Michael.1
Insolvency and related law and policy, and more

Michael Murray is an Australian author and commentator on corporate and personal insolvency law and related issues, in Australia and internationally. He has a strong law and policy background, is independent of any connections, and his views are his own. He gives no legal advice. 

Fightback! SMEs get a new restructuring tool

The federal Treasurer has announced a new restructuring regime for struggling small to medium enterprises (SMEs)[1] which adopts a ‘debtor-in-possession’ model for companies owing less than $1 million. There is already much comment about the government’s announcement of major changes to Australia’s corporate insolvency laws.  We don’t propose to comment on them in detail – in particular given that the draft legislation is yet to be released – but rather on how the proposed changes address what we have been saying are some deficiencies in our existing insolvency and restructuring laws and processes – ones that politicians and regulators and the private profession often don’t acknowledge. 

That is, Australia needs more government involvement in the operation of its insolvency laws given their public interest elements and the inherently unprofitable nature of insolvency administration.  That is evident in relation to what is expected to be a large number of businesses that have failed as a consequence of COVID-19 leaving no remaining assets but many unpaid creditors and employees. The proposed reforms also likely won’t save many SMEs that were insolvent even before COVID-19 and that have limped through the past six months on a combination of government and creditor support programs. That is, the present reforms don’t address the reality that many businesses will have nothing left in the cupboard to fund their restructuring or liquidation and no new insolvency procedure that necessarily relies upon professional input will fix that.

The need for an effective insolvency law is not in question and need not be explained, save to refer to its universally recognised legal, economic and social purposes of protecting and discharging the debtor, recycling underused capital, providing recourse and accounting for creditors, and enforcing and maintaining business standards, among others.

We have recently argued that these purposes can only be properly met by a greater role being accepted by government to support the structure and operations of the system, insolvency being inherently unprofitable,[2] significant economically and also presenting the potential for illegality.

That role of government is needed in particular because, in common with many other jurisdictions, Australia’s economy relies heavily on SMEs; consequently, its insolvency numbers come largely from that sector. The figures show that most businesses entering liquidation have remaining assets of under $50,000.[3] The system does not adequately deal with those types of businesses – there are not enough funds remaining to pay anyone to assess whether they could be saved, or even to formally wind them up.  They are “too poor to go broke”.

These figures explain why in 92% of liquidations the estimated return to creditors is nil and in only another 4% of cases is the estimated return of over 11c in the dollar. That is, only 4% of all liquidations estimate a meaningful return to creditors. The figures also show that in 17% of company liquidations the liquidator is paid nothing, with a similar proportion of 10% of voluntary administrators paid nothing.[4]

The requirement that liquidators attend to these matters (as ‘Official Liquidators’), even for no fee, was ended by the government in 2017. As the government said, liquidators should expect to be paid. If not, then this may mean fewer assetless companies being liquidated; the inevitable process is that they would simply be deregistered with no examination of their dealings.[5]

Unlike the UK and New Zealand, there is no government agency in Australia to attend to the examination and accounting of failed companies – the Official Receiver and the Official Assignee respectively.  To the extent that liquidators do work for free – to the tune of over $40 million annually,[6] those costs are passed on to the larger collapses with assets – their creditors therefore pay through a process of cross-subsidisation,[7] or, as one judge described, of “swings and roundabouts”.[8]

What the government is doing, implicitly, is trying to reduce the costs of the smaller jobs but, in our view, not by nearly enough. The government itself should assume (or at least pay for) what is fundamentally a public interest role. Creditors receive nothing from over 90% of insolvencies, and not simply because insolvency practitioners are paid for their time, but rather because the companies had no assets and the files had no prospects of recovery. If liquidators aren’t acting to promote creditor interests, then in whose interests are they acting? It is clear, the answer is the in public interest. Investigations into conduct, including phoenixing, and filing reports with ASIC do not serve creditor interests, particularly when creditors would have to pay ASIC to even look at the reports. These actions by liquidators are taken in the public interest, and we believe that the public should pay for this either through a government liquidator’s office funded to do the work or through significantly expanding the Assetless Administration Fund to pay for … assetless administrations.

The new regime

We will come back to that background later, but the big news receiving attention is that the government is proposing a new restructuring mechanism for small to medium enterprises (SMEs) in order to deal with what is expected to be a large number of business collapses that will occur when the current COVID-19 protections end this year.  Significantly, it is a ‘debtor-in-possession’ model which adopts some aspects of the US Chapter 11 bankruptcy process. The legislation enacting this new regime is to be released soon with a view to the new law commencing on 1 January 2021. For those businesses which do not qualify for the new process, a more streamlined liquidation process is also proposed.

