- It is common for creditors to think that liquidation is a useful mechanism for getting their due from a debtor company. The evidence does not support this
- After winding up, and the payment of liquidator remuneration and expenses, usually there are zero cents left for the remaining unsecured creditors
- If a liquidation has been pursued, creditors should be involved in the liquidator remuneration and expense approval process in order to keep costs reasonable
- In light of these low returns, creditors should be realistic about expecting a financial return from a liquidation process
Estimated reading time: 8 minutes
When a debtor company owes money to a creditor, a creditor needs to decide what their best prospect for getting that money back is. One option is for a creditor to apply to the court seeking the winding up of the debtor company due to insolvency. After all, if a company is not paying its bills it might be reasonable to conclude that the company is unable to do so. Once wound up, the remaining assets of the company must be distributed to all creditors in accordance with the ‘priority rules’ set in the Corporations Act 2001. Besides the low rate of return (a matter we will return to in a moment), the court process is expensive and requires that the creditor prove the insolvency of the company.
In light of this, a useful option for a creditor before pursuing insolvency is to issue a statutory demand for payment of debt (‘statutory demand’). This demand can be issued where the debt is greater than $2000, and the demand for payment is in a form specified in the Corporations Act 2001 and associated regulations. This is often a cheaper and more efficient method for the creditor to get their debt paid than pursuing a claim in court for ‘judgement debt’. This also has the added advantage that it can be the first step in proving insolvency for the purposes of a court liquidation. Read more about this process here.
If the creditor does not wish to proceed with the court appointed liquidation option another option for pursuing a liquidation is a creditors voluntary liquidation (CVL). If a director forms the opinion that the company is insolvent, and no declaration of solvency can be made, they can convene a meeting of members and resolve to pass a special resolution (75% of members after quorum is needed), to wind the company up. This means creditors are required to pay for a Court application.
Note that, despite its name, it is the members (and effectively, the directors, who convene the meeting of members) and not the creditors, that initiate this type of liquidation. In light of this, this is may be a better liquidation option for creditors who are also a director of the debtor company.
Unsecured creditor prospects in liquidation
In a liquidation, priority for the proceeds of the winding-up goes to secured creditors. Even among secured creditors, some interests, such as a Purchase Money Security Interest will have ‘super-priority’ over other secured interests.
For unsecured creditors, funds are also distributed in order of priority as set out in section 556 of the Corporations Act 2001:
- The costs and expense of the liquidation, including liquidators’ fees;
- Outstanding employee wages and superannuation;
- Outstanding employee leave of absence (including annual leave and long service leave);
- Employee retrenchment pay;
- Remaining unsecured creditors.
Given the order or priority, what are the prospects of the remaining unsecured creditors getting a return?
- In 2017 Australian Securities and Investments Commission (ASIC) data suggests returns to general creditors average 11 cents or less on the dollar in 96% of cases;
- In 2018, prospects of creditors reduced further with 97 per cent of cases resulting in returns of between zero and eleven cents.
These ASIC statistics are somewhat unhelpful because they include outliers (such as 100c returns) that distort the true average.
As such, these (miserable) statistics overstate the prospect of a return for the median creditor. Outcomes are skewed by a few larger businesses leaving more significant pay-outs. In our experience, the expected return for the median unsecured creditor is zero cents on the dollar. As the overwhelming majority of windings up end up in Australia are small-sized and family businesses with a small asset base, it is unsurprising that zero assets are leftover in so many cases.
However, it is not simply the state of the business itself that is resulting in such low returns. It is also clear that substantial liquidators remuneration and expenses are eating up the remaining assets in many cases. For a recent court decision that looked into the practice of excessive liquidator fees, consider Lock, in the matter of Cedenco JV Australia Pty Ltd (in liq) (No 2)  FCA 93. In that case, the Federal Court objected to the liquidator’s rates as unreasonable (for example, $700 per hour for partners), when they were clearly out of step with market rates.
Our intention is not to demonise insolvency practitioners: they perform an important function to recycle business assets and oversee the integrity of this process. Their business model is risky because they are often committed to appointments where they might not be paid in full or at all (assetless companies). What can be criticised is the practice of target billing.
Target billing is where the insolvency practitioner loads up on billing in insolvency administrations that have assets, in order to compensate for assetless jobs. This practice is unfair to the creditors that miss out on dividends because of unreasonable fees.
It is also worth observing that the loss from over-the-top liquidator fees is not just a loss to individual creditors but constitutes a significant loss to taxpayers as well; the Australian Tax Office (ATO) is almost always the largest unsecured creditor and yet they have no priority and so are usually unable to recover unpaid taxes.
