Secret Harbour?

Must a listed company disclose that it has taken steps to ‘enter’ the Safe Harbour regime?

Doing so would almost certainly result in the withdrawal of trade credit facilities and thereby cause a liquidity crisis. But the ASX listing rules impose a quite rigorous continuous disclosure regime, requiring disclosure regardless of the damage it may cause to a business.

The update to Guidance Note 8 Continuous Disclosure: Listing Rules 3.1 – 3.1B released this month and available here directly addresses the question, providing very helpful guidance.

Background

Rule 3.1 requires immediate notification to the ASX of:

“any information concerning it that a reasonable person would expect to have a material effect on the price or value of the entity’s security”

Paragraph 5.10 of GN 8 specifically confirms that rules applies to companies experiencing financial difficulties:

“The fact that information may have a materially negative impact on the price or value of an entity’s securities, or even inhibit its ability to continue as a going concern, does not mean that a reasonable person would not expect the information to be disclosed. Quite the contrary, in ASX’s view, this is information that a reasonable person would generally expect to be disclosed.”

Taking steps to enter Safe Harbour is evidence that directors are concerned about solvency. Surely the forming of a view that safe harbour is appropriate falls in the category of information that would have a materially negative impact on share price?

Updated Guidance

The updated Guidance Note directly addresses the issue, explaining that:

“ASX has been asked whether the fact that the entity’s directors are relying on the insolvent trading safe harbour in section 588GA of the Corporations Act requires disclosure to the market”

Updated paragraph 5.10 recognises that Safe Harbour is a conditional carve-out from a director’s potential liability for insolvent trading. GN 8 highlights that the legislation does not include an exemption from disclosure obligations, and so Rule 3.1 continues to apply – but goes on to explain:

“The fact that an entity’s directors are relying on the insolvent trading safe harbour to develop a course of action that may lead to a better outcome for the entity than an insolvent administration, in and of itself, is not something ASX would generally require an entity to disclose”

The guidance recognises that investors would always expect directors of an financially stressed business to consider whether there was a better alternative than an insolvency administration:

“The fact that they are doing so is not likely to require disclosure unless it ceases to be confidential, or a definitive course of action has been determined.”

A practical outcome

This is a very practical position for the ASX to take. Companies can maintain essential confidentiality rather than disclose issues that would almost certainly trigger a crisis of confidence, the freezing of credit facilities, and a severe liquidity crunch.

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

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

Debt Agreement Reform

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

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

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

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

One Year Bankruptcy

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

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

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

The Report

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

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

Other posts about the Bankruptcy and Debt Agreement reforms:

Back where we started? Director disqualification

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

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

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

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

Government submissions on the Government proposals

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

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

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

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

Right back to where we started from?

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

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

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

PAG v RBS: Calling for Valuations – A final outcome

Property Alliance Group is an ex-customer of the Royal Bank of Scotland so unhappy about its treatment by GRG – RBS’ workout unit – that it took legal action against the bank.

Some of the issues raised by PAG concerned an interest rate hedging program entered into before the transfer to GRG, and are not relevant to restructuring and turnaround practitioners. However, PAG also complained about management by GRG, including decisions to seek updated valuations, which resulted in breach of a loan to valuation ratio, and led to a subsequent renegotiation of terms.

As discussed here, PAG was unsuccessful in its first attempt before the UK High Court, but it kept on fighting, with an appeal. PAG argued that the judge at first hearing was wrong to decide that RBS’ contractual power to call for a valuation was completely unrestricted – PAG said that there were implied terms which meant that for example RBS could not call for a valuation capriciously or vexatiously.

In a judgement (available here) handed down last week, the Court of Appeal agreed with PAG that the power was ‘not wholly unfettered’ – but it found that RBS was free to seek an updated valuation if it was for a purpose related ‘to its legitimate commercial interests.’

On that point, on the facts the Court held that it was

‘very far from apparent, however, that the Judge would have held the valuation at issue to have been pointless, lacked good or rational reason or been commissioned for a purpose unrelated to RBS’s legitimate commercial interests or when doing so could not rationally be thought to advance them…’

After providing some rare behind-the-scenes glimpses of a loan workout, it appears that we have now reached a final resolution, leaving the law probably as most impartial observers expected the position to be.

Bank support for small business turnaround

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

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

The principles are:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Is there a User Pays shock coming for auditors?

