Senate Inquiry Report: Credit and financial services targeted at Australians at risk of financial hardship

On 22 February the Senate Economics Reference Committee inquiry into Credit and financial services targeted at Australians at risk of financial hardship issued its report, available here.

Much of the report deals with the regulation of credit providers, but one aspect will be of interest to Restructuring & Turnaround professionals, recommendation 8:

The committee recommends that the government implement a regulatory
framework for all credit and debt management, repair and negotiation activities
that are not currently licensed by the Australian Financial Security Authority,
including:

  • compulsory membership of the Australian Financial Complaints Authority, giving clients access to an External Dispute Resolution scheme;

  • strict licensing or authorisation by the Australian Securities and Investments Commission or the Australian Financial Security Authority;

  • prohibition of upfront fees for service;

  • prescribed scale of costs;

  • an obligation to act in the best interests of their clients; and

  • banning unsolicited sales.

There seems to be growing recognition of the problems caused by phoenixing, and growing concern about the role played by those unscrupulous “pre-insolvency advisers” who promote and facilitate phoenixing.

A regulatory framework ‘for all credit and debt management, repair and negotiation activities’ has the potential to apply to pre-insolvency advisers – although the detail suggests that it is personal credit which is the primary focus for the Committee.

Restructuring and Turnaround professionals who believe – as I do – that there is a pressing need for regulation of pre-insolvency advisers should take any opportunity via submissions or otherwise to ensure that legislators understand the link between phoenixing and pre-insolvency advisers, and the importance of any regulatory framework extending to business and corporate ‘debt management.’

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.

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).

Building a better buggy whip? The Debt Agreement Reform legislation

On 7 December the Senate referred an exposure draft of the Bankruptcy Amendment (Debt Agreement Reform) Bill 2017 to its Legal and Constitutional Affairs Legislation Committee.

From their introduction in 1996, Part IX Debt Agreements have provided individuals with a low-cost alternative to bankruptcy.  Part of the cost saving structure was a mechanism that operated without the involvement of Bankruptcy Trustees, and it seems that it was originally anticipated that Debt Agreements would be implemented and managed by debtors themselves, their friends or relatives, or by not-for-profit financial counsellors.

In fact, commercial operators leapt into the vacuum, and a new industry was created.  Probably in part due to aggressive promotion by those commercial operators, as Michael Murray has identified, today Part IXs almost rival bankruptcy in popularity.

There was significant reform in 2007, with changes intended to adjust the regime to reflect the widespread involvement of commercial operators.  These latest reforms (draft legislation available here) some ten years later will further regulate those commercial operators, but there are other, significant changes.

Access to the Part IX process

Probably the most important change is a very significant expansion of access – the maximum asset limit will be doubled, to $223,350.

Restrictions on debtor contributions

Another significant change is the introduction of limits on debtor contributions, with a limit on the time frame over which payments can be made – 3 years – as well as a percentage limit (not yet set) referenced against the debtor’s income.  Those limits will apply to original proposals and any later variations.  The Official Receiver will also have a new power to reject proposals even within these limits if they would cause ‘undue hardship’ to the debtor – although this is to be used only in ‘exceptional circumstances.’

Alignment to bankruptcy

There are a number of changes that will align the regulation of Debt Agreement Administrators to the regulation of Bankruptcy Trustees.  Debt Agreement Administrators will be required to:

  • Consider whether a debtor has committed any offences under the Bankruptcy Act and, if so, refer the matter to the appropriate authority.
  • Follow the same funds handling procedures as Bankruptcy Trustees, with failure to constitute an offence.
  • Maintain ‘proper books and records’ to the same standard as Bankruptcy Trustees, with failure to constitute an offence.
  • Obtain and maintain appropriate professional indemnity insurance to the same level as Bankruptcy Trustees.
  • Refrain from charging expenses to the debt agreement fund unless there is specific prior disclosure in the Debt Agreement.

The Inspector-General’s investigation and inquiry powers will be extended to encompass ‘any conduct of a Debt Agreement Administrator’ and the grounds on which the IG can issue a ‘show cause’ notice – seeking a written justification of continued registration – will also be expanded.

