If you build in an earthquake-prone area, you need to shore up the foundations with soil compaction, gravel or concrete. But sometimes, no matter what you do, liquefaction will occur. The same principle applies to company liquidations. Sometimes, no matter what a director has done to try and avoid a liquidation, it will loom on the horizon as the only option when a business is no longer viable. There is nothing left to do but to get out of the building before it sinks into an oozing puddle. But in that situation, directors still need to know: what things should they take on the way out or avoid doing?
In this article we look at:
- The different types of liquidation;
- The core consequences of liquidation;
- Steps a director can take to either avoid liquidation or lessen its impact;
- Illegal phoenix activity and why it’s a bad idea;
- Positive steps to take when liquidation is inevitable.
Estimated reading time: 6 minutes
What are the different types of liquidation?
What does it meant to be liquidated? In a liquidation, an insolvency professional is appointed to a company with the power to wind it up and ‘realise’ its remaining assets. There are several different types of liquidation in Australia:
- Where the company is no longer viable as it is unable to pay debts as they fall due and payable (i.e. it is ‘insolvent’), directors can initiate a creditors’ voluntary liquidation (CVL). Sometimes this option is pursued, not as a means of ending the business once-and-for-all, but in order to restructure (this can be achieved by utilising ‘safe harbour’ provisions of the Corporations Act 2001);
- Where the company is solvent (and directors can attest to that fact), the more straightforward members voluntary liquidation (MVL) route can be chosen. In an MVL, the liquidator need not be independent of the company and directors have significant control over the process;
- Where a creditor has applied to the court, a compulsory liquidation may occur. Note that in a compulsory liquidation, there is usually a shorter timeframe between the court decision, and the date that the liquidator takes over. In light of this, it provides a shorter timeframe for directors to take any necessary precautions (more about these below), before the appointed liquidator takes over.
What are some of the consequences of liquidation?
The effect of liquidation on the company is clear. Once it is wound up, and the assets liquidated, all that remains is a ‘shell’ that will be de-registered by the Australian Securities & Investments Commission (ASIC) in time. But what are some of the consequences for directors? Liquidation has a range of negative possible consequences for directors including:
- Reputational damage. Unfortunately, there is a stigma that surrounds the term ‘liquidation’. This is not entirely justified – liquidation can happen for many different reasons and does not necessarily mean business failure. However, now that liquidations and the names of directors are published online, the news is more likely to remain accessible and continue to tarnish the name of the director;
- The calling in of director personal guarantees. In the common situation where directors have personally guaranteed debts, at the point of liquidation these are likely to be called in;
- Mortgages on director’s property. Any collateral provided to support a loan to the company is likely to be called in after liquidation (the ‘secured monies’);
- Loan accounts. It is common for directors to draw down on a loan account instead of drawing a salary. This must be properly documented in the company’s accounts. At the point of liquidation, this becomes payable.
- Liquidator action for breach of director duties. If a director has been in breach of their duties (such as the duty to prevent insolvent trading), the liquidator could take legal action against that director- unlikely except in the worst cases;
- Director Penalty Notice (DPN). These are notices sent from the Australian Tax Office (‘ATO’) that can make the director personally liable for some types of tax debt (namely PAYG and Superannuation Guarantee Charge);
- Unreasonable director-related transactions. These are transactions between the company and a director or their associate which are unreasonable. A transaction is defined as ‘unreasonable’, where a reasonable person in the company’s circumstances would not have entered into it, having regard to the benefits and detriments to the company and the interests of the other party to the contract (see section 588FDA of the Corporations Act 2001);
- Director banning. If a director has been involved in at least two companies that have been liquidated in the past seven years paying creditors less than 50 cents in the dollar (i.e. most CVLs), ASIC may disqualify them for up to five years;
- Loss of licences for directors. In Queensland, the director of a construction company will have their licence cancelled on the appointment of a liquidator. For an authorised energy retailer or licensee, the appointment of a liquidator is classed as a ‘retailer of last resort’ event, and can result in the revocation or their authorisation.