ASIC was very careful to highlight the risk of sample error when it briefed the Parliamentary Joint Committee on Corporations and Financial Services about the outcome of a 2017 review of audit quality – but still came firmly to the conclusion that ‘ongoing attention to this area is warranted.’

ASIC told the 16 February hearing that:

“in 25 per cent of the 390 key audit areas that we reviewed across the 93 audit files at firms of different sizes, auditors did not obtain reasonable assurance that the financial report as a whole was free from material misstatement.”

According to the most recent ASIC Cost recovery implementation statement, available here, ASIC allocates $5.003m to regulating the auditors of disclosing entities, and $1.013m towards general regulation of 4,367 registered auditors.

The cost of regulating disclosing entity auditors will be prorated based on fees earned, so there will be considerable variation around the average figure of $43,885. The other costs will be recovered by a flat levy, which means that most auditors will pay a levy of around $250.

It seems likely that ASIC will allocate more resources to the regulation of auditors – if only to ascertain whether or not the 25% deficiency rate is representative of overall audit quality, or whether it is a statistical anomaly.

ASIC allocates $10.196m to regulating 711 registered liquidators. The notional average recovery is therefore around $14,300 – but in practice some liquidators will pay the $2,500 minimum, and some will pay considerably more.

If ASIC increases the budget for the auditor regulation to a level near that for liquidator regulation, there may be some very significant User Pays charge increases on the way for auditors.

Open-ended investment vehicles: how should they be restructured?

In August 2017 Treasury invited consultation on a plan to introduce a new form of company: Corporate Collective Investment Vehicles.

CCIVs are intended to replace trust-based managed investment schemes – currently the only collective investment vehicle providing a flow-through tax treatment – with ‘a more internationally recognisable’ structure, similar to the UK’s ‘Open-ended Investment Vehicle’ regime. By doing so, the Government hopes to make it easier to attract international investment and inbound capital flows.

Key features of a CCIV

Details of the regulatory framework for the CCIV are on the Treasury website here, but in summary:

The CCIV itself will be an ‘umbrella entity’ with at least one, and probably several, sub-funds (in the UK: ‘protected cells’).
The CCIV will create and allocate a new class of shares for each sub-fund, but those sub-funds will be notional and will not be separate legal entities.
A CCIV must have a single corporate director, which itself must be a public company holding an Australian Financial Services License. The duties of a corporate director will align to those currently owed by the responsible entity of an MIS scheme.
A CCIV which accepts investments from retail investors must hold its assets via a separate ‘depositary’ company – also a public company with an AFSL.
Each sub-fund will be ‘ring fenced’ or ‘bankruptcy remote.’ The assets of a sub-fund belong exclusively to that sub-fund, and are not available to the creditors of any other entity – including the umbrella CCIV.

What will happen to an insolvent sub-fund?

Treasury has adopted a phased approach to development of the new CCIV framework, and consideration of restructuring issues has been deferred until later.

There appear to be three main options:

Apply the current MIS framework. MIS schemes are wound up by Court order made under section 601ND, with almost any other issues addressed by an application for directions under section 601NF. Reliance on court directions – rather than a legislative framework as for liquidation and administration – has led some to describe MIS wind ups as the closest that Australia has to the cumbersome and expensive Chapter 11 process.
Follow the UK approach. The UK legislation provides that a sub-fund is to be wound up ‘as if it were an open-ended investment company‘ treated ‘as if it were a separate legal person for the purposes of winding up.’ Like the current Australian regime, winding up is the only option – there is no scope to restructure a sub-fund.
Allow a broader range of restructuring options. If there is a policy reason why MIS schemes and sub-funds must be wound up and cannot be restructured, it has not been articulated. There should be some consideration given to allowing sub-funds to have access to a broader range of restructuring options such as voluntary administration and schemes of arrangement.

Treasury has flagged future consultation on winding up of CCIV funds, likely to be later this year.

Superannuation Guarantee Integrity Package – consultation underway

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

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

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

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

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

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

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

Background

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

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

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

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

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

Issues with the legislation as drafted

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

Suggested solutions

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

A more direct path to achieve the legislators’ intention

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

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

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

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

Anti-abuse protections

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

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

Additional administrative remedy to address non-compliance

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

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

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

For some comments on the draft legislation see here.

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

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

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

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

Collection of information

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

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

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

How often will trustees need to request prosecution?

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

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

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

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

Possible Alternatives

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

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

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

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

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

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

A copy of my submission is here.