What do the recent Insolvency Reforms mean?
Josh Frydenberg, the Federal Treasurer for Australia, has announced a new restructuring regime for struggling small to medium enterprises (SMEs) which adopts a ‘debtor-in-possession’ model for companies owing less than $1 million.
Given that the legislation is yet to be released, we don’t intend to comment in great detail. In this article, the C&D Restructure and Taxation Advisory team is going to break down what we do know about the changes, from the perspective of an insolvency advisor.
What sparked the changes?
COVID-19 has unveiled some considerable flaws within existing laws and processes. Insolvency laws require government attention due to public interest elements and the inherently unprofitable nature of insolvency administration. This is evident when looking at the large number of businesses that have failed as a consequence of COVID-19 leaving no remaining assets but many unpaid creditors and employees.
That said, the proposed reforms likely won’t save many SMEs that were insolvent before COVID-19. The present reforms don’t address the reality that many businesses will have nothing left up their sleeve to fund their restructuring or liquidation, and no new insolvency procedure that relies upon professional input will fix that.
Why should the government be more accountable in terms of Insolvency and Restructuring?
The need for an effective insolvency law is not in question. That role of government is needed in particular because Australia’s economy relies heavily on SMEs. Consequently, its insolvency numbers come primarily from that sector. The figures show that most businesses entering liquidation have remaining assets of under $50,000. The system does not adequately deal with these types of businesses – there are not enough funds remaining to pay anyone to assess whether or not they can be saved, or even to wind them up formally. They are, for a lack of a better phrase, “too poor to go broke”.
These figures explain why in 92% of all liquidations, the estimated return to creditors is nil, nada. In just 4% of cases is the estimated return of over 11c on the dollar. Leaving only 4% of all liquidations with an estimate including 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.
The requirement that liquidators attend to these matters, even for no fee, was ceased by the government in 2017. Liquidators should expect payment. If not, then this may mean fewer ‘assetless’ companies liquidated. The inevitable process is that someone would deregister them with no examination of their dealings. The government itself should assume (or at least fund) a public interest role. Creditors receive nothing from over 90% of insolvencies, and not because insolvency practitioners get 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? The answer is in the 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 in the public interest, so we believe the public should pay for this. We aim to see an implementation of a government liquidator’s office funded to do the work or significantly expanding the Assetless Administration Fund to pay for assetless administrations.
The new regime
The big news is that the government is proposing a new restructuring mechanism for SMEs to deal with 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’ (DIP) model. The legislation enacting this new regime is to be released soon with a view to the new law commencing on the 1st of January 2021. For those businesses which do not qualify for the new process, a more streamlined liquidation process is also proposed.
Who is eligible?
There are several elements announced which include eligible companies and are viewable on the official government website.
There are many issues to be resolved about the finer details, of which at this stage, we mention only two. Employee entitlements that are ‘due and payable’ must have been paid in full before creditors vote on the plan. We anticipate that will be a problem for many SMEs in light of the extent of non-compliance in specific 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 appropriately disclosed its affairs.
C&D Restructure: Our Thoughts on Australian Insolvency Reforms 2020
Based on the information released, C&D Restructure Insolvency Advisors have put together some comments based on the following headings.
Debtor In Possession
DIP allows the debtor to remain in control of the business throughout the restructuring process. Given that business owners can remain, DIP regimes can 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. DIP aims to change this.
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 the 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.
We think that a DIP model is worth pursuing, but safeguards will need to be implemented 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. Besides, international guidance on SME insolvency emphasises the need for government or judicial oversight and regulation.
The Voluntary Administration regime
Even before the COVID-19 crisis, there were concerns that the current voluntary administration regime, introduced in the early 1990s, had become too expensive for many businesses and was not appropriate for most small businesses in turmoil.
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 due to the time needed for the independent administrator to assess the business, to investigate, 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. Dissenting creditors often challenge matters in complex court processes, which might naturally encourage administrators to err on the side of caution by including more detail into their reports, avoiding criticism for leaving out material information.
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 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 be an option to transition from the new procedure into a VA or streamlined liquidation process.
C&D Restructure Thinks Insolvency Reforms Could be of Some Values to SMEs
Subject to some final comments when the legislation details are released, we see the reforms to be of value for some, but not all businesses struggling through the economic fallout from COVID-19. The carve-outs to the new regime will need careful planning. The focus needs to be on maintaining a proper balance between the needs of the debtor and its creditors. Overall, there is a 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 critical.
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, we will likewise have an insolvency system that treats business failure in the same constructive way.
There’s a clear 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 an SBRP if it means the bank will enforce the guarantee over their home, and merely including such guarantees within the 20 business days, the initial moratorium isn’t much comfort.
We don’t point this out to argue 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.
We don’t forget 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, the law continues to require extensive communication and reporting to them. That communication and the technology used should be limited to minimise the cost.
Creditors need to look after their 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 that the reforms will add much, if anything, to the recoupment of creditors’ losses. Not only 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 on a 1c dividend is still only 2c.
So, what do the reforms not address?
C&D Restructure opened this article with a broader perspective of what we need beyond that of the proposed reforms. We have argued that any insolvency system needs external financial support -especially in a developed country like Australia. While there is a government trustee in bankruptcy, to administer the 85% of bankruptcies that have no remaining money 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’re paid from any remaining assets of the insolvent business, in priority to any payments 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 insolvency requires professional work that does not benefit creditor returns. It also acknowledges that refinement is required according to the type of business involved, and circumstances of the insolvency. One-size-fits all is no longer appropriate.
Merely reducing the expenses in the ways proposed will still not achieve any purpose if there are minimal to no remaining funds. 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, then how 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 straightforward 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.
While the focus of the reforms is on the rescue for 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. You can draw parallels 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 which we don’t address at this stage, including as to the oversight and regulation of what will be a significant change in insolvency administration and practice in Australia.