Phoenix company activity

What is phoenix activity and how does the law (attempt to) regulate it?

Summary

  • Phoenix activity is the ‘rebirthing’ of an enterprise by stripping one company of its assets and transferring them into a new entity which is essentially the same business
  • Phoenix activity is often, but not always, illegal
  • Existing law is available to crack down on illegal phoenix activity, but enforcement is weak. The new phoenix activity bill working its way through Parliament is unlikely to solve the enforcement problem entirely
  • Phoenix activity harms both individual creditors and the Australian economy, but the harm is impossible to quantify
  • Phoenix activity is being carried out by directors and encouraged by a range of rogue operators for many different reasons. Creditors need to take action in advance if they are to properly protect their interests.

To learn about past attempts to crack down on illegal phoenix activity and why those attempts matter, watch  Ben Sewell of Sewell & Kettle Lawyers  in this in-depth discussion of the matter.

In Sewell’s view, the key problem has been a lack of appetite for enforcement. Ideally, this would be rectified with a whole new raft of laws that would task someone, or some agency, with the responsibility for regulating and controlling this area.

Sewell was also interviewed by TaxTalks for a podcast on phoenix activity. Listen below:

Estimated reading time: Eight minutes

What is the definition of phoenix activity?

There is no universally agreed upon definition of ‘phoenix activity’ (or ‘phoenixing’, as it is sometimes called), whether in Australian law or wider commentary. It is not defined in the ‘Bible’ of Australian commercial law, the Corporations Act 2001, nor in any other piece of legislation currently on the books.

Focusing on the word itself we can say that, in broad terms, phoenixing occurs where there is ‘rebirthing’ of an enterprise by stripping one company of its assets and transferring them into a new entity which is essentially the same business.

Thought of in this way, phoenix activity is not necessarily illegal. This is the approach taken by the Phoenix Research Team who categorised phoenix activity into the five categories set out below:

  • 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 current 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.

In light of these different categories, the important question becomes not what is phoenix activity, but rather, which phoenix activity is legal and which phoenix activity should be illegal?

To find out more about the definition of phoenix activity, and whether we can (or should) consider it as a form of accounting fraud, read our article: Is phoenix activity accounting fraud?

Illegal Phoenix Activity in Australia

Focusing on the illegal element we arrive at the definition used by the Australian Securities and Investments Commission (ASIC):

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).

While there may be no offence specifically called ‘phoenix activity’ at the moment, there are a range of ways in which the existing law prohibits this activity and might be used to take action against individuals.

The persons or bodies that can pursue directors who undertake phoenix activity, and the potential law breaches that may be involved, include:

  • Liquidators: They may commence actions against directors for  uncommercial transactionsinsolvent trading and unreasonable director-related transactions against directors and their associates
  • ASIC: It may take action against directors for breaches of duties (e.g. the duty to act in the interests of the company and the duty to act for a proper purpose) and may appoint their own liquidators
  • Australian Tax Office (ATO): Appointing and funding liquidators to take actions
  • Prosecutors: Accepting prosecution briefs where there is an element of dishonesty in the phoenix activity and it therefore constitutes an offence under the Corporations Act 2001.

The main complaint of creditors is that, as the liquidator of the phoenix company often has no funds, they do not undertake serious investigations and initiate enforcement action.

What has the Federal Government announced it would do to stop phoenix activity?

The Federal Government announced in August 2018 that they would get tough on phoenix activity. The measures announced included:

  • Create new phoenix offences to target those who engage in and facilitate illegal phoenix transactions;
  • Prevent directors from backdating their resignations to avoid personal liability;
  • Prevent sole directors from resigning and leaving a company as an empty corporate shell with no directors;
  • Restrict the voting rights of related creditors of the phoenix company at meetings regarding the appointment or removal and replacement of a liquidator;
  • Make directors personally liable for GST liabilities, as part of extended director penalty provisions;
  • Extend the ATO’s existing power to retain refunds where there are outstanding tax lodgements.

While the Bill introducing these measures was dropped in the run-up to the federal election, they are now back on the table with a Bill progressing through Parliament. This bill defines for the first time the activity of engaging in a ‘creditor-defeating disposition’:

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).

The main criticism of these measures is that they do not address the issue of enforcement and its costs. There are already significant powers that liquidators have (including clawing back phoenix transactions and claiming compensation from parties that benefit) that aren’t enforced.

