How to avoid a voluntary administration of your company (for small or medium-sized enterprises)

Summary

We have already discussed how to prepare for a voluntary administration, and here we set out the steps you need to take to avoid a voluntary administration in the first place. In short:

• Voluntary administration is only a live option for directors where the company is insolvent or likely to become so. Get your accounting file (on Xero or MYOB) in order so that you know whether you are in that situation;
• Avoidance is about quickly implementing good business practices – usually aggressive downsizing and addressing the root causes of business problems;
• Once on the brink of insolvency, voluntary administration becomes a live option. But the loss of control to someone with no incentive to turnaround the business is a big risk to take if you are serious about engineering a restructure;
• Directors need to seek professional advice on whether a pre-pack insolvency arrangement is viable instead of a voluntary administration;
• Voluntary administration is a ‘Hail Mary’ – something to consider when all other options are exhausted. It protects directors and creates a short moratorium on legal action, but has low chances of success.

A recap on voluntary administration

When the directors of a company come to the conclusion that the company is insolvent, or is likely to become insolvent, they have the option to enter into voluntary administration.  This involves an independent, suitably qualified individual taking control of the business from directors. Their goal (in theory) is to save the company. If that cannot be achieved, they aim to reach compromise – a Deed of Company Arrangement (DOCA) – with creditors.

During the voluntary administration, creditors cannot pursue claims against the company and they are unable to call in personal guarantees pledged by directors either.

It is important to note that voluntary administration is rarely forced upon directors, usually only in cases of appointment by a liquidator or a secured creditor. A formal insolvency appointment is sometimes mandated by law – including the requirement not to trade whilst insolvent.

The success rates for voluntary administration are abysmal – less than 1 percent of insolvent companies utilise voluntary administrations and end up surviving. Why is this? Some insolvency practitioners will claim this is because voluntary administration usually occurs when a business is already beyond redemption. However, there are central features of voluntary administration that point to its ineffectiveness:

• Director loss of control. Directors have the drive to keep the business going – and not just for financial reasons. For most small to medium-sized enterprises (SMEs), the director’s business is their passion. The voluntary administrator has no such drive.
• The voluntary administrator is on an hourly rate and is paid no matter what the outcome of the voluntary administration. Should we expect anything less than the failure of most voluntary administrations?

For more information see: The Complete Guide to Voluntary Administration

Factors which may lead to insolvency

Given the poor success rates of voluntary administration, the likelihood is that the business will end up liquidated. What can directors do to avoid this scenario? The key is avoiding insolvency. Insolvency is defined in section 95A of the Corporations Act 2001 as the inability to pay debts as they become due and payable.

Whether a company is in a state of insolvency is a holistic question, depending on the facts of the case. In ASIC v Plymin & Ors (2003) 46 ASCR 126, the Supreme Court of Victoria set out a range of key indicators for insolvency. Important indicators included continuing losses, overdue taxes, a poor relationship with the bank, inability to raise equity, unpaid creditors and judgments or warrants issued against the company.

But these are indicators that all apply after a business is already in difficulty. What are some of the fundamental contributors to insolvency to look out for? While it depends on the industry and business in question, some of the key contributors include:

• Poor bookkeeping. It is common for directors of SMEs who are devoted to the day-to-day running of the business itself to fall behind with their financial recordkeeping. This is a sure-fire way for debts – particularly tax debts – to get out of hand;
• Poor cost accounting. This is related, but distinct, from the last point. It is common for directors with poor bookkeeping practices to lose track of the real cost of their goods and services which can lead to consistent under-pricing;
• ‘Overtrading’. Often SMEs try and grow too quickly. They take on too much work, requiring extra investment in capacity where there is insufficient cash to fund it.

None of those contributors are decisive, however. In this author’s view, the most common proximate cause of insolvency in SMEs is ‘ostrich syndrome’. Business owners are often embarrassed by our own deficiencies, and instead of facing the problems head on as they arise, we hide from them.

