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Second Chance for an insolvent SME: Alternative Pre-pack insolvency arrangements – part 2

Table of contents (Part 2)

Directors and advisors of SMEs
9. What are the principal legal duties of directors?
10. What is insolvent trading?
11. Why do directors need to watch out for Director Penalty Notices (DPNs) from the ATO?
12. What penalties can directors face for insolvent trading and breach of duty?
13. What immediate actions should directors of an SME take if their company is insolvent?
14. What types of professional advisors assist with a pre-pack insolvency arrangement?
15. What are the duties of professional advisors advising insolvent SMEs?

Liquidators of SMEs
16. What are liquidators and what do they do?
17. What is the downside of a liquidation firesale?
18. When can a liquidator claw back transactions made to related entities including a new company?

 

DIRECTORS AND ADVISORS OF SMEs

9. What are the principal legal duties directors have?

The duties of company directors include both common law and statutory duties. These duties are set out below:

Common law (or fiduciary) duties

  • Duty to act in good faith

Directors have a duty to act in good faith in the interests of the company as a whole. The test as to whether this duty has been complied with is a subjective test of “honesty or good faith”.

Directors are in breach of this duty where they fail to give proper consideration to the company’s interests. When considering the interests of the company, a director must take into account the interests of shareholders and creditors (in the case of an insolvent company).

  • Duty to exercise power for a proper purpose

Directors must not use their powers for an improper purpose. The test of whether a director has used their powers for an improper purpose is an objective test. Improper purposes may include when a director uses their power to gain an advantage for themselves[1], or by manipulating voting power.

Regardless of whether the improper purpose is the dominant cause behind or one of a number of contributing causes to a director’s decision, the act will be invalid if, but for the improper purpose, the decision would not have been made.[2]

  • Duty to retain discretion

Directors must not put themselves in a position where they are unable to act in the best interests of the company. For example, a director cannot contract with a third party to vote in a certain direction at board meetings.

  • Duty to avoid conflicts of interest

Directors must not put themselves in situations where their personal interests conflict with the interests of the company. If a director’s duty to avoid conflicts is breached the director becomes liable to the company for any benefit derived, or to indemnify the company’s loss. In addition, the company may void any contract that a director enters or has entered into as a result of the conflict of interest.

Statutory duties under the Act

  • Section 180(1) – Duty to act with care and diligence

Section 180 (1) reinforces the common law duty of the same name. Section 180(1) requires an objective standard of care, stipulating that a director or other officer of a corporation must exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise if they:

  • were a director or officer of a corporation in the corporation’s circumstances; and
  • occupied the office held by, and had the same responsibilities within the corporation as a director or officer.[3]

Additionally, a director will be considered to have acted with the due care and diligence required when they have complied with the “business judgment rule” in making decisions relevant to the business of the company. The business judgment rule provides that a director must:

  • make the judgment in good faith or for a proper purpose; and
  • not have a material personal interest in the subject matter of the judgment; and
  • inform themselves about the subject matter of the judgment to the extent they reasonably believe to be appropriate; and
  • rationally believe that the judgment is in the best interests of the corporation.[4]
  • Section 181(1) – Duty to act in good faith

This duty is consistent with the equivalent common law duty. Section 181(1) requires a director or other officer of a corporation to exercise their powers and discharge their duties:

  • in good faith in the best interests of the corporation; and
  • for a proper purpose.[5]
  • Section 182 – Duty not to make improper use of position

This section provides that a director must not improperly use their position to gain an advantage for themselves or someone else, or to cause a detriment to the corporation.[6]

This duty is breached if a director has the intention and purpose of obtaining an advantage or causing a detriment, regardless of whether an actual benefit or detriment occurs in fact.[7]

  • Section 183 – Duty not to make improper use of information

This section provides that a person who obtains information because they are, or have been, a director of a corporation must not improperly use the information to:

  • gain an advantage for themselves or someone else; or
  • cause detriment to the corporation.[8]

This duty continues after the person stops being an officer or employee of the corporation.

