What are the shortcomings of voluntary administration? La La Land meets Suicide Squad

Yes, the title is a bit of tongue in cheek!

La La Land is a movie about a couple meeting and falling in love (while pursuing their dreams). Suicide Squad is another movie that is half comedy and half action blockbuster. Both movies have nothing to do with insolvency law in Australia.

The takeaway is that directors shouldn’t expect ‘la la land’ when they appoint a voluntary administrator but they should also make sure they’re not bringing a ‘suicide squad’ into their business.

Voluntary administration is the most important legal process in Australia for formal restructuring of insolvent small-to-medium sized enterprises (SMEs). Directors should be aware of the benefits and shortcomings of voluntary administration before they take the plunge. The decision to appoint a voluntary administrator to an insolvent company is likely to be the most stressful and important decision that any director will make. The consequence of failure (to achieve the objective behind the appointment) would likely be closure and fire sale of the business.

The key shortcomings of voluntary administration as a tool for directors of SMEs are:

  1. Insolvency practitioners aren’t required to disclose the real consequences of appointment to the directors (directors usually don’t have a clear concept about what voluntary administration actually involves)
  2. A clean outcome through a DOCA is unlikely (directors don’t know that the chances of persuading creditors to agree to a genuine ‘haircut’ are low)
  3. Getting finance is almost impossible for a company in voluntary administration (directors don’t know they could be called on for money during the process)
  4. Creditors that are ‘out of the money’ may control the process (creditors that won’t get any return can still vote down a DOCA)
  5. The voluntary administrator doesn’t owe any duties to the owners of the business (they only owe legal duties to the company itself and the creditors)

Setting the scene: The rush to appoint a voluntary administrator

When directors realise that their company is insolvent they’ll usually reach out to their accountant and their lawyer first to seek advice. [To learn more about the legal definition of insolvency read our blog posts: What is the legal meaning of insolvency? and What ASIC v Plymin tells us]

It is still illegal for a company to trade whilst insolvent in Australia, so unless the directors can take advantage of the new safe harbour protection they’ll need to either cease trading or undertake a formal appointment. [For more information about the safe harbour protection watch our podcast: Interview on the safe harbour from insolvent trading].

The formal appointments that directors can consider are either liquidation or voluntary administration.

[To learn more about voluntary administration read our post: Who appoints a voluntary administrator?]

[To learn more about voluntary liquidation read our post: When is a voluntary liquidator appointed?]

If a company director hasn’t been through an insolvency process before. they’re going to be looking at a very complicated and risky process. It is risky because they could face personal liability for insolvent trading or tax debts if they make a mistake.

[To learn more read our blog posts: I received a Director Penalty Notice: what do I do? and Insolvent Trading]

Directors don’t have the time to thoroughly understand the insolvency process in Australia before an appointment and they may be trapped in conflicts of interest with their advisers. Two keys conflicts that directors need to consider are:

Takeaway for directors: Carefully consider your position before you appoint a voluntary administrator and read our blog post: When shouldn’t you appoint a voluntary administrator?

 

There is no requirement to thoroughly disclose the consequences of appointment to directors

If a director “starts developing” a restructuring plan they can take advantage of the new safe harbour from the insolvent trading prohibition and continue to trade (even if their company is insolvent). On the other hand, appointing a voluntary administrator is a public statement that could result in a catastrophic loss of confidence in the business (because everyone will know that it can’t pay its debts).

Before a voluntary administrator is appointed, there is no requirement that anyone (including the prospective voluntary administrator) is required to thoroughly explain the consequences of the appointment or whether an informal alternative should be pursued first. The process of appointment only involves a meeting of directors passing a resolution and an insolvency practitioner providing written consent.

The direction of the regulation of financial markets is towards improved consumer protections and greater disclosure of pertinent information to investors. Unfortunately, no one is looking after directors of small-to-medium sized businesses to the extent that investors are being protected from sharks. The insolvency industry is still a ‘closed shop’ and there are no effective protections for SME directors from being given misleading or conflicted advice by insolvency practitioners and their armies of referrers. The prospective insolvency practitioner is under no obligation to issue a “prospectus” or capability statement or even look into the individual circumstances of their appointor.

Take-away for directors: Get as much information as you can from a trusted (and capable) advisor before appointing a voluntary administrator. [Read our blog post: Help, my company is insolvent! Who should I call?].

A clean outcome through a DOCA is unlikely

Once the directors appoint a voluntary administrator they will be required to work through the process dictated by the Corporations Act and they will not have control of the company and its business. Voluntary administrators can be dismissed by the creditors at the first creditors’ meeting. However, voluntary administrators cannot be dismissed by the directors – even if they’ve been appointed by the directors.

