Is phoenix activity accounting fraud?

Summary

  • Accounting fraud involves a deliberate deceit that results in a misleading representation or misstatement in financial accounts
  • Phoenix activity, of itself, involves non-payment of debt but not necessarily accounting fraud
  • Company directors should ensure that accurate financial statements and tax returns are lodged, even if engaging in phoenix activity
  • It is possible for directors and officers of companies to be penalised under the law for any accounting fraud committed in conjunction with phoenix activity;
  • If engaged in phoenix activity directors should obtain professional advice to ascertain whether they are protected by the corporate veil or whether a company liquidator, the ASIC or the ATO can make claims against them personally

What is phoenix activity?

There is no universally agreed definition of ‘phoenix activity’ (or ‘phoenixing’, as it is sometimes called) whether in the law or wider commentary. Furthermore, even where there may be agreement on which behaviour counts as phoenix activity, there is often disagreement as to when it is, or should be, considered illegal.

In broad terms, phoenix activity can be understood as the process of creating a ‘new’ business from the ashes of an original, failed one. In some cases, this could be part of a legitimate company restructuring within the bounds of the law. In other cases, it could be illegal, as demonstrated in the following recent statement:

“Illegal phoenix activity occurs where there has been a transfer of assets (often below market value) to a new company, and the old company deliberately liquidated with the intention of defeating the interests of creditors (such as the ATO and employees and suppliers)” – Explanatory Memorandum, Treasury Laws Amendment (Combating Illegal Phoenixing) Bill 2019

There is currently a Bill before the Commonwealth Parliament, the Treasury Laws Amendment (Combating Illegal Phoenixing) Bill 2019 which would introduce new laws forbidding specified phoenix activity. A new concept of a ‘credit-defeating disposition’ would be created and is defined as a:

“disposition of company property for less than its market value (or the best price reasonably obtainable) that has the effect of preventing, hindering or significantly delaying the property becoming available to meet the demands of the company’s creditors in winding-up.”

It will be an offence to engage in reckless conduct which results in prohibited credit-defeating dispositions, and civil penalties will be applicable to individuals who engage in such conduct where a reasonable person would have known it was prohibited.

Why has it taken such a long time for such law changes to be set in motion? The primary reason is the perceived risk that such legal prohibitions would chill legitimate restructuring. As mentioned earlier, ‘re-birthing’ a company does not necessarily involve an intention to defeat the interests of creditors; in some cases it is a legitimate business restructuring activity (such as implementing a ‘scheme of arrangement’). Already the Senate’s Standing Committee for the Scrutiny of Bills Has expressed concern that there is not enough in this Bill to protect businesses with legitimate intentions.

Another area of resistance to regulating phoenix activity, is the fact that policing the area would require a government liquidator and firming investigatory powers being exercised by the Australian Securities and Investments Commission (ASIC). Neither the government, nor private insolvency practitioners have expressed significant interest in changing these roles. Privately appointed liquidators have very little incentive to challenge phoenix activity if there is not a good likelihood of recovery.

In the rest of this article, we take a step back from these proposed reforms, and look at how phoenix activity may breach the existing law. In particular, we are focusing on how phoenix activity may constitute accounting fraud.

If you would like to understand more about phoenix activity you can:

Types of phoenix activity

There have been multiple successive attempts to categorise and classify the different forms of phoenix activity, in the hopes of providing a basis for a legislative definition and regulatory scheme. As outlined above, the recent Phoenix Activity Bill focuses on the dispositions of property that defeat creditors in its definition of illegal phoenix activity. However, it is useful to consider phoenix activity as a broader concept in order to consider how it may fall foul of the law in other ways.

A paper from the Australian Securities Commission in May 1996, ‘Project One: Phoenix Activities and Insolvent Trading’, suggested that phoenix activity can be divided into three categories:

  • Innocent phoenixing: where a struggling business under financial stress tries to legally reinvent itself, leading to practices such as inappropriate bookkeeping, poor financial recording, and mismanagement of cash flow.
  • Occupational hazard: where an operator is forced, coerced, or encouraged into phoenix behavior by virtue of their skillset and/or industry focus, which necessitates the creation of businesses by locking them in to a particular career.
  • Careerist offenders: where individuals or groups deliberately engage in recurrent phoenix activities for the purpose of exploiting the system for personal financial gain.

Building on this, in December 2014 the Phoenix Research Team released the most up to date classification of phoenix activity, called ‘Defining and Profiling Phoenix Activity’ which divided phoenix activity again according to the intentions of the directors and their advisers. They suggested that there were five distinct forms of phoenix activity:

  • Legal phoenix: also known as ‘business rescue’, where directors have no intention to defraud creditors, and saving the business (but not the company) is the best course of action for all stakeholders and the economy in the circumstances.
  • Problematic phoenix: technically legal, where there is no evidence of directors intending to defraud creditors, but the net effect of the phoenixing is not beneficial to creditors or wider society (may involve director/s who have had past business failures).
  • Illegal type 1: where a company was set up with the best intentions, but finds itself in financial difficulty, whether by bad practice or unfortunate circumstances. An intention to defraud creditors is then formed at or immediately before the time of business failure.
  • Illegal type 2: phoenix as a business model, where the company is incorporated and designed for the sole purpose of engaging in personally profitable phoenix activity (i.e. the business was never operated so as to succeed).
  • Complex illegal: phoenix as a business model which also coincides with and occurs alongside more serious crimes perpetrated by the same individuals within the same framework, involving practices such as creating false invoices (e.g. GST fraud), false identities, fictitious transactions, money laundering, visa breaches, and misusing migrant labour.