  • Section 588G – Duty not to trade whilst insolvent

This section provides that directors must ensure that the company does not incur a debt while insolvent. A person breaches this duty where:

  • he or she is a director of the company when it incurs a debt;
  • the company is insolvent at the time, or becomes insolvent by incurring the debt;
  • at that time, there are reasonable grounds for suspecting that the company is insolvent, or would become insolvent by incurring the debt; and;
  • he or she failed to prevent the company from incurring the debt.[9]

A director may also face criminal penalties for breaching this duty if his or her failure to prevent the debt was dishonest.[10]

  • Section 191 – Disclosure of material personal interests

This section provides that a director of a company who has a material personal interest in a matter that relates to the affairs of the company, must give the other directors notice of their interest.[11]

There are various exceptions to this rule, including section 191(5), where companies with only one director are excluded.

  • Section 286 – Financial records

This section provides that a company must keep written financial records. This requirement relates to a director’s duty of care and diligence and provides that directors may be subject to a penalty for failing to maintain proper financial records.

Directors who breach their duties may not only receive civil penalties, as in certain circumstances, but they may also be guilty of a criminal offence. For more information on penalties for breach of director’s duties, see section 12 below.

10. What is insolvent trading?

Directors are under a duty to prevent insolvent trading under section 588G of the Act. A claim is under section 588G is only available to a liquidator after a company has been placed into liquidation.

For a liquidator to make a claim for insolvent trading against a director or former director, the following elements must be satisfied:

  • the person was a director at the time that the debt was incurred;
  • the company was insolvent at that time, or became insolvent by incurring the debt;
  • at that time, there were reasonable grounds for suspecting insolvency, or that the company would become insolvent by incurring the debt; and
  • at the time, the director was aware that there might be grounds for suspecting insolvency, or a reasonable person in a like position would be so aware.

If the director suspects that the company was insolvent at the time the debt was incurred and their failure to prevent the debt was dishonest they are also liable for criminal punishment.

Liquidators have a period of 6 years after their appointment to commence a claim against a Director for insolvent trading. After this date the commencement of a claim is statute barred.

If the liquidators choose not to pursue a claim for insolvent trading, the company’s creditors (individually or in a group) may commence their own actions against the directors for insolvent trading, but this is limited to the debts owed to the creditors. Creditors may make a claim at any time if they have consent from the liquidator but they may only request the liquidator’s consent after the liquidator has been appointed for 6 months.

The Federal Government have stated that they intend to legislate, as part of their innovation program, to create a safe harbour for directors from insolvent trading laws. If the proposals are legislated, directors will be able to avoid liability for insolvent trading by appointing a restructuring advisor to assist with the reorganisation of a company’s affairs. This proposal is aimed at encouraging innovation, as it removes the threat from directors who want to/ intend to continue to trade. It should be noted however that while the insolvent trading penalties can be quite severe it is not a remedy that is frequently pursued by liquidators.

11. Why do directors need to watch out for Director Penalty Notices (DPNs) from the ATO?

A director of a company is under an obligation to ensure that their company remits all withheld Superannuation Guarantee Charge (SGC) and PAYG amounts to the Commissioner of Taxation (the Commissioner). A director can be held personally liable for a penalty equal to the amount of the company’s unpaid PAYG and SGC debts, upon failing to ensure these debts are remitted when due.

To recover a penalty from a director, the Commissioner will issue a DPN and must wait until the 22nd day after issuing the notice before commencing proceedings (the timeframe for compliance with a DPN commences the date on which it is posted).

If a director is issued with a DPN there are limited options available to have the penalty remitted, however in order for the penalty to be remitted, action must be taken within 21 days of the notice being issued. For unpaid amounts that were reported in the company’s Business Activity Statements (BAS) or Superannuation Guarantee Statements (SGS) within three months of their due date, the penalty will be discharged upon payment of the debt, or if an administrator is appointed under the Act or a liquidator is appointed to wind up the company. If the unpaid amount was not reported within three months of the due date, the debt must be repaid by the company to have the director’s personal liability remitted.

This means that the directors of the company are personally responsible for the debt if the company leaves it unpaid.

