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Adopting a business rescue culture

Australia has seen significant and long overdue positive legislative changes in 2017 and 2018 intended to encourage a business’ survival rather than costly, and often unnecessary, insolvency appointments.  

Adopting a business rescue culture
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  • Eddie Griffith
  • April 20, 2018
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Launched in December 2015, the National Innovation and Science Agenda seeks to update Australia’s insolvency laws and encourage more Australian businesses to implement corrective measures when faced with financial uncertainty and try to turn their business around rather than immediately placing their business into voluntary administration or liquidation.

There is always a period where it is difficult to establish whether a company is trading solvently or insolvently. This is often referred to as the ‘twilight zone’ and the problem arises as the precise date of insolvency is often only clear in hindsight.

Under section 588G of the Corporations Act 2001, company directors have a duty to prevent insolvent trading and may be held personally liable for debts incurred should trading continue whilst insolvent.

In recent years, many directors may have prematurely placed their company into administration or liquidation for fear of being held personally liable for insolvent trading, with the subsequent negative impact to the economy and society.

The government had been seeking to strike a reasonable balance between the protection of creditors and encouraging directors to be innovative and take greater risks to recover their businesses. The current formal restructuring regimes (for examples the Part 5.3A Voluntary Administration procedure and Schemes of Arrangement) are deemed to be costly and largely inaccessible to Australia’s SME market.

“Australia’s draconian insolvent trading laws have finally been changed to provide greater protection for directors undertaking restructuring,” says Jason Harris, Associate Professor at the UTS Faculty of Law and PhD Student at University of Adelaide. “This should help more businesses avoid unnecessary insolvency appointments.”

Directors' safe harbour protection from insolvent trading

On 11 September 2017, the government's two-staged legislative reform roll-out passed through the Senate. On 18 September 2017 the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill 2017 (“the Bill”) received royal assent and ‘safe harbour’ came into effect the next day.

Safe harbour is intended to encourage entrepreneurs and honest directors; permitting them to retain control of a distressed company provided reasonable steps are being taken to trade out of difficulties. Subject to certain thresholds, directors can place a company into safe harbour and develop strategies to trade out of financial distress.

The bill states that whilst a company is under safe harbour, directors are protected from personal liability arising from insolvent trading. This effectively means additional debt may be incurred by the company provided directors reasonably believe it will result in a better outcome than immediate liquidation. Safe harbour is not an insolvency appointment under the Corporations Act and does not need to be disclosed or made public (with some exceptions for listed entities).

Automatic stay on ipso facto clauses

Ipso facto clauses are contractual provisions that allow one party to terminate or modify the operation of an existing contract upon the occurrence of an insolvency event (such as the appointment of an administrator).

Parties enforcing their contractual rights to terminate upon formal insolvency, destroys the viability and value of a company’s business and assets which a registered liquidator is attempting to realise for the benefit of creditors. The bill introduces an automatic stay on the enforcement of ipso facto clauses in a formal insolvency event.

The new ipso facto provisions will only apply to contracts entered into after 1 July 2018. A useful point to note is that the automatic stay on ipso facto clauses will not apply to contracts entered into prior to 1 July 2018 – even where those contracts are amended after this date and do not include ipso facto clauses.

Entering the safe harbour

In order for directors to obtain safe harbour protection, the company must receive advice from an ‘appropriately qualified professional’ who is able to form the view that enacting safe harbour is reasonably likely to result in a better outcome than immediate liquidation or voluntary administration. In addition, the company must meet the following thresholds:

- fully compliant with its tax reporting obligations (not necessarily paid);

- able to pay employee entitlements, including superannuation;

- has maintained appropriate books and records.

Opportunities for business turnaround

Corporate rescue is the idea that companies in distress can be rescued and that there should exist a flexible legislative based process that can be applied to help turn around or rescue viable businesses.

In the ABS ‘Counts of Australian Businesses’ on actively trading businesses operating at the end of 2016-17, 98 per cent had an annual turnover of less than $2 million. About one-third (34.7 per cent) had a turnover of $50,000 to less than $200,000; a further one-third (33.9 per cent) of businesses had a turnover of $200,000 to less than $2 million. Less than 3 per cent of businesses had an annual turnover of $5 million or more.

