UPDATED APRIL 2020
Small and medium-sized enterprises (SMEs) are being hit hard by COVID-19 and its economic consequences in Australia (and everywhere, for that matter). This may mean that directors are questioning whether insolvency is on the horizon, and considering the possibility of a formal restructuring by appointing a voluntary administrator.
For SMEs in this position – don’t panic. There are provisions in the law, including those recently introduced through the Coronavirus Economic Response Package Act 2020, which give you the time and breathing space to evaluate your options, without breaking the law.
Here we set out five reasons why you may need to think twice before appointing a voluntary administrator:
- Insolvency is now harder to prove (for directors – that’s a good thing), and where a company is insolvent, there is new protection for directors;
- Voluntary administration is rarely successful. In many cases, it’s a ‘glorified liquidation’;
- Voluntary administrators are not required by law to be transparent with directors;
- Attracting new finance is nigh-on impossible during voluntary administration;
- Creditors with little stake can hold the process to ransom and effectively force a liquidation.
Estimated reading time: 10 minutes
Insolvency is now harder to prove and directors have new protection for liability
When directors decide to appoint a voluntary administrator, they are often motivated by one thing: fear. They are concerned about insolvency (that is, not being able to pay their debts as they fall due), and reach out to their lawyer or accountant for advice, who will usually emphasise that insolvent trading is illegal. If a company director hasn’t been through an insolvency process before, they are staring at a very complicated and risky path. At the top of the director’s mind will be personal liability under the Corporations Act 2001 for insolvent trading, or tax debts if they misstep. This fear may, in turn, lead to the premature appointment of a voluntary administrator to avoid any possible liability for insolvent trading.
Before rushing into anything, directors need to take into account several new (and relatively new) legal provisions that protect their position during times of business difficulty:
- Relaxed time periods and increased minimums for ‘statutory demands’. The most common way for an un-paid creditor to prove insolvency (and therefore start the winding up of a company), is to issue a statutory demand for payment of debt (‘statutory demand’). If the debtor fails to pay a demanded amount within a certain period of time, they can be deemed insolvent and winding up proceedings can be initiated. The new Coronavirus Economic Response Package Act 2020 increases the amount that must be owed before issuing a statutory demand from $2,000 to $20,000 and extends the period for the debtor to respond from 21 days to six months.
- The COVID-19 Safe Harbour. The Coronavirus Economic Response Package Act also provides a new temporary ‘safe harbour’. 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;
- Standard Safe Harbour. This safe harbour was introduced in 2017, but not all directors understand its implications well. It provides that the duty of a director not to trade while insolvent does not apply if:
- at a particular time after the director suspects insolvency, the director develops a course of action that is reasonably likely to lead to a better outcome for the company; and
- the company debt is incurred in connection with the course of action.
The net effect of these three provisions is that directors have time to seek advice and properly evaluate their options before appointing a voluntary administrator or a liquidator. In addition, directors will not be breaching their duty, even if they are insolvent, if they take out debts in the ordinary course of business, or they are developing a ‘course of action’ for responding to their situation.
Directors should consider whether they can utilise the safe harbour from insolvent trading, and enter into a a pre-pack insolvency arrangement, to avoid relying on a formal appointment to restructure their business.
Takeaway for directors. Don’t rush into appointing a voluntary administrator. Take the time to seek professional advice and consider whether a ‘safe harbour’ can be used to restructure your business.
For more information on the COVID-19 insolvency changes see Hit pause on appointing a voluntary administrator during COVID-19
For more information generally on ‘safe harbour’ provisions and ‘statutory demands see an Interview and podcast on the safe harbour from insolvent trading and What are the grounds to set-aside a statutory demand?
Voluntary administration is rarely successful — in many cases it’s a ‘glorified liquidation’
When a voluntary administration occurs, an independent professional is appointed to the business to take control of the company from the directors, and to facilitate creditor agreement to a ‘Deed of Company Arrangement’ or ‘DOCA’. Through the DOCA, creditors can agree as to how the company’s assets should be dealt with. This is in complete contrast to the United States, where directors remain in control and their proposals are put before Courts through Chapter 11 proceedings.
It is fair to say that voluntary administration has not been a popular option. The Productivity Commission estimates that only 13% of insolvent companies appoint voluntary administrators and, of those, the prospects of a successful DOCA is very low.
Recent research by Professor Jason Harris found that, over a long-range sample, 29% of administrations entered into a DOCA. The percentage of successful DOCAs that delivered long term trading enterprises is unknown, but believed by the author to be low and something in the order of 25% of DOCAs.
The probability of a successful voluntary administration might be estimated as follows:
- Insolvent companies utilising Voluntary Administration (13%), multiplied by
- estimate of DOCAs being approved by creditors (29%), multiplied by
- estimate of successful DOCAs (25%)
The resultant insolvent companies successfully restructuring through voluntary administration? 1%.
The poor track record of voluntary administration, and the likelihood that the company will be wound up in the end, has led to a perception that the process is a mere ‘glorified liquidation’, with little prospect of a successful restructure. This can have a significant impact on the reputation of all businesses that go into voluntary administration.
