Australian small-to-medium businesses (SMEs) have been put into a debt hibernation cycle by the government (via the COVID-19 safe harbour). The announcement that Virgin Australia (airline) has gone into voluntary administration is raising the question for many directors: Will I have to go into voluntary administration once the COVID-19 safe harbour ends? And how can I prepare for this possibility? Here we set out, step-by-step, how you should prepare for the possibility of voluntary administration. The steps you should take are as follows:
- Conduct a preliminary assessment of the books;
- Establish insolvency and commission an independent, professional, solvency review;
- Work out your strategy (turnaround or terminate);
- Work out your potential legal liability from a liquidation scenario;
- Where absolutely necessary, actually appoint the voluntary administrator.
Estimated reading time: 7 minutes
Preliminary assessment of the Books
In voluntary administration, an independent and qualified insolvency accountant (the ‘voluntary administrator’) takes control of the company with the goal of trying to save it, or if that isn’t possible, obtaining the best return for creditors.
Directors can consider the appointment of a voluntary administrator where they consider that the company is insolvent or likely to become insolvent. Note: a voluntary administrator may also be appointed, on occasion, by a liquidator or secured creditor. The alternative is a voluntary liquidation (initiated by creditors) or a restructure through the safe harbour from insolvent trading.
Before directors can make decision about a voluntary administration, they should properly assess the accounting books (MYOB, Xero, etc). Only by doing this can a director know just how much trouble the company is in, and whether an independent ‘solvency review’ is necessary. When doing this analysis, directors should consider:
- The state of the bookkeeping. Sometimes directors neglect to keep their books-up-to-date and this, in itself, can be a significant factor leading to insolvency. If your accounting is a little untidy – don’t despair, but now is the time to get on top of it. Track down any missing invoices or receipts and instruct your bookkeeper to reconcile your accounts to date;
- Is your current ratio (current assets/current liabilities) greater than 1? That is, do you have enough cash to cover your most pressing debts? To understand this, you’ll need to have your accounts reconciled and a correctly aged receivable and payable ledger;
- Unpaid creditors. Take particular note of whether you can continue to meet employee entitlements. Note also, whether any statutory demands for payment of debt have been made. Under section 459C (2) of the Corporations Act 2001 (Cth), a failure to comply can be a shortcut to insolvency (note, however, that the payment period and minimum amounts have been temporarily relaxed due to COVID-19);
- Tax debts. You need to work out accurately what your tax debts are. Directors should consider negotiating payment terms for any existing debts with the Australian Tax Office (ATO), in order to defer insolvency. Directors need to be particularly careful if issued with a Director Penalty Notice (DPN) from the ATO. The issuing of this notice means that the director becomes personally liable for the tax debt if not paid within 21 days;
- Review title to assets. Which entity in a corporate group owns the core assets of the company? This will determine which assets are at risk in the case of insolvency and possible liquidation. Any restructuring adviser will take a keen interest in which entities in your business hold title to assets because it may be the key to a restructure.
Establish insolvency and get a professional solvency review
Once you have pored through accounts, what next? You need to work out whether the company is insolvent (or likely to become so). Insolvency matters because if you suspect that your company is or may become insolvent, yet continue to trade and incur debt, you may be breaching your duty to prevent trading whilst insolvent (see section 588G of the Corporations Act 2001). Note that there are exceptions to liability under this section in the form of the ‘safe harbour’. We consider these in more detail below.
So, what exactly is insolvency? Insolvency occurs when a company is unable to pay its debts as they become due and payable. The courts in Australia use what is known as the ‘cash-flow test’ to establish insolvency but will also consider the ‘balance sheet test’ too.
Via the cash-flow test, the court looks at:
- The company’s existing debts;
- Whether the company’s debts are payable in the near future;
- The date each debt will be due for payment;
- The company’s present and expected cash resources; and
- The dates any company income will be received.
Taking into these factors, an overall judgement must be made: Is the company suffering from a ‘temporary lack of liquidity’ or a ‘chronic shortage of working capital’? Only in the latter case is the company insolvent. Justice Owen in The Bell Group Limited (In Liquidation) v Westpac Banking Corporation [No.9] (2008) WASC 239 describes the threshold as “insurmountable endemic illiquidity”. Basically, is the business past “the point of no return”?
In many cases, individual directors won’t be able to tell if the company is solvent or insolvent. For this reason, it is essential that an independent accounting professional is consulted to conduct a solvency review and make a determination.
Work out your strategy
Depending on the outcome of the solvency review, directors need to consider what their strategy is. While voluntary administration is an option in the case of insolvency or likely insolvency, it is not compulsory. And in many cases – it’s a bad idea. In this author’s estimate, about 1 per cent of insolvent companies use voluntary administration to achieve a successful outcome: i.e., a business that continues to successfully trade after getting creditor agreement to a ‘Deed of Company Arrangement’ (‘DOCA’).