If no action is taken before the 22nd day after the DPN is issued to the director, the penalty is not remitted and the director is held personally liable for the penalty amount until it is paid in full. To enforce this claim against the directors personally the ATO will then issue court proceedings for a liquidated claim in the amount of the outstanding debt.

New directors are not immune from the personal liabilities incurred by a DPN but a new director will not become liable for any existing PAYG or SCG debt until they have served as a director for 30 days. If the director remains a director of the company after the 30 day period has elapsed, they are then also personally liable for any outstanding PAYG and SGC debts. New directors however, will not be subject to the restricted remission options until 3 months after they become director of the company, regardless of how long the company has been liable for the debt.

12. What penalties can directors face for insolvent trading and breach of duty?

Directors can face a number of consequences for insolvent trading and breach of their duties. The penalties include civil penalties, compensation proceedings and criminal charges.

All company directors have a duty under section 588G of the Act to prevent insolvent trading. A director of a corporation must also exercise their powers and discharge their duties with a certain degree of care and diligence as stipulated by sections 180-184 of the Act.[12] A breach of either of these fundamental responsibilities by a director can lead to significant consequences for the directors personally, and the company as a whole.

Penalties include;

  • On application for a civil penalty order, the court may order compensation; [13]
  • If a court finds a person guilty of an offence under s588G(3) in relation to the incurring of a debt by a company whilst insolvent, the criminal court may order compensation;[14]
  • A creditor may sue for compensation;[15] and
  • A director may be held liable to indemnify the Commissioner of Taxation for unpaid debts.[16]

Criminal penalties

Section 184(1) of the Act provides that:

“(1) a director or other officer of a corporation commits an offence if they:

  1. are reckless; or
  2. are intentionally dishonest;

 

and fail to exercise their powers and discharge their duties:

  1. in good faith and in the best interests of the corporation; or
  2. for a proper purpose.

 

Schedule 3 of the Act provides that for a breach of section 184 above, directors may face fines of up to $360,000 or 5 years imprisonment, or both.”

Section 206B of the Act provides for the automatic disqualification of directors from managing corporations if they are convicted of a criminal offence related to the company.

Civil penalties

ASIC is responsible for the Australian securities regulation and has the power to apply for a declaration of contravention, a pecuniary penalty order and/or a compensation order under section 1317J of the Act. A creditor may also sue a company under the Act, for compensation. The Court may also order, on application by ASIC, to disqualify a director from managing corporations.[17]

Under division 4 of the Act, a director is liable to compensate the company for loss resulting from insolvent trading.[18] The director may face one of a number of consequences for any loss occurring to the company as a result of insolvent trading:

  • The court may order the director to compensate the company for an amount equal to the loss or damage caused by the breach.[19]
  • A creditor may recover from the director an amount equal to the loss or damage caused by the breach.[20]
  • If the breach is proven to be as a result of the director’s dishonesty, the director may be found guilty of a criminal offence, punishable by a fine or imprisonment.[21]

13. What immediate actions should directors of an SME take if their company is insolvent?

If a business is insolvent and it is unable to pay its debts when they fall due and payable, there are a number of risks that directors need to be prepared for. The first issue to consider is whether the insolvency is temporary, or whether there is an endemic shortage of working capital. If there is an endemic shortage of working capital the first steps should be:

  • Consider whether to seek further working capital (debt or equity);
  • Take steps to improve the quality of real time financial information for decision making; and
  • Talk to your professional advisors to develop a game plan (exit or business continuity).

Seek more working capital

The first step may be to seek further working capital for the business, however in the long term this does not solve the problem if there is a loss making business model. Immediate options are:

  • Receivables finance: Many businesses as a first step look at unlocking debtors by utilising receivables finance (also known as invoice discounting). This has the benefit of providing immediate access to funds waiting to be paid by debtors.
  • Friends, fools and family: You can seek working capital (either debt or by granting equity) from those close to you. However, there is unlikely to be an alignment of interests and your lenders are unlikely to be able to assess the risk of lending to you. This may put pressure on your relationship in the event of non-payment and permanently damage relationships.
  • Trade suppliers: You can contact your trade suppliers and ask them to extend terms. This will have the same effect as a bank overdraft extension on your financial position.