Key elements announced include that eligible companies –

  • must have liabilities of less than $1 million
  • will be able to keep trading while they develop a ‘debt restructuring plan’
  • will need to engage a specialist “small business restructuring practitioner” (SBRP) who will help them prepare the plan, certify it to the creditors, and oversee payments once the plan is in place
  • will be protected by a moratorium on unsecured and some secured creditor claims for the period of 20 business days allowed to develop the plan.

Creditors will then have 15 business days to vote on the plan, including the remuneration of the SBRP and a vote of more than 50% in value will be required for the plan’s approval. Related party creditors will be prohibited from voting on the plan.

Directors of SMEs trading on under a plan will presumably also gain the protection of the pre-COVID safe harbour against insolvent trading under s 588GA where the plan is trying to provide a better outcome for the company than an immediate liquidation, and assuming other conditions of that section are met.

There will also be a streamlined liquidation process for companies that cannot be revived by this process.

There are many issues to be resolved about the detail of which at this stage we mention only two. Employee entitlements that are ‘due and payable’ must have been paid in full before the plan is voted on by creditors; we anticipate that will be a problem for many SMEs in light of the extent of non-compliance in certain sectors often reported by the ATO and by the Fair Work Ombudsman.  Also, the details of the SBRP are not explained, save that their experience and qualifications will allow a much lower fee; nevertheless, they have the task of “certifying” whether the business can meet the proposed repayments and that it has properly disclosed its affairs.

We make these comments on the proposed regime under various headings.

Debtor in possession

This proposal is being sold as ‘borrowing the best elements of US Chapter 11 bankruptcy’. The only thing this has in common with US Bankruptcy Code Ch 11 is that it is a ‘debtor-in-possession’ regime. Chapter 11 is a court-driven process where the conduct of the debtor’s business is managed under strict court orders, including over-use of encumbered assets and obtaining new finance. The need for court control comes from the debtor being in control, there is no external monitor or supervising trustee (although the court can appoint an examiner). The committee of unsecured creditors acts as a monitor over the bankruptcy case and has extensive powers, but these are rarely appointed in small business Ch 11 cases.[9]

There are many other debtor in possession regimes around the world, including in Canada (Companies Creditors Arrangements Act 1986) and in the UK (Company Voluntary Arrangements under Pt 1 of the Insolvency Act 1986) but these arrangements involve a registered insolvency practitioner being appointed as a supervisor to represent the creditors’ interests and report back to the court.[10] This new proposed procedure does not clearly state that only a registered company liquidator can take on the role of the small business restructuring practitioner. The success or failure of the procedure will be based on creditor support and having a qualified, experienced and independent supervisor is key.

There has often been resistance to Ch 11 and to its DIP feature in particular.  DIP allows the debtor to remain in control of the business throughout the restructuring process; in contrast, under Australia’s voluntary administration regime, the directors are removed and replaced by an independent administrator.  Given that business owners can remain, DIP regimes are said to prompt business owners to seek assistance earlier, which is vital in any business decline. Australian directors will defer seeking help if they confront the prospect of their immediate removal when they appoint a voluntary administrator.[11]

This is a significant change from our insolvency law of the past 150 years which has treated company management as not only having been responsible for the decline of the business and therefore not capable of addressing the reasons for its failure, but also as likely having engaged in misconduct in the process.  Registered company liquidators, independent of the company, are therefore appointed to manage the process and to deal directly with the creditors and to investigate any corporate misconduct.

The consistent argument, in Australia at least, has been that a DIP model leaves those responsible for the company’s financial problems in charge – the ‘fox in the henhouse’ type argument. However, to base an insolvency system on an assumption that every corporate failure is necessarily management’s fault is too simplistic, more so that breaches of the law must have occurred, and particularly during a global pandemic and what is the worst recession in decades.

DIP is also seen as more suited to SMEs, given the unique knowledge and involvement of the management in the business, and their ongoing relationships with creditors, suppliers and customers. Removal of the risk of being displaced can reverse what can be a real disincentive for the MSE debtor to seek timely assistance. Also, and significantly, the limited funds available in SME insolvencies can be insufficient to fund the appointment of an insolvency representative, an issue we discuss again below.[12]

We therefore think that a DIP model is worth pursuing, but safeguards will be needed to ensure creditor confidence in the system. In foreign DIP procedures, those safeguards are court control or registered insolvency practitioners as monitors. The current proposal does not appear to involve either of those features. In addition, international guidance on SME insolvency emphasises the need for government or judicial oversight and regulation.[13]

