The fine line between pre-pack insolvency arrangements and phoenix transactions
Below is a recording of a seminar given to lawyers in 2014 to explain the legal differences between pre-pack insolvency arrangements and phoenix transactions. The objective of the seminar was to educate legal practitioners about pre-pack insolvency arrangements and phoenix transactions. This seminar is useful for professional advisers who want to understand how to implement informal restructure of small-to-medium-sized businesses without being accused of phoenix activity.
What is a pre-pack insolvency arrangement?
Pre-pack insolvency arrangements (pre-packs) are still relatively unorthodox in Australia but are implemented regularly in the UK. If properly planned, pre-packs are legal and allow a business to be rescued through a quick transfer of the assets of the insolvent company.
In a pre-pack, the transfer of the business assets is negotiated prior to the appointment of an administrator or liquidator over the insolvent company. The elements of a successful pre-pack are:
- An insolvent company (Oldco);
- The transfer of Oldco’s assets for commercial consideration to a related entity (Newco); and
- A result that is justifiable as commercial to creditors, employees and other stakeholders.
Is a pre-pack difficult to undertake?
The answer is generally, yes.
The valuation of the business assets of the insolvent company is likely to be difficult. By its very nature, an insolvent company is unlikely to have any goodwill value (who would buy it anyway?) and the valuation of saleable assets on a break-up value could be low. One insolvency firm advocates that the pre-pack asset sale price should be the mid-point of the liquidation (i.e. fire sale) and going concern values of the business assets.
Why would an insolvent company undertake a pre-pack?
A pre-pack sale is generally quick, which can enable the business to continue trading through Newco in a liquidation scenario. Existing employees may also be retained by the Newco and the goodwill of the business may be preserved.
The costs of voluntary administration can be substantial and in some cases may exceed the value of the goodwill of the business. In such cases, it may be worth considering whether a pre-pack will increase the returns for creditors by reducing the professional costs of a voluntary administration process and also preserve the goodwill value of a business. Voluntary administrations are generally looked at pessimistically by the market. It is also possible to implement a pre-pack whilst in a safe harbour informal restructure.
What is phoenix activity?
It is important to distinguish between a legitimate pre-pack and what is commonly referred to as “phoenix activity”.
Phoenix transactions occur where there is:
- An insolvent company (Oldco);
- The transfer of Oldco’s assets for inadequate consideration to a related entity (Newco); and
- The result is detrimental for creditors, employees and other stakeholders as they receive less than what they would have received from a voluntary administration or liquidation scenario.
Phoenix activity is illegal and directors and professional advisers involved may be liable for civil and criminal penalties under the Corporations Act.
Another methodology of phoenix activity is to use the liquidation of successive payroll entities to retain PAYG and other taxes rather than remit these monies to the ATO.
Who pursues directors for phoenix activity?
- Liquidators: Commencing claims for uncommercial transactions, insolvent trading and unreasonable director-related transactions against directors and their associates
- ASIC: Taking action against directors for breaches of duties, appointing their own liquidators
- ATO: Appointing liquidators and funding liquidators to take actions
- Prosecutors: Accepting prosecution briefs where there is an element of dishonesty and taking action in the criminal courts
- Fair Entitlements Guarantee, Department of Employment: Taking action against negligent liquidators and funding action by diligent liquidators
What is the direction of policy?
There are no policy proposals to make pre-pack insolvency arrangements illegal being considered by the Federal Government.
In 2017 and 2018 The Federal Government has announced that it was going to get tough on phoenix activity (Ministerial announcement, 16 August 2018, “Legislation to combat illegal phoenix activity released for consultation”).
The Federal Government faces a quandary, however. Because to “get tough” on phoenix activity it would need to both fund significant investigations through liquidators and also issue more draconian measures than Australian small business will swallow. For example, the government has stepped back on a policy to require all businesses in Australia to implement one touch payroll. The Federal Government has also not taken any steps to increase the funding of ASIC and liquidators to more thoroughly police this area.
To learn more about phoenix transactions read our article: What is phoenix activity?