Takeaway for directors: A voluntary administration is unlikely to result in the survival of the business and can carry a stigma as a “glorified liquidation”.
To learn more see What are the Success Rates of Voluntary Administration?
Voluntary administrators are not required to be transparent with directors
Before a voluntary administrator is appointed, there is no requirement that anyone (including the prospective voluntary administrator), thoroughly explain the consequences of the procedure or whether an informal alternative should be pursued first. The process of appointment only requires that a meeting of directors pass a resolution, and an insolvency practitioner provide written consent.
In making the decision to enter into voluntary administration, directors need to understand all the consequences of that decision. However, voluntary administrators are under no obligation to disclose this to directors before they are appointed. For example, a voluntary administrator is under no obligation to disclose that:
- by developing a restructuring plan, directors can take advantage of a safe harbour from the insolvent trading prohibition and continue to trade (even if their company is insolvent);
- the appointment of a voluntary administrator can lead to an incredible loss of confidence in the business as it amounts to a public declaration that the company is unable to pay its debts.
In general, business regulation has moved to increased transparency to consumers and investors, but this has not been applied to directors when it comes to insolvency law. 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.
Insolvency practitioners also lack a range of other obligations which would protect the interests of directors. They do not have a duty to act in the interests of directors and the potential for a conflict of interest is significant: 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.
If misleading conduct by insolvency practitioners or their referrers does lead to the appoint of a voluntary administrator, there is no effective recourse for the director. Furthermore, the regulatory framework for insolvency practitioners incentivises them not to provide pre-insolvency advice – it may prevent them from being appointed as a voluntary administrator (as their new obligation to creditors could result in a conflict or perceived conflict of interest).
By contrast, in a lawyer-supervised informal restructuring process, such as a ‘pre-pack insolvency’, there are strong duties of disclosure, to avoid conflicts and to act in the interests of the director (the client).
Take-away for directors: Get as much information as you can from a trusted (and capable) advisor before appointing a voluntary administrator.
Getting finance is almost impossible
A crucial part of recovery for many struggling businesses is getting ‘rescue’ finance to tide them over. This need is particularly acute for SMEs who have restricted financing options in the first place. However, the voluntary administration process does not encourage or enable that financing and, often, acts as a barrier to such financing.
The Corporations Act 2001 does not have a mechanism for financing during the insolvency process. 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. There is little incentive for a voluntary administrator to make themselves personally liable: They are being paid an hourly rate after all and do not receive a success fee.
In a SME voluntary administration, financing may be limited to “friends, fools and family” of the owners. Directors should be aware that if the company in administration is unable to pay both the voluntary administrator’s fees and trading expenses from its assets, the directors will be asked to contribute further funds or face liquidation.
The Australian process can be contrasted with Chapter 11 of the United States Bankruptcy Code or the Singapore Companies Act which give ‘super-priority’ to rescue and restructuring finance over other creditors. Without sufficient working capital at bank there is no chance that a voluntary administration will succeed – because in that circumstance the voluntary administrator will simply stop trading.
By utilising an informal restructuring process such as a ‘pre-pack insolvency arrangement’, directors may be able to access financiers that would not find it viable to lend to a company in voluntary administration, or who are otherwise ‘put off’ by the stigma of a formal insolvency process. Either the COVID-19 safe harbour or the standard safe harbour might be utilised by directors for this purpose, depending on the circumstances.
Takeaway for directors: Undertake a cash flow analysis of the voluntary administration and honestly assess whether you can afford to fund any shortfalls in trading receipts and also pay the voluntary administration professional fees. Consider the possibility of informal restructuring arrangements, as well as the use of new Government-backed financing for small businesses in the wake of COVID-19.
Creditors that are ‘out of the money’ can hold the process to ransom
Australia has a ‘creditor-centric insolvency regime’. The creditors (through a vote at the second meeting) make the decision to accept a director’s compromise (the ‘DOCA’), or put the company into liquidation.
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.
This contrasts with the Chapter 11 bankruptcy process in the United States, for example, where the re-organization plan (the DOCA-equivalent) is supervised by the Court. The Court can enforce a ‘cramdown’ – force the plan to go through in spite of the objection of some creditors or class of creditors.
Takeaway for directors: Evaluate your creditors. Is it realistic that they will agree to a DOCA where they get nothing? This will affect how likely you are to get a ‘clean’ DOCA.
While there are circumstances where voluntary administration will be appropriate, it is a ‘one-size-fits-all’ solution, which is often inappropriate for SMEs. New legal protections relating to statutory demands and insolvent trading (some of them temporary), mean that businesses under pressure in the current economy have ‘breathing space’ to consider whether this is the right action for them. Voluntary administrations lack transparency to directors, have a poor success rate, restrict the availability of financing and give creditors absolute power.
On top of these considerations, voluntary administration is expensive. Due to the liability taken on by voluntary administrators and a constrained supply of practitioners the premium prices are often too much for SMEs.
Professor Jason Harris has raised the question on numerous occasions, whether there needs to be a special restructuring process available for SMEs. We have raised our own concerns with the regulatory framework for insolvency in Australia here.
In the meantime, SME directors should seek advice on using existing safe harbours to arrive at new restructuring or re-organisation arrangements.