisers who actively promote phoenixing.

These new offences go part of the way, but ASIC will need to have the resources to investigate potential offences and prosecute where appropriate.  Today ASIC is able to act on only a very small proportion of the potential offences that liquidators currently report, and so adding to the already long list of potential offences without an appropriate enforcement budget will have little real impact.

Safe Harbour a defence

Effective 16 September 2016 there is a ‘Safe Harbour’ (discussed here) which protects directors from insolvent trading claims.  The CDD recovery regime will exclude transactions which are entered into whilst a company is within that ‘Safe Harbour’ – a commendable policy alignment.

Other changes

The proposals also include:

  • A 28 day limit on backdating director resignations.
  • Prohibition on director resignations that would leave the company with no directors.
  • Related parties who acquire debt can only vote for the amount paid – not the face value of the debt – when voting on resolutions dealing with the appointment, removal or replacement of an external administration.
  • The current Director Penalty Regime will be extended to cover GST, luxury car tax and wine equalisation tax.

Details of the proposals can be found here.  Submissions are due by 27 September 2018.

A fix for construction industry insolvency? The Murray Report

Last month the government released the Murray Report: A Review of Security of Payment Laws.  It is a welcome – if low profile – step towards a national scheme, although the lack of fanfare, and the delay between delivery of the report in December 2017 and its release in May this year, do not reflect the sense of urgency that many would be hoping for.

The review was intended to identify ‘legislative best practice’ to improve ‘consistency in security of payment legislation’ and the better protection of subcontractors: the question is clearly not whether there should be a national scheme, but rather, what a national scheme should look like.

East Coast v West Coast

One of the major issues addressed by the 382 page report (available here) is the type of model to be used – essentially a choice between the ‘East Coast Model’ – deployed in NSW, Victoria, Queensland, South Australia, Tasmania and the ACT – and the ‘West Coast Model’ used in Western Australia and the Northern Territory.

There are variations even between the states that use the same model, but in broad outline the key differences are:

  • The East Coast model provides a statutory payment scheme that can override contractual provisions whereas the West Coast model provides ‘legislative assistance’ to supplement the existing contractual arrangements.
  • The East Coast model only allows claims ‘up the line’ i.e. to a head contractor but not to a sub-contractor – compared to the West Coast Model allows claims in both ‘directions.’
  • Under the East Coast Model a failure to provide a ‘payment schedule’ in reply to a payment claim and to pay by the due date creates a statutory debt for the claimed amount, capable of enforcement.
  • The West Coast model allows the parties in dispute to select the adjudicator that they believe is best suited to resolve the dispute, an adjudicator is independently allocated under the East Coast Model.

The report recommends a modified East Coast Approach.

Statutory Trusts

Murray recommends that a deemed statutory trust model should apply to all parts of the contractual payment chain, in preference to any expansion of the limited Project Bank Account regimes currently in place in WA and Queensland.

There is extensive discussion of the administration burden imposed by PBAs, and it seems clear that some of those who welcome the protection that a PBA provides would prefer to avoid the paperwork involved in providing similar protection to their own sub-contractors!

The report states:

“…the concept of a deemed statutory trust has not only been operating in large parts of North America for many years without inhibiting the smooth functioning of the industry, but it has also (unlike the case of the various security of payment laws in Australia) not been the subject of significant critical reviews.”

Surprisingly, it seems that the review was undertaken without any input from ARITA, or any individual insolvency practitioner.  Perhaps that is why the report has not identified any of the practical problems that arise from creating the type of trust arrangements that it proposes, or explained whether and how such problems have been solved in those overseas jurisdictions.

Next steps?

The website of the Department of Jobs and Small Business explains that the Government is using the Building Ministers’ Forum (BMF) – the group of Federal, State and Territory Ministers with responsibility for building and construction – to consider and respond to the review, and that Federal Government responsibility has been transferred to the Department of Industry, Innovation and Science.


For comment on the Queensland regime, introduced whilst the Murray review was under way – and recently delayed until 17 December 2018 – see here.

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:

  1. “Nothing found to suggest that the grounds for the proposed pre-packaged sale are unreasonable”
  2. “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”
  3. “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

Anti-phoenix measures announced in the 2018/19 Budget

In the budget speech tonight the Treasurer said “We are making sure small businesses don’t get ripped off by other businesses who deliberately go bust to avoid paying their bills, with tough new anti-phoenixing measures.”