What is accounting fraud?

Margret and Peck defined accounting fraud in their 2015 book, ‘Fraud in Financial Statements’ as follows:

“Fraud in financial statements is an act of deliberate deceit that results in a misleading representation, material misstatement, or intended exclusion in a business entity’s financial accounts. The deception is committed with the intent to mislead shareholders and other stakeholders about the financial state of the business entity. The fraud may misleadingly relate financial circumstances, or an otherwise non-financial material fact.”

The authors also referred to Cressey’s theory of the fraud triangle which, when simplified, identifies the influences leading to fraud, being opportunity, rationalisation, and pressures. These influences are also likely to affect phoenix operators and shape their choice to engage in phoenix activity.

How is accounting fraud captured in Australian law?

Just as with illegal phoenix activity, there is no one single offence that captures accounting fraud in Australia. Rather, companies, and their directors and officers, have a range of obligations in relation to keeping and presenting financial records and it is a breach of the law, and in some cases, an offence, to dishonestly breach those obligations. For example, under section 286 of the Corporations Act 2001, a company must keep financial records that:

  • Correctly record and explain financial position and performance and
  • Enable fair and true financial statements to be prepared and audited.

Under section 344 of that same Act it is an offence to breach those obligations dishonestly. This dishonesty could be established in various different ways such as through evidence of deliberate destruction of records or evidence that a decision was made not to keep records to avoid detection of an offence.

Is phoenix activity a form of accounting fraud?

The short answer is no. Accounting fraud, as seen in the definition above, is characterised by ‘deliberate deceit’ with the ‘intent to mislead’. Applying this definition to the categories of phoenix activity, it will only definitively catch complex illegal phoenix activity, and may occasionally apply to illegal type 1 and 2.

A more helpful way to think about the relationship between phoenix activity and accounting fraud is that phoenix activity might be carried out in conjunction with fraudulent accounting practices. Phoenix activity in its more serious forms can be facilitated by accounting fraud.

Consider the case of breaching section 344 of the Corporations Act as outlined above: We could imagine a phoenix operator deliberately altering financial records in order to placate creditors until the last moment, thereby allowing the process of avoiding creditors to be less confrontational and drawn out.

It would also be possible for a phoenix operator, engaging in below market value transactions for the transfer of assets, to make misleading representations or material misstatements about the health of the company to creditors in order to quiet any suspicions or concerns.

Understanding how the two concepts, phoenix activity and accounting fraud, are related, and then looking at how accounting fraud is policed and penalised, is an essential step in working out how best to respond to phoenix activity in its ‘illegal’ forms.

What are the legal implications of considering phoenix activity as accounting fraud?

Accounting fraud is a frequently litigated area with strong legislative protections and a universally accepted definition. Whilst it would be an oversimplification to consider phoenix activity ‘as’ accounting fraud, from a policy perspective, it may be useful to consider the ways in which we might treat phoenix activity similarly to how we treat accounting fraud.

The penalties available for accounting fraud can target both the company itself, and the directors responsible, piercing the corporate veil with criminal convictions in the most serious circumstances. The jurisdiction of the Australian Tax Office over these matters means that their plentiful resources of investigation and enforcement mechanisms are available against companies engaging in accounting fraud. If the tax office were to be given a clear mandate over policing phoenix activity, it would likely facilitate more thorough and informed investigation, with a view to consequences such as director disqualification, stopping ‘careerist offenders’ and preventing future phoenix activity.

Making phoenix activity actionable would enable better recourse for creditors, particularly vulnerable, unsecured creditors such as employees, therefore resulting in more justice for all stakeholders and less pressure on the government’s Fair Entitlements Guarantee.

Conclusion

Currently, phoenix activity is not a specific criminal offence, nor is it otherwise specifically forbidden in the law. Although a Bill is currently before the Commonwealth Parliament looking to change that, neither that Bill or the enforcement of the existing law pays sufficient attention to the connection between phoenix activity and accounting fraud.

While phoenix activity does not itself fall into the category of accounting fraud, in many cases it is likely that it happens in conjunction with accounting fraud. If this was better recognised by those enforcing the law, this could be a powerful tool for cracking down on destructive phoenix activity.

Overall, what is needed is a statutory definition of phoenix activity, and an accompanying legislative regime which clearly lays out what is legal and illegal in terms of rebirthing a company, and facilitates recourse for creditors.

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