There is also a vicious cycle for businesses in financial difficulty.  At the point of insolvency, directors often spend most of their time putting out fires (working in the business not on the business). And in doing so they may lose sight of whether their pricing, employee retention and overall strategy continues to be viable.

Avoiding getting to the point of insolvency

While there are some mechanisms available to a business to help them survive if they do reach the point of insolvency (see our discussion of the safe harbour below), unless the fundamentals are in place, they only delay the inevitable. Ultimately, directors have to take early action to get their business back on track. Every company in financial difficulty needs to:

• Get early strategic business advice. This can be difficult for SMEs – there may be few advisers who can assist. The business’s usual accountant may be too busy to provide this kind of advice. A bespoke approach to achieve a better outcome is essential;
• Get the bookkeeping in order. Get a complete write-up through an accounting software package such as MYOB or Xero, to see what figures you are working with. This will also be essential information for the Australian Tax Office (ATO) if applying for any financial support they have available during the COVID-19 pandemic;
• Slash expenses. All non-essential expenses need to be cut;
• In accordance with employment laws, terminate under-performing and non-performing employees. When your business is in difficulty, you cannot afford for your time and money to be sucked up by bad employees;
• Don’t forget the income side of the equation. Under the Coronavirus Economic Response Act, creditors will not be able to issue statutory demands for debts less than $20,000 and the compliance dates for statutory demands will change from 21 days to 6 months. This means that your chances of recovering outstanding debts have dropped dramatically. Consequently, you should consider taking your payment terms up a notch, to allow for ending a supplier’s contract soon after non-payment;
• Don’t wait to pivot on strategy. While the business is on the brink of insolvency, you may need to make some bold moves. If you see high-value opportunities you need to take them as soon as possible.

Once on the brink of insolvency, is voluntary administration the only option?

Recall that directors aren’t required to choose voluntary administration. If the business is insolvent or likely to become insolvent, the directors need to make a decision as to whether an administration appointment is the best step for them. There is a misunderstanding by some directors that being insolvent requires going into voluntary administration or liquidation. This is not necessarily true. The ‘safe harbour’ applies to mean that under some circumstances, insolvent businesses can continue to trade and re-structure without directors being personally liable for insolvent trading under the Corporations Act 2001.

The safe harbour under section 588GA of the Corporations Act 2001, means that directors are not personally liable for allowing insolvent trading where they “start to develop a course of action” with the purposes of turning around the business.

Directors should consider the possibility of using this mechanism to implement a ‘pre-pack insolvency arrangement’ (‘pre-pack’). This is a restructure whereby the business of one company is transferred for commercial consideration to a related entity.  Note that this option requires professional advice to ensure that no illegal phoenix activity is occurring. Transferring assets out of an insolvent company for less than market value may result in legal action from the incoming liquidator or from regulators. This type of methodology needs a business that is viable long-term and also has a low asset value on its balance sheet.

For more information see What you need to know before you pre-pack (to avoid phoenix activity).

Is voluntary administration ever a good idea?

In some cases, a pre-pack will not be appropriate for an insolvent business: It may not be possible to restructure while avoiding illegal phoenix activity. For example, it may not be possible for the company’s assets to be purchased for fair value. In such a case, voluntary administration might be the last ‘Hail Mary’ to have some possibility of achieving a reasonable DOCA and continuing to trade.

In other cases, directors might feel that liquidation is inevitable, and desire voluntary administration in order to get their affairs in order and stall the liquidation as long as possible. During the voluntary administration, any personal guarantees directors have made for company loans cannot be enforced.

Key takeaways

• It is worth avoiding voluntary administration if you possibly can – especially if you are the director of a SME;
• The first step to avoiding voluntary administration is avoiding insolvency itself. The key message here is: don’t be an ostrich. When things start going off-track, take a deep breath and seek professional advice to try and turn things around;
• Once insolvency is on the horizon, voluntary administration might still be avoided. You can seek professional advice on utilising the ‘safe harbour’ in the Corporations Act 2001 in order to legally restructure your business with a ‘pre-pack’;
• There may be some cases where all other options are inappropriate, and you should appoint a voluntary administrator.