The objective of a voluntary administration is to maximise the chances of the company being able to continue to exist and remain in business, or if that is not possible, to procure a better return for the company’s creditors than the creditors would otherwise receive if the company were immediately wound up. This means that the first objective of voluntary administration is the preservation of business value.

At the second meeting of creditors the directors can propose a compromise that is voted on by the creditors. The intention of the legislators here was to create a relatively quick process by which creditors could take a haircut on their debts and then everyone could get back to business afterwards. The reality, however, is quite different and the writer’s view is that there is a 95% chance that a straightforward outcome will not occur. [For more information read our blog post: What are the success rates of voluntary administration?]

What is a clean DOCA? A clean Deed of Company Arrangement would involve the directors contributing a deed fund (of say 5-10c in the dollar) towards unrelated creditor claims from their own pocket. The creditors would vote in favour of accepting the compromise and then continue doing business with the company after the directors had completed their obligations under the DOCA. The creditors would be satisfied with the process and investigations carried out by the voluntary administrator and close the book on the insolvency.

Takeaway for directors: Think about what you want to propose to creditors before appointing a voluntary administrator and give it the “pub test”. If you’re in an industry that resists voluntary administration (such as building and construction) think about alternatives to voluntary administration and use it only as a last resort. The “pub test” is a good way to consider whether your creditors are really going to vote in favour of receiving 5c in the dollar.

Getting finance is almost impossible

The Australian insolvency system is more interested in punishing and investigating directors than facilitating restructuring. The best example of this is that financing is not encouraged during the voluntary administration process.

Unlike the law in the United States and Singapore, the Australian Corporations Act does not provide a mechanism for financing during the insolvency process. Further, if a company in voluntary administration needs finance to continue to trade, its financier doesn’t get a priority and the voluntary administrator themselves is required to personally guarantee the debt. The voluntary administrator has no incentive to become personally liable for any finance because they have no “skin in the game”; they are being paid an hourly rate after all and do not receive a success fee.

The result is that in SME voluntary administrations it is almost impossible to obtain finance for ongoing operations other than “friends, fools and family” of the company. Directors should be aware that if the company in administration is unable to pay both the administrator’s fees and trading expenses from its assets, the directors will be asked to contribute further funds or face liquidation.

The consequence is that if funding is required to preserve the value of the business then the directors will be called upon by the voluntary administrator. If the directors can’t loan the company money then the voluntary administrator can initiate a fire sale of assets to pay the cost.

Takeaway for directors: Have you undertaken a cash flow analysis of the voluntary administration and can you afford to fund any shortfalls in trading receipts and pay the voluntary administration fees?

Creditors that are out of the money control the outcome of the process

Australia has a ‘creditor-centric insolvency regime’ and the creditors (through a vote at the second meeting) make the decision to accept a director’s compromise or put the company into liquidation. This is in contrast to other jurisdictions where courts have a role in the approval process and creditors who don’t have a material interest in the outcome (i.e. through the compromise offer or liquidation) can’t control the outcome of the process.

The terms of the director’s offer of compromise are put to creditors by the voluntary administrator in a report along with a recommendation. The voluntary administrator will provide creditors with an opinion about whether they should accept or reject the offer. Whether the voluntary administrator recommends that creditors accept the proposal is a matter for their professional judgment. The vote requires both a majority in number and a majority in value of the creditors to support the proposal for it to succeed.

If the creditors do not accept the offer of compromise then the company will be placed in liquidation.

Takeaway for directors: Carefully consider whether the creditors are likely to accept your proposal, give it the “pub test”, and remember that creditors with nothing to gain can still vote. [Read our blog post: When shouldn’t you appoint a voluntary administrator?]

The voluntary administrator doesn’t owe any duties to the owners of the business

Company directors that appoint voluntary administrators often complain that they have a “Jekyll and Hyde” relationship with their voluntary administrator before and after appointment.

Before their appointment the voluntary administrator may be aggressively canvassing for the job and making promises about how the appointment will be run and what outcome the directors will receive. After the appointment is made none of the pre-appointment representations are enforceable because the voluntary administrator’s primary role is to investigate the company’s affairs and report back to creditors. The voluntary administrator becomes an officer of the company in the place of the directors and their strict duties are owed to the company itself, not its directors and shareholders.

Takeaway for directors: Voluntary administrators don’t actually work for directors and they can’t be held to any pre-appointment undertakings.

Postscript: Important empirical research is on the way

One of the main issues with insolvency in Australia is that there is very little empirical research. There are very few detailed case studies into voluntary administration and so no one has actually looked into whether voluntary administration works!

Recently Professor Jason Harris announced on his blog (https://australianinsolvencylaw.com) that he would be releasing his findings in a series of blog posts followed by a thesis about the effectiveness of the voluntary administration process in Australia.

Congratulations to Professor Harris on his work and the incredible effort he has put into researching 25 years of voluntary administrations in Australia.

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