Obtain reliable financial information

Reliable financial information will help prevent a business from choosing the wrong strategy by giving the directors insight into why the business isn’t achieving the required rate of return. There are three simple ways to ensure a business has reliable financial information:

  1. Draw up an annual budget and cash flow forecast, as the year goes on compare the budget cash flow with actual figures;
  2. Ensure you know what your product/service costs to produce and what affect it would have on profits if for example, sales were increased or decreased by 10%; and
  3. Make sure your assets are valued correctly.

When a business is failing it can be tempting to get ‘creative’ with accounting and this is one symptom of impending business failure. Avoid the temptation to:

  • Delay producing financial statements;
  • Continue paying dividends (i.e. drawings) through incurring debt rather than retained earnings;
  • Cut expenditure on routine maintenance;
  • Start treating extraordinary income as ordinary income and vice versa;
  • Change ownership title of main assets of the business;
  • Value assets at inflated figures;
  • Meet company debts out of your own pocket; and
  • Value stock of finished products at the current market selling price rather than at cost.

What is your end game? Business continuity or business exit?

When a business hits rocky times the directors need to develop a clear business strategy. If the directors do not have a clear strategy they may get lost in the details of keeping the business afloat rather than driving towards their end game. If there is a profitable core that is worth saving there is a choice between keeping the business and attempting to salvage it or selling the business.

A pre-pack insolvency arrangement is an alternative to appointing a voluntary administrator to salvage business value. The pre-pack insolvency arrangement gives the director the opportunity to consider a more orderly approach to a restructure before any formal appointment.

14. What types of professional advisors assist with a pre-pack insolvency arrangement?

The worst case scenario would be for a director of an insolvent SME to engage a group of different advisors without having one particular coordinating advisor. It is likely that a lawyer, small firm accountant and insolvency practitioner with different briefs would pull in opposite directions. Each professional would have a different methodology, timeframe, priorities and task list.

There are a number of different advisors who market themselves as being capable of providing advice, and helping with the setup of, and/or supervision of, pre-pack insolvency arrangements. These are:

Small Firm Accountants

Most directors will have an existing relationship with an accountant. These accountants are typically based at small suburban accounting practices with 2-3 partners or a sole practitioner.

Small firm accountants often provide advice regarding:

  1. Business growth and working capital;
  2. Estate planning and superannuation;
  3. Business and personal taxation; and
  4. Audit compliance.

Small firm accountants are usually members of either CPA Australia or the Chartered Accountants; however it is not a legal requirement for a practicing accountant to be a member of either professional body. While these professional bodies do have entry requirements, neither organisation requires its members to have deep insolvency knowledge. Small firm accountants are unlikely have thorough insolvency training and their knowledge is often obtained from attending creditors meetings, reading liquidation and administration reports, and talking to clients about their business failures. Deep knowledge of insolvency would require both a detailed understanding of the Act and policy regarding the insolvency regime and training in strategy from insolvency practitioners.

Accountants usually charge fees at an hourly rate broken down into 6 minute units. Small firm accountants are not usually paid per deliverable and their charging is opaque to an end client because the client has no understanding about the steps required to complete the task they engage their accountant to complete.

General accountants at small, non-specialist firms are unlikely to have extensive or up-to-date knowledge of insolvency law and practice. It is also unlikely that they work specifically, or regularly in the area of insolvency. While a small firm accountant can provide advice on certain aspects of a pre-pack insolvency arrangement, such as the taxation implications of transactions, they are unlikely to be ready to supervise or set-up a pre-pack arrangement as they generally do not have the specialist insolvency knowledge necessary.

Insolvency Practitioner

Insolvency practitioners are individuals registered with ASIC as liquidators. The peak body in Australia that represents insolvency practitioners is the Australian Restructuring, Insolvency and Turnaround Association (ARITA). Much like the accountants above, it is not essential that registered liquidators are members of this body. Insolvency practitioners are qualified to provide advice, and assist in the setup, or supervision of a pre-pack arrangement. Insolvency practitioners are likely to have a thorough and up-to-date understanding of insolvency law and practice, developed through education and day-to-day work on company liquidations and administrations.

