Heard Phillips Expands, Illegal Phoenix Activity, ASIC Wind-Ups and ATO Recovery Action

Heard Phillips expands

We open this quarter’s newsletter with the fantastic news that our firm, started by Andrew and Anthony eight years ago, has proudly taken the next step in its growth path.

We are pleased to announce that on 1 September, long term employee and associate director Mark Lieberenz became an equity director in our firm.

Mark has a long history in insolvency having started in 1994 and has worked without break in the industry (including a stint in his native Canada) since 1997.

Those of you familiar with Mark know that he is a dynamic and passionate practitioner with a strong history in agribusiness and regional insolvency matters. Mark loves nothing more than rolling up his sleeves and working hard to solve difficult commercial problems.

Mark’s appointment is well deserved and reinforces our firm’s desire to be the first choice for critical SME insolvency, restructuring and forensic accounting matters in South Australia.

Illegal phoenix activity

ASIC has long warned business operators of their intolerance of illegal phoenix activity. Phoenix activity is generally described as the situation where a business grows again from the embers of a failed business. It is important to note that not all phoenix arrangements are illegal and therefore we shall describe what distinguishes legal and illegal phoenix activity and provide some insight into the possible consequences of illegal phoenix activity.

Illegal phoenix activity involves the intentional transfer of assets from an indebted company (“OldCo”) to a new company (“NewCo”) to avoid paying creditors, tax or employee entitlements. Typically the arrangement involves the directors leaving OldCo with no assets to pay creditors and NewCo, often operated by the same directors, is created to continue on the business of OldCo using the assets, staff and goodwill of OldCo.

Not all company failures that are followed by a start-up of a new company will be considered illegal phoenix activity and therefore it is important to recognise what makes phoenix activity illegal.

It becomes illegal when those in control of companies (old and new), such as directors or former directors, are deliberately avoiding liabilities by the process. Typically this involves the following scenarios:

  • NewCo does not pay or pays inadequate consideration, for the assets of OldCo; and/or
  • NewCo pays as its consideration for the purchase of the business the assumption of selected creditors (or related party creditors) of OldCo, leaving some without any or inadequate payment.

ASIC and the ATO consider that phoenix activity is bad for business competition as the practice can disadvantage creditors and can give unviable business operators an unfair competitive business advantage. Often the key issue to be ascertained is whether appropriate value is paid for the continued business by NewCo.

It is acknowledged that the value of a business is severely compromised by an external administration occurring. In some cases there may be a limited market of potential purchasers, or some businesses operate in industries whereby ipso facto clauses will trigger revenue collapse in the event of external administration. However, all businesses will have a value when sold in situ that will be greater than the forced sale auction realisable value of its assets.

It is therefore up to the directors to walk a tricky tightrope of fiduciary duties, noting that they must act in the best interests of the vendor in one sense and the purchaser in the other. These duties come into focus concerning the value paid and the allocation of that value to ensure that no creditor is disadvantaged by the transaction entered into.

Having identified what is an illegal phoenix, we now consider what its consequences are.

Under the Corporations Act 2001 (“Act”) a liquidator appointed to OldCo has the capacity to review the sale transaction and make void the sale to NewCo as:

  • an uncommercial transaction (s. 588FB);
  • an unreasonable director-related transaction (s.588FDA);
  • a transaction to defeat creditors (s. 588FE(5)); or
  • an agreement or transaction to avoid employee entitlements (s. 596AB).

There can also be other consequences for entering into an illegal phoenix including prosecution for failure to properly exercise directors’ duties such as:

  • Duty of care and diligence (s. 180);
  • Duty to exercise powers and discharge duties in good faith in the best interests of the corporation, and for a proper purpose (s. 181);
  • Duty to not use position improperly to gain an advantage for oneself or someone else, or to cause detriment to the company (s. 182); or
  • Duty to not use information improperly to gain an advantage for oneself or someone else, or to cause detriment to the company (s. 183).

ASIC can take further action in appropriate circumstances such as seek an order to disqualify a director for:

  • contravention of civil penalty provision (s. 206C);
  • being involved with two or more insolvency appointments inside of 7 years (s. 206D – Court Ordered and 206F ASIC Ordered).

In addition, an extreme transaction could result in a criminal breach of directors’ duties (s. 184). Liability for the effect of the breach of duties could also extend to advisors if they were found to be an accessory to the directors’ breaches of duty (s. 79).

Further, there could be additional tax consequences for NewCo imposed by the ATO. Pursuant to s. 255-100 of Schedule 1 to the Taxation Administration Act the Commissioner of Taxation may obtain security from a taxpayer for any existing or future tax liability, including the superannuation guarantee charge, if the Commissioner considers that the taxpayer intends to carry on an enterprise for a limited time only, or if it is otherwise appropriate.

As can be seen, there can be many pitfalls to embarking on a scheme to avoid creditors of a failed company through an illegal phoenix arrangement. Our advice is that if ever circumstances occur where a director feels that the only future for the business is through a phoenix arrangement, that the interests of all the creditors are placed higher in the list of priorities than the interests of the directors seeking to resuscitate their fortunes through the arrangement.