The Voluntary Administration regime

Even before the COVID-19 crisis, there were concerns that the current voluntary administration regime, which was introduced in the early 1990s, had simply become too expensive for many businesses and was not appropriate for most small business failures.[14]

Voluntary administration typically costs at least $30,000-$50,000 on average and even more if a deed of company arrangement (DOCA) is entered into to implement a financial restructuring. That cost is consumed by the time that is needed by the independent administrator to assess the business, and to investigate and communicate and report to creditors, and to report misconduct to ASIC.  Personal liability imposed on the administrator by the law for expenses incurred adds to the legal costs.  Matters are often challenged by dissenting creditors in complex court processes, which might naturally encourage administrators to err on the side of including ever more detail into their reports, lest they be criticised for leaving out material information.

This is not to say that VA is not suitable for restructuring, and in particular for restructuring larger enterprises, and there are many examples of this, including Arrium, Ten Network and Virgin Airlines. VA might still be the best option for some SMEs too that need the particular protections provided in the VA moratorium or that wish to use a DOCA to restructure their company’s finances. The Treasurer’s proposal states that there will an option to transition from the new procedure into a VA or streamlined liquidation process.

Of some value for struggling SMEs

Subject to some final comments, and of course any later comments when the legislation details are released, we see the reforms as likely to be of value for some, but not all, businesses struggling through the economic fallout from COVID-19. Indeed, the carve outs to the new regime will need to be carefully planned. If too many restrictions are imposed in order to stave off phoenix operators then the changes will ring hollow as a claytons’ reform, just as the 67 exceptions to the ipso facto changes in 2018 made them of little use in most restructurings.[15]

Given the expected high numbers, the focus needs to be on maintaining a proper balance between the needs of the debtor itself and its creditors, and overall, the need to maintain confidence in the system.  Having high quality SBRP’s, and clear regulatory guidelines that are transparent to both debtors and creditors, will be key.

The proposals properly move away from a system premised on misconduct or fault. Just as we have a tax system that relies upon taxpayer self-assessment subject to audit and review, so we should likewise have an insolvency system that treats business failure in the same constructive way.

Personal insolvency

What clear omission is the need to consider the relationship between personal and corporate insolvency for SMEs. AFSA statistics reveal that business debtors make up 36% of bankruptcies, 42% of Pt X Personal Insolvency Agreements and even 7% of Pt IX Debt Agreements. The most common form of finance to small business comes from loans supported by related party personal guarantees (usually company directors and their spouses) and by personal credit cards and loans from the business owners. A small business owner is unlikely to volunteer to engage with a SBRP if it means the bank will enforce the guarantee over their home, and merely including such guarantees within the 20 business day initial moratorium isn’t much comfort.

We don’t point this out to argue (as the ASBFEO has done) that director guarantees over the family home should be exempt from enforcement, but rather to note that this will put a dampener on the take-up of this procedure. The idea that this will ‘save’ tens of thousands of businesses from collapse is unrealistic. As we said above, many of these businesses were insolvent before the pandemic.

Creditors

We are not forgetting creditors in this process.  They are the ones that suffer when a business fails and they remain unpaid.  Many of the creditors of small businesses in distress will themselves be small businesses.

Dividend payments to creditors under our current laws are minimal, if at all. We have explained the reasons for this.  Yet, as we have explained, the law continues to require extensive communication and reporting to them. That should be limited and technology used to minimise the cost.

We should also add that creditors need to look after their own interests better, and adjust their credit processes, with security taken and extensions of credit limited.  Harsh as it may be to say, we do not anticipate the reforms will add much more, or any more, to the recoupment of creditors’ losses, whatever the political message might be otherwise. This is not simply because the costs of external administration are too high, but because the companies’ financial position when they enter external administration is beyond redemption.

A 100% increase in a 1c dividend is still only 2c.

What the reforms don’t deal with

So, what do the reforms not address?

We opened this article with a broader perspective of what is needed beyond that of the proposed reforms. We have previously argued that any insolvency system inherently needs external financial support certainly in a developed country like Australia.  While there is a government trustee in bankruptcy, to administer the 85% of bankruptcies that have no remaining moneys to fund the bankruptcy process, there is no government liquidator. Liquidators from private firms are the sole resource to administer our corporate insolvency laws.  They are paid from any remaining assets of the insolvent business, in priority to any payments being made to creditors, and they necessarily operate at a profit.