Insolvency practitioners generally charge an hourly rate, broken down into 6 minute units. Different staff members working below them then charge at different rates based on experience in formal appointments. The limit on fees charged by insolvency practitioners is usually the value of the assets of the company in liquidation or administration, however there may also be creditor or director funding beyond this. In formal appointments the fees charged need to be approved by creditors, although failing this approval the insolvency practitioner can apply to the Court for approval. Insolvency practitioners will usually discuss options that directors have before taking an appointment as liquidator or voluntary administrator and often they do not charge for this advice because they generally expect to recover their fees once they are appointed.

Insolvency practitioners are subject to rules which limit their capacity to provide advice, help with the setup or supervision of a pre-pack arrangement. When they are approached, insolvency practitioners are required to turn down a formal appointment if they have a conflict of interest. The ARITA Code of Professional Practice for insolvency practitioners states that an insolvency practitioner must refuse an appointment where the practitioner has provided non-general advice to one of the directors of the insolvent company in respect of the director’s duties to the insolvent company.[22] Insolvency practitioners are also required to refuse appointment where they have had a professional relationship with the insolvent company within the previous two years.[23] As a result of these conflict rules, insolvency practitioners are disqualified from advising and setting up and supervising a pre-pack arrangement if they intend to be later appointed as voluntary administrator or liquidator. The rationale for this limitation is that giving any kind of specific advice regarding a pre-pack arrangement may undermine an insolvency practitioner’s impartiality.

There is also a larger issue to be considered by a company director. It is unlikely that an insolvency practitioner will receive a fraction of the fees that they could generate from a voluntary administration. Therefore, insolvency practitioners are more likely to steer directors towards a voluntary administration than a less expensive pre-pack.

Lawyers

Specialist insolvency lawyers can advise regarding the legality of a pre-pack arrangement and supervise the setup of a pre-pack arrangement. Lawyers who specialise in the field will have an up-to-date knowledge of insolvency law, however lawyers are not usually experienced in all aspects of a pre-pack insolvency arrangement. Whilst they are qualified to supervise the pre-pack process and provide advice on its legality, most lawyers are not experienced in the financial and practical aspects of setting up of a pre-pack insolvency arrangement. This is principally because lawyers generally only provide “legal services”.

Specialist insolvency lawyers are generally more expensive, charging rates of around $400-$600 per hour, broken down into 6 minute units. Legal services are defined in section 6 of the Legal Profession Uniform Law as “work done, or business transacted, in the ordinary course of legal practice”.[24] Most tasks in the preparation of a pre-pack arrangement relate to consulting and business strategy and therefore are not strictly “legal services”. Most lawyers will choose not to undertake these tasks, and are likely to want to restrict their involvement to providing services that are within the scope of legal services (i.e. advising on the transactions involved in the pre-pack arrangement and drafting documents). Relying on lawyers to co-ordinate may put the directors at risk, by having a number of professional advisors pulling in different directions as a result of not sharing the same brief.

On the other hand it may be useful to have a lawyer draft a business sale or asset sale contract rather than prepare one yourself. This may put you at risk of the transaction being unwound by a liquidator.

Pre-insolvency Advisors

There are a number of consultants that hold themselves out to be pre-insolvency advisors. They do not offer legal or accounting services and are not qualified insolvency practitioners. Pre-insolvency advisors are often led by a charismatic individual who will have experience in some field of business without necessarily having extensive experience in insolvency. Pre-insolvency advisors are also often employed by financiers and insolvency practitioners for lead generation (i.e. business development on a commission-business).

Their charging structures vary depending on the particular advisor, but there is often a sign-up fee involved as well as a fee based on a percentage of turnover of the company.

Pre-insolvency advisors are not registered with ASIC. They do not have an overarching body with a code of conduct to which they need to comply, or any necessary level of experience or training benchmarks. This is in contrast to both lawyers and insolvency practitioners who have professional bodies to whom they are answerable to. The key takeaway is that these advisors frequently have inadequate knowledge and experience of insolvency. Due to their inadequate training and lack of insolvency experience, pre-insolvency advisors often have no explainable methodology for company restructuring.