In most cases, voluntary administration is a ‘glorified liquidation’: the end result is the same as a regular liquidation – except the business is all the poorer due to the costs. For more information, read our article: What are the success rates of voluntary administration?
Another option for directors to consider is utilising the safe harbour to restructure the company. Under section 588GA of the Corporations Act 2001 a director will not be liable for insolvent trading where developing a “course of action that is reasonably likely to lead to a better outcome for the company”, and debt is incurred in the process. This means you have time to come up with a restructuring plan.
A restructuring plan might be achieved through a ‘pre-pack insolvency arrangement’ (‘pre-pack’). This may include:
- During the period of COVID-19 economic uncertainty, remember that there is significant government support for business lending that you may be able to access;
- Restructuring or changing your company’s activities.
What directors should keep in mind is that a pre-pack insolvency isn’t an easy option and that if it is done incorrectly it will result in an accusation that the directors have engaged in phoenix activity (and possible legal action). Careful due diligence and appropriate professional advice should be obtained to ensure that a pre-pack insolvency is feasible as a restructuring technique.
For more information see: What you need to know before you pre-pack (to avoid phoenix activity)
Note also that there is a new temporary safe harbour in response to COVID-19, under the Coronavirus Economic Response Package Omnibus Act 2020. This holds that directors will not be personally liable for insolvent trading where they meet the following conditions:
- The debt is incurred in the ordinary course of business;
- The debt is incurred in the six-month period from when the law comes into effect;
- The debt is incurred before the appointment of the voluntary administrator or liquidator.
Is a pre-pack, or some other informal option for keeping the business alive, always the best plan? No. Sometimes voluntary administration makes sense.
This might be the case, for example, where:
- A debt deferral strategy is not working, and the company is unable to access rescue finance. If your only available loans are from ‘fools, friends or family’, you may need to decide whether the business is truly viable;
- The business is hopelessly, chronically, insolvent;
- Where a restructure by purchasing assets at market value (a requirement in order to avoid illegal phoenix activity), cannot be executed – for example when there is a secured creditor that objects.
Work out your potential legal liability
Once it has been decided that voluntary administration is the best option, directors then need to consider their potential liability. If the voluntary administration ends up in liquidation (as is common), there are a range of legal risks for directors. Liquidators may be able to pursue directors for:
- Loan accounts. If directors have drawn down on the company via a ‘loan account’ (i.e. not via a taxed salary), then a liquidator can pursue this against the director;
- Unfair Preference claims. These occur where a creditor has received payment (or another advantageous transaction) for something they are owed, giving them an advantage over other creditors. These can be ‘clawed back’ by a liquidator where they were received by a creditor who knew, or ought to have known, that the company was insolvent;
- Uncommercial transactions. These occur where it may be expected that a reasonable person in the company’s circumstances would not have entered into the transaction, having regard to its benefits/detriments. However, insolvency must be proved at the time of the transaction by the liquidator.
- Unreasonable director related transactions. These occur when a director or close company associate enters into a transaction where a reasonable person in the director/associate’s circumstances would not have entered into the transaction, having regard to its benefits/detriments. Insolvency need not be proved.
- Creditor defeating disposition (‘illegal phoenix activity’). This occurs when there has been 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.” This is a new cause of action and you’ll need professional advice on this because there are no court cases to date that deal with it.
Actually appoint the voluntary administrator
Once an individual director has determined that they wish to appoint a voluntary administrator, they need to:
- Seek agreement of a suitable qualified individual to be appointed voluntary administrator;
- Convene a meeting of directors to pass a resolution that the company is insolvent, or likely to become so;
- As a group, appoint the voluntary administrator.
While the voluntary administrator is in place, directors will have no control over the company. However, they do have a duty to co-operate with the voluntary administrator. The directors must:
- Advise the voluntary administrator where company property is;
- Hand over the company’s books and records;
- Advise the voluntary administrator on the whereabouts of other records;
- Provide a written report about the company’s circumstances within five business days of appointment;
- Meet with the voluntary administrator, as required, to help with inquiries.
For more information on the role of directors during voluntary administration, see: Insolvency: A guide for directors.
- If you are a director, don’t take the appointment of a voluntary administrator lightly: Most voluntary administrations end up in the liquidation of the company;
- The decision should follow a structured process. Begin with a preliminary assessment of your own accounting records. Then, if necessary, commission a solvency review to determine if the company is insolvent or likely to become insolvent;
- If insolvent, or likely to become insolvent, you should still consider other options that may be available such as a ‘pre-pack insolvency’;
- If a voluntary administration is appropriate, you should consider the realistic likelihood of liquidation and what your legal liability may be;
- Once the voluntary administrator is appointed, ensure that you comply with your legal obligations to support the voluntary administrator.