By shifting the administration of this new SME regime to SBRPs, and reducing the process requirements for restructuring, including the need for investigations, the government is at least acknowledging that the administration of an insolvency requires much professional work that does not benefit creditor returns. It also acknowledges that some refinement is required according to the type of business involved and the circumstances of the insolvency. One-size-fits all is no longer appropriate.[16]

But simply reducing the expenses in the ways proposed will still not achieve any purpose if there are no, or not enough, remaining funds in any event. And this new proposal is not itself a costless innovation. The SBRPs will need to be paid. If a small business operator couldn’t afford a liquidator pre-COVID, why will they be able to afford an SBRP now? Creditors’ voluntary liquidations are often said to cost a minimum of $8,000-$15,000 in a relatively straight-forward matter. Is the government assuming the SBRP will charge much less? If it is, then we also need to question the quality of the service.

Our point is that while the focus of the reforms is on business rescue of potentially viable businesses, inevitably there will be many failures that do not qualify for revival and the reforms gloss over those. What is needed is a government role to take on the assetless companies, that have no hope of paying anyone for their liquidation and devise an ordered process for their accounting and disposal. Some parallel can be drawn with the role of the government Official Trustee in Bankruptcy and with the government official receiver agencies in the UK and New Zealand.

There are other proper roles of government in insolvency to which we have referred but which we don’t address at this stage, pending further information, including as to the oversight and regulation of what will be a significant change in insolvency administration and practice in Australia.[17]

Jason Harris

Professor of Corporate Law, Sydney Law School

www.australianinsolvencylaw.com

02 8627 8157

Michael Murray

www.murrayslegal.com.au

michael@murrayslegal.com.au

0402 248 353

28 September 2020

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[1] Insolvency reforms to support small businesses recovery, 24 September 2020.

[2] Insolvency law failing small business, 6 August 2020 https://www.sydney.edu.au/law/news-and-events/news/2020/08/06/insolvency-law-failing-small-business.html

[3] That is, 78% of companies where a EX01 Sch B Report was filed with ASIC; and note that 58% of companies have less than $10,000 in assets.

[4] See ASIC Report 647 for FY18-19 (released Dec 2019) based on EX01 Sch B reports from IPs (92% by liq’n, only 7% by VA).

[5] Explanatory Memorandum to the Insolvency Law Reform Bill 2015 at [9.137] “As a result of the change, where a person is petitioning the court to wind up a company the person will likely have to provide a guarantee of a minimum amount to the corporate insolvency practitioner in order for the corporate insolvency practitioner to agree to the appointment. This may mean a reduction in the number of assetless companies liquidated as corporate insolvency practitioners would not be expected to commence such administrations without some form of guarantee or where they do not believe they are likely to be remunerated”.

[6] An analysis of official liquidations in Australia, February 2013, A Phillips – necessarily a dated figure.

[7] Explanatory Memorandum to the Insolvency Law Reform Bill 2015 at [9.135].

[8] Young J, “… a liquidator who takes on a non-paying liquidation will be assumed to act in the public interest on the basis of the well-known swings and roundabouts principle”: Re Greater West Insurance Brokers Pty Limited [2001] NSWSC 825.

 

[9] See further, Harris, ‘Restructuring nirvana? Chapter 11 bankruptcy and Australian insolvency reform’ (2015) 16(3) Insolvency Law Bulletin pp. 42-46.

[10] See further, https://australianinsolvencylaw.com/2019/01/07/assessing-va-comparing-outcome-for-business-rescue-laws/

[11] See ASBFEO, Insolvency Practices Inquiry, Final Report, 2020. https://www.asbfeo.gov.au/inquiries/insolvency-practices

[12] See the draft text on a simplified insolvency regime, 3 March 2020, UNCITRAL and an unpublished thesis – To the rescue: An investigation into an effective restructuring regime for Australian micro and small-sized enterprises – by Samantha Pacchiarotta, Maastricht University, 2020.

[13] Ibid.

[14] Productivity Commission, Business Set-up, Transfer and Closure, Report no 75, 30 September 2015; ASBFEO, Insolvency Practices Inquiry, Final Report, 2020.

[15] Harris and Symes, ‘Be careful what you wish for! Evaluating the ipso facto reforms’ (2019) 34 Australian Journal of Corporate Law 84.

[16] Harris, (2014) Should voluntary administration remain a one-size-fits-all procedure? Do we need a fast track system for small business rescues? In S. Griffiths, S. McCracken, A. Wardrop (Eds.), Exploring Tensions in Finance Law: Trans-Tasman Insights, (pp. 101-126). Wellington, New Zealand: Thomson Reuters.

[17] See Insolvency Law Reform: The Role of the State (1999) NZLRev 569, Paul Heath.

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