However, if a pre-insolvency advisor has industry-specific knowledge built up from experience this may be useful. They are unlikely, however, to have the legal skill to develop the terms and documentation for the pre-pack.

15. What are the duties of professional advisors advising insolvent SMEs?

Advisors are obliged to comply with the Act. In particular, section 79 of the Act provides that an advisor is involved in a contravention of the Act if the person: has aided, abetted, counselled or procured the contravention; or has induced, whether by threats or promises or otherwise, the contravention; or has been in any way, by act or omission, directly or indirectly, knowingly concerned in, or party to, the contravention; or has conspired with others to effect the contravention.

This means that professional advisors have accessorial liability for breaches of director’s duties by their clients where they have aided the client to breach their duties.

The ARITA also has a Code of Professional Practice, which has become an established part of the insolvency industry in Australia. Although it is not legally binding, courts have referred to the importance of insolvency practitioners adhering with the code.

The Somerville case

In the case of ASIC v Somerville & Ors [2009] NSWSC 934, the Supreme Court of New South Wales found Mr Somerville, a solicitor, guilty of aiding and abetting directors to breach their duties by devising an “asset stripping” scheme.

Mr Somerville advised a number of directors of companies in financial difficulty. His advice was to restructure each of the companies, as follows:

  • The old company ceased to trade;
  • A new company was established;
  • The old company sold its assets to the new company on the following terms:
    • Assets transferred from old company to new company;
    • New company issued “V” class shares to the old company as consideration for the purchase of assets;
    • Employees of the old company were terminated and offered employment with the new company;
    • New company took over plant, equipment and leases through the asset sale;
    • Debts and liabilities remained with the old company.

The Court found the transactions were for inadequate consideration, no dividend was intended to be paid by the “V” class shares.

The Court found that Mr Somerville had breached section 79 of the Act as the transaction had no commercial basis and was considered asset stripping

 

LIQUIDATORS OF SMES

16. What are liquidators and what do they do?

A liquidator is a person who is registered with ASIC as a liquidator and who is authorised to be a liquidator and voluntary administrator of a company. Registered liquidators act in a fiduciary capacity and have total management control of the affairs of a company once appointed as liquidator. The role of the liquidator in an insolvent liquidation is to collect and deal with the company’s assets and where available, distribute the recoveries to the unpaid creditors of the company in liquidation. There are generally two categories of liquidators:

  1. Registered liquidators (registered with ASIC) who can accept non-insolvency appointments; and
  2. Official liquidators who can accept all types of appointments, including court ordered appointments and voluntary administrations.

 

When a company is in liquidation due to its insolvency, the liquidator has a duty to all of the company’s creditors. The liquidator will investigate the financial affairs of the company and it is a primary role of the liquidator to establish when and what caused the company to become insolvent. Establishing the date of insolvency is an important part of the liquidator’s job, because the date of insolvency will help to determine whether any transactions can be clawed back for the benefit of creditors.

A liquidator has the following functions:

  • To collect and take control of the company’s assets;
  • Review the company’s pre-liquidation transactions to ascertain whether any may be voidable as uncommercial transactions[25] or unfair preferences;[26]
  • Conduct investigations as to whether they may be any causes of action against directors for insolvent trading or other breach of duty;
  • Make recoveries;
  • Report findings to the creditors and ASIC;
  • Evaluate claims against the company by creditors (proofs of debt);
  • Distribute funds available towards the payment of the liquidators costs, and creditors’ claims, with regard to the prescribed priorities for payment including employee entitlements; and
  • Apply for deregistration of the company at the finalisation of the liquidation process.

The duties of liquidators, once appointed, are principally focused on complying with the Act and, more specifically, acting in the interests of creditors. Any undertaking given by liquidators before their appointment is unenforceable at law.

17. What is the downside of a liquidation fire sale?

A fire sale is likely to result in a sale price (and process) that is suboptimal. It may be suboptimal because the price is based upon a breakup value of assets through a rushed sale process where the purchasers have an expectation of a heavy discount.

