How to prepare for a voluntary liquidation

How to prepare for a voluntary liquidation (for SMEs)

Summary

In this article, we look at the steps that directors of small to medium-sized enterprises (‘SMEs’) need to consider, before initiating a voluntary liquidation (otherwise known as a ‘voluntary winding-up’). We look at:

  • the purpose of voluntary liquidation;
  • whether appointing a voluntary liquidator is ever a good idea;
  • getting the books in order prior to liquidator appointment;
  • commissioning a professional solvency review;
  • assessing your own legal situation before appointing the voluntary liquidator;
  • what the directors (you) need to do while the liquidation process is being carried out.

Estimated reading time: 9 minutes

Define your objective – terminate business or quarantine debt

The terms ‘liquidation’ and ‘winding up’, just like the terms ‘bankruptcy’, ‘tax office’ and ‘new season of Married at First Sight’, carry a degree of anxiety.  But they shouldn’t. Liquidation, or the ‘winding up’ of a company, can happen for many different reasons: it does not necessarily mean that the business is broken beyond repair. Liquidation has a different impact on a company depending on how, and why, it was initiated. Matters to consider include:

  • Has a winding up petition been filed in court with respect to the company? If so, depending on whether you can fight the petition in court, the company may be wound up and liquidated, whether you like it or not. This is an ‘involuntary’ or ‘compulsory’ liquidation.
  • Is the company financially healthy, but no longer fit-for-purpose, or superfluous for some reason? In this case you may be able to consider a ‘Members’ Voluntary Liquidation’ (‘MVL’).
  • Is the company insolvent, or likely to become insolvent? A company is insolvent when it is unable to pay its debts as they fall due and payable. At this point, voluntary administration, or Creditors’ Voluntary Liquidation (‘CVL’), become possible options.

Let’s consider this third option in greater detail. In voluntary administration, an independent professional is handed the reins by the directors, in an attempt to negotiate a ‘deed of company arrangement’ (‘DOCA’) for the payment of creditors. In a CVL, a liquidator is appointed in order to terminate a company and realise its remaining assets for the benefit of creditors.

The appointment of either the voluntary administrator or liquidator also has the effect of stopping all action for debt recovery from creditors. It is worth noting that while liquidation does end the life of a particular company, it doesn’t necessarily mean the end of the ‘business’, broadly conceived. When a voluntary liquidation is deployed as an element of a pre-pack insolvency arrangement (‘pre-pack’), the substance of the business can survive in another form.  We discuss this possibility in more detail below.

When might voluntary liquidation be a good idea?

If your business is insolvent, or likely to become insolvent, you need to take immediate action. If you don’t take some kind of action, you may be in breach of your duty as a director to prevent insolvent trading of the company (see section 588G of the Corporations Act 2001). What are the possible actions you might take?

  • You could sell business assets to third parties to pay down debt;
  • You could appoint a voluntary administrator;
  • You might consider an informal ‘work around’, such as securing rescue finance, an extension of terms from suppliers, or a payment plan with creditors, in order to bring the company definitively back into solvency;
  • You might consider informal restructuring via a pre-pack. In a pre-pack, the assets of the existing company are sold for appropriate consideration to a new company (which may have the same directors as the old company). The old company is then liquidated. The transaction might be completed before or after appointment of the liquidator, depending on the circumstances of the case.

For more information on pre-packs, see What you need to know before you pre-pack (to avoid phoenix activity).

There may be situations where none of the above possibilities are appropriate. For example, where there is no longer a valuable business proposition underlying the business at all. In that case, it may make sense for directors to appoint a liquidator immediately.

It may also be sensible to appoint a liquidator where creditors are about to pursue the winding up of the company via a compulsory liquidation. This way, directors can retain some control over the appointment process.

Note also that temporary COVID-19 reforms mean that there is reduced urgency to rush into liquidation or voluntary administration. These reforms mean that:

  • it is much more difficult for a creditor to pursue a compulsory liquidation, as the criteria for statutory demands for payment of debt (‘statutory demand’), which are commonly employed as evidence of insolvency, have changed. The minimum amount required for a statutory demand has increased from $2,000 to $20,000, and the time for payment has extended from 21 days to 6 months;
  • directors have an additional ‘safe harbour’ from insolvent trading, where loans are acquired in the ordinary course of business. A ‘safe harbour’ means that the director of the company is not liable for allowing insolvent trading under the Corporations Act 2001 while pursuing the permitted business rescue activity.

You can read more about this at Is your business insolvent because of COVID-19? What to do next (for SMEs).

How are directors going to know if a voluntary liquidation is the right move? Below we set out the steps that should be taken in working this out.

Preliminary assessment of the books

As we discussed in our guidance on preparing for a voluntary administration, the first step is to get the books in order to get a clear picture of your financial situation. This will determine whether formal insolvency options should be pursued, or whether you still have informal options open to you.