The Australian Small Business and Family Enterprise Ombudsman recently launched an inquiry into the effect of insolvency practices on small businesses. You can read more about it here.
Options for creditors to reign in the costs of the liquidation
In response to a perception that insolvency practitioner fees are too high and are having a negative impact on liquidation outcomes, a range of reforms were introduced in 2016, including enhanced powers for creditors to approve liquidator remuneration and expenses and the appointment of a ‘reviewing liquidator’. In the liquidation process, creditors need to consider.
- The remuneration and expenses approval process. In the case of a CVL, remuneration and fees must be approved by the creditors themselves, a committee of inspection or the Court. If fees are not settled by either resolution of creditors or the committee of inspection then they must be set by the Federal or Supreme Court. To read more about the fee approval process see How do liquidators charge fees?
- Appointment of a Reviewing Liquidator. Creditors also have the option of appointing a ‘Reviewing Liquidator’ who is a registered liquidator appointed to review the remuneration and costs charged. There are two mechanisms for appointing a reviewing liquidator:
- by a resolution of creditors. If this occurs, the costs of appointing the reviewing liquidator are added to the costs of liquidation;
- without a resolution, but with the consent of the liquidator. If this occurs, the applicant creditor must bear the costs of appointing the reviewing liquidator.
This Reviewing Liquidator can only look into:
- remuneration approved in the prior six months; and
- costs or expenses incurred during the previous 12-month period.
To learn more about the Reviewing Liquidator process click here. It is worth noting that, as the cost of the Reviewing Liquidator is added to the costs of the liquidation, this can further reduce the pool of money available to unsecured creditors. If the liquidator doesn’t have sufficient funds then the creditors may be called upon to provide an indemnity.
Another option for creditors seeking to reign in excessive liquidator remuneration and expenses is to make a court application. Under section 447A of the Corporations Act 2001, the court has broad powers to make orders as it sees fit in relation to liquidation. This application allows creditors, others with a financial interest and directors apply to the court for an order:
- For a determination in relation to any matter related to the liquidation;
- An order that an individual be replaced as the liquidator;
- Remuneration orders.
As always with court proceedings, this will be an expensive and time-consuming process. This is why creditors aren’t enthusiastic about Court application.
Alternatives to liquidation for creditors
Given the poor prognosis for unsecured creditors, what other options do they have available to them? We already mentioned in the first section of this article that creditors could consider issuing a statutory demand for payment in order to ‘scare’ the debtor company into payment.
Other possible options include:
- Voluntary Administration. This process that is usually initiated by the directors of the company, seeks to arrive at a ‘Deed of Company Arrangement’ (DOCA) by agreement of creditors that will provide them with a better outcome than proceeding directly to liquidation. Note, however, that the rates of return for this process are also dire for unsecured creditors. Through a DOCA, creditors receive, on average, 5-8 cents on the dollar. You can read more about the success rates of voluntary administration here.
- Schemes of arrangement. These relatively uncommon arrangements, regulated under Pt 5.1 of the Corporations Act 2001, are binding, court-approved agreements, allowing for the reorganisation of the rights and liabilities of members and creditors of a company. Note, however, that as this is a court-supervised process involving significant input from the ASIC, it is by no means a cheap or quick option. However, this option is limited to big corporates.
- Informal mechanisms. Another possibility is for creditors to consider negotiating directly with the company without putting them into liquidation. While, in some cases, creditors may appreciate the satisfaction in ‘punishing’ debtors through liquidation, the non-liquidation is likely to lead to a better financial outcome for the creditors. This is ruled out however when creditors don’t have sufficient trust in place.
All-in-all, forcing a liquidation is often not a cost-effective and efficient means for a creditor to get a return on what they are owed. There has been a significant rise in CVLs and a reduction in court-appointed liquidations in recent years. This, perhaps, recognises both the expense in creditors going through the court process, as well as a tendency for existing liquidation processes to benefit the debtor company and liquidators more than creditors. For example, it is likely that directors often use CVL process to avoid their own liability in many cases, such as personal liability for tax debts.
In light of this, it is worth non-director creditors exploring other options, besides liquidation, in order to get the best chance of a return on their debt. Often an informal negotiation process for repayment of the debt may be the best option for creditors. Otherwise, creditors may need to be realistic! Steer clear of bad payers and clients with poor credit to avoid liquidations. Credit insurance is another protection option.