Brokers, referrers, and conflicts of interest 

The explanatory memorandum refers to concerns that ‘an unscrupulous administrator is in a position to exploit a debtor’s lack of knowledge,’ and several measures appear intended to address this:

  • Proposed Administrators will be required to disclose broker or referrer information to the debtor, and creditors.
  • The Debt Agreement Administrator and related entities will be unable to vote on the acceptance of the proposal, or any resolution to modify or terminate the debt agreement.
  • It will be an offence for a Debt Agreement Administrator to provides creditors with an incentive to vote in a certain way.
  • Debtors will be able to seek termination of the debt agreement where an administrator has committed a breach of duty.

Professionals only!

The industry will be fully professionalised – only a registered Debt Agreement Administrator or registered Bankruptcy Trustee will be able to administer a debt agreement – but this is really only a symbolic change, because in practice these are the only parties who do such work now.

A better buggy whip?

The changes impose additional work on Debt Agreement Administrators, most notably the requirement to investigate and report offences.  That additional work will probably translate to additional costs, which will be charged to the deed fund and ultimately be borne by creditors.  Whilst that represents a shift away from the low cost objective that led to the introduction of Part IX, it is otherwise hard to argue against changes which do no more than align to the standards currently imposed on Bankruptcy Trustees.

But however worthwhile the changes are, they may have limited practical impact.  If the one-year bankruptcy discussed here is implemented then it is hard to see why many debtors would bother with a Debt Agreement.  It seems likely that the unscrupulous ‘non-mainstream advisers’ will tell their clients that they can simply ignore any efforts that a bankruptcy trustee will make to assess and collect income contributions in years two and three  – which means that a twelve month bankruptcy will be not only far quicker but also far ‘cheaper’ than a three-year debt agreement.

Submissions

The committee is seeking submissions by 16 February to gather stakeholder feedback on ‘issues of concern’ and to allow the committee ‘to consider expert views on impacts,’ and is due to report by 19 March 2018.


Update:  The first (and only, at the date of writing) submission to the inquiry, by Vivien Chen, Lucinda O’Brien and Ian Ramsay, provides a link to their thoughtful & structured analysis on insolvency reform. ‘An Evaluation of Debt Agreements in Australia’, available here.

New anti-phoenix measures

Not to be outdone by the Queensland Government – which tabled legislation in the last week of August to safeguard against construction industry phoenixing, discussed here – the Federal Government today issued a media release announcing a range of measures intended to address ‘illegal phoenixing.’

The most developed initiative appears to be a proposal to introduce a unique Director Identification Number (DIN) – a reform proposed by Professor Helen Anderson and advocated by ARITA.  Although the release does not address this point it, seems that there will be some kind of bank-style 100 point identification regime; and the release did refer to the use of the DIN to cross-reference against government databases, to allow ‘mapping’ of relationships.

The announcement also flags consultation about a range of other possible measures intended ‘to deter and disrupt the core behaviours of phoenix operators,’ including:

  • The introduction of specific ‘phoenixing offences’
  • A single point of contact for reporting illegal phoenix activity
  • Extension of the director penalty provisions, to cover GST liabilities
  • Applying tax avoidance promotion penalties to those promoting phoenixing
  • Prohibiting related entities to the phoenix operator from appointing a liquidator.

There will be a focus on identifying ‘high risk individuals’ – if not a ‘blacklist, a ‘greylist,’ it seems – who may:

  • Be required to provide the ATO with a security deposit.
  • Not be allowed to appoint the liquidator of their choice.
  • Be the subject of immediate recovery action following the issuance of a Director Penalty Notice.

It is not completely clear what ‘Prohibiting related entities to the phoenix operator from appointing a liquidator’ means – but laws that prevent the appointment of a liquidator to an insolvent company will require careful thought, especially given their potential to intersect with the laws that require directors to make an appointment to avoid personal liability.

A proposal to prevent ‘high risk individuals’ from appointing the liquidator of their choice may be less effective than hoped.  The ILRA changes that made it easier for creditors to replace a liquidator surprisingly did not include any anti-abuse measures, and so a restriction on appointment may need to be accompanied by a comparable restriction on replacement.

The release explains that the government intends to open a consultation process shortly.


Update: The consultation process began on 28 September 2017, with responses due by 27 October 2017.  Two of the specific measures are discussed in Taxi! A cab-rank system for insolvency appointments? and Department of Liquidation? The possible creation of a Government Liquidator…

Opposite directions: Phoenix busting or second chance?