Budget paper #2 available here provides more detail:

Reforms to combat illegal phoenixing

The Government will reform the corporations and tax laws and provide the regulators with additional tools to assist them to deter and disrupt illegal phoenix activity. The package includes reforms to:

  • introduce new phoenix offences to target those who conduct or facilitate illegal phoenixing;
  • prevent directors improperly backdating resignations to avoid liability or prosecution;
  • limit the ability of directors to resign when this would leave the company with no directors;
  • restrict the ability of related creditors to vote on the appointment, removal or replacement of an external administrator;
  • extend the Director Penalty Regime to GST, luxury car tax and wine equalisation tax, making directors personally liable for the company’s debts; and
  • expand the ATO’s power to retain refunds where there are outstanding tax lodgements.

Illegal phoenixing involves the deliberate misuse of the corporate form. It affects all working Australians, including: customers who get scammed by not receiving their paid goods or services; small business and sole-trader creditors through lost payments; employees through lost wages and superannuation entitlements; and ultimately all Australian taxpayers through lost tax revenue. In addition, illegal phoenix operators gain an unfair advantage over their honest competitor businesses, which has a broader economic impact.

In fiscal balance terms, the cost to the budget of extending the Director Penalty Regime is estimated to be $40.0 million over the forward estimates, as existing GST debt is collected and paid to the States and Territories. There is no revenue impact in fiscal balance terms over the forward estimates as the GST and related liabilities have already been recognised. In cash terms, this initiative is estimated to have nil net financial impact on the Commonwealth. The expansion of the ATO’s ability to retain refunds is estimated to have a small but unquantifiable gain to revenue over the forward estimates period.

The reforms to combat illegal phoenixing complement and build on the work of the Government’s Phoenix, Serious Financial Crime and Black Economy taskforces, and other announced reforms such as a Director Identification Number, a combined black economy and illegal phoenixing hotline, and reforms to address corporate misuse of the Fair Entitlements Guarantee and to tackle non-payment of the Superannuation Guarantee Charge.”

Many of these measures were the subject of consultation in October 2017, as discussed here, but there are some new measures, namely the extension of the directors penalty notice regime and expansion of the ATO’s power to retain refunds.

 

Two strikes? Queensland-only anti-phoenix regimes

As well as regulating labour hire, Queensland’s new Labour Hire Licensing Act  includes an anti-phoenix element.  This is not Queensland’s first use of industry-exclusion to address phoenixing, a similar structure was used in the 2017 Building Industry Security of Payment legislation – but the ambit of the labour hire regime is far broader than many would anticipate.

Building Industry Fairness (Security of Payment) Act 

As discussed in more detail here, the Building Industry Fairness (Security of Payment) Act 2017 implemented a range of measures aimed at protecting sub-contractors from the risk of non-payment.

The anti-phoenix element arises from exclusion from the building license regime if an office bearer of a company acted as a director or secretary of a construction company that entered into insolvency administration in the prior two years.

Labour Hire Licensing Act 2018

The Labour Hire Licensing Act 2018 which commenced on 16 April 2018 to introduce a regime for registration of labour hire participants likewise includes an anti-phoenix element.  The requirement that all directors of a company must be ‘fit and proper persons’ is hardly unusual, but the criteria includes two that are particularly focused on insolvency, referencing prior directorship of a company that:

  • entered into a formal insolvency administration.
  • has failed to pay tax or superannuation due to its employees.

The changes are noteworthy because the LHLA has a reach that is far broader than would be anticipated from its name.  The regime is not limited only to external labour hire arrangements, it appears that it extends to internal arrangements that are very common in corporate groups: the use of a designated payroll company.  As a result it seems that a group employer in any industry – whether headquartered in Queensland or not – will need to register and comply with the regime in respect of any Queensland employees.

At a time when the Federal Government is implementing changes intended to reduce the stigma of business failure, it seems that the Queensland government is heading in the opposite direction – further expanding a ‘one-strike’ regime that will restrict those involved in a financial failure from acting as company directors.

No doubt the Federal Government’s Anti-Phoenix Taskforce is aware of the Queensland approach and will be watching the outcome with great interest.  If the industry-exclusion model does appear to provide a more effective means to deal with the problem of phoenixing, there may be moves to implement it more broadly.