When looking at your financials, you need to consider:

  • Your bookkeeping systems. Without having an accurate and up-to-date record of your revenue, expenses, assets and liabilities, you will have little idea whether your company is solvent or insolvent;
  • Assess your cash position. Look at your current ratio (current assets/current liabilities), quick ratio (liquid current assets/current liabilities) and operating cash flow ratio (operating cashflow/current liabilities), to determine whether you have the cash coming into keep paying your bills;
  • The state of your accounts payable. Note, in particular, whether any statutory demands for payment of debt have been made, and whether you can cover your upcoming tax liability;
  • Review asset structuring. Does the company in difficulty actually own the relevant assets (or are they leased from another entity, for example)? This means you can assess which assets would need to be liquidated if a liquidator is appointed;
  • What is the state of the directors’ loan accounts? It is common for directors of SMEs to draw down on the business through a loan account, rather than be paid entirely through a salary. There is the potential for this loan to be called in, when a liquidator is appointed, so you need to work out what your position is here.

Solvency review

Once you have informally assessed your finances, you need to get a professional to conduct a solvency review.  This is crucial, because if the company is solvent, then this has an impact on which options are available to directors to save the business. Directors of a solvent company can initiate an MVL rather than a CVL. The advantage of this option is:

  • It is likely to be cheaper, as there is no need to appoint a registered liquidator;
  • Members (i.e. shareholders) get to control the direction of the liquidation;
  • The liquidator need not be independent of the company;

If, after a solvency review, the company is determined to be insolvent, an MVL will not be an option. At this point, you need to consider other options, including:

  • Voluntary administration. Like the appointment of a liquidator, the appointment of a voluntary administrator will halt any claims against the company, while the voluntary administrator attempts to negotiate a ‘deed of company arrangement’ with the creditors. Unfortunately, the rate of success of voluntary administration, particularly for SMEs, appears to be abysmal. For more information see: What are the success rates of voluntary administration?;
  • Use the ‘safe harbour’ under section 588GA of the Corporations Act 2001, to enable an informal workaround to insolvency. This could include negotiating more favourable payment terms with creditors or accessing rescue finance;
  • Use the safe harbour to restructure using a pre-pack. This will also result in the liquidation of the original company (though, done correctly, the substance of the business will continue);
  • Immediately initiate a CVL. This will mean a halt to all creditor proceedings against the company. However, this will also mean the end of the business as a going concern.
  • Hire an insolvency expert to see if you can develop a bespoke hybrid solution (call Sewell & Kettle Lawyers).

Assessing your liability before appointment of the liquidator

An important consequence of a liquidator being appointed is that the liquidator is empowered to investigate the affairs of the company. This means that they can question, and potentially take action, with respect to prior actions of directors. Directors need to consider the possibility of:

  • Uncommercial transactions. Transactions are deemed uncommercial if it is deemed that a reasonable person, considering the benefits and detriments of a given transaction, would not have entered into it. An uncommercial transaction can only occur where insolvency can be proven at the time of the transaction;
  • Unfair preference claims. These happen where a creditor is paid for something that they are owed, which gave them an advantage over other creditors, where that creditor knew or ought to have known the company was insolvent;
  • Unreasonable director-related transactions. These transactions are ones where directors enter into transactions that a reasonable person in the director’s circumstances would not have;
  • Creditor defeating dispositions. These transactions are commonly referred to as ‘illegal phoenix activity’. They occur where there is 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.”

In general, directors need to take a strategic approach to the payment of their debts before the CVL commences. In particular, they should look at whether any debts which have director personal guarantees attached can be paid. Note however that in doing so, legal advice must be sought to ensure that legal liability is not incurred for any of the matters set out above. Restructuring an insolvent business with asset transfers requires expert professional opinion to ensure that none of the above illegal or voidable transactions are undertaken.

Director action during and after a CVL

Once the liquidator is appointed, directors are obligated to support the conduct of the CVL in various ways. This includes:

  • advising the liquidator on the location of company property;
  • providing books and records;
  • providing a written report about the company’s affairs within five business days;
  • meeting with the liquidator to help with their inquiries, as reasonably required;
  • if requested, attending a creditors’ meeting to provide any required information.

The CVL will come to an end once the liquidator has realised and distributed the company’s remaining assets and lodged a final account with the Australian Securities & Investments Commission (‘ASIC’).

Three months after this point, the company will be automatically de-registered.

Key takeaways

  • Liquidation comes in many forms. Not all liquidations imply something has gone wrong in a company;
  • Before considering appointing a liquidator, directors need to take stock of their financial situation. This means basic bookkeeping, looking at key financial ratios and assessing the state of creditors;
  • The next step is getting a professional opinion on the solvency of the company. This will determine which type of liquidation is available (MVL or CVL);
  • Once it has been determined that a liquidator should be appointed, directors need advice in order to carefully assess their legal liability;
  • Once a CVL is underway, directors need to support the liquidator in various ways as required by law.

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