ASIC winds up abandoned companies

In previous newsletters we have commented on the power of ASIC to wind up companies that have been abandoned in an effort to enable employees to access the Fair Entitlements Guarantee (“FEG”) scheme to secure payment of their entitlements.

Whilst there have been relatively few ASIC initiated windings up in South Australia, recent statistics produced by ASIC show that it has wound up 31 abandoned companies in the 2014-15 financial year, in a bid to help almost 100 employees access almost $1 million in unpaid entitlements.

So, if you have clients who have entitlements left unpaid by a business that has shut down without appointing an external administrator, and there is no winding up application in progress, it is possible for the employees to engage with ASIC who will commence an application to have the company wound up so those entitlements can be paid.

It is important that employees do not delay too long in initiating contact with ASIC as it only delays the recoupment of eligible employee entitlements.

For employees it is important to note the FEG scheme will only respond to claims made within 12 months of the cessation of employment or the date of the insolvency event (i.e. liquidation) whichever is the latter.

Competing creditor priorities in a receivership

When a company passes into receivership recent case law has made it less clear cut regarding what employee entitlements will be discharged by the receiver and what will not. The traditional view of priorities in a receivership is that employee entitlements will be discharged from the net realisations of circulating charged assets (debtors or stock etc.) and will not be discharged from the net noncirculating assets, unless the secured debts are paid in full.

An interesting question concerns the proposition of who shares in the spoils of profits from trading in receivership i.e. are they available for employee entitlements or not. The matter of Re CMI Industrial Pty Ltd (in liquidation); Byrne & Ors v CMI Limited [2015] QSC 96 addressed this point.

In this matter, liquidators and receivers were appointed and during the receivership the receivers continued to operate the businesses of the company, purchase additional inventory and generated a trading profit as a result.

A supplier (CMI Limited) also held a charge over the assets of the company, although it was not the appointer of the receivers. CMI Limited claimed that the trading profits made by the receivers should be paid to it in accordance with its charge. The liquidators contended that the receivers’ trading profits should be paid to priority creditors under s. 433 of the Act.

In relation to circulating security interests’ s. 433(3) of the Act provides that the receiver “…must pay, out of the property coming into his, her or its hands, the following debts in priority to any claim for principal or interest in respect of the debentures…”

The liquidators considered that the receivers’ obligation to pay priority creditors under s. 433 was ongoing and applied to all property “coming into” the receivers’ hands, including property acquired after the date of the receivers’ appointment.

The Supreme Court of Queensland rejected the liquidators’ proposition and held that the priority under s. 433 related to the date of the receiver’s appointment and operated in respect of assets “coming into” the receivers’ hands at the date of the receivers’ appointment.

Accordingly, s. 433 did not confer any statutory entitlement on priority creditors in respect of trading profits made by receivers after the date of their appointment, as the profit was not an asset identifiable at the date of the appointment of the receivers. The source of funds available to meet priority creditors extends only to those assets in existence at the date of the appointment of the receiver.

As a result of this decision, secured creditors will have greater comfort knowing that they can be paid from the proceeds of post appointment profitable trading, without those proceeds being eroded by priority creditor claims.

Increased ATO recovery action and hidden issues for directors

Throughout this year we have seen an increase in activity emerging from the ATO in pursuing winding up action against small business debtors. This increased activity should be a warning to company directors to be vigilant when paying their company’s tax.

We know many small businesses struggle to keep up with the payment of key suppliers and have a tendency to leave the ATO unpaid. However, that debt ultimately must be repaid and when negotiating a payment arrangement with the ATO there are some important things to consider.

Firstly, the directors must satisfy themselves that the plan being put to the ATO is achievable. We regularly see evidence of plans being promoted to the ATO that are promoted as being what the ATO want, rather than what the company can afford. These plans almost always lead to a further default occurring and the problem escalating.

When a solvency crisis arises as a result of ATO arrears, we recommend that directors ask themselves what changes can happen in their business that will result in improved cash flow sufficient to enable a repayment plan to the ATO to be achieved. If the arrangement is to be supported by other borrowings, ensure consideration is made for the repayment requirements to the new lender, or if the arrangement is supported by a business restructuring, what certainty is there of its success and what are the expected cash flow timings. If an ATO repayment plan is unsupported by this sort of analysis, then the plan is likely to be a means by which the ultimate failure of the company is delayed, not averted.

In these circumstances, there is further danger for directors to consider. In the event of the subsequent failure of the company, directors may find themselves in further hot water as a result of their failed repayment plan. Liquidators, when appointed, often seek to recover money paid to the ATO under a payment arrangement at a time when the company was insolvent as an unfair preference. Should this happen, directors can find themselves exposed to personal liability pursuant to a statutory indemnity in favour of the ATO (s. 588FGA of the Act). In this way the company’s liability to tax can ultimately lead to director personal liability to the ATO (a situation far worse than may have been the case if the company had been liquidated when the solvency crisis first arose).

Therefore the rule is, if in arrears to the ATO and making a repayment plan, make sure that it is a demonstrated viable, achievable and realistic plan. If the ATO does not accept the plan that is put, then the solvency crisis facing the company becomes an insolvency event that would require the appointment of an external administrator. There seems to be little to be gained, and potentially much to be lost, by promoting non-viable payment plans to the ATO that merely delay rather than avert the ultimate failure of the business.