The principal issues with a forced sale of business assets in a liquidation scenario are that:

  • Going concern value may be lost if the business ceases trading;
  • It is unlikely to deliver an optimal price;
  • There is insufficient motivation to maximise the sale price on the part of the liquidator;
  • There is no control over who purchases the business;
  • Third party purchasers may take advantage of timing limitations; and
  • There is no guarantee the business will even be sold.

The going concern value may be lost if the business ceases trading

A liquidator is under no obligation to continue trading after appointment; it is therefore rare that they would continue to trade a business as they may become liable for incurred debts. On the other hand a voluntary administrator or receiver has scope in their appointment to continue to trade the business with a view to selling the assets as a going concern.

If a business ceases to trade it is unlikely that a seller will be able to persuade a purchaser to value the business using a multiple of maintainable earning methodology. The result would be that the purchase price is determined by the break-up value of the assets and that there would be no value attributed to the goodwill of the business.

Under Australian law liquidators are limited in their ability to trade a business, and the scope extends only so far as it is necessary for its beneficial disposal.[27] Liquidators would be likely to seek the approval of a committee of creditors before taking a risk and on trading a business.

Unlikely to deliver an optimal price

The downside of liquidation is that the liquidator is not under any obligation to manage the sale process with a view to obtaining an optimal price for the assets. A forced sale for asset value alone may mean that a third party purchaser obtains a price below the economic value of the business.

On the other hand, if the existing proprietors are the only interested party in the purchase of the business they may be able to repurchase the business from a liquidator below its economic value.

The liquidator’s legal obligation is to deal with assets only so far as is necessary for the beneficial winding up of the company.

Lack of motivation to optimise sale price on the part of the liquidator

Without exploring a theory of motivation for economic players it may be sufficient to point out that a liquidator has no “skin in the game” in the sale process.

A liquidator is renumerated on a fixed fee or hourly basis. Therefore liquidators have a positive motivation to avoid a complicated or protracted sale process because it won’t improve their fee income significantly. Most of a liquidator’s fees will be generated by having junior staff conduct due diligence, deal with various stakeholders and otherwise “tick boxes”.

This may be described as an agency problem. The Australian insolvency system (unlike the United States and Chapter 11) is designed to ensure that an impartial independent insolvency practitioner is appointed.

The liquidator’s first priority is usually to receive money into the liquidation to pay their costs and disbursements and comply with their statutory responsibilities overall. There is no bonus structure in place to reward a liquidator who achieves a superior outcome in any sale process. The nature of hourly fees has been criticised as encouraging unethical and inefficient practices in business because it is not aligned with the deliverable to maximise economic value.

Lack of control over who purchases the business

The liquidator has the following options in a business sale process:

  1. Private contract;
  2. Public auction;
  3. Tender; or
  4. Clearance sale.

It is illegal for a liquidator to enter into a binding arrangement regarding a sale before their appointment (with the directors) and therefore it is a risk that directors of insolvent businesses may not be able to repurchase the business after liquidation.

There are no “black letter” rules that require a liquidator to implement any particular sale process and it comes down to individual judgment. The Courts have historically been reluctant to interfere in a liquidation sale process unless there is clear evidence of prejudice to the interests of creditors.

If directors are looking to execute a pre-pack arrangement it would reduce their risk to execute the transaction before the appointment of a liquidator. After appointment the liquidator is obliged to consider the best interests of creditors and therefore the economic interests of owners may be ignored.

Third party purchasers may take advantage of timing limitations

Purchasers involved in a liquidation sale process (frequently advertised as a Mortgagee-in-possession sale) will understand that the seller (i.e. the liquidator) is focused on selling without much delay. This doesn’t give the liquidator room to adjust their strategy and if the sale process has few purchasers there is unlikely to be any “bid tension”.

There is no guarantee that the business will even be sold. The liquidator is not penalised if the sales process falls through, and it frequently does. If a sales process fails a liquidator may transfer any plant and equipment and other goods to an auction for a scheduled auction sale.

18. When can a liquidator claw back transactions made to related entities including a new company?

A related entity is defined with an exhaustive list of persons who are related in some way to the directors or shareholders.[28] This includes relatives, spouses, trusts, and companies owned by the director, shareholders or their relatives.