On his blog, Australian Insolvency Law, Mr Harris undertakes an analysis of the December 2017 ASIC statistical report and finds that corporate insolvencies exist in two very different universes “that of the large mega insolvencies and restructurings (such as Arrium) where there are large amounts of assets and large numbers of creditors; and that of the small firm with few employees, little assets and few creditors who almost always receive nothing.”

“Australia’s corporate laws have not been supportive of turnaround efforts as they are too focused on assessing blame for financial distress,” says Mr Harris. “This is starting to change with the new safe harbour provisions and new protections against ipso facto clauses in contracts during formal appointments.”

The big question is whether these legislative changes will have a positive impact by making restructuring accessible to the small and medium-sized and family businesses – that which the ABS reported to make up 97 per cent of the Australian economy in 2016-17.

“While some progress has been made in dragging Australia’s draconian insolvency laws into the modern age, with safe harbour and ipso facto protections, there is still too much focus on blame and shame for corporate failure.” says Mr Harris. “We have a long way to go before Australia develops a productive corporate rescue culture.”

The Turnaround Management Association, a global professional body dedicated to corporate renewal that was at the forefront of successfully advocating for these legislative changes is optimistic and believes the “ambition of innovating business cultures to accept that corporate rescue should be contemplated early in a business cycle is achievable in the near to medium term”.

Combating illegal phoenixing

‘Illegal phoenixing’ is the process whereby directors transfer assets out of one company into another (often related) entity. They then leave dormant or declare the original company insolvent, thereby leaving a trail of unpaid employees and creditors, including the Tax Office. This places a heavy burden on the tax payer.

The vast majority of directors operate their companies diligently and honestly, however, the recent increase in illegally phoenixed companies is estimated to cost the Australian economy over $3.2 billion per year.

Phoenix activity has been attributed to multiple causes, from the lack of availability of an accessible legislative restructuring regime for small, medium and family businesses through to dodgy pre-insolvency advisers who prey on distressed business owners. These are identified as being unqualified, uninsured and frequently give fraudulent advice which places assets out of the reach of creditors. These few dishonest operators tarnish an industry where the vast majority of qualified and experienced advisers provide an important professional contribution to the Australian economy.

The ASIC Supervisory Cost Recovery Levy Regulations 2017 became effective on 1 July 2017 and aims to recover ASIC’s costs in regulating auditors, advisers, registered liquidators and security dealers (to name just a few). A whopping $246 million is expected to be recovered by ASIC from this initiative.

ASIC has further determined that it will now take preventative action by way of introducing an anti-phoenix task force. Included in the September 2017 Consultation Paper, is the introduction of Director Identification Numbers, tightened compliance surrounding the issuing of Director Penalty Notices (including GST), establishing a hotline to report illegal activity and extending penalties that apply to capture unscrupulous advisers who assist illegal phoenix operators.

The message is clear – compliance

The government has announced that it will allow the ATO to disclose tax debt information of businesses to registered Credit Reporting Bureaus (CRB) on 21 days’ notice.

While the circumstances and exceptions for disclosure are under consultation and yet to be confirmed through the passage of law, the ATO indicates it will only disclose tax debt information of a business to a CRB if the business has an ABN, tax debt of $10,000 or more overdue by 90 days and is not effectively communicating with the ATO.

At present, it is understood that flexibility will be afforded to the ATO, so this measure can be used in conjunction with targeting illegal phoenix activity.

Accountants and advisers must remain vigilant

If it is discovered that your client’s business is in distress, it is crucial that they seek professional advice early, as this maximises available options. Early intervention can further protect advisers and directors from potential personal liability.

A Turnaround Practitioner's prior experience within an industry is important, however, their experience in making effective and calculated decisions in crisis situations is absolutely paramount. Qualified Turnaround Practitioners are trained in operational restructuring and turnaround, which means they are adept at treating the upstream ‘root cause’ of a company’s issues, not just cash flow difficulties (which are usually a symptom of the underlying issues).

Eddie Griffith, partner, TurnAbout 

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