In the last week of August the Queensland Government tabled legislation which is intended to better protect construction industry subcontractors from the risk of non-payment.

The Building Industry Fairness (Security of Payment) Bill 2017 available here includes a number of measures.

Project Bank Account Regime

PBAs are effectively trust accounts which operate to quarantine money paid to a head contractor that is expected to be on paid to their subcontractors.

Initially the PBA regime will apply only to Queensland Government projects, and will only protect ‘first tier’ subcontractors – it will not extend to those subcontractors who directly or indirectly work for the first tier subcontractors.

However, the legislation provides a mechanism for extension of the PBA regime to all construction projects over $1m- ie whether government or private – by proclamation.  Likewise there is a mechanism to extend the regime to all subcontractors – not just tier 1 subcontractors – by a separate proclamation.

Dispute Resolution and adjudication

The legislation incorporates the existing Subcontractors’ Charges Act 1974 regime, but it tightens the rules which require a head contractor to respond to a sub-contractor’s ‘payment claim’ with a ‘payment schedule.’

The extent to which criminal sanctions will apply is noteworthy.  Head contractors apparently commit an offense if they do not:

  • Provide a payment schedule on time.
  • Pay an amount owed when it falls due.
  • Pay an adjudicated amount within five business days of receiving a written decision.

Financial Reporting

The legislation will reinstate requirements for licensed builders to provide financial information to the Queensland Building and Construction Commission.  The QBCC will also be given power to require the production of financial information so that it can better assess whether a builder continues to meet the minimum financial requirements.

Phoenix-busting

The legislation includes a measure that is described as clamping down on ‘corporate phoenixing’ – by restricting those involved with a recent financial failure from holding a QBCC license.

The current licensing regime already bars those who were a director or secretary of a construction company in the twelve months prior to its liquidation or administration from holding a building license.  The amendments will extend the period to cover the two years prior to liquidation or administration.  Further, the exclusion mechanism will also take into account the activities undertaken by a person – not just the office they occupy – including those who:

  • act as the chief executive officer or general manager
  • give instructions to officers of the company which are generally acted upon
  • participate in making decisions that affect a substantial part of the business
  • present themselves to others in such a way as to lead them to believe that they control or influence the business.

The intention is to ensure that the regime also captures ‘shadow directors’ – those who manage companies without holding the office formally.  Whilst the Corporations Act extends the definition of directors to those who act in the position of a director, as demonstrated most recently in the Akron Roads decision that extension may not cast the net as widely as once thought.  In Akron Roads it was held that a person who:

  • dealt with creditors,
  • attended executive meetings,
  • negotiated with the bank and attempted to obtain finance,
  • had financial accounts prepared and was responsible for short-term cash flow,  forecasting and cash management

was not a shadow director, because none of those activities ‘involve a board decision or fall within the responsibilities of the directors…[who] do not carry out managerial tasks.’

The exclusion will also apply to those who directly or indirectly control 50% or more of a class of shares in the company.

Opposite Directions?

The Federal Government is undertaking reforms that are intended to de-stigmatise business failure, and encourage entrepreneurialism.

The Queensland government appears to be moving in the opposite direction however,  by introducing a ‘one-strike’ regime specifically aimed at preventing those involved in a financial failure from going straight back into business.

The new focus on activities will require a qualitative assessment, and so it will be critical that the QBCC has the skills and resources to take the assessment process in a new direction.

If the Queensland initiative is successful in tackling phoenix activity, there will some who use its success to argue the framework should be applied more widely in a universal director-licensing regime.


Update: on 12 September 2017 the Federal Government announced its own anti-phoenix measures, details here.

Further update: The Building Industry Fairness (Security of Payment) Act 2017 was passed on 26 October 2017, with some measures to be effective from 1 January 2018, however most of the measures await proclamation.  The 143 amendments to the original draft legislation detailed here are mostly matters of clarification, correction of typographical errors, or the consolidation of definitions.  However there are some noteworthy changes: allowance for ‘reasonable excuse’ into some offence provisions, and a review of operation after 12 months.

And another update: On 12 June 2018 the Queensland government announced that the commencement of security of payment changes had been changed from 1 July 2018 to 17 December 2018.