A liquidator can claw back transactions before liquidation on the basis that the transaction was an insolvent transaction. The policy is that if a transaction was entered into whilst a company was insolvent it should be examined by a liquidator.

Liquidators have powers under the Act to claw back assets and payment transfers that occurred in the time period immediately before the company went into liquidation.

Voidable insolvent transactions include the following:

  • Unfair preference payments

Under section 588FA of the Act, a transaction may be considered an unfair preference payment to a creditor if:

  1. a) the company and the creditor are parties to the transaction (even if someone else is also a party); and
  2. b) the transaction results in the creditor receiving from the company, in respect of an unsecured debt that the company owes to the creditor, more than the creditor would receive from the company in respect of the debt if the transaction were set aside and the creditor were to prove for the debt in a winding up of the company.
  • Uncommercial transactions

Under section 588FB of the Act, a transaction of a company is considered an uncommercial transaction if it may be expected that a reasonable person in the company’s circumstances would not have entered into the transaction, having regard to:

  1. a) the benefits (if any) to the company of entering into the transaction;
  2. b) the detriment to the company of entering into the transaction;
  3. c) the respective benefits to the other parties to the transaction; and
  4. d) any other relevant matter.
  • Unreasonable director-related transactions

Under section 588FDA of the Act, a transaction is considered an unreasonable director-related transaction if:

  1. a) the transaction is:
  2. i) a payment made by the company; or
  3. ii) a conveyance, transfer or other disposition by the company of property of the company; or

iii) the issue of securities by the company; or

  1. iv) the incurring by the company of an obligation to make such a payment, disposition or issue; and
  2. b) they payment, disposition or issue is, or is to be, made to:
  3. i) a director of the company; or
  4. ii) a close associate of a director of the company; or

iii) a person on behalf of, or for the benefit of, a person mentioned in subparagraph (i) or (ii); and

  1. c) it may be expected that a reasonable person in the company’s circumstances would not have entered into the transaction, having regard to:
  2. i) the benefits (if any) to the company of entering into the transaction; and
  3. ii) the detriment to the company of entering into the transaction; and

iii) the respective benefits to other parties to the transaction, of entering into it; and

  1. iv) any other relevant matter.

In addition, a liquidator may commence a claim against a related entity for a benefit resulting from an insolvent transaction under section 588FH of the Act, where the transaction has the effect of discharging, to the extent of a particular amount, a liability (whether under a guarantee or otherwise and whether contingent or otherwise) of a related entity of the company.

[1] Mills v Mills (1938) 60 CLR 150 at 185.

[2] Whitehouse v Carlton Hotel Pty Ltd (1987) 162 CLR 285.

[3] Section 180(1) Corporations Act 2001 (Cth).

[4] Section 180(2) Corporations Act 2001 (Cth).

[5] Section 181(1) Corporations Act 2001 (Cth).

[6] Section 182(1) Corporations Act 2001 (Cth).

[7] R v Byrnes (1995) 130 ALR 529.

[8] Section 183(1) Corporations Act 2001 (Cth).

[9] Section 588G(1), (2) Corporations Act 2001 (Cth).

[10] Section 588G(3) Corporations Act 2001 (Cth).

[11] Section 191(1) Corporations Act 2001 (Cth).

[12] Corporations Act 2001 (Cth).

[13] Ibid, s588J.

[14] Ibid s588K.

[15] Ibid, 588R and 588T.

[16] Ibid 588FGA.

[17] Corporations Act 2001 (Cth) s206C.

[18] Ibid s588M.

[19] Ibid s588M and 588K.

[20] Ibid s588M.

[21] Ibid 588G(3) and Schedule 3.

[22] ARITA Code of Professional Practice for Insolvency Practitioners Rule 6.8.1(B).

[23] ARITA Code of Professional Practice for Insolvency Practitioners Rule 6.8.

[24] Legal Profession Uniform Law (NSW) Section 6.

[25] Corporations Act 2001 (Cth) s588FB.

[26] Ibid, s588FA.

[27] Section 477(1)(a) Corporations Act

[28] Corporations Act 2001 (Cth) Section 9.

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