What’s wrong with Phoenix Activity?

Illegal phoenix activity harms specific creditors by defrauding them out of being paid debts. In the video above, Sewell emphasises that perhaps the Australian Tax Office (ATO) is the creditor with the most to lose as it misses out on income tax, PAYG, GST, and other taxes.

Perhaps even more significant, is the harm to the wider economy through flow on effects to cheated individuals and businesses and a loss of confidence that bills will be paid. The unfair advantage this gives to phoenix companies over their competitors also damages the efficiency of the market.

How might this harm be quantified? The Phoenix Team in its 2015 report, “Quantifying phoenix activity: Incidence, cost and enforcement” found that all reports that estimate figures are only guesses, and therefore, there was no way to measure it.

A July 2018 report by PricewaterhouseCoopers, prepared for the Phoenix Taskforce, estimated the annual direct cost to businesses, employees and government as a result of potential illegal phoenix activity to be between $2.85 billion and $5.13 billion in 2015-16.

So, why do directors do it?

Given the wide-ranging damage that phoenix activity can have, why do company directors do it? The most obvious reason, perhaps, given the ATO’s position as a major creditor, is the rationale of evading taxes. However, looking more specifically at psychological motivations of directors, it is worth considering:

  • It may be a temporary solution to a crisis – i.e. disaster recovery, such as from losing a principal customer or the sickness of the main proprietor
  • Directors may be trying to finance drug, gambling or alcohol problems
  • Businesses with unsustainable business models may be looking for a ‘quick fix’ – in some industries it may even be expected that phoenix activity is priced into quotes
  • It may be a response to insolvency caused by normal issues like poor management, a big project that lacks sufficient working capital and/or poor accounting systems

Who else might be encouraging phoenix activity?

Directors might make the final decision to engage in phoenix activity, but they don’t operate in a vacuum. Where do they get the idea from? While there is no systematic empirical evidence to draw upon, it may well be that accountants and former liquidators as well as lawyers are promoting the asset stripping.

Much has been written in the media about the ‘unmasking’ of phoenix operators. These are the people that are the co-ordinators of phoenix activity and may represent a number of clients. The ATO has stated in the past that it is targeting both ‘high risk’ and ‘medium risk’ phoenix operators with strong scrutiny and legal sanctions.

In its own reports, the Phoenix Research Team lists several cases of specific phoenix operators including a solicitor, management consultant, barrister, insolvency practitioner, and a few company directors. However, none of these examples illustrates the “high risk” offenders that are currently being targeted by the ATO.

A good example of the latter activity might be the activity discussed in the ‘Plutus Payroll Scam’. Payroll scams involve a business being approached by a phoenix operator who suggests to the business that it outsource all its payroll and staffing to the operator, who will take care of it and give the business a kickback.

In the Plutus case specifically, the operation involved using  dummy directors and rebirthing companies over and over again. Its clients were various businesses around Australia that had outsourced their payroll and received a kickback, which was a proportion of the unpaid income tax and PAYG tax.

As a further specific example of illegal phoenix activity, consider Sewell’s discussion in the video linked above of a solicitor accused of facilitating Phoenix activity under section 79 of the Corporations Act 2001 (Cth), and found to be an accessory to Phoenix activity. ASIC took action against the solicitor, and a banning order was issued against the solicitor.

See also Sewell’s discussion of Australian Securities and Investments Commission v Somerville [2009] NSWSC 934 for a case involving lawyer encouragement of ‘asset-stripping’.

What can creditors do to protect themselves?

Even if enforcement action against illegal phoenix activity were to improve, from a creditor’s point of view, it is better to take risk minimisation steps to avoid exposure to phoenix company activity rather than fund liquidator litigation or hope ASIC will put the company into liquidation and support action.

The key techniques for risk minimisation are:

  • Having credit limits on goods and services contracts;
  • Reviewing contracts and making sure they are up to date with the latest developments in the law;
  • Taking security and utilising the PPSR to become a secured creditor; and
  • Avoiding unethical businesses.

Further reading and information

The temptation to engage in phoenix activity is exacerbated in small-to-medium sized businesses and we have created materials to help other professional advisers steer clients away from phoenix activity and towards legitimate restructuring work.

You can watch, listen to or read the following to help develop a better knowledge about the area:

made by avanavo.com

×