What steps can a director take to avoid these consequences?
Sometimes directors can rush into liquidation. Fear of allowing insolvent trading may scare directors into moving for liquidation earlier than they need to. In light of this, it is important that directors consider whether liquidation is truly necessary. This includes:
- Taking early solvency advice to determine whether the company truly is insolvent, or is, perhaps, experiencing a temporary shortage of working capital;
- If solvent, carrying out an MVL rather than a CVL. As there are (usually) no unpaid creditors, this is more of a low-key affair than a CVL;
- Taking advice on carrying out a ‘prepack insolvency arrangement’ (‘prepack’), which results in the liquidation of a company, but allows for the business to endure in another form;
- Seeking professional advice to avoid recovery against directors personally (e.g., moving assets into a discretionary trust).
Directors should not stoop to ‘phoenix activity’
Directors must be careful that, in preparing for a possible liquidation, they do not engage in illegal phoenix activity, or allow someone else to do so on their behalf. Illegal phoenix activity (read more on ASIC) is the transfer of property out of the company before liquidation (for less than market consideration). This is defined as a ‘creditor-defeating disposition’ under the law, and creates a risk of liability for both directors and their accountants or advisors. Other related activities that are prohibited include:
- Destruction of books and records. This may be attempted in order to hinder investigations and hide property and transactions from liquidators;
- Using fake names of directors or using ‘dummy’ directors – that is, directors who act on behalf of a non-director;
- Backdating documents.
As well as the serious legal consequences, directors need to consider the following matters before attempting phoenix activity:
- Phoenix activity is unlikely to work. Austrac will disclose to liquidators all transactions above $10k, and the liquidator has full access to bank accounts. Directors can forget about trying to hide any transactions;
- The ATO’s DPN regime means that a failure to file tax returns can result in personal liability for directors;
- In addition to the liquidators and the ATO, creditors will not hesitate to dob in any conduct they have seen that is improper;
- Even if liquidators have limited funds to pursue directors, the ATO, ASIC and the Fair Entitlements Guarantee (‘FEG’) Scheme will also fund actions to recover assets, or discourage non-compliance and fraud.
Overall, it is clear that attempting phoenix activity will, at the least, be a major source of stress to directors – it’s probably not worth it in the end. A much better approach is to get on with saving the business, rather than fighting running battles with creditors and liquidators that may take years.
It is worth noting, however, that directors should still seek professional advice to protect their interests. There are many changes that could be made to protect director interests that are perfectly within the law.
What to do when liquidation can’t be avoided
So, if phoenix activity is out of the question, what next? If companies are insolvent, directors need to move quickly to:
- Carry out a bookkeeping writeup. This means directors will understand exactly where they stand, and what the returns are likely to be on liquidation. That way, they can plan their next step;
- Consider voluntary administration. In this process, an independent professional is appointed to take control of the business and attempt to work out a compromise with creditors, known as a ‘Deed of Company Agreement’ (or ‘DOCA’). While the success rates of voluntary administration are poor, it does give directors one thing – It delays any possible liquidation, which can be essential for directors to get their affairs in order;
- Negotiate with creditors. Directors may be able to come to an arrangement with creditors so that they do not pursue a personal guarantee or a mortgage they have over director property;
- Seek legal advice. Directors may need to engage experienced counsel to negotiate with the liquidator after appointment. This way, directors may be able to pursue a sensible settlement, rather than litigation. Remember that liquidation moves slowly, so it may result in 1-3 years of investigation and negotiation.
- The negative consequences of liquidation for directors are significant, so this step should not be taken lightly;
- Directors of companies in difficulty need to seek professional advice early to avoid liquidation, especially a compulsory liquidation;
- Illegal phoenix activity is dangerous for directors and their advisors, and may not work anyway;
- When liquidation cannot be avoided, professional advice should be sought